UK inflation will stay low for some time, BoE says

UK inflation will drop below the Bank of England's (BoE) 2% target later this year and remain there "for the medium term", the central bank said in its quarterly inflation report, published today.

But, the BoE warned, predicting inflation into 2010 and 2011 was extremely uncertain. "There are significant risks to the inflation outlook in each direction," it said. On the upside, continuing weakness of sterling against other currencies and the £125 billion quantitative easing plan is expected to push inflation up. On the downside, the recession has reduced domestic demand, which would tend to drive inflation down.

The BoE admitted considerable uncertainty around the recovery from recession, with scenarios ranging from a return to growth in 2009 on the optimistic side, to a continuing recession in early 2012 on the pessimistic side. The spread of inflation projections included levels in mid-2011 of between -0.5% and 3.5%, although projections centred on a return to 1.5%-2% inflation by the start of 2011.

Current breakeven rates (the spread between nominal and real yields) imply low inflation expectations in the short and medium term, with the breakeven moving from 0.75% at the two-year point, 1.53% at five years, 1.87% at eight years and 2.17% at the 10-year mark.

However, breakevens have been driven by technical factors in recent months - in particular the continuing quantitative easing gilt purchase programme, which could act to push down yields on nominal bonds.

Expectations of low inflation in the near term might also distort the breakeven curve further out. "The five-year forward rate five years ahead is often seen as providing a cleaner indication of long-horizon inflation expectations than, say, a 10-year breakeven rate because it should, at least in principle, be unaffected by near-term inflation expectations," commented Peter Hördahl, an economist at the Bank for International Settlements (BIS), in a paper published in the most recent BIS quarterly review in March. The 5y5y rate for sterling is significantly higher than the 10-year breakeven rate, at 3.914%.

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