Interest rates set to remain low

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Interest rates are set to remain low for some time despite signs that the recession is easing its grip on the economy, a new report from the Bank of England suggests.  

The latest inflation report from the central bank warns that the road to economic recovery could be a rocky one, with the economy likely to remain fragile until 2010. Mervyn King, governor of the Bank of England, says that while the UK economy is set to shrink by 5.5% during the whole of 2009, growth should return at the end of the current year before rising to around 3% in two years' time.

The Bank of England's report concludes that the recession seen in the UK has been "deeper" than previously expected, but optimistically suggests that the 'trough' in economic output is near.

King says: "It is likely that [economic] output stabilised in the middle of this year, and business surveys and other short-run indicators suggest that growth is more likely than not to resume over the next few quarters."

He adds that measures taken by the Bank of England - including bringing the base rate down to an all-time low of 0.5% and increasing the supply of money through quantitative easing - have helped to stimulate the economy.

However, the fact that banks are still restricting the amount they are prepared to lend to both businesses and households is likely to hinder recovery, King warns.

The report also notes that the outlook for inflation - or the cost of living - remains unclear. Earlier this month, the Bank of England's Monetary Policy Committee (MPC) voted to maintain the base rate at 0.5% and increase quantitative easing measures to £175 billion amid signs that inflation will fall substantially below its target of 2%.

The official measure of inflation, the Consumer Prices Index, is currently just 1.8%. While this is expected to increase slightly when VAT returns to 17.5% at the start of next year, the Bank of England's central projection is for inflation to fall below 1%.

Many economists now believe that quantitative easing measures could be extended further - despite concerns this could cause inflation to rocket - and that the base rate will remain low for some time.

Charles Davis, economist at the Centre for Economic and Business Research, explains: "The Bank of England’s central expectation is for inflation to dip below 1%. This implies three things.

"First, more quantitative easing is on the cards – our rough and ready estimate is a further £50 billion. Second, the Bank of England is clearly not expecting to roll back the quantitative easing at all soon. Third, the base rate is likely to remain lower for longer than the markets expect."

And he adds: "Even assuming the base rate remains at 0.5% until the end of 2011, the Bank of England expects inflation to undershoot the target rate until the final quarter of 2011."

The inflation report also suggests the stockmarket has priced in interest rate hikes too early.

Vicky Redwood, UK economist at Capital Economics, says the current market expectations are for a rise in the base rate to 2% by the end of 2010 and almost 4% by the end of 2011.

But she adds that, if these expectations are realised, inflation will undershoot its target.

"The forecasts based on constant 0.5% rates (and £175 billion of quantitative easing) show inflation is broadly on target – on the face of it suggesting that the MPC thinks it has now provided enough support to the economy," Redwood adds.

"But the forecasts are still based on a very sharp V-shaped recovery. If the recovery is more sluggish than this – as we expect – more quantitive easing is likely to be necessary. Overall, monetary policy looks set to remain extremely loose for some time yet."