Bank governor Sir Mervyn King warned inflation was now expected to remain “stubbornly” high until early 2016, but indicated there was little prospect of interest rates rising as it sought to support recovery efforts.
The pound slumped to a six-month low against the dollar and dipped nearly 1 per cent against the euro after the forecast, despite assurances from Sir Mervyn that a “recovery is in sight”.
Presenting the Bank’s quarterly inflation report, he said that while the path ahead for the UK economy would not be smooth, there was cause for optimism.
The Bank’s forecast shows a “slow, but sustained recovery” with annual gross domestic product (GDP) rising to around 2 per cent by the end of 2014 and remaining in positive territory, boosting hopes that the UK will avoid a triple-dip recession.
But its inflation outlook made for grim reading as it heralded a further squeeze on consumers, while savers and pensioners look set to suffer rock-bottom rates for years to come.
Inflation is now expected to rise to 3 per cent or more by the summer and not fall back towards the 2 per cent target until 2016 – far later than previously thought.
The Bank has been criticised for failing to bring inflation down to target since the financial crisis, but Sir Mervyn said doing so “would risk derailing the recovery and undershooting the target in the medium-term.
“So long as domestic cost and price pressures remain subdued, we will continue to look through the temporary, albeit protracted, period of above-target inflation in order to support the recovery in growth and employment,” he added.
His comments come just a week after incoming governor Mark Carney told MPs he favoured so-called flexible inflation targeting.
Philip Shaw, chief economist at Investec Securities, questioned whether the Bank could become more flexible with its monetary policy.
“With inflation above the 2 per cent target for 90 per cent of the time over the past five years, the Monetary Policy Committee has already been flexible,” he said. “How this might become even more flexible is not clear at all.”
The gloomy inflation forecast means that one of Mr Carney’s first tasks could be to write a letter to the Chancellor to explain why inflation is more than 1 per cent above target. Figures yesterday confirmed that Consumer Prices Index (CPI) stayed at 2.7 per cent for the fourth month in a row in January.
The Bank blamed higher tuition fees and energy costs for recent inflation pressures, saying they had added around 1 per cent to CPI at the end of last year and would continue to drive inflation higher.
Sterling’s recent weakness had added to inflation woes and there was a further sharp fall after Sir Mervyn said the Bank stood ready to take action on the economy.
Currency expert Eimear Daly, head of market analysis at Monex Europe, said: “The most likely conclusion is that the Bank will use monetary easing to devalue the pound in order to boost exports, as private demand is now immune to further quantitative easing.”
There was a chink of light for the wider economy as the Bank held off from further growth downgrades as it said improvements in financial markets and an easing in global conditions was supporting the recovery.
The Bank and Treasury’s multibillion-pound Funding for Lending (FLS) scheme – launched last year to provide cheap money to lenders – is also helping by boosting credit for consumers and businesses, according to the report.