Wednesday, the Bank of England said in its latest quarterly Inflation Report that the CPI inflation is likely to drop further below its target in the coming months.

Downward pressure from the margin of spare capacity signals that inflation is more likely to stay below target in the medium term than above, the bank said. This is based on the assumption that the Bank Rate moves in line with market rates and asset purchases using central bank reserves reaches GBP 175 billion. But, the central bank finds significant risks to the inflation outlook in both directions.

The BoE said that inflation is more likely to fall below 1% in autumn, requiring an open letter from the Governor to the Chancellor. Risks of inflation being above or below the 2% target at the two-year horizon are broadly balanced.

Although at a slower pace, output declined further in the second quarter. Reasons for the moderation in the rate of contraction in the second quarter are key to assessing whether that easing will continue in the second half of 2009. The turnaround could in part reflect the inventory cycle, the BoE added.

Output is now estimated to have declined 5.6% over the last year, which was the largest four-quarter fall since records began in 1956. The Monetary Policy Committee continues to judge that the stimulus should lead to a slow recovery in economic activity, but the timing and strength of that recovery remains highly uncertain, the bank said.

Since the May Report, funding conditions for banks have improved a little, the central bank said. Credit conditions are expected to remain tight as banks continue to restructure their balance sheets. Banks need to restructure their balance sheets in order to improve their capital and funding positions.

The Inflation Report is produced quarterly by Bank staff under the guidance of the members of the Monetary Policy Committee.

At a news conference, BoE Governor Mervyn King said the recovery could be slow and protracted. He added that given the depth of the recession, to erode the margin of spare capacity that has been created will require an extended period of robust growth. Further, he said the strength of the recovery will be affected by necessary balance sheet adjustments of the banking, household and public sectors.

Last week, the central bank had unexpectedly raised the size of the quantitative easing measures by GBP 50 billion to GBP 175 billion. Expressing surprise at market reaction to that announcement, King today said the minutes of July MPC meeting had signaled that policymakers had not made up their minds on stopping quantitative easing measures. BoE increased the asset purchase programme to raise the supply of money and so boost nominal spending in order to meet the 2% inflation target.

Peter Dixon, Commerzbank analyst commented that BoE's GDP growth projection is a bit stronger than Commerzbank's own assessment whilst the CPI forecasts are rather weaker. Analyst noted that its too early to talk about exit strategies although King reiterated that it would depend on whether the BoE meets its inflation target. Based on today's inflation forecast, there appears to be little need to rush for the exit, Dixon said.

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