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Britain’s fragile recovery is being plagued by high inflation, low interest rates and mayhem in the world’s financial markets Sir Mervyn King warned that the headwinds facing Britain’s fragile economic recovery were becoming “stronger by the day”, as the Bank of England cut its growth forecasts. City analysts predicted that interest rates would remain at their record low of 0.5% until 2013, after the governor used his quarterly inflation report briefing to warn that the UK could not be isolated from the turmoil in the global economy. As George Osborne, the chancellor, prepared to address the House of Commons on Thursday on the risks for the UK from the mayhem in world financial markets, the Bank’s nine-member monetary policy committee (MPC) downgraded its growth forecast to about 1.5% this year. That was down from 1.8% in its last report three months ago, and weaker than the 1.7% pencilled in by the Office for Budget Responsibility. King warned that the Bank’s number-crunchers had not included in their forecasts what he called “the unimaginable and the unmentionable” – risks impossible to quantify, such as a full-blown sovereign debt crisis in the eurozone. “It is very important that we do not see the development of a sovereign debt crisis.” For 2012, the Bank is now projecting growth of about 2%, against the OBR’s 2.5%. It expects cash-strapped consumers, hit by tax rises and rapid increases in the cost of living, to continue tightening their belts. “The squeeze in households’ real incomes is likely to continue to weigh on domestic demand, especially over the next year or so,” the MPC said in the report. “But expansionary monetary policy, prospective growth in global demand and the current level of sterling should mean that, after some near-term weakness, GDP growth picks up.” King said that the drama in the markets reflected the fact that the imbalances built up in the global economy during the boom years had still not been resolved, and the Bank would be unable to cushion the UK from the fallout. “There’s a limit to what monetary policy can do,” he said. “There are significant adjustments that need to be made.” The governor made clear that a fresh round of “quantitative easing” – the injection of electronically created money into the economy – remains an option if the situation deteriorated further. Peter Dixon, UK economist at Commerzbank, said, “unsurprisingly, Sir Mervyn King maintained his long-standing view that the BoE still had some shots in its locker, including more asset purchases if necessary.” The governor rejected the idea that the Bank could follow the US Federal Reserve and make a long-term commitment to keep interest rates at current levels, however. In a bid to calm chaotic financial markets, the Fed suggested on Tuesday that borrowing costs would remain at their current exceptionally low levels until 2013. But King argued: “I think it’s very dangerous to try to make a commitment. To lock in monetary policy now for two years does not seem to me to be particularly sensible.” He added that financial markets in Britain already expected interest rates to be held for the foreseeable future. George Buckley, chief UK economist at Deutsche Bank, noted that the Bank’s forecasts suggested that without fresh monetary stimulus, such as a new round of quantitative easing, inflation would be below the MPC’s 2% target in two years. “The Bank’s signalling may be less obvious than that of the Fed, but in its own way it is telling us that rates are likely to remain low for a long period,” added Buckley. After King’s bearish assessment, RBS joined other City banks in forecasting that there would be no rise in interest rates until 2013 at the earliest. The MPC expects inflation to peak later this year at about 5%, driven by soaring utilities bills, but to fall rapidly in 2012, as the effect of oil price rises and the VAT increase wear off. The MPC’s analysis suggested the deep recession that followed the credit crunch has left lasting scars on the economy. “Output is likely to remain significantly below its pre-recession trend,” it said, warning that even by 2014, GDP growth is only, “a little more likely to be above its historical average than below it”. Brendan Barber, TUC general secretary, said: “This recovery is already the slowest on record, and the Bank’s assessment that it may take another three years for us just to recover lost ground shows that the pain is set to continue for some time.” King said it was far too soon to say whether there was any connection between economic weakness and the riots. He stressed that the private sector had created many more jobs than had been lost through public-sector cuts over the past 12 months. ‘The unimaginable and the unmentionable’ The risks too scary for the Bank of England to calculate: Eurozone break-up As the continued sell-off in European markets makes clear, the future of the single currency looks alarmingly uncertain. Perhaps hard-hit Greece will decide it’s had enough and leave – or maybe the entire 17-member bloc will be blown apart. Middle East conflagration A worst-case scenario has the stand-off in Libya and the Syrian unrest spiral into a much wider conflict, sending world oil prices rocketing. 1930s-style protectionism As Mervyn King said, creditors and debtors – east and west, China and the US – still have to work out how to share losses from the financial crisis. The pain could be evenly shared or end in a tit-for-tat trade war, with everyone worse off. Military conflict The world economy is already perilously weak, and confidence is in tatters. Any sabre-rattling, from North Korea to the Caucasus, could be shattering. Bank of England Mervyn King Economic growth (GDP) Economics Interest rates US Interest rates Inflation Global economy Stock markets Euro Heather Stewart guardian.co.uk