Page last updated at 17:45 GMT, Wednesday, 12 November 2008

Bank warns of recession into 2009

Mervyn King on the continuing economic gloom

The Bank of England says the UK has probably entered a recession in the middle of 2008 and is likely to continue to contract well into 2009.

In its quarterly inflation report, the Bank warns that the economic landscape has changed dramatically since August.

It says that the UK economy could shrink by 2% over the next year, much worse than its previous forecast.

Bank governor Mervyn King also said the Bank would be prepared to cut interest rates further if needed.

"[It is] very difficult to know precisely how long we'll be in recession," Mr King said. "I think we probably are in recession now."

The Bank now also expects inflation to decline to 1% by 2010, below its 2% target, in a dramatic change to its last forecast.

This would mean that the Bank had scope for further rate cuts in order to maintain inflation at its target rate in two years' time.

'Unprecedented'

"This is a difficult and unprecedented time, but we will come through this," Governor Mervyn King said.

GDP projections
The unambiguous message of this chart is that there will be a fairly painful recession in 2009
Robert Peston, BBC business editor

"We will come out of recession and get back to a period of low and steady inflation and economic growth."

His comments came after unemployment hit an 11-year high, while the pound fell further on international markets.

The Bank of England's central projection is for the economy to contract sharply next year - although this may change if the government introduces further fiscal stimulus to the economy.

Ross Walker of the Royal Bank of Scotland told the BBC that markets were surprised by how big a fall in inflation the Bank of England had projected, and said he now expected another rate cut in December of at least 0.5%.

"Conditions are going to get worse before they get better," he added.

Financial crisis

The governor said: "we have seen the biggest banking crisis since World War I", coupled with a dramatic fall in business and consumer confidence, and very sharp drops in commodity prices.

Inflation projections

Last week, the Bank of England cut UK rates from 4.5% to 3%, a much more dramatic reduction than had been expected.

Mr King said that the Bank had acted to cut rates so sharply "because the facts had changed" and rejected criticism that it was caught unawares by the crisis.

Markets are now expecting rates to go below 2% within a year, the lowest Bank of England interest rate since it was set up in 1694.

And the governor admitted that Retail Price Index inflation, which includes housing costs, could actually become negative as interest rates fell.

Prices are expected to fall largely thanks to the steep decline in oil prices. They have already fallen to below $60, a cut of more than half since their peak in the summer.

A long recession?

Deputy governor Charles Bean said that the contraction in the UK economy would be broadly similar to the declines seen in Sweden, Finland and Norway in the 1990s, which were deep but relatively short-lived.

We are certainly prepared to cut Bank rate again if that proves to be necessary
Bank of England Governor, Mervyn King

He pointed out that the early moves to recapitalise the banking sector should help to limit the depth of the recession - in contrast to the situation in Japan, where a slow response from government extended the recession.

He also said that the 20% decline in the value of sterling could help boost exports and pull the economy out of recession.

The governor, however, pointed out that too great a fall in the pound could lead to further inflation in the future.

Fiscal stimulus

Governments around the world have pledged to spend billions to protect their financial systems and boost their economies since the credit crisis took hold.

Mr King said that there was a stronger argument for fiscal stimulus than previously, because the banking crisis had meant that monetary policy was less likely to be effective.

But he warned that any short-term fiscal stimulus had to be temporary and consistent with the long-term path of fiscal discipline.

Otherwise, he warned, long-term interest rates would rise, undoing some of the effects of any economic boost.

In the House of Commons, Prime Minister Gordon Brown said that he had to employ "very special means to deal with special circumstances" and said that a worldwide fiscal stimulus was needed to counteract the slowdown.

The government is expected to announce its new spending plans on 24 November in the Pre-Budget Report.

International agreement

Mr King said that a new international agreement on regulating the world financial system was important for a long-term resolution of the crisis.

He said that he was hopeful that the meeting of world leaders in Washington at the weekend could make a useful start on a "process of reform" that would take some months.

The governor said that the objective should be to ensure that countries which had capital surpluses, such as China, also had an obligation to take action to correct financial imbalances.

And he added that this was exactly the problem that the economist John Maynard Keynes had identified when the system of international financial rules were set up in 1944 at Bretton Woods.



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