Bank of England forecasts slow growth

Britain’s economy will grow less than previously estimated as ongoing fiscal consolidation and tight credit conditions will hamper economic growth, according to the Bank of England (BoE) Inflation Report.

Although the Bank does not name a number, the report contains a chart illustrating the committee’s best collective judgement for fourth-quarter GDP growth.

Assuming that the Bank Rate follows market interest rates and the stock of purchased assets remains at £200 billion, the chart suggests that GDP is likely to grow by 3%. However, according to the fan-shaped illustration, Britain’s economy could grow by as much as 5.9% or contract by as much as 0.6%.

For the first half of 2010, economic growth was close to its historical average. During the second quarter, for which final numbers are not yet available, GDP is estimated to have risen by 1.1%.

The Bank highlights that a number of temporary factors have had an effect on the pattern of growth over recent quarters. The considerable stimulus from monetary policy, combined with a further expansion in world demand and the past depreciation of sterling, sustained the recovery.

However, the strength of growth is likely to be tempered by the continuing fiscal consolidation, the persistence of tight credit conditions and relatively high inflation.

With 3.2%, inflation in June was well above the 2% target and higher than anticipated. According to the Bank, the high rate of inflation rose because of temporary effects from increased oil prices, the restoration of the standard VAT rate of value added tax to 17.5%, and the past depreciation of sterling. (article continues below)

Increasing VAT to 20% in January next year will add to inflation throughout 2011.

At its August meeting, the committee said the recovery was likely to continue and the forthcoming increase in VAT to keep inflation above the 2% target until the end of 2011. After then, the committee says, inflation was likely to fall back, reflecting the persistent margin of spare capacity.

Therefore, the committee decided to maintain the Bank Rate at 0.5% and the size of the programme of asset purchases financed by the issuance of central bank reserves at £200 billion was appropriate to meet the inflation target over the medium-term.

In its latest UK Data Response, Capital Economics says that the committee has previously over-estimated the disinflationary influence of the weakness of demand and spare capacity in the economy over the last year. Still, the economists at Capital Economics agree that the spare capacity – coupled with low wage growth and weak money supply growth – will bring inflation back below its target.

If the economic recovery disappoints, Capital Economics says, it is likely that a further bout of quantitative easing may well be forthcoming.

Howard Archer, the chief European economist at IHS Global Insight, also expects that the Bank is likely to keep interest rates down at 0.5% during the rest of 2010 and through the early months of 2011. Furthermore, Archer writes in his IHS Global Insight view that interest rates are likely to remain at record lows for a while, regardless of when they first start to rise.

Archer says monetary policy will need to remain loose for an extended period to offset the impact of the major, sustained fiscal squeeze.