Interest rates to stay low as hope of growth fades

In its quarterly inflation report, the Bank’s most likely scenario for this year was for flat output, compared with 0.8 per cent in its last estimate in May, as the threat of the eurozone and tight lending conditions drag on the economy.

The assumptions are based on market expectations of interest rates falling next year and not rising beyond current levels of 0.5 per cent until the middle of 2015 – keeping the pressure off borrowers but creating prolonging misery for savers.

Most economists agreed the report paved the way for further emergency support measures, although the Governor played down suggestions that a rate cut was likely.

Commenting on the report, Howard Archer, chief UK and European economist at IHS Global Insight, said: “We certainly would not rule out a future trimming of interest rates from 0.5 per cent to 0.25 per cent, but we believe it is more likely that they will stay at 0.5 per cent through until at least late-2014.”

The Bank also slightly lowered its forecast for 2013 to around 1.9 per cent from just over 2 per cent in its May estimate, while 2 per cent growth is predicted for 2014.

The downbeat outlook was seized on by opposition politicians as another sign that Chancellor George Osborne’s austerity measures were choking recovery.

Presenting the gloomy report, Sir Mervyn said: “As I have said many times, the recovery and rebalancing of our economy will be a long, slow process.”

Sir Mervyn offered some hope as he said the underlying picture in the last three quarters – Britain’s longest double-dip recession since the 1950s – was not as bad as headline figures suggested and reassured that the economy was “slowly healing”.

The governor raised doubts over the accuracy of official figures showing a large drop in construction figures, as “out of line” and “at odds” with other surveys.

Sir Mervyn said the extra bank holiday in June for the Diamond Jubilee celebrations will have reduced output by around 0.5 percentage points and should unwind in the third quarter.

Eurozone woes are hitting demand for UK exports and efforts to rebalance the economy “will require patience”, Sir Mervyn said, as he repeated his call for an effective response to the crisis from European leaders.

He warned: “The economy will continue to face headwinds over the forecast period, from the fiscal consolidation and tight credit conditions at home, as well as from the difficulties in the euro area and a broader slowing in the world economy.”

But Sir Mervyn offered some hope as he said early indications on the £80bn “funding for lending” scheme to unclog the flow of credit were positive, with some banks cutting their loan rates.

The Governor also raised the “puzzle” of recent robust employment figures, which stand in “marked contrast” to the decline in output since October last year.

The rate of inflation is now expected to hit the Government’s 2 per cent target towards the end of this year, earlier than previously expected, and could slow further to around 1.5 per cent towards the end of 2013, the report said.

The lower forecast reflects softer oil prices, the report said, which were around 7 per cent lower in the run-up to the August. But Sir Mervyn said a rate cut was not a move the Bank would “contemplate immediately” as it would damage some financial institutions, such as building societies.

Vicky Redwood, chief UK economist at Capital Economics, said: “The door is clearly open to more stimulus and we still expect both more QE (quantitative easing) and a further interest rate cut in November.”

Looking ahead, Monetary Policy Committee member Spencer Dale said the Olympics should have a small positive contribution to the economy in the third quarter between July and September.

Rachel Reeves MP, Labour’s Shadow Chief Secretary to the Treasury, said: “With growth forecasts slashed yet again, not just this year but in future years too, it is clear that we cannot go on with the same failing plan from this Government. The Chancellor’s policies aren’t only causing short-term pain, but long-term damage to our economy too.”

TUC General Secretary Brendan Barber said: “We all know the economy is currently stuck in a rut but it’s now looking less like a blip and more like a much longer slump. The UK’s dire economic performance is causing permanent damage and putting thousands of jobs on the line.”