Page last updated at 16:58 GMT, Wednesday, 14 May 2008 17:58 UK

UK inflation woe 'set to worsen'

Bank of England governor Mervyn King

The outlook for UK inflation has "deteriorated markedly", the Bank of England governor Mervyn King has said.

Government figures on Tuesday showed that the rate of consumer inflation reached its highest level in 13 months driven by high food and fuel costs.

Mr King said inflation would probably stay above the government target of 2% for two years, hampering the economy.

He added that house prices were set to fall further, though no one could be certain how far they would decline.

'Tricky position'

Mr King also spoke of the difficult balancing act the Bank had in juggling a slowing economy and accelerating inflation.

"The balancing act faced by the Monetary Policy Committee (MPC) is even more challenging than it was in February," he said as the Bank presented its latest quarterly inflation report.

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"The MPC is facing its most difficult challenge yet. For the time being at least, the nice decade is behind us."

The state of the economy has put the Bank of England in "a tricky position, to put it mildly", says BBC business editor Robert Peston.

If the Bank keeps rates where they are, then the outlook for growth will be dismal and the UK could be tipped into recession.

If it cut rates, then its credibility as a "crusader against the wickedness of inflation" could be severely damaged, especially as it expects inflation to be well above target later this year, our business editor adds.

Consumer squeeze

Mr King said that external factors, such as high food and fuel prices, and problems in the global financial markets and the subsequent credit crunch, were hitting the UK and would have a noticeable impact on the economy.

"The central projection is for growth to slow sharply in the near term," he said.

We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot and should not try to prevent that adjustment
Mervyn King,
Bank of England governor

While he was expecting growth to rebound in 2009, there would be a squeeze on living standards for many people living in the UK.

"The credit cycle has turned, commodity prices are rising," he explained.

"We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot and should not try to prevent that adjustment.

"The MPC must focus on bringing inflation back to the target in the medium term."

Eventually, the UK economy would absorb the problems and bounce back, helped by a weaker pound and easier access to financing in the global financial markets, he said.

Mr King explained that the slowdown in the economy would reflect a squeeze in real incomes, before credit conditions began to ease and the depreciation of sterling started to boost exports and reduce imports.

However, Mr King warned that that "the balance of risks to the outlook for growth is to the downside in the medium term".

Credit crunch

Speaking about the problems in the global financial markets, Mr King said that financial organisations and banks were in the process of rethinking how they operate.

"In some ways we're only beginning to see the difficulties that have faced banks feed through now to conditions in the credit markets for companies and for households," he said. "We are reverting to a more sensible and prudent approach to lending and borrowing," he added.

A simple guide to inflation by Richard Scott

Referring to a plan that would let UK banks swap problem mortgages for some 50bn of government bonds, Mr King said it had been successful "so far, but it will take a long time before its effects feed through".

The Bank of England hopes the scheme will encourage banks to lend to each other again and also to homeowners, easing the credit crunch that has started to affect consumers and their spending patterns.

"It will take time to rebuild that sense of confidence in the banking system and during that period credit conditions will be more difficult than they would normally be," he said.

"I think the events of the last six to nine months are not ones that people will forget in a hurry."




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