UK economy set for 'painful adjustment', say Banks

Bank of England governor Mervyn King today warned of a period of economic stagnation as the UK goes "through a difficult and painful adjustment".

Projections from the Bank show output broadly flat during the next year, but City economists said with inflation set to remain above target for some time it was unlikely that interest rates would come down in the near future.

The Bank's assessment of the UK economy is much gloomier than in May's quarterly report, amid weaker prospects for consumer spending and investment.

Mr King did not rule out the possibility that the UK could enter a period of recession, as defined by two successive quarters of negative growth.

He said that with economic growth forecast to be broadly flat, it was "bound to be the case that there's a quarter or two of negative growth".

The Bank's report said with no rate cuts in the next two years, inflation would most likely peak at just below 5% in the coming months before falling sharply next year and dipping below the official 2% target in two years' time.

Mr King said: "The adjustment of the UK economy to higher commodity prices and a more realistic pricing of credit will be painful.

"The next year will be a difficult one, with inflation high and output broadly flat. But with monetary policy focused on its task of bringing inflation back to the target, we will come through the adjustment.

"And we will return, if not to the 'nice' decade, then at least one that, as central bankers say, is not so bad."

Rising food and energy prices yesterday pushed up CPI inflation to 4.4% in July. The Bank warned today there were serious upside risks to its projections, particularly from rising energy bills and wage growth.

Global Insight chief economist Howard Archer said: "Although the report dilutes fears that the Bank of England will raise interest rates, it also suggests that any cuts will be some time off as the Bank is determined to show its commitment to bringing inflation down to 2%.

"While we would not rule out a cut in November - particularly if the economy slows markedly further and oil prices continue to retreat - we are maintaining our view that interest rates will stay at 5% until early 2009.

Economists at Royal Bank of Scotland said the projections in today's report pointed to economic growth of 1.5% this year, down from previous estimates of 2%, while expectations for 2009 fell to about 0.75% from 1.5%.

They noted the Bank expected a return to growth in the third quarter of 2009, with a similar improvement in the following quarter.

RBS said: "The balance of risks surrounding the central projection is judged to be on the downside - so implicitly, technical recession is more likely than not."

Mr King said the increases in food and energy bills were expected to intensify the squeeze on take-home pay in real terms, with many households unlikely to see any growth this year.

He added: "The British economy is going through a difficult and painful adjustment - to higher energy and commodity prices, and in banking, credit and housing markets.

"This adjustment to our economy cannot be avoided. And as a result, inflation is rising and growth is slowing."

However, he said the growth rate of real take-home pay should recover as food and domestic energy prices stabilised.

British shadow treasury chief secretary Philip Hammond said: "Mervyn King has given us a frank assessment of Britain's economic prospects - in marked contrast to the tired mantra from [UK prime minister] Gordon Brown that Britain is well prepared for the economic downturn.

"Today we have had a triple dose of bad economic news - inflation forecast to hit 5%, economic growth at a standstill and unemployment rising at its fastest rate since 1992.

"Gordon Brown failed to prepare our economy for this slowdown. Instead of hiding in his bunker, it's time he was straight with people about the problems we are facing."

Liberal Democrat spokesman Vince Cable said the report was an "obituary" to Brown's economic credibility.

He said: "This report gives added authority to other forecasts which suggest next year will be truly dreadful.

"With no growth and inflation running higher than at present levels, we can expect to see a squeeze on living standards and rising unemployment.

"The Bank of England is undoubtedly right to hold out the prospect of improved conditions in two years time, providing that interest rate discipline is maintained.

"However, it is very difficult to see how a weakening government with minimal political authority is going to stagger though next year, when economic conditions are deteriorating.

"This report reads like an obituary for Gordon Brown's economic credibility."