Bank downgrades UK growth forecasts

A continued surge in energy prices - including the cost of crude oil and soaring utility bills - will hit growth and increase the cost of living in 2011 and 2012, the Bank warned.

The rate of inflation, currently at 4%, is now expected to hit 5% this year and remain above the Government target throughout 2012 before falling back in 2013 - but only if interest rates rise in line with market expectations from the third quarter of this year.

Bank governor Mervyn King warned inflation remains “volatile” and warned the outlook for the cost of living will be “unusually uncertain”.

The weak forecasts are likely to raise concerns over the strength of the UK economy in the face of Chancellor George Osborne’s fiscal squeeze.

The Bank downgraded its expectations for gross domestic product in 2011 to around 1.7%, from about 2% in its February report. In 2012, GDP is expected to be around 2.2%, from just under 3%.

The Bank said the gloomier outlook reflected the dampening effects of rising energy prices and the impact that disappointing real wages will have on consumer spending.

The report warned the Government’s fiscal consolidation - which includes £81 billion worth of spending cuts - will continue to weigh on activity over the next two years.

However, the Bank still said the “pace of the recovery was more likely than not to pick up from its recent soft patch” following tepid growth figures for the first quarter of 2011.

The Bank has forecast inflation to hit around 5% this year before falling back to about 2.5% next year and returning to target in early 2013. The report said this reflected an increase in VAT, as well as higher energy and import prices.

Triggered by political unrest in North Africa and the Middle East, the Bank forecast a 15% rise in domestic gas bills and a 10% hike in electricity in the second half of 2011 - compared with the 5% increase for gas prices signalled in its previous report.

Today’s economic forecasts are made on the assumption that interest rates, currently at an historic low of 0.5%, increase in line with market expectations, which currently show rates hitting 1% by the first quarter of next year.

Jonathan Loynes, chief European economist at Capital Economics, said: “On the face of it, the report seems to endorse expectations of some policy tightening later this year, continuing in 2012.”

However, he said weaker growth in the face of the fiscal squeeze, as well as possible falls in oil and commodity prices, could mean that inflation falls back further than the Bank expects.

Mr Loynes added: “A hike in August or later is clearly still a danger, but we stick to the view that rates won’t rise either this year or next.”

The latest downgrade to economic forecasts comes exactly a year after the formation of the coalition Government.

Mr King said he expected the recent softness in activity to be temporary, with a recovery in output likely to be driven by a rise in business investment and a positive contribution from net exports.

However, he added: “Household spending may have further to adjust to the significant squeeze in real incomes and there is substantial uncertainty over the speed at which net exports will pick up.”

Inflation is also likely to continue to show “sharp” month-to- month movements, he added.

Mr King said: “As the economy gradually recovers from a deep recession, and rebalances towards a more sustainable path, the outlook for growth and inflation is likely to remain unusually uncertain.”

He also warned there was a risk that companies will resist the squeeze inflation is having on employees’ incomes by lifting wages, which in turn will push inflation higher.

Downing Street said David Cameron had always made clear that rebuilding the economy would not be easy and that the recovery would be a “choppy” one.

The Prime Minister’s official spokesman said Mr Cameron had stressed in a speech earlier this year that the Government was not in a position to “just flick on the switch of government spending or pump the bubble back up”.

TUC general secretary Brendan Barber said: “Today’s inflation report is a clear warning signal against the Government’s deep and rapid spending cuts.

“Growth forecasts have been downgraded yet again, despite the global economic recovery.

“With the recovery weak and inflation predicted to stay above target until 2013, the big squeeze on wages looks set to continue.

“The coalition is now a year old and has a direct hand both in the weak state of our economy and the pain that is being exerted on household incomes.

“The Government must change course or its austerity measures will prolong our poor recovery and cause an even greater decline in people’s living standards.”

For Labour, shadow Treasury chief secretary Angela Eagle said the latest downgrade of the Bank’s growth forecasts showed that the Government’s economic strategy was failing.

“Cutting too deep and too fast, as this Conservative-led Government is doing, is a vicious circle,” she said.