Since my last report, the near-term outlook for inflation has deteriorated further.That will intensify the squeeze on real take-home pay which, for many households, is unlikely to increase this year.
These are circumstances in which both consumer spending and house prices are likely to weaken together.
Lenders' concerns about the credit-worthiness of their borrowers have increased, against a backdrop of a softening economy and falling property prices.
The result has been a sharp contraction of underlying growth in money and credit.
The impact of this reduced availability of credit has been very clear in residential and commercial property markets, where activity has slowed as prices have fallen. Intelligence gathered by the Bank's regional agents, and other indicators, point to a substantial slowdown in residential investment, which could exert a sizable drag on economic growth (GDP) in the near term.
Companies too have scaled back their plans for capital investment, reflecting the tougher short-term outlook for the economy.
The latest official estimates show GDP slowing further, to 0.2% in the second quarter of 2008 , and subsequent data on industrial production imply a small downward revision to this figure is likely.
Consumer spending appeared to slow in the first half of the year. But the extent of the moderation is uncertain, with surveys of retailers suggesting an earlier and sharper slowdown than official estimates. However, the surveys seem more consistent with the pronounced squeeze on real take-home pay and the reduced availability of credit mentioned above.
Business surveys and reports from the Bank's Agents are consistent with broadly flat output in the third quarter.
Overseas, the expansion of global economic activity in the first half of 2008 was somewhat stronger than expected. But the near-term prospects for activity in the developed economies look to be fragile. By contrast, output growth in Asia and commodity-exporting economies has remained robust.
Turning to costs and prices, wholesale prices of oil and gas initially rose sharply since May, but have subsequently fallen back. Manufacturing and service sector output prices have risen, and near-term pricing intentions of businesses have remained elevated, particularly in the manufacturing sector.
Measures of expected inflation one year ahead have increased. That is consistent with households expecting the rise in inflation to be temporary. But there is a risk that the medium and longer-term inflation expectations of households and businesses will be affected by the higher near-term expectations and that these become embedded in wage and price-setting.
As usual, the Bank's forecasts are conditioned on market views of the outlook for interest rates, which are for little change in Bank Rate during the forecast period.
On the Monetary Policy Committee's central view, output is broadly flat over the next year. Sluggish real income growth and constraints on the ability of households to borrow dampen consumer spending, while the weak outlook for demand and the housing market lead to falls in business and residential investment.
Thereafter, GDP growth gradually picks up, as the restraining effect of higher energy prices on demand and output dissipates, credit conditions ease and the lower level of sterling continues to support exports. The balance of risks around this forecast is judged to be on the downside. This is a noticeably weaker forecast than when I last reported in May.
Rising food and energy prices have pushed up annual consumer price (CPI) inflation to 4.4% in July. Recent announcements of rises in retail gas and electricity prices mean that inflation is likely to rise further this year and peak at around 5% in the coming months.
Inflation is expected to fall back sharply towards the middle of next year, as the contribution of retail food and energy prices wanes. The central projection is for CPI inflation to fall a little below the 2% target in the medium term.
The inflation outlook is unusually uncertain and there are significant risks on both sides of the central projection.
On the downside, the key risk is the possibility that higher energy prices and the dislocation in credit markets lead to a deeper and more prolonged period of subdued demand. That would open up a larger margin of spare capacity in the economy, which could cause inflation to undershoot the target.
On the upside, the main risk is the possibility that the period of inflation well above target prompts an increase in the medium-term inflation expectations of households and businesses, which feeds into higher wages and prices. Both risks are judged to have increased since May. But, overall, the balance of risks to the inflation forecast is judged to be on the upside.
In conclusion, in setting interest rates the MPC continues to face a balancing act between these upside and downside risks to inflation.
The adjustment of the UK economy to higher commodity prices and more realistic credit markets will be painful.
The next year will be a difficult one, with inflation high and output broadly stable. But with monetary policy focused on its task of bringing inflation back to the target, we will come through the adjustment. And we will return, if not to what the Bank of England Governor Mervyn King has coined the nice (non-inflationary, consistently expansionary) decade, then at least to one that is not so bad.
At its August meeting, the Bank's MPC held interest rates at 5%. The Bank's latest Inflation Report, published on August 13, is available on the Bank's website at
www.bankofengland.co.uk/publications/inflationreport/index.htm
Source: Nottingham Evening Post
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