BOE Inflation Report: Downward Revision in Growth and Inflation Forecast, More Easing Highly Likely

At the February Inflation Report, the BOE unveiled downside risks to economic recovery. The MPC members believed that growth in the United Kingdom has been and will continue to be driven by the considerable stimulus from the easing in monetary policy, global growth and depreciation of sterling. However, spare capacity is likely to persist over the forecast period, weighing on the general price level.

The MPC revised down the growth forecasts to about +3.2% yoy in the second quarter of 2011, compared with about 4% previously.

Concerning inflation, the MPC said that recent overshoot in inflation was due to strong energy prices and a return of VAT to 17.5% from 15% in the beginning of the year. CPI inflation is expected to be below the +2% target for most of the time in the forecast period. The central bank forecasts its consumer price index at around +1.2% in the beginning of 2012, assuming market interest rate will increase in 3Q10.

We worry that the MPC may have underestimated inflationary pressure in the UK. In fact, before the VAT hike in January, CPI excluding energy, tobacco and food surged +2.8% yoy in December, This was the biggest rise since 1997, suggesting underlying inflation has been strong.

At the press conference, Governor Mervyn King said ‘It is far too soon to conclude that no more purchases will be needed…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’, February’s pause in expansion of the asset purchase program does not mean the end of the QE.

GBP plunged while gilts surged after the report as it indicated the government will not be exiting its expansionary measures anytime soon. In there’s rising possibility that the BOE may leave its policy rate unchanged for the while 2010 while more stimulus measures will be implemented.