London (MNI) – The following is the full text of the policy section
of Bank of England Governor Mervyn King’s annual report to the
Treasury Select Committee.

Past voting record and the outlook

In the past year the UK economy has experienced an unpleasant
combination of high inflation and weak output growth. We have seen a
reluctant recovery to date because of the headwinds associated with
the rebalancing process that is underway at home. But in recent months
developments abroad, and especially in the euro area, have increasingly
threatened that process of rebalancing and recovery.

Over the past year demand has been held back by weak real income
growth, tight credit conditions and the fiscal consolidation, despite
accommodative monetary policy. Indeed household consumption has fallen
back to the level seen in the trough of the recession, and before that
at the start of 2005. In the latest data output remains some 4% below
its peak, and more than 10% below its pre-crisis trend.

The fall in output has surely left a margin of spare capacity in
the economy – not least in the labour market, where the unemployment
rate had been hovering around 8% for some time, before picking up in the
latest data. Over time I would expect this to put downward pressure on
inflation. The size of this margin of spare capacity, and its effect on
inflation, is however very uncertain.

Underlying domestic inflationary pressure has indeed been subdued
over the past year, as can be seen in the below-par rate of wage growth.
Headline CPI inflation was, however, pushed to above 5% by the
contribution of increases in energy prices, import prices and the rate
of VAT. We expect inflation to fall back sharply as these price rises
drop out of the annual comparison early next year, although the precise
timing and extent of the fallback in inflation are uncertain. But as
ever it is the outlook for inflation in the medium term that bears on
monetary policy.

For much of the past year there have been two key risks to that
inflation outlook. On the one hand is the risk that a persistent margin
of spare capacity and subdued wage growth result in inflation moving
below target in the medium term. And on the other hand is the risk that
the period of above-target inflation could cause medium-term inflation
expectations to drift up, putting persistent upward pressure on
inflation. These are the risks that have framed the policy debate over
most of the year.

Seeking to balance these risks, in each MPC meeting from December
last year to September this year I judged that it was appropriate to
maintain Bank Rate at 0.5% and the quantity of asset purchases at
Stg200bn.

In recent months, however, events abroad have affected the outlook
for the UK economy.

The unfolding euro-area crisis and the associated tensions in
financial markets and the world economy – working through weaker net
trade, higher credit spreads and the likelihood that elevated
uncertainty will cause businesses to postpone investment and households
to spend less now threaten the UK recovery. The outlook for output
growth in the near term is considerably weaker than even three months
ago. Indeed it now seems likely that the level of output will be broadly
flat over the next six months.

The outlook for inflation in the medium term is correspondingly
weaker, and there is a significant risk that it will undershoot the
target.

In October, in response to this downwards shift in the prospects
for the UK economy, the MPC voted unanimously for an additional Stg75bn
of gilt purchases.

This policy seeks to increase the amount of money in the economy.
The money received by those selling assets to the Bank can then be used
to buy a wide range of other assets, including private-sector
securities. In turn, this will raise asset prices and lower the costs of
borrowing for private-sector companies, with the aim of boosting overall
money spending and ensuring that it grows at a rate that is consistent
with meeting the inflation target in the medium term.

In taking this action we are treading a fine line between stimulus
to demand in the short run and the longer-term need to continue the
process of rebalancing and deleveraging.

In November I voted to maintain that looser policy stance. In
common with every member of the MPC, I stand ready to adjust policy – in
either direction – as the balance of risks to the outlook for inflation
changes.

[TOPICS: M$$BE$]