The Bank of England may have to pump more money into Britain's fragile economy, Governor Mervyn King said on Wednesday after the central bank forecast inflation would stand well below target in two years.
Presenting the BoE's quarterly Inflation Report, King said economic recovery from the worst recession since World War Two would be slow and it would take a long time for output to return to pre-crisis levels.
That gloomy outlook did not even factor in the likelihood of fiscal policy being tightened aggressively after an election expected on May 6.
The pound fell and government bonds rallied as investors bet that it would be a long time yet before the BoE started raising interest rates from their record low of 0.5 percent and could even boost its 200 billion pound asset-purchase scheme.
"It is far too soon to conclude that no more purchases will be needed," BoE Governor Mervyn King told a news conference. "So the Committee will keep its options open, and further purchases will be made if they prove necessary to keep inflation on track to meet the target in the medium term."
The BoE paused its asset purchase scheme — quantitative easing or QE in the jargon — last month after 11 months of buying mostly gilts with newly-created money in an effort to revive an economy which only emerged from an 18-month recession at the end of 2009.
Few analysts had expected the BoE to expand the scheme further but King's comments make clear that policymakers had not decided one way or the other.
"The door to further policy action is still wide open," said Jonathan Loynes, economist at Capital Economics.
The central bank's forecasts show that inflation, which it is charged with keeping at 2 percent, would stand at around only 1.2 percent in two years — the usual policy horizon — if interest rates start going up later this year.
Inflation is shown below the target even if rates stay where they are now.
FISCAL RISKS
Economic activity, meanwhile, recovers only very slowly, with output taking until around mid-2011 to return to pre-crisis levels, according to the central bank's forecasts. GDP growth is seen at a rate of around 3.5 percent in two years' time.
"There is much uncertainty — about both the outlook for the world economy and the strength of domestic spending," said King.
Chiefly affecting the latter could be what happens to government spending and taxes after the election. The opposition Conservatives are favourites to win and have promised a budget within 50 days of taking office that would tighten policy quicker than the ruling Labour Party's plans.
Markets have been getting jittery about the prospect of a hung parliament where no party has an overall majority or the mandate to force through fiscal consolidation measures.
King said that there was enough of a political consensus on the need to reduce the deficit that he did not think such an outcome would be a big hurdle for the bank's Monetary Policy Committee.
He dismissed the notion that Britain was about to lose its 'AAA' credit rating or was in any way facing a Greek-style debt crisis, as has been alluded to by the Conservatives.
The governor also gave short shrift to suggestions he was in collusion with any political party about plans to keep interest rates low — something the Conservatives have also suggested.
"Much remains in the air, depending on what the fiscal stance will be after the forthcoming election," said Rob Carnell of ING.
"A tighter fiscal stance than implied by the pre-budget report might well see the Bank of England keeping rates on hold for far longer than markets currently expect, which should keep sterling under even more downward pressure."
