It is now “very likely” that the UK will enter a recession before 2008 is over, the Bank of England has warned in its latest inflation report.
The central bank warns that the current health of the British economy is probably worse than it forecast back in the summer, thanks to the rise in unemployment, the banking crisis and high inflation. All these factors have taken their toil on consumer confidence, with the retail sector and housing market both suffering as a result.
The Q3 inflation report, which is the largest ever produced by the Bank of England, reiterates the general forecast that inflation will fall back significantly following its peak of 5.2% in September, as a result of cheaper oil and commodity prices.
The report paints a gloomy outlook for consumers, with the squeeze on people’s spending power initially brought on by higher household bills likely to continue. The Bank of England says that although falls in commodity prices should alleviate much of the pressure on families hit by higher energy, petrol and food bills, rising unemployment will cause a new host of problems with real incomes offset by a weaker job market.
Jonathan Loynes, chief European economist at Capital Spreads, says the inflation report – the last this year – sets a strong case for further interest rate cuts.
“November’s inflation report gives a very strong indication that the Monetary Policy Committee expects to cut interest rates much further over the coming months,” he explains.
The report’s bearish tone in part explains the extraordinary base rate cut in November, where 1.5% was shaved off the official rate of inflation - the largest cut since 1981. Most economists were only expecting a 0.5% cut, with some suggesting a full percentage point reduction at the most.
Richard Snook, senior economist at the Centre for Economics Business Research, says the report confirms its speculation that the central bank is concerned about the risk of deflation.
The Bank of England’s inflation projection admits the possibility that this could fall below 1% in 2010, and could even hit 0% if interest rates remain at 3%.
“While deflation was commonplace prior to the 20th century, it is considered to be extremely damaging in a modern economy,” says Snook. “Deflation will normally occur at a time of sharply falling demand and economic output (such as during the Great Depression) - the primary danger is that once deflationary expectations are entrenched, consumers will delay spending and businesses will delay investing as this can be done more cheaply in the future.
“As a result, deflation can contribute to downward economic spirals and turn a recession in to a deep and lasting depression.”