King Signals U.K. Inflation Is ‘Obstruction’ to More Stimulus

Bank of England Governor Mervyn King
Mervyn King’s forecast for persistent inflation led economists to speculate that policy makers are reversing their shift toward adding more stimulus . Photographer: Chris Ratcliife/Bloomberg

Bank of England Governor Mervyn King’s forecast for persistent inflation led economists to speculate that policy makers are reversing their shift toward adding more stimulus.

King yesterday unveiled officials’ higher predictions for inflation next year and said it is equally likely to exceed or undershoot the 2 percent target in two years. With evidence the bank is becoming more concerned on consumer prices after fretting about the threat of deflation since 2008, the pound climbed and the 10-year gilt yield rose the most in six months.

“The thing that surprised the market was the near-term inflation projection,” said Alan Clarke, an economist at BNP Paribas in London. “The door is open to more quantitative easing, but the near-term inflation is a massive obstruction. The risks are QE could be delayed or cancelled.”

With inflation above the government’s 3 percent limit and economic growth rebounding in the strongest two consecutive quarters for a decade, the Bank of England last week declined to follow the U.S. Federal Reserve in adding stimulus. That halted U.K. policy makers’ creep toward extending aid after a widening debate that King described yesterday as “vigorous.”

The bank’s forecasts showed inflation, at 3.1 percent in September, may stay above the goal through 2011 because of an increase in sales taxes and higher commodity costs. It suggested the recovery can weather Prime Minister David Cameron’s budget squeeze that will cut 490,000 public-sector jobs.

King said that there is a “high probability” inflation will exceed the 3 percent limit long enough for him to have to write a letter of explanation to finance minister George Osborne after three sent so far this year.

Market Reaction

The pound rose as much as 0.8 percent against the dollar after the release of the inflation report and was at $1.6084 as of 5.30 p.m. yesterday in London. The yield on the benchmark 10-year government bond gained the most since May 7, climbing as much as 15 basis points, and closed at 3.156 percent. The U.K. 10-year breakeven rate rose 4 basis points to 290 basis points, the biggest one-day gain since Oct. 12.

“It’s a sea change” relative to the previous reports during and after the recession, said David Tinsley, an economist at National Australia Bank in London and a former Bank of England official. Compared with previous inflation reports in the past year “where markets had been surprised on the dovish side,” it was “the reverse this time,” he said.

The central bank said its near-term inflation forecast is higher compared with its last quarterly economic predictions released in August, and that consumer-price growth will exceed the goal through 2011. The bank also said it “stood ready to respond in either direction as the balance of risks evolved.”

BOE Split

The bank’s nine-member Monetary Policy Committee last week kept its bond-purchase plan at 200 billion pounds ($321 billion) and its interest rate at a record low of 0.5 percent. Officials said in October that further stimulus was becoming more likely. They split three ways as Andrew Sentance called for higher interest rates to combat inflation, Adam Posen pushed for more stimulus to sustain the recovery, and the rest sought no change.

“It sounds as though the dovish caucus of the committee is quite a bit smaller than we thought and King is a bit less dovish,” said Neville Hill, an economist at Credit Suisse Group AG in London and a former U.K. Treasury official. “There needs to be a clear perception that the economy has deteriorated seriously from where we were in order to see more QE.”

While the economy expanded 0.8 percent in the third quarter, more than economists forecast, there have still been some signs that the recovery may be faltering even before the government’s budget cuts take effect.

‘Challenging’ Environment

Retail sales unexpectedly fell in September and jobless claims rose the most in eight months. The Bank of England says that the housing market has shown “a weakening in demand” and J Sainsbury Plc, the U.K.’s third-biggest supermarket company, said yesterday that it expects the “economic environment to remain challenging.”

“The growth risks are still immense and we shouldn’t just suddenly start moving from dove to hawk,” said Brian Hilliard, an economist at Societe Generale in London and a former central bank official. Still, yesterday’s report caused a “washing out” among investors of “the hope or expectation in the short term of more QE.”

National Australia Bank’s Tinsley said the Bank of England’s shift may continue in the coming months as it raises its inflation forecast again to re-establish “credibility” with investors.

“They’ve consistently underestimated inflation,” he said. “We’d been saying that they wouldn’t do more quantitative easing” and the bank’s report “further underlines that.”

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