Bank: No significant slowdown - but 3.5% inflation spike

The Bank of England today said Government cuts should not throw the recovery off track, but sent out a stark warning to households over a spike in inflation over the coming months.

Soaring commodity costs, energy bill hikes and the impending rise in VAT are among factors likely to see inflation rise to around 3.5% over the coming months - higher than previously expected by the Bank.

Its quarterly inflation report, the first since the spending review, delivered some reassuring news on the economy, confirming Britain should avoid a double dip recession despite "substantial" Government deficit-busting measures.

Experts said the Bank's tone suggested further money-boosting efforts were unlikely in the near-term, although the report is thought to have left the door open for more quantitative easing (QE) next year.

Governor Mervyn King said: "Overall the risks to growth are on the downside, but the central view is that there will not be a significant slowdown."

The Bank expects UK growth to be "broadly similar" to that forecast in the August report, with the recovery looking to have peaked in the second half of this year and falling back to around an annual rate of 2.5% in 2011 before gradually picking up to just over 3% in late 2012.

However, Mr King cautioned the UK economy was vulnerable amid "difficult and dangerous times" in the world economy and called for a cooperative message from this weekend's G20 summit.

"Whether the recovery will be sustained depends heavily on developments in the rest of the world," he said.

His comments follow a cautionary report from the International Monetary Fund yesterday, which said the UK's banks were heavily exposed to further troubles in debt-laden European countries such as Greece and Ireland.

There are also risks closer to home, with the strength of the recovery "highly uncertain" until the degree of belt tightening among households and businesses become clearer as the public sector spending cuts kick in.

Britons, already under pressure from austerity measures as well as rising food and energy costs, were braced for tough times ahead as the Bank increased its near-term forecast for inflation.

It predicted an end of year surge in Consumer Prices Index (CPI) inflation - currently at 3.1% - and for CPI to remain above the 2% target until the end of 2011 before easing back and sliding below 2% through 2012.

Mr King calmed fears of a knee-jerk reaction by the Bank to raise interest rates, saying it needed to look at the medium-term forecast.

"We have to get used to a world in which it is not possible for the Monetary Policy Committee to prevent short-term movements around the target," he said.

Howard Archer, chief European economist at IHS Global Insight, said it remained likely the Bank would hold rates at their record low of 0.5% until the fourth quarter of next year, when they may rise to 0.75%.

"One thing that does seem clear from the inflation report is that whenever interest rates do finally start to rise, the increase will be both gradual and limited," he said.

He added: "This is a pretty balanced view coming from the Bank of England, which keeps all of its options open.

"The inflation forecasts certainly keep the door open for the Bank of England to re-engage in QE should growth falter markedly over the coming months as the fiscal tightening increasingly bites."

James Knightley, economist at ING Bank, said he believes so-called QE2 could now come in the second quarter of 2011 rather than this year.

Today's report confirmed the recovery had been stronger in recent quarters than the Bank expected, with gross domestic product up by a robust 0.8% in the third quarter, according to official estimates.

This is unlikely to be sustained given recent industry surveys showing falling levels of output and confidence, added the Bank.

Mr King stressed while it "won't be an easy path for the next few years" as the economy rebalances away from the public sector, the private sector should be strong enough to offset Government cuts.

"It is clearly feasible and not at all unreasonable to see a shift in employment between the public and private sector. It can be done," he said.