Britain's economy is likely to get steadily weaker through the rest of this year, and the Bank of England's future decisions on asset purchases will be largely driven by overseas developments, BoE chief economist Spencer Dale told Reuters.
In his first public comments since the BoE's Monetary Policy Committee surprised markets by launching a second round of quantitative easing last week, Dale said that Britain was suffering one of the worst ever periods of financial turmoil.
Britain's economy has largely stagnated for the past 12 months, and Dale said the deepening euro zone debt crisis had increased the downside risks to inflation further down the line.
Asked if the 75 billion pounds of gilt purchases over the next four months that the MPC approved last week would be enough to help Britain's economy turn the corner, he said: I think it will depend critically on what happens in our economy but even more importantly in the rest of the world.
The main reason why our economic outlook has deteriorated very substantially over the past few months is what's happening in the rest of the world, and therefore, how we will set the stance of policy going forward, he added.
Dale said the failure of euro zone leaders to tackle Greece's debt crisis had been a major factor behind a downward spiral in global economic confidence, and that the BoE would be keeping a close eye on future developments.
Until August this year Dale had been in a minority of MPC members who supported higher interest rates. He declined to confirm if he had backed last week's expansion in QE, saying this would become clear in the MPC minutes next week.
He endorsed BoE Governor Mervyn King's assessment that the financial crisis was the worst since the 1930s, but stressed that conditions in the economy as a whole were better.
I can't think of any obvious period in history where we've seen such an acute and prolonged period of financial turmoil. But I think what's very different now to the Great Depression is what's happening in the real economy.
Dale still saw upward inflation pressures and said September's consumer price inflation, due to be reported next week, was highly likely to have jumped above 5 percent from its current level of 4.5 percent.
Notwithstanding this, inflation was likely to fall sharply at the start of 2012 due to one-off factors from higher sales tax and oil prices dropping out of the picture, and the latest economic weakness had added to downward pressures, he said.
The ultimate judge of the success of QE is whether we hit the inflation target -- so in a couple of years' time whether we've managed to support demand and we've hit the inflation target, he said. I will keep on emphasizing this.
The effect of high inflation in reducing households' disposable income had been a major factor behind disappointing growth over the past year, he added.
A big feature of the weakness of growth this time around isn't something related to the financial crisis and a 'lost decade', but that households' real incomes are being squeezed by increases in imported commodities and other imports prices, he said.
WILL QE WORK?
Dale saw some grounds for why this round of quantitative easing may be more effective than the previous 200 billion pounds of asset purchases conducted between March 2009 and February 2010.
Investors' preference for safe-haven assets is even more marked than when the BoE started its first round of QE, and the BoE's gilt purchases should encourage the funds that hold them to diversify into riskier, higher-return assets such as corporate bonds and equities, Dale said.
He rejected the notion that banks would sit on any money they receive from quantitative easing and would not lend it on.
This is one thing that frustrates me more than most, when I see descriptions of quantitative easing working through the banking systems as us 'giving money to the banks'. That is not the way quantitative easing works. We go round the banking system, he said.
Dale welcomed finance minister George Osborne's proposals for 'credit easing' measures to boost the flow of lending to smaller firms, and added that the credit risk involved meant it was right that the finance ministry should take the lead in designing the plans.
Critics of quantitative easing argue that due to the bleak economic outlook, Britain is close to a liquidity trap, akin to that faced by Japan in the previous decade, in which firms do not want to invest and banks are unwilling to lend.
Dale accepted that there was a problem with business confidence, but denied that the BoE had become powerless.
I don't think we're in a liquidity trap, he said. What we showed last month is we were willing to act quickly and decisively in order to support demand in our economy and hopefully that will help to add to some extent to people's confidence about the future.
(Editing by Hugh Lawson)