British inflation will fall well below its 2 percent target in two years, even if interest rates remain at record lows, the Bank of England said on Wednesday, leaving scope for further policy easing if the economy worsens.
The BoE noted that the prospects were highly uncertain and it was ready to move policy in either direction, but the central bank's August Inflation Report is likely to reinforce analysts' expectations that interest rates will stay at a record low of 0.5 percent for some time to come.
In its August Inflation Report, the central bank sharply revised up its 2011 inflation forecasts but said price growth would slow rapidly to around 1.4 percent the following year when a January 1 2011 increase in value-added tax drops out of annual comparisons.
This end-point was broadly similar to the two-year forecast in May's Inflation Report.
Growth is expected to be slower -- seen at a rate of just over 3 percent in two years time -- because of the extra fiscal tightening announced in the government's June budget, weaker business and consumer sentiment and credit conditions remaining tighter than the central bank had expected.
Looking ahead, the UK economy is facing a major rebalancing away from private and public consumption and toward net exports. Achieving that rebalancing, while confronting these headwinds, is likely to mean a choppy recovery, King told a news conference.
In May, the central bank had predicted growth of around 3.6 percent at its two year forecasting horizon.
Ten-year gilt yields fell to a fresh 16-month low and sterling dropped against the euro after the release of the report, as investors bet that more monetary easing was possible.
Late on Tuesday the Federal Reserve gave a somber assessment of the U.S. economic outlook and said it would reinvest the proceeds from its mortgage-backed securities portfolio into U.S. government bonds.
I think the policy measures they announced yesterday were ones that were much more designed to maintain the stance of policy to avoid an inadvertent tightening of policy, King said. I interpret that as largely being to try to maintain the relatively easy stance of policy they've adopted.
The BoE left interest rates at a record low of 0.5 percent last week and maintained its 200 billion pounds ($315 billion) quantitative easing program which had pumped money into the economy.
With the GDP downgrade it looks like in the short term the policy bias is probably toward further QE ... but on balance we still think there will be no change, said David Page, economist at Investec.
(Reporting by Sumeet Desai and David Milliken, editing by Mike Peacock)