King set to see term of office end with inflation still above target

British consumers face another two years of high inflation, weaker economic growth and a continuing struggle to maintain living standards, according to the Bank of England.

In its latest Inflation Report, the Bank slashed its growth forecast for the British economy and warned that inflation will hit 5 per cent this year. With prices rises "uncomfortably high", households will be hit by a continuing squeeze on disposable incomes – not least from a projected rise in gas and electricity bills of 15 per cent and 10 per cent respectively this year.

The Bank's own calculations imply that its Governor, Mervyn King, has only an evens chance of seeing inflation return to the 2 per cent official target by the time his term of office ends in June 2013.

Reading through the Bank's "fan charts", Threadneedle Street appears to have reduced its growth figure for this year from around 2 per cent to 1.7 per cent and for 2012 from 3 per cent to closer to 2.5 per cent. Inflation is set to remain higher than 2 per cent into 2013 now. Pre-recession levels of output will only be recovered in mid-2012.

In a subdued performance, Mr King said that "it is now clear that underlying activity slowed markedly around the turn of the year. Looking through the volatility caused by the heavy snow last December, the level of output appears to have been broadly flat over the past two quarters". That was against an expansion of output of about 1.5 per cent over the six-month period that had been expected by the Bank last year.

The "soft patch" in the recovery was due to weakness in construction and the fiscal consolidation and fragile household confidence, Mr King said. But it is expected to be "temporary" with "a continuing rise in business investment and a positive contribution from net exports".

Mr King said: "There are clear downside risks... household spending may have further to adjust to the significant squeeze in real incomes and there is substantial uncertainty over the speed at which net exports will pick up."

The latest trade figures were, though, encouraging and suggestive of a continuing "rebalancing" in the economy, with export volumes posting quarterly growth of 5 per cent in the first three months of the year, but import volumes slipping by about 2 per cent.

The rapid rise in imported commodity prices left the deficit increasing to £7.7bn in March, from £7bn in February. The Bank again laid the blame for inflation on global commodity prices and the VAT hike to 20 per cent in January, some three-quarters of which has been passed through to consumers.

Overall, the Bank argues that between 3 and 5 percentage points of the inflation can be attributed to these special factors, which have pushed prices higher by 13 per cent since 2006. The general expectation is that the Bank will raise interest rates by 25 basis points by the end of the year and rates will rise to 2 per cent by 2013. The Bank said that the economic impact of the royal wedding could be "sizeable", on the basis of the 2012 Golden Jubilee celebrations, and it would complicate the picture.

Yesterday was not the first occasion the Bank has had to simultaneously downgrade its growth forecast while admitting inflation will be higher than thought, suggesting to some observers a structural weakening in the economy. Although the Bank concedes that the "events of the past two years" may have affected productivity, it maintains that there is no reason to adjust its view of the long-term potential growth rate, allowing for immigration.

The Bank instead points to high and volatile commodity prices driving headline inflation up and sucking purchasing power out of the economy as the main explanation for the worsening outlook for growth, price rises and living standards.

The 'Kate effect'

The Bank's attempts to see what is really going on in the economy over the last two quarters have been hampered by the extreme snow conditions over the winter.

The picture in the current, second quarter of this year may also be obscured by the impact of the royal wedding, its associated bank holiday and the 11-day vacation many Britons took as a result. Usually dismissed as trivial, the Bank argues that the impact of the nuptials may be "sizeable" if it proves comparable to the impact that the Queen's Golden Jubilee had in June 2002.

At that time the Office for National Statistics said that it depressed second-quarter GDP in 2002 by between 0.2 per cent and 0.7 percentage points, but it then bounced back over July to September. Thus we may only be able to discern the present situation when the third-quarter GDP data are published in late October – just in time for a modest rate rise in November, as markets expect.