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Last Updated: Wednesday, 23 January 2008, 01:07 GMT
Economic trials ahead - Bank boss
Mervyn King
Mr King has said that targeting inflation is a priority for the Bank

The governor of the Bank of England, Mervyn King, has warned that the UK economy faces its toughest challenges since 1997.

The UK faced "a period of above-target inflation and a marked slowing in growth", he told business leaders.

Mr King spoke after the US Federal Reserve slashed interest rates to 3.5% from 4.25% in a surprise move that saw global markets recover some ground.

His comments suggest that UK rates will not come down by much, say analysts.

2008 is likely to see higher energy prices, higher food prices and higher import prices
Mervyn King, Bank of England chief

BBC business editor Robert Peston said that Mr King's speech to Institute of Directors members in Bristol was the gloomiest he had heard from the Bank of England governor.

"It means it's going to be a pretty difficult year with slowing economic growth, unemployment rising but the cost of money not coming down as much as businesses and consumers would like," he said.

Balancing act

The Bank of England's rate-setting Monetary Policy Committee will meet on the 6 and 7 February to decide on the direction of interest rates from their current level of 5.5%.

It confirmed it would not be making a decision before that, as the US central bank, the Fed, did on Tuesday to bolster confidence in the US economy, which is the world's largest.

Many analysts expect a rate cut at the MPC's next meeting, but Mr King's inflation concerns will prevent the Bank from making as dramatic a reduction over the coming months as the US has done.

He warned that "2008 is likely to see higher energy prices, higher food prices and, with a lower exchange rate, higher import prices, pushing inflation above the 2% target".

And he said he thought it was "possible" that consumer price inflation - measured by the Consumer Price Index (CPI) - would rise to 3% or more.

This would mean he would need to write a letter of explanation to the Treasury, possibly on more than one occasion.

Mr King is obliged to inform the government in a letter when inflation is more than one percentage point above the government's inflation target of 2%.

Expensive borrowing costs

On the other hand, Mr King warned that problems in the banking sector relating to huge losses as a result of soured investments in US sub-prime home loans mean businesses and consumers would face higher borrowing costs for the foreseeable future.

"It is likely that a less buoyant housing market will go hand-in-hand with slower growth of consumer spending," he said.

"Tighter credit conditions mean that, as a nation, we are likely to save more of our income this year than in the recent past.

"In the short run, that will slow economic activity, possibly quite sharply. And there is a risk that weaker activity and lower asset prices could result in another round of losses for banks and a further tightening of credit conditions."

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