Bank of England points to slow recovery
The Bank of England says the economic downturn in the UK has started to moderate but warns the timing of a full recovery is still uncertain.
In its latest inflation report, which outlines expectations for inflation and the base rate, the central bank notes that the world economy remains in “deep recession” with banking and financial systems fragile and lower levels of international trade.
But it points to “promising signs”, with the pace of the decline starting to slow. “There is considerable economic stimulus stemming from the easing in monetary and fiscal policy at home and abroad, the substantial depreciation in sterling, past falls in commodity prices, and actions by the authorities internationally to improve the availability of credit,” the Bank of England states.
However, offsetting this is “the process of adjustment under way in the UK economy” – this includes individuals increasing the amount they save and reducing their spending, while banks restructure their balance sheets.
“[This] will continue to act as a significant drag on economic activity,” the Bank of England says.
Although the central bank does predict the UK economy will start to grow again in 2010, it warns that a full and sustained recovery is likely to be slow and prolonged.
The latest inflation figures recently revealed that the cost of living, as measured by the Retail Prices Index (RPI), turned negative in March for the first time since 1960. It is now -0.4%, down from 0% in February.
The Consumer Prices Index (CPI) – the official measure of inflation that, unlike the RPI, does not include mortgage interest payments – fell to 2.9% in March, down from 3.2% in February and 3% in January.
The Bank of England’s inflation report notes that CPI still remains well above its 2% target but is likely to drop to below target later in the year as a result of cheaper food and fuel.
Wages are also expected to fall – this has already started, with the latest unemployment figures revealing the first fall in wages since 1996.
However, the Bank of England adds that there is a substantial risk that inflation could actually rise. “The significant depreciation of sterling has raised companies’ import costs. The extent to which the adjustment to sterling’s depreciation will come through higher prices rather than lower wages is a key uncertainty surrounding the inflation outlook.”
Jonathan Loynes, chief European economist at Capital Economics, says the inflation report shows "sensible caution" against those that are calling a recovery.
"The clear message is that any renewed tightening of policy – either in the form of a reversal of quantitative easing or a rise in the base rate – is a long way off," he adds.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).