BoE sounds warning on recession and deflation

Sterling plunges below $1.50 and hits new record low against the euro

The Governor of the Bank of England, Mervyn King, yesterday made his clearest pledge yet that he is "prepared to see Bank rate move to whatever level is necessary" to avoid deflation.

Mr King admitted that "it is very likely that the UK economy entered a recession in the second half of this year". The Governor's words saw the pound fall to a record low against the euro of €1.19 and pushed sterling below $1.50 during trading, its lowest since 2002.

The forex markets seemed unimpressed by Mr King's remarks that "if sterling falls far enough this will be a concern, and it will have an impact on inflation... It's something we keep a very careful eye on. We have no wish to see it fall very sharply".

Predictions of recession and the possibility of deflation led many economists to forecast that interest rates, now down to 3 per cent, will almost certainly fall much lower. Alan Clarke, UK economist with BNP Paribas, commented: "We expect a minimum 1 percentage point rate cut in December and a trough below 1 per cent".

Such a level would be the lowest seen since the Bank was granted its royal charter in 1694.

Mr King also issued a thinly veiled threat to the Government that any package of tax cuts and public spending measures to lift the economy out of recession must be "temporary", and accompanied by a clear plan to return tax and spending to a "sustainable" footing in the medium term.

The Bank indicated that it expected to see the economy shrink at an annual rate of up to 2 per cent next year, with an overall shrinkage over the course of 2009 of about 1.5 per cent, a markedly gloomier figure than the "broadly flat" picture presented in August.

However, this is on the basis of unchanged fiscal plans, an unlikely outcome, and on expectations for rates prevailing before the Bank's 1.5 percentage point cut in rates last week. Thus, the Bank's predictions may exaggerate the depth of the recession, which is in any case expected by the Bank to be a relatively short, if sharp, one, with output bouncing back sharply in early 2010. Many City economists dispute this, believing that house prices and output will continue to fall during that year.

Inflation too is forecast to drop quickly, from today's 5.2 per cent to the 2 per cent target by the middle of next year, and to 1 per cent in 2010. The Bank refused to be drawn on how high it thinks unemployment will climb: it rose yesterday to an 11-year high of 1.825 million.

The Bank cited three recent factors behind the radical alteration to its forecasts, denying that it was "behind the curve" in not cutting rates sooner: the very sharp downturn in confidence and orders; the banking crisis, which the Governor argued was "extraordinary" and the worst for almost a century; and the plunge in commodity prices.

Mr King hinted that he would be prepared to see the fiscal rules altered, provided certain conditions were met. "In these extraordinary circumstances, it would be perfectly reasonable to see some use of fiscal stimulus, provided two conditions are met. One, that it's temporary. Secondly, that it would be clear there was a medium-term plan to bring tax and spending into balance." If not, Mr King implied, interest rates would be higher.

Mr King's deputy governor for monetary policy, Charlie Bean, added: "If it's not clear how fiscal plans are going to be brought into a sustainable pattern further down the road, that's likely to lead to concerns... The crucial thing is how the fiscal policy action affects investors' perceptions of the medium term."

Mr King said that inflation, on the old Retail Price Index measure, will probably fall into negative territory next year for the first time since 1960, as mortgage rates come down. Mr King said that the nation was "moving into very difficult times", but that "we will come through it".

Mervyn King: Then and now

May 2008

* "The challenge facing the Monetary Policy Committee is to balance two conflicting risks to inflation in the medium term. On the downside, a sharper than expected slowing in activity could pull inflation below the target. On the upside, inflation, after a significant period above target, could have a greater tendency to persist... the balance of these risks around the central projection is to the upside."

* "The central projection is for growth to slow sharply in the near term, reflecting the squeeze on real incomes, before recovering as credit conditions begin to ease."

November 2008

* "For some time, the MPC has faced a balancing act between the upside risk to inflation... and the downside risk... The prospects [have turned] decisively to the downside."

* "It is very likely that the UK economy entered a recession in the second half of this year."

* "Following the failure of Lehman Brothers, the most serious banking crisis since the outbreak of the First World War reduced the supply of credit to the real economy, and, in some cases, led to a cessation of lending altogether."