LONDON (Reuters) - The Bank of England cut its growth forecasts on Wednesday, left the door open for a second bout of quantitative easing and signalled interest rates will stay at record lows for a long while to come.
Bank Governor Mervyn King stopped short of following the U.S. Federal Reserve, which said it was likely to leave rates near zero for another two years, committing neither to keep rates on hold indefinitely or to conduct further government bond purchases with new money.
But he did say British growth faced major downward risks — especially if the euro zone debt crisis worsens — and market endorsed forecasts that pencil in barely any rate increases before the end of next year.
“Since we last met, the mood in markets has taken a sharp turn for the worse,” King told a news conference. “There are a number of headwinds to world and domestic growth over the forecast period, not least the public and private debt overhang, and these headwinds are becoming stronger by the day.”
The Fed, as well as its comments on rates, said on Tuesday it would also consider further steps to help growth, while the European Central Bank overcame some internal opposition to begin buying the bonds of debt-laden Italy and Spain this week.
King would not make a two-year commitment on rates but noted that markets were already pricing in only one quarter-point rate rise by the end of 2012.
That, and his emphasis on the downside risks, pushed 10-year government bond yields to a record lows of barely 2.5 percent.
“The tone of the report is much softer than we expected,” said Jens Larsen, economist at Royal Bank of Canada. “The MPC comes very close to endorsing current market (rate) expectations ... and the report also brings back the prospect of further asset purchases.”
Economists at Royal Bank of Scotland estimate there is now a 40 percent chance of more quantitative easing next year, while RBC views it more as an option if the euro zone crisis deepens markedly.
The Bank bought 200 billion pounds of government bonds with newly created money between March 2009 and February 2010, and King said that further asset purchases could still prove effective in a crisis.
“We are not out of tools,” he said.
But he warned that monetary policy could only do so much to relieve the pain of the economic reforms needed after the financial crisis.
“There are limits to what monetary policy can do. There are significant adjustments that have to be made in every major economy, not just the UK,” he said.
The Bank forecast that inflation would peak around 5 percent later this year — the same as it predicted in May — before falling steadily to 1.8 percent in two years time, a shade lower than it expected three months ago.
Upside risks remain to the forecast, but the Bank sees a stronger chance that it will meet its 2 percent inflation target within the next two years than it did three months ago.
This fall in the inflation forecast comes despite the fact that much less monetary tightening is factored into the Bank’s forecasts than in its May projections.
Short-term market interest rates are only predicted to rise to 0.8 percent by the end of 2012 — implying just one quarter point increase in official rates, compared to a 1.7 percent rate in May’s forecast.
There appeared to be more consensus on the 9-member Monetary Policy Committee than three months ago, with the report noting “a range of views” about the outlook on growth and inflation, rather than the “wider than usual” range referred to in May.
The Bank said there were substantial downside risks to Britain’s economic recovery, the biggest of which came from the euro zone fiscal crisis.
“Were they to crystallise, the risks emanating from the euro area have the potential to have a significant impact on the UK economy,” the Bank said. The damage caused was hard to quantify, and therefore could not be fully factored into forecasts.
Nonetheless, it still cut its growth forecast for 2011, and to a lesser degree, going forward. By the fourth quarter of 2011, the Bank now sees an annual rate of growth of 2.0 percent, down from 2.5 percent in May — translating to full-year growth for 2011 of about 1.4 percent.
Growth is likely to be a little over 2 percent next year, and after two years, it is forecast to be running at an annual rate of around 2.7 percent, a fraction lower than in May’s forecasts.
But the Bank still sees the economy struggling to make up the ground lost in the 2008-09 recession, with a growing likelihood that there has been lasting damage.
“The MPC continue to expect that the level of GDP in coming years will stay far short of the pre-recession trend,” said Citi economist Michael Saunders. “In other words there has been a sizeable and lasting loss of potential GDP, implying a permanent erosion of living standards.”
Addtional reporting by Matt Falloon, Olesya Dmitracova and Peter Griffiths; editing by Mike Peacock