Last Wednesday, Bank of England (BOE) Governor Mervyn King released the central bank’s inflation and economic growth projections for the next two years.
The report was predictably bearish, as it was the first inflation testimony since the economy was reported to have fallen into a recession again. Here are three main points to remember from the report.
1. Inflation forecasts were revised higher… again
The central bank estimates that inflation rate would probably remain above 2.5% until 2013. It is 0.50% higher than what the BOE had previously predicted. As it turned out, the stubbornly high inflation rate was mostly caused by higher energy prices and indirect taxes. Recall that BOE Member Adam Posen hinted at this previously, when he switched his stance from more quantitative easing” to “no more quantitative easing.”
If the BOE’s forecasts come true, then 2013 will be the eighth straight year that the inflation rate has gone above the central bank’s 2% mandate. It seems that the Monetary Policy Committee members don’t really care much about a high inflation rate when determining monetary policy. This is quite odd considering they constantly claim that the inflation rate is the main driver behind their decisions.
2. Lower growth rate for the U.K.
In addition to a higher inflation rate, the central bank also changed its GDP estimates. Instead of growing at a pace of 1.95% for the fourth quarter, the BOE believes that the economy would only expand by 1.25%. In addition, the BOE predicts that growth would only be at 2.6% in two years and not 3.0% as it had previously predicted.
Apparently, the revival in consumer spending that the BOE was hoping for was slower than it had initially expected. The persistent level of inflation put downward pressure on consumers’ purchasing power, which hurt growth.
3. The BOE has been preparing for a disorderly resolution in the euro zone
Come to think of it, what central bank worth its salt hasn’t been? Mervyn said that the BOE has been drafting contingency plans for quite some time now, as they believe that the U.K. is facing “turbulent waters with a risk of a storm” from the euro region.
Mervyn added that the possibility of a disorderly resolution in the euro zone debt crisis has already weighed on asset prices, bank funding costs, and overall economic confidence. In fact, he also indicated that even if an actual disorderly resolution is avoided, the mere possibility of it happening will be enough to dampen investor confidence.
The bearish reports got many analysts thinking that while high inflation is keeping the BOE from adding to its asset purchases, it won’t take much to tip the scale in favor of more QE, especially if growth disappoints further.
This is probably why the pound got sold heavily minutes after the report was released. EUR/GBP had shot up from its 3 ½ -year lows and stayed near its intraday highs before it ended the day 31 pips higher than its daily open price.
Predictions for QE aren’t set in stone though. On Tuesday next week, market players are going to pay close attention to the U.K.’s CPI report to see just how stubborn high consumer prices are.
On Wednesday next week, we’ll also get hold of the MPC meeting minutes, which will shed light on just how many central bankers had argued for more QE. Did anyone take the place of Adam Posen in the hawk camp? If the MPC shows signs of wavering from its no-additional-QE stance, then we might see more losses for the pound.