Lower and slower

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The Inflation report points to lower inflation and slower economic growth. Mervyn King sums it up:“The economy will continue to face headwinds over the forecast period… The recession in the euro area is damaging demand for our exports; a black cloud of uncertainty is hanging over investment; and the weakening euro is a further obstacle to the adjustment we need to make in our net trade position. Our efforts to bring about a rebalancing of the UK economy will require patience.”

Key points

Inflation is now expected to fall from its current level to be around or a little below target for much of the forecast period as external price pressures ease and domestic cost pressures stay muted.

Growth forecasts have been lowered across the forecast period. Growth in 2012 is now expected to be close to zero, down from 0.8% expected in May. The medium term outlook for growth has also been revised down from the May report to just over 2% for the rest of the forecast period.

Output has been volatile over the last couple of months but much of that is due to factors such as the jubilee which do not give a good indication of the underlying picture of the economy. Despite these though, output has been broadly flat over the past two years.

Household spending has been held back by weak real income growth but pressure should start to ease. Consumption is now expected to recover gently over the next year to provide moderate support for growth.

Business investment may pick up on the back of a gentle recovery in consumer spending. Further information on corporate cash balances shows that there is probably some scope for businesses to increase investment but, as we have previously suspected, whether this eventuates is difficult to anticipate and depends on how companies respond to the environment. Some interesting points:

- Two measures show that cash holdings have been increasing steadily over the past decade but it is difficult to know how much of this is held by non-financial corporations and so is available for investment.

- There are alternative uses for cash that companies may be more inclined to go with, particularly in an uncertain environment. These could include dividends, paying down debt and equity buy backs.

- A continuing of the uncertain environment may lead companies choosing to hold on to their cash to either shore up their balance sheet so they are in good position for further shocks, or to wait until the investment environment becomes more favourable.

Trade and external demand have been somewhat weak. Euro area developments are likelyto have a pervasive impact on the UKs economic prospects but a modest recovery in global demand will lead to a pickup in export growth.

Productivity growth has been surprisingly weak and is expected to recover gradually but may stay below the long-run average for much of the forecast period.

Rising bank funding costs which are feeding through to higher rates for domestic borrower on the back of the Eurozone crisis have been concerning. However, the bank expects the funding for lending scheme to reduce funding costs which could then feed through into lower lending rates. Assessment by the bank, although very uncertain, indicates that the reduction in funding costs relative to current market conditions for the major UK banks could range between around 100 to 200 basis points if these banks used the scheme to borrow and also maintained their stock of net lending.

All up, the picture suggests a lengthening of the recovery period. Mervyn King said the process of rebalancing will require patience - but it also requires action. The Government needs to have a clear plan for how it will seek to support growth and provide the right environment for businesses to grow.

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