–Updates Version Published At 1550 GMT; Adds Detail
–Deflation Threat Has Not Gone Away
–Inflation Likely To Fall Back Below Target

LONDON (MNI) – The Bank of England’s Monetary Policy Committee must
be sensitive to the risks of tightening policy prematurely and the the
threat of deflation has not gone away, BOE Executive Director Markets
Paul Fisher said in remarks released Tuesday.

Fisher highlighted the uncertainty at present surrounding estimates
of the UK’s output gap, but said the economics suggested inflation would
fall from its highs. He warned, however, that if inflation pressures do
prove resilient in the medium term, it was clear what the MPC would have
to do.

Fisher’s MPC colleague Andrew Sentance has called for gradual
monetary policy tightening to start now, voting for a 25 basis point
rate hike at the MPC’s June meeting, but Fisher’s remarks show a more
cautious approach.

“We need to be sensitive to the risk of tightening policy
prematurely, stifling the nascent recovery. In that case, some of the
flexible response to the recession could be swept away, delivering
higher unemployment, more company failures and the risk of
inflation significantly undershooting the target,” Fisher said.

He added that “The risk of deflation … may have faded, but it
hasn’t gone away and would require greater efforts to deal with, if it
materialised now.”

Against this, if it seems “likely that inflationary pressure is
sustained at a higher level into the medium term, then it is clear what
our mandate would require us to do,” Fisher added.

Fisher’s remarks were based on a talk he gave in Liverpool on June
14 but were only published by the BOE Tuesday, and their release comes
the day after Sentance gave an interview to Reuters, setting out the
case for tightening policy.

Fisher said “the rise in inflation since mid-2009 was surprising
given that it happened against the background of a deep recession.”

He said this increase in inflation appeared to reflect two
elements: firstly, the downward pressure from the recession has not been
as large as it might have been and, secondly, a number of temporary
factors have pushed inflation up.

On the recession’s impact, Fisher said UK companies have not
behaved in this recession in the same way as the past.

Unemployment has risen much less sharply than might have been
expected, with employers shortening work hours and freezing wages rather
than laying off staff.

Business surveys, however, suggest “the degree of spare capacity in
firms is rather less than implied by the fall in output.”

As a result, output gap estimates “are extremely uncertain at the
current juncture. The output gap appears to be much smaller than the
fall in demand alone would have suggested, but there is little evidence
of widespread destruction of supply capacity,” Fisher said.

It also appears that “many firms have maintained prices, not cut
them, in the face of weak demand.”

Fisher said that if firms behaved the same way in the recovery as
they had in the recession, this would suggest inflation pressure should
not be created in the upswing, with firms able to use flexibly the
labour they held on to.

“When demand growth strengthens, output could be flexibly ratcheted
up, reversing the processes seen during the downturn,” Fisher said.

If this happens “it is unlikely that substantial inflationary
pressure would be generated as the result of a recovery in demand.”

He warned, however, that this “is clearly a major uncertainty and
hence a risk in our projections of future inflation.”

Fisher said the weak downward pressures on inflation from the
recession cannot fully explain the elevated inflation outturns.

High recent inflation rates have also been due to the temporary
factors, including the fall in sterling, changes in VAT rates and the
rise in the oil price.

With the government cutting VAT to 15% support demand and then
returning it to its previous 17.5% level, Fisher said the likely swing
in the inflation rate due to this was 1.5 percentage points between end
2009 and early 2010. The new administration subsequently announced it
would hike VAT to 20% from January next year, which will add further to
inflation.

The BOE executive director said sterling’s fall “likely reflects a
re-appraisal of the UK economy given the financial crisis and the
significance of the financial sector to the UK.”

With the currency falling for these reasons “we would expect to see
a large part of the exchange rate depreciation reflected in higher
prices for goods and services imported into the UK and hence higher CPI
inflation.”

Fisher said it is difficult to estimate the impact of sterling’s
fall on inflation, but it is “probably adding between 1 and 2.5
percentage points to the current inflation rate.”

Nevertheless, Fisher said the impact of sterling’s depreciation was
“likely temporary”.

On balance, Fisher said inflation was likely to fall back .

“Given the expected degree of spare capacity in the economy over
the next few years, and that the temporary factors should wear off, the
most likely outcome is that inflation falls back to below target over
the next couple of years,” he said.

–London bureau: +4420 7862 7491; email: ukeditorial@marketnews.com

[TOPICS: M$B$$$,M$BDS$,MT$$$$,M$$BE$]