Mervyn predicts inflation-free zone

By Hugh Pym
Economics editor, BBC News

Mervyn King is prepared to cut interest rates still further

The governor of the Bank of England painted a picture of the UK's economic landscape next year which could hardly be more different from the outlook prevailing in the earlier part of this year.

High inflation caused by rocketing food and energy bills will give way to deflation and falling prices.

A cost of borrowing at more than 5% will seem like ancient history when interest rates fall close to zero.

Mervyn King was sketching the outlines implied by the charts in the Bank of England's latest Inflation Report.

He stressed that there had been the biggest fall in inflation predictions over three months (when the last Report was published) in the history of the Monetary Policy Committee. Plunging oil and commodity prices had transformed the outlook.

Consumers may find it hard to get their heads around this concept. Prices in supermarkets seem to have been going up relentlessly.

What about those gas and electricity bills? And isn't it a nightmare paying to fill up on the forecourt?

But with bewildering speed, the story of the first half of 2008 is giving way to the story of the next year or more.

Turning negative

The new narrative sees utility bills falling rapidly, declining wheat and feedstuff costs flowing through to lower prices in the grocer's, and pump prices falling.

The net result of all this, according to Bank, is that inflation will fall rapidly from its current level of 5.2%. It could fall close to zero on the main target measure, the Consumer Prices Index (CPI).

On the wider measure, RPI, which includes mortgage payments, it could fall below zero.

Negative inflation - the governor himself said as much. Another word for it is deflation.

That's not a problem if it lasts no more than a few months (the most recent experience of something similar was in 1960 and that was no disaster).

Deflation becomes a serious issue if it becomes embedded and a spiral of declining prices and activity develops.

Recession looms

Along with very low or negative inflation will go record low interest rates. The governor made it plain that the Bank was ready to cut official rates below the current 3% level.

The UK has never seen the cost of borrowing fall below 2%. There was a strong hint we could go there sometime next year. The Bank of England's hope is that further interest rate cuts will help the economy recover.

So far, not too bad, you might say. Falling prices in the shops and ultra-low interest rates - sounds OK? But it goes with a probable recession lasting a year or more.

Unemployment, underlined by the latest big increase announced today, is already at its highest in 11 years and set to rise further. From 1.82 million now, many experts predict it could get to two million by the New Year.

Lower retail prices will not be much of a comfort to the hundreds of thousands of extra people who find themselves out of work over the next few months.