Bank of England keeps economic options open

Mervyn
King, governor of the Bank of England, has urged banks to boost their balance
sheets before emergency support runs out.

Mr. King
has held out the prospect of a fresh round of emergency “quantitative easing”
as he warned that the economy is still “bumping along the bottom”.

The
Bank’s nine-member monetary policy committee last week decided to suspend its
£200bn scheme of injecting money into the economy, amid tentative evidence of
recovery.

But in
his quarterly Inflation Report, King stressed the formidable
“headwinds” from a weakened banking sector, and made clear the MPC
stands ready to do more.

“The
additional money created by the asset programme will continue to boost the
economy for some time to come. But the nature of the headwinds means that the
recovery is likely to be slow,” he said, stressing that it was, “far
too soon,” to conclude that quantitative easing is over.

Inflation
has been much higher than the MPC expected over the past year, causing some
analysts to predict that interest rates would soon start to rise. King insisted
the inflation spike was due to short-term effects such as rising oil prices and
the end of the 2.5% VAT cut, which would fade later in 2010 as the downward
pressure from weak demand takes over.

“It
seems clear that at present there is significant spare capacity in the economy
that will act to dampen inflation,” he said.

However,
the governor conceded that he may be forced to write an open letter to the chancellor
next week, when official figures are released showing inflation for January,
which the Bank expects to have jumped above 3%.

City
economists scrambled to revise their forecasts in the light of the inflation
report’s dovish tone, with many predicting interest rates would start to rise
later than they had previously thought.

“While
we continue to think the MPC’s rhetoric could change swiftly, the downplaying
of inflation surprises in the central forecast is enough to call for the first
tightening move from the MPC back to November from August,” said Malcolm
Barr, UK
economist at JP Morgan.

Brendan
Barber, general secretary of the TUC, seized on the MPC’s warning of a weak
economic recovery to urge them to avoid raising rates too soon. “It’s
clearly going to be some time before the economy is out of the woods, and the
prospect for jobs and for the millions of people trying to get back into work
still looks bleak. The worst move now would be a premature return to interest
rate rises – both business and jobs could do with a period of stability to get
back on their feet,” he said.

Despite
his caution about the outlook, King said he believed the economy expanded more
strongly in the final quarter of 2009 than the 0.1% estimated by the office for
national statistics.

That view
gained fresh support with news that output from Britain’s factories jumped by 0.5%
in December – much more strongly than the ONS had first thought.

But the
governor urged the public to focus on the “big picture,” of an
economy blown catastrophically off course by the credit crunch. “Output
has fallen by 6% since the crisis began: that’s a massive fall, and 0.1% or
0.2% is not going to make a massive difference to that picture; it’s going to
take a long time for that to be earned back.”

The
report made clear that the Bank continues to be concerned about the impact of
the battered banking sector on the economy’s ability to recover. “While
the banking system reduces its leverage, there will continue to be downward
pressure on the supply of credit to businesses and households,” King said.

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