British inflation will fall well below its 2 per cent target in two years, even if interest rates remain at record lows, the Bank of England said today, leaving room for more policy easing if the economy worsens.
The BoE said economic prospects were "highly uncertain" and it was ready to move policy in either direction.
But a downward revision to growth forecasts in its August Inflation Report and a dovish tone from Governor Mervyn King reinforced analysts' expectations that interest rates will stay at 0.5 per cent for some time to come.
Ten-year gilt yields fell to a 16-month low and sterling fell against the euro after the release of the report, as investors bet that more monetary easing was possible given the downside risks to the economy.
"There are clearly risks," Mr King told a news conference. "Business and consumer sentiment have shown signs of softening, measures of financial fragility remain elevated and there is great uncertainty about the outlook for both the United States and our most important trading partner, the euro area."
Yesterday, the Federal Reserve gave a sombre assessment of the US economic outlook and said it would reinvest the proceeds from its mortgage-backed securities portfolio into US government bonds.
Mr King said he viewed this decision as an attempt to avoid inadvertent policy tightening as bonds matured.
The BoE sharply revised up its 2011 inflation forecasts, but said price growth would slow rapidly to around 1.4 per cent the following year when a January 1 2011 increase in value-added tax drops out of annual comparisons.
This end-point was broadly similar to the two-year forecast in May's Inflation Report.
Growth is expected to be slower - seen at a rate of just over 3 per cent in two years time - because of the severe fiscal tightening announced in the government's June budget, weaker business and consumer sentiment and credit conditions remaining tighter than the central bank had expected.
"Looking ahead, the UK economy is facing a major rebalancing away from private and public consumption and towards net exports. Achieving that rebalancing, while confronting these headwinds, is likely to mean a choppy recovery," Mr King said.
The BoE left interest rates at 0.5 per cent last week and maintained its £200 billion quantitative easing programme which had pumped money into the economy until early this year.
"This is a pretty dovish report which suggests that the Bank is unlikely to raise interest rates any time soon. And if it acts at all in the near term, it is more likely to revive quantitative easing," said Howard Archer, chief UK economist at IHS Global Insight.
In May, the central bank had predicted growth of around 3.6 per cent at its two year forecasting horizon.
Nonetheless, the new, lower growth forecast is still well above that of most private sector economists and the government's quasi-independent fiscal watchdog, the Office for Budget Responsibility.
Reuters