By Marcus Leach

Bank of England governor Sir Mervyn King has warned that economic growth in the UK will be “flat or close to zero” over the next six months.

In a letter to the Treasury Committee King outlined the fact that economic growth in the near future will be weaker than three months ago.

His gloomy prediction comes on the back of the OECD suggesting that a European recession was growing increasingly likely.

Sir Mervyn King’s Letter:

In the past year the UK economy has experienced an unpleasant combination of high inflation and weak output growth. We have seen a ‘reluctant’ recovery to date because of the headwinds associated with the rebalancing process that is underway at home. But in recent months developments abroad, and especially in the euro area, have increasingly threatened that process of rebalancing and recovery.

Over the past year demand has been held back by weak real income growth, tight credit conditions and the fiscal consolidation, despite accommodative monetary policy. Indeed household consumption has fallen back to the level seen in the trough of the recession, and before that at the start of 2005. In the latest data output remains some 4% below its peak, and more than 10% below its pre-crisis trend. The fall in output has surely left a margin of spare capacity in the economy — not least in the labour market, where the unemployment rate had been hovering around 8% for some time, before picking up in the latest data. Over time I would expect this to put downward pressure on inflation. The size of this margin of spare capacity, and its effect on inflation, is however very uncertain.

Underlying domestic inflationary pressure has indeed been subdued over the past year, as can be seen in the below-par rate of wage growth. Headline CPI inflation was, however, pushed to above 5% by the contribution of increases in energy prices, import prices and the rate of VAT. We expect inflation to fall back sharply as these price rises drop out of the annual comparison early next year, although the precise timing and extent of the fallback in inflation are uncertain. But as ever it is the outlook for inflation in the medium term that bears on monetary policy.

For much of the past year there have been two key risks to that inflation outlook. On the one hand is the risk that a persistent margin of spare capacity and subdued wage growth result in inflation moving below target in the medium term. And on the other hand is the risk that the period of above-target inflation could cause medium-term inflation expectations to drift up, putting persistent upward pressure on inflation. These are the risks that have framed the policy debate over most of the year. Seeking to balance these risks, in each MPC meeting from December last year to September this year I judged that it was appropriate to maintain Bank Rate at 0.5% and the quantity of asset purchases at £200 billion.

In recent months, however, events abroad have affected the outlook for the UK economy. The unfolding euro-area crisis and the associated tensions in financial markets and the world economy — working through weaker net trade, higher credit spreads and the likelihood that elevated uncertainty will cause businesses to postpone investment and households to spend less — now threaten the UK recovery. The outlook for output growth in the near term is considerably weaker than even three months ago. Indeed it now seems likely that the level of output will be broadly flat over the next six months. The outlook for inflation in the medium term is correspondingly weaker, and there is a significant risk that it will undershoot the target. In October, in response to this downwards shift in the prospects for the UK economy, the MPC voted unanimously for an additional £75 billion of gilt purchases.

This policy seeks to increase the amount of money in the economy. The money received by those selling assets to the Bank can then be used to buy a wide range of other assets, including private-sector securities. In turn, this will raise asset prices and lower the costs of borrowing for private-sector companies, with the aim of boosting overall money spending and ensuring that it grows at a rate that is consistent with meeting the inflation target in the medium term.

In taking this action we are treading a fine line between stimulus to demand in the short run and the longer-term need to continue the process of rebalancing and de-leveraging.

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