Inflation to rise and growth to be slower

Nov 15 2007 by Peter McCusker, The Journal

MORTGAGE bills are set to fall next year as the economy faces a short-term squeeze from higher inflation and slowing growth, the Bank of England predicted yesterday.

The Bank’s latest quarterly report signalled two rate cuts on the way in 2008, saying that inflation would meet its 2% target if borrowing costs fall by 0.5% from the current 5.75%, as expected by markets.

But Governor Mervyn King admitted inflation was likely to remain above target for the whole of next year as the economy faces a “less benign” environment, with pressure from soaring food costs, higher oil prices and a weaker pound.

Uncertainty over the long-term effects of the summer credit crunch, which sparked the crisis at mortgage lender Northern Rock, also overshadowed the Bank’s predictions.

Capital Economics economist Vicky Redwood said the report “gave a pretty clear signal” that lower interest rates lie ahead.

But she added: “With the Bank still clearly concerned about various upside risks to inflation, we do not expect it to start cutting until early next year.”

Policymakers are expecting sharply lower growth in the first half of 2008 amid the impact of the summer’s credit crunch, a slowing housing market and consumer spending reined in by five rate hikes in 15 months.

Mr King said the short-term outlook for the UK economy was “one of slowing growth and rising inflation”.

He said there were “some difficult decisions ahead” as rate-setters walk a tightrope between adding to inflation pressure by cutting rates too soon, or waiting too long and risking a recession.

The report downgraded growth forecasts for next year to around 2.2%, bringing the Bank into line with most economists’ predictions as well as the Treasury, which lowered growth expectations in October’s Pre-Budget Statement.

Global Insight chief UK economist Howard Archer, who predicts rate cuts in February and May next year, said: “The Bank has become markedly more pessimistic on the growth outlook, particularly in the near term. Consumer spending growth is seen slowing, while there are concerns that companies may delay or reduce their business investment plans.”

While the Bank expects consumer prices index (CPI) inflation to settle on its 2% target in two years’ time and a faster pace of growth in 2009, it said key risks were the economic problems in the US and the impact of the tighter credit conditions since the summer on household finances and businesses.

The Governor said the financial system was “structurally sound”, but added that it was hard to assess the full impact of the credit squeeze and said the shockwaves could take months to fade away. “The problem is putting a number on the change in credit conditions. We still have many more months of the stress we have seen in financial markets, but this will be gradually worked through by the middle of next year, although there is a great deal of uncertainty and fragility still there,” the Governor said. Although a host of major banks have revealed losses from spiralling mortgage defaults among high-risk US borrowers – the main trigger for the credit crunch – Mr King said the impact was small compared to the banks’ profits made over the past three years and the capital cushion of their balance sheets.