King Says BOE Will Probably Start Stimulus Exit by Raising Rate

By Scott Hamilton and Svenja O’Donnell
June 17 (Bloomberg) -- Bank of England Governor Mervyn King said officials will probably raise interest rates before selling bonds when they decide to remove stimulus in the economy, which is still struggling to shake off the effects of the recession.
The Monetary Policy Committee "will not hesitate to begin to withdraw the current degree of stimulus when we judge that is necessary," King said yesterday in London. "That is most likely to be through a rise in bank rate with asset sales being conducted later in an orderly program over a period of time, leaving bank rate as the active instrument."
While U.K. inflation still exceeds the government’s 3 percent upper limit, Bank of England officials predict the rate will decline in the aftermath of the economic slump. The Bank of England last week kept its 200 billion-pound ($297 billion) bond stimulus in place to aid the economy as finance minister George Osborne prepares the deepest spending cuts in a generation.
"If prospects for growth were to weaken, the outlook for inflation would probably be lower and monetary policy could then respond," King said, speaking at the Mansion House in the City, London’s financial district. "A range of indicators point to spare capacity in the economy rather than excess demand."
The central bank has kept the key interest rate at a record low of 0.5 percent since March 2009. King’s signal that it may increase before assets sales echoes the preferred strategy of a majority of U.S. Federal Reserve policy makers under Chairman Ben S. Bernanke, according to the minutes of their April meeting. The Fed has bought more than $1 trillion in mortgage- backed securities and kept its interest rate near zero.

Fitch’s View

Fitch Ratings said last week Britain’s new coalition government needs to accelerate budget-deficit cuts to protect the nation’s top credit rating. In his emergency budget on June 22, Osborne will outline the scale of the spending cuts required to eliminate a deficit of 11.1 percent of gross domestic product, the highest since World War II.
"The steady reduction in the very large structural deficit over a period of a parliament cannot credibly be postponed indefinitely," King said. "It is important that, in the medium term, national debt as a proportion of GDP returns to a declining path."
The debt crisis afflicting the euro region poses a risk to U.K. economic growth, he said. The European Central Bank last week cut its growth forecast for the euro region in 2011 to 1.2 percent from an earlier projection of 1.5 percent because of weaker domestic demand. The euro area accounts for about half of British exports.

Recovery Threat

"Much of the recent market volatility reflects concerns about the ability of governments to service their own debt and provide assistance where necessary to weakened banking systems, especially in the euro area," King said. "Such risks have the potential to derail recovery and we cannot ignore them."
King said that the U.K. already has a lack of demand, highlighted by the unemployment rate close to 8 percent. Signs of inflation persisting are also lacking, including low measures of growth in money supply, earnings and spending.
Inflation still accelerated to a 17-month high in April and was at 3.4 percent in May, holding above the bank’s 2 percent target for a sixth month.
Consumers’ expectations for price increases in the coming year rose to the highest since 2008 in May, a quarterly Bank of England survey showed.
"The MPC is conscious that there are always risks to the upside, and the apparent rise in inflation expectations is one that concerns us," King said. "We have always explicitly recognized that there is a significant chance that inflation may turn out to be above target."
Still, King cautioned that the bank shouldn’t react to increases in the inflation rate based solely on commodity-cost fluctuations.
"Our ability to keep measured inflation close to the target has been hindered by movements in world oil and commodity prices," King said. Such cost pressures on their own "do not generate the continuous rise in prices to which monetary policy should respond."