BoE Puts British Economy on Danger Watch

Bank of England governor, Mervyn King, warned of impending threats to the economy, including the risk of inflation due to energy and commodity prices

Mervyn King, the Governor of the Bank of England, yesterday issued his starkest warning yet of the dangers facing the British economy, amid fears of a worsening of the global credit crisis and threats to both domestic inflation and growth.

Mr King warned MPs on the House of Commons Treasury Select Committee of "rather uncomfortable" times ahead, with a "big risk" that the credit squeeze could intensify. He said the "sheer uncertainty" and fear of what lies ahead among US banks in particular was driving wholesale interest rates back up to levels seen at the height of the summer credit crises.

Mr King added: "In recent months, the near-term outlook for both inflation and growth has become less benign." He also had a particular word of caution for those in the property market. "For the UK, the consequences of [turmoil in financial markets] are difficult to assess and are likely to be evident first in the housing and commercial property markets."

The immediate challenge facing the Bank and its Monetary Policy Committee is where to set interest rates, with the MPC due to meet next Thursday. The bank has already indicated, in its Nov-ember Inflation Report, that it expects to follow the path indicated by market rates for the next year and a quarter, which would bring interest rates down by more than 1 percentage point, to around 5 per cent in early 2009.

The question is one of timing, with City expectations running at about 60/40 against the chances of a quarter percentage point reduction in the policy rate next week, and the delicacy of the MPC's task was acknowledged yesterday by the Governor.

"The challenge for the MPC is that inflation may rise in the near-term, posing a risk to inflation expectations, and could fall below target further ahead in the event of a sharp slowing in output growth," Mr King said. "There is certainly a risk, particularly given the elevated level of inflation expectations, that it [the MPC] will not be able to keep inflation close to the target in the wake of these further increases in commodity and energy prices. There are risks to inflation, there's no doubt about that. We're trying to balance the risks to inflation with the downside risk if activity slows sharply."

David Blanchflower, an external member of the MPC also giving evidence to the MPs, voiced a concern that the Bank should "get ahead of the curve". Mr Blanchflower is regarded as a "doveish" figure in bank circles, and voted for a reduction in interest rates last month, finding himself in a minority of two with the Bank's Deputy Governor for Financial Stability, Sir John Gieve.

Mr Blanchflower put the probability of an American recession at 50/50. His warn-ing came as the White House lowered its economic growth forecasts for 2008. The White House said the effect of problems in the housing and credit markets, and high oil prices, would be to reduce growth next year to 2.7 per cent from the 3.1 per cent it had previously hoped for.

The Bank of England is also concerned about other international factors, such as the failure of the Chinese government to revalue the renminbi. This has meant that the brunt of the adjustment in the American trade deficit has fallen on to other currencies, principally the euro, and made the task of dealing with global economic imbalances more difficult.

Mr King warned: "That's not an easy thing to try to bring about when the flexibility of exchange rates is blocked somewhat by a reluctance of one part of the system to have flexible exchange rates at the same time as another part of the world economy does have flexible exchange rates."

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