THE governor of the Bank of England has said inflation could turn negative in the spring and that interest rates could fall even further than the current historic low.
Publishing the Bank’s latest forecasts yesterday, Mark Carney said the consumer price index (CPI) measure of inflation was “more likely than not” to turn negative. He said the bank’s monetary policy committee (MPC) stood ready to cut interest rates or re-start its money-printing programme if deflation or very low inflation were to set in.
However, the pound rose as the governor added: “Unusual as that [deflation] is, it arguably isn’t the main story. The headlines today mask stronger underlying dynamics which will determine UK output and inflation tomorrow.”
He also emphasised the strength of the UK’s economic growth and said that a gradual rise in interest rates over the next two years was still the more likely outcome.
Mr Carney said the MPC would look through the current low figures, which are being caused by a slump in oil and food prices, and that rate rises may even be speeded up if the boost to growth from increased spending power causes prices to bounce back faster than previously expected.
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He said: “The combination of rising wages and falling energy and food prices will help household finances and boost the growth of real take-home pay this year to its fastest rate in a decade. This will support solid growth in consumer spending.”
The Bank’s quarterly inflation report nudged up expectations for CPI at the end of the coming three-year period, predicting the factors currently pushing it lower would fade and lifting forecasts for wages and economic growth.
As a consequence, the pound climbed to a seven-year high against the euro – a sign that currency dealers expect an earlier UK rate hike.
The forecast for inflation in the next few years contrasted with near-term predictions, suggesting CPI would average around zero in the second and third quarters of this year, before starting to climb.
Although rare in modern times, falling prices, or deflation, is widely feared by economists, who cite Japan’s “lost decades” of stagnation and the possibility that consumers will delay making purchases because they think goods will become cheaper, causing a damaging negative spiral.
Mr Carney said the current period of low inflation was positive for the economy, and that a short period of declining prices should not be defined as deflation at all.
But he indicated that should it prove more persistent than currently expected and threaten a “self-reinforcing” spiral, the MPC would need to provide “more support”.
This could include an expansion of its £375 billion money printing programme, known as quantitative easing, or a cut in interest rates further towards zero from the current rate of 0.5 per cent.
In the eurozone, which has already fallen into deflation, base interest rates are now negative.
The latest official figures showed Britain’s CPI fell to 0.5 per cent in December, equalling an all-time low and obliging Mr Carney to write a letter to Chancellor George Osborne explaining why it is so far from the Bank’s 2 per cent target.
Economists struggled to interpret the latest forecasts from the Bank, most deeming it unlikely that rates will be cut further.
Rain Newton-Smith, director of economics at business group the CBI, said: “While the risk of deflation is growing, it is unlikely that we will see falling prices for a prolonged period”
But Howard Archer, chief UK economist at IHS Global Insight, said: “Critically, the Bank’s consumer price inflation forecasts show inflation moving up from the fourth quarter as the impact of falling energy and food prices drop out of the comparison.”
• Why is inflation so low?
Latest figures showed CPI inflation fell to 0.5 per cent in December, equalling its lowest level on record. The figure has been driven down by tumbling oil prices, leading to lower petrol costs, as well as the supermarket price war. There is likely to be further downward pressure as household energy tariffs are cut, meaning that the Bank of England now believes there will be a period of negative inflation, or deflation, in the spring.
• Should we be worried if inflation goes below zero?
A short period of negative inflation is likely to be beneficial for the UK economy as it would boost household spending power. However the recent drop in inflation might become more persistent and result in a lowering of inflation expectations and pay growth. Negative inflation could arrive at the time of year when a large proportion of pay claims are settled, possibly boosting the chances of a self-perpetuating deflationary spiral.
• What is the outlook for inflation?
Inflation is expected to turn negative by the spring before rising to 1.8 per cent in 2016 and 2.1 per cent in 2017. The Bank sees no signs of a deflationary spiral, with a pick up in wage growth helping to boost consumer spending.
• What’s the next move for interest rates?
Mr Carney said the Bank will cut interest rates from their record low of 0.5 per cent if inflation remains low for a prolonged period. However he admits the next move for rates is likely to be higher. The longer term projections for inflation in today’s report suggest that economists have gone too far in expecting rates not to rise until the third quarter of next year. With the Bank fairly relaxed about the prospects for deflation, experts at Capital Economics think there is a reasonable chance of a rates hike before the end of this year.
• Can interest rates go any lower?
This option is still open to the Bank, particularly as banks and building societies have beefed up their balance sheets in the wake of the financial crisis and are better able to cope with an interest rate cut. Interest rates in the eurozone have already been slashed to 0.05 per cent while cheap credit has been offered to banks to stimulate lending. Earlier today, Sweden’s central bank cut its key interest rate to a record low of minus 0.1 per cent as it also launched a programme of bond purchases to stimulate the economy.