Page last updated at 13:39 GMT, Wednesday, 12 August 2009 14:39 UK

'Fragile recovery' for UK economy

"Any 2010 recovery will be fragile"

The Bank of England has warned that the UK economy still has some way to go before it recovers from the effects of the financial crisis.

In its latest quarterly Inflation Report, the Bank warns that any recovery in 2010 will be "fragile".

The report will be bad news for the chancellor, who has predicted that the UK will rebound sharply in the future.

If it does not, then his record budget deficit of £175bn will be even bigger, with a greater need for spending cuts.

On the outlook for inflation, the Bank said it was "more likely than not" that the annual rate of growth in consumer prices would temporarily fall below 1% in the autumn and stay low until the end of its two-year forecast period.

This implies, unless something changes, that interest rates could stay at 0.5% until well into 2011, BBC economics reporter Steve Schifferes says.

'Uncertain pace'

The Bank has recently added another £50bn of new money to the economy, as part of its programme of quantitative easing (QE) to spur economic growth.

By Steve Schifferes, Economics reporter

The Bank of England is being far more downbeat about the future prospects for the economy than much of the private sector, or indeed the government.

This is because they recognise that the banks and the governments will have to further rein in their activity over the next few years to rebuild the damage caused by the credit crunch.

They also warn that although economic growth will recover by mid-2010, it will still feel like a recession to many people because economic output will take several years to return to the level it reached before the downturn hit.

And the downturn could be made worse if unemployment starts to rise sharply as more firms shed workers.

So it expects to keep interest rates low for some years to come.

Its report said there were "encouraging signs" that the steps taken to stimulate the economy had been having an impact.

However, Bank governor Mervyn King was downbeat about whether the policy had been fully effective.

He hinted that the Bank might have to consider additional measures, although he warned that with the public finances in such a perilous state, there was little room for further expansion to help boost economic growth.

"The pace of recovery over the next few years is highly uncertain," he added.

Following his comments, economists suggested the bank would inject more new money into the economy.

"More quantitative easing is on the cards," said Charles Davis from the Centre for Economics and Business Research. "Our rough and ready estimate is a further £50bn."

"The reality of a deep recession and sluggish recovery has dawned upon [the Bank], recognising that insipid growth and downward pressure on prices is the greater concern."

Deeper recession

Mr King accepted that had been some signs of short-term recovery in the last few months, and that growth may resume to its long-term average of around 2.5% to 3% by the middle of next year.

Mervyn King presents the Bank's Inflation Report
Mervyn King is still pessimistic about the prospects for the UK economy

But since its last report in May, the Bank has also revised downwards its view of how deep the recession was during the last quarter of 2008 and the first quarter of 2009.

It says that the very depth will make any sustainable recovery unlikely until banks, households and governments rebuild their balance sheets.

What this means in practical terms, says BBC economics reporter Steve Schifferes, is that it does not expect banks to resume large-scale lending for some years to come.

And the need for further cutbacks in public spending and or higher taxes will add to the deflationary pressures on the economy, our reporter adds.

Downside risks

The Bank has identified several downside risks that could make the recovery more fragile.

First, unemployment could rise even faster in the future. The Bank says that so far, unemployment has fallen more slowly than in previous recessions.

That could be because workers have become more flexible, and are willing to work shorter hours, and for lower pay, than in previous recessions.

But the report warns that "if demand does not recover sufficiently, it will become more difficult for [firms] to maintain employment."

Higher unemployment rates, in turn, could further dampen down consumer demand, and also limit the modest recovery in the housing market.

Sterling fears

In relation to inflation, the main pressure pushing inflation upwards has been the effective 20% devaluation of sterling since the financial crisis began.

This has helped manufacturers by making their products cheaper abroad, but it has raised the prices of imported goods sold in the UK.

This effect has been modest so far, because the weakness in the economy has prevented firms from raising prices - but if there was a sustained recovery, a further fall in sterling which raised inflation would force the bank to raise interest rates.

This seems some distance away, however, as the Bank's current projections for inflation suggest it will still be under its 2% target in two years' time - suggesting that interest rates will stay at around 0.5% for a long time to come.

In addition, the governor refused to be drawn on whether he regarded the Conservatives' plans to hand over regulatory powers to the bank as a good thing.

But he did warn against any "half-baked" schemes of financial reform being adopted at the upcoming G20 summit.

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