Bank warns of sharp slowdown

Inflation forecasts revised up; Report signals two rate cuts next year; Risk of further shocks

The Bank of England did not use the trendy new word "slowflation" in its Inflation Report yesterday, but it is clearly signalling a combination of slower growth, higher inflation and lower interest rates for the UK next year – "not an outcome we've seen very often" in the words of the Bank's Governor, Mervyn King. Indeed, the Bank already believes that "GDP growth may have begun to slow in the fourth quarter", with what Mr King termed a "dichotomy" between the housing and financial sectors, hit by the credit squeeze, and the rest of the economy.

In a markedly more gloomy outlook than in its last round of forecasting in August, the Bank believes GDP growth will slow to around 2.4 per cent next year, from more than 3 per cent for 2007. That compares with a central projection of about 2.7 per cent for 2008 in the August report.

Mr King admitted growth would "slow sharply" and that there was a risk of a bigger slowdown than predicted. Reflecting much general uncertainty in Bank circles, the report stated: "Although conditions in some markets have since improved, the global financial system remains vulnerable to further shocks. The possible impact on spending of recent and prospective developments in financial markets represents a key uncertainty surrounding the outlook."

Mr King expressed a degree of surprise that equity markets are as bullish as they are – "there must be some downside risks in this".

The possibility of a recession – two quarters of "negative growth" – does not appear on the likely range of Bank expectations, partly because of a technical point about the way it charts GDP trends.

The Bank's forecasts are predicated on expectations that the Bank rate will fall from 5.75 per cent now to 5.5 per cent in the first quarter of next year, to 5.3 per cent in the second half of the year, and then to 5.1 per cent to 5.2 per cent in early 2009. That may provide some respite for homeowners who have seen their disposable incomes squeezed. It may also aid those more marginal borrowers – households and companies – the Bank has identified as being at risk as banks tighten their lending criteria. In any case, the Bank says "consumer spending may not be particularly sensitive to modest falls in house prices".

Overall, the Bank says that the "risks to growth are on the downside, while those to inflation are balanced". The relative confidence about inflation, notwithstanding the blip, is because "past increases in bank rate, tighter credit conditions, lower house price inflation and heightened uncertainty are expected to dampen spending growth".

The Bank indicated its central prediction was for inflation to remain at about 2.25 per cent for most of 2008 because of higher energy prices, before easing back to the official target of 2 per cent by mid-2009. Thus the Bank is signalling inflation will stay close to target – even with interest rate cuts and the price of oil approaching $100 a barrel, and increasingly volatile.

However, it will be looking at data on inflationary expectations, credit conditions and on pay and labour markets (such as yesterday's small rise in joblessness) especially carefully. Yesterday unemployment rose again. Mr King said that "trying to describe the outlook in terms of adjectives is less helpful than in terms of numbers. It's a matter of data, not a matter of time."

Analysts agreed that the immediate prospect is for rates to come down, with some envisaging a cut by Christmas. Alan Clark of BNP Paribas said: "We now believe the MPC will deliver the first interest rate cut at the December MPC meeting ... and the Inflation Report suggests that February is the latest that we should expect a cut to be delivered." The Bank of England signalled that interest rates will need to fall in the coming months as it downgraded growth forecasts for next year in its first quarterly inflation report since the global credit crisis swept financial markets in August.

"The ... report is markedly more dovish and indicates that at least two interest rates cuts are likely," said Global Insight economist Howard Archer. "However, it remains somewhat uncertain as to when exactly the first cut in interest rates will occur, with [Bank of England Governor] Mervin King indicating that the timing will be driven by the data."

The Bank said that the key risks to growth were posed by a potential slowdown in the US economy and reduced household spending and business investments due to tighter credit conditions.

"Recent financial market events are likely to bear down on demand growth, although it is too early to assess the full impact," it said.

King 'did not consider quitting'

* Mervyn King said that he had had "more important things" on his mind than whether he was going to serve a second term as Governor after June 2008, and replied "no" when asked if he had considered resigning over Northern Rock. He will leave consideration of his position until the new year. More broadly, Mr King added: "I would urge everyone to see the losses in the context of past profits and the capital cushion of the banks... about £100bn of profits. They will provide the cushion which guarantees the stability of the banking system and it is strong and stable."