May 19, 2008	Monday	Jamadi-ul-Awwal 13, 1429

The Bank of England in its Inflation Report last week warned that the British economy is heading towards a recession. However, other indepdenent economists see a serious bout of stagflation round the corner as production is slowing down visibly at a time when inflation rate is threatening to hit four per cent against the annual target of two per cent.

”As those price increases feed through to household bills, they will lead to a squeeze on real take-home pay, which will slow consumer spending and output growth, perhaps sharply,” Marvyn King BoE governor said.

King for the first time refused to rule out the prospect of a recession, saying that “one or two quarters” of falling output were possible as consumers suffered rising prices and the credit crunch. He blamed increasing food and fuel prices for the rising cost of living.

King has also delivered a pessimistic assessment of the prospects for 2008 and 2009, warning that growth would slip to around one per cent by the end of this year while inflation would climb close to four per cent. The rising inflationary trend is expected to limit the bank’s ability to ease the pain on consumers by cutting interest rates.

The bank report’s main projection is for growth to slow sharply in the near term, reflecting the squeeze on real incomes, before recovering as credit conditions begin to ease and the depreciation of sterling boosts exports and reduces imports.

King has also warned that family budgets could remain under pressure right up until the next election. “Real take-home pay has not risen by much in the past four years - by well below one per cent a year. The next couple of years are going to see at least as great a squeeze on living standards that will erode purchasing power.”

The combination of stagnant output and high inflation not seen for decades is set to haunt policy makers for months if not years to come.

In April, consumer price inflation hit three per cent, well above the official target rate of two per cent, and a couple of points away from the level at which the Governor of the Bank of England, Mervyn King, is obliged to write an open letter to the Chancellor of the Exchequer explaining the failure of policy.

The jump, from 2.5 per cent last month, is the most dramatic since 2002. The retail price index, which includes housing costs, rose to four per cent, up from 3.8 per cent the previous month. Increases in the sort of basic items that families have to buy were the highest. Food is 7.2 per cent up on a year ago, with analysts expecting 10 per cent inflation in a few months. And it’s the essentials that are up the most – bread by 13 per cent, butter by 32. 2 per cent and eggs by a third. The increase in food prices is the fastest since 1990.

The 15 per cent decline in the value of sterling has exacerbated inflationary pressures. The fall is hitting living standards, especially for pensioners and the poorest.

Electricity bills are 8.3 per cent higher and gas up 3.7 per cent. Heating oil is a staggering 59.4 per cent more expensive than this time last year. Last week, British Gas became the latest energy supplier to threaten yet more price rises by the end of the year, having raised its tariffs by 15 per cent in January. Average household gas bills could top £1,000 in 2008. The average price of petrol rose by 1.9p per litre between March and April this year, with diesel up by 4.2p a litre.

Most ominously, this week saw a sharp rise in the number of “forced sales”, consistent with last week’s poor news on repossessions of houses. The accidental leak by the Housing Minister, Caroline Flint, of an expectation of a five to 10 per cent decline in house prices is being regarded as optimistic by some standards.

“We still think interest rates will eventually fall considerably further as the economy continues to weaken and inflation concerns finally fade. But a June cut now looks pretty unlikely and any further loosening will be modest in the foreseeable future - seriously bad news for the economy,” said Jonathan Loynes, Chief European Economist of Capital Economics, a London-based research company.

The CPI forecast based on market interest rate expectations - of rates falling to around 4.5 per cent - has been revised up sharply from February’s Report, now peaking at close to four per cent at the end of this year and remaining above three per cent for a number of quarters - suggesting that King will have to write a number of explanatory letters to the Chancellor.

If interest rates remained constant at five per cent, the bank projections suggest inflation would suffer a similar short-term bump but return to target early in 2010.

The report notes that the BoE’s Monetary Policy Committee concludes the balance of risks to inflation are on the upside.

However, it is also concerned about the pressures stemming from higher import prices, the extent to which companies will pass on higher costs to consumers, and the risk that a prolonged period of high inflation will affect decisions on wages and prices.

“We are travelling along a bumpy road as the economy rebalances,” Mr King said. “Monetary policy cannot, and should not try to, prevent that adjustment.”