The Bank of England will today dramatically downgrade its forecast for growth in the British economy and warn that inflation is set to continue to rise.
The Bank will forecast a collapse in economic growth to about 1 per cent next year, heightening fears that the British economy may soon slide into recession. It will also signal still higher inflation over the next few months, probably peaking at more than 5 per cent by September.
The Bank's quarterly Inflation Report comes just a day after food inflation hit a 28-year high of 13.7 per cent. Overall inflation rose to 4.4 per cent in July, as measured by the consumer price index (CPI), a jump of 0.6 per cent on June's annual rate of 3.8 per cent. Such a downgrade in the Bank's forecasts will be deeply unwelcome to ministers, as they prepare the Government's economic recovery programme in time for the Labour Party conference next month and the pre-Budget report in October.
Lower growth assumptions make it much harder for the Treasury to stick to its fiscal rules and to fund any large-scale public spending programmes to get the economy moving or rescue the housing market.
Hefty rises in the price of food and fuel were again behind most of the rise in inflation, though economists also pointed to a worrying upward trend in "core" inflation, with volatile items such as food removed.
On the retail price index, which includes mortgage interest payments and reflects movements in house prices and accommodation costs, inflation stands at 5 per cent, a level last seen in July 1991, with food inflation the worst since July 1980.
Most economists see inflation topping out at 5 to 5.5 per cent over the autumn, before the recent decline in oil prices feeds through early next year. A return to the official target of 2 per cent may take more than a year.
The Bank will have been aware of the inflation figures when it left interest rates on hold last month, suggesting it sees the spike in inflation as sharp but essentially short-lived.
Nonetheless, Governor of the Bank, Mervyn King, has repeatedly warned of the squeeze on living standards that will have to be endured as a result of the effects of the credit crunch and the boom in commodities prices. Mr King will in all likelihood repeat his gloomy prognostications today.
With inflation at more than double the Government's target, and the UK already named and shamed by the EU for being in breach of its financial obligations under the Maastricht Treaty, ministers will have broken virtually all of their economic disciplines.
At the moment the Treasury is still sticking to forecasts for growth made by Alistair Darling in the Budget in March, but the range of 2.25 to 2.75 per cent is, even now, looking ludicrously optimistic and out of line with the consensus of independent forecasts, of about half that level. The IMF predicts the UK will grow by 1.1 per cent in 2009, down from the 1.7 per cent for 2009 that it previously predicted. The Bank's figures are unlikely to be far out of line.
A lower official growth estimate in the pre-Budget report will make it virtually impossible to keep the total of national debt to the Government's "sustainable" limit of 40 per cent. There have already been strong hints that the fiscal rules – limiting the size of government borrowing – will be fudged in the light of the credit crunch, an unprecedented economic event that may be used as a justification for finally abandoning the pursuit of prudence.
How we measure inflation
Despite criticism that they don't reflect the "real" cost of living, the consumer price index (CPI) and the retail price index (RPI) are the best guides to what is happening to prices. They cover more than 120,000 prices – from salted peanuts and inkjet cartridges to mortgage fees and the cost of roadside repairs. They include seldom purchased items, such as used cars, which have seen lower inflation, as well as "high visibility", frequently-bought consumables like bread and petrol, which have been going up more. The CPI dates from 1997, and is "harmonised" to be on the same basis as other EU nations' statistics.
The RPI is used in wage negotiations and for the uprating of benefits, rail fares and index-linked bonds. The RPI includes mortgage interest payments and reflects to an extent house prices and rentals; the CPI only includes rents and is the official target for interest rate policy. Many, including the Bank of England Governor, Mervyn King, believe that the target should include house prices.