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A crumbling economy, the most severe banking crisis since the first world war and the halving of oil prices were cited by Mervyn King yesterday as the catalysts for a radical rethink of policy that resulted in last week's 1.5-point drop in interest rates from the Bank of England.
Unveiling Threadneedle Street's quarterly healthcheck on the economy King, the Bank's governor, said a combination of the three factors had forced it into the biggest downward revision of its inflation forecast since being granted independence by Gordon Brown in 1997.
The Inflation Report showed how the Bank abandoned its concerns over the risk of rising inflation as the economy took a turn for the worse during the autumn. Threadneedle Street cut rates by half a point to 4.5% in October and earlier this month announced the biggest drop in bank rate - Black Wednesday apart - since the early 1980s.
The tone and the content of the report showed a marked change in the Bank's view since August, when Tim Besley, one member of the nine-strong monetary policy committee, even voted for a quarter-point increase in borrowing costs.Yesterday's 46-page document illustrated how the majority on the committee capitulated to the views espoused throughout the summer by David Blanchflower, another MPC member, who warned repeatedly that the UK was following the US into recession.
In terms of content, the Bank is now pencilling in the risk of a recession as pronounced as that of the early 1990s and puts the probability of deflation at about 15%. Although the economy started to show signs of weaker growth in the second half of last year the Bank's earlier inflation reports saw no chance of a recession in November 2007 or in February 2008.
Six months ago, in the second quarter of 2008, the economy had stalled but the Bank thought there was merely a 10% chance of growth declining briefly to zero. As recently as August the Bank expected GDP to be "broadly flat" over the next year, and King said then there was the possibility of a quarter or two of negative growth, but was not anticipating the scale of the recession now believed to be in prospect. The MPC discussed raising rates in September, but rejected the idea.
Asked why the Bank had failed to read the signs, King said the "world has changed" and the MPC's view was that the UK faced "falling output for a year or so" in which consumers would bear the brunt of the downturn.
Threadneedle Street believes the economy would begin a gradual recovery in the second half of next year as banks respond to the government's capital injections by supplying more credit, consumer spending is boosted by falling commodity prices and the weaker pound helps exporters. King said three factors had transformed the outlook:
• The state of the economy. There had been a sharp fall off in demand, both at home and abroad so that growth in the final three months of 2008 was likely to be "materially weaker" than the MPC had expected in August.
• The intensification of the financial turmoil. Following the collapse of Lehman Brothers in mid-September, the "most serious banking crisis since the outbreak of the first world war reduced the supply of credit to the real economy and, in some cases, led to a cessation of lending altogether". This, the governor said, would restrain demand in 2009.
• Oil prices. At the time of the August inflation report, the Bank had pencilled in an oil price of $124 a barrel, whereas the November report assumed a level of $64 a barrel. "In the space of a few months, we have gone from the highest rate of manufacturing input price inflation in nearly 30 years to the lowest monthly rate on record. And measures of short-run inflation expectations have fallen back sharply."
The gloomier forecasts meant the report had a markedly more dovish tone. It no longer contained the familiar warning that higher commodity prices might prompt a surge in pay settlements. Instead, it noted that private sector wage settlements had remained broadly unchanged since the middle of 2007.
It also emphasised that there was no longer a need to be concerned about the level of inflation expected by voters and pointed out that the Baltic Exchange Dry Index - a measure of commodity prices - had fallen by 90% since May. All three points have made by Blanchflower during the course of this year.
Simon Ward, chief economist at New Star, said: "The inflation report ... will boost expectations of a fall in Bank rate to below 2% by early 2009 ... However, the commitment to maximum policy stimulus sits oddly with the ... forecast of a relatively shallow and short recession. Markets may begin to worry about a loss of financial discipline."
David Page, economist at Investec, said: "The Bank's Inflation Report projected a dire outlook for GDP and inflation, which ... looks likely to herald further aggressive rate cuts."
- Bank of England
- Economic policy
- Credit crunch
- Recession
- UK banking sector
- Banks and building societies
- Interest rates
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