Osborne needs to hold the line

Even governors can be wrong. The Bank of England’s quarterly inflation report is expected to downgrade its original growth forecasts and predict a sharp increase in inflation, albeit one that peaks this year and returns to the target rate by 2012. A spike in inflation is scarcely surprising given the planned VAT rise, and the Bank’s original growth forecasts were, like Alistair Darling’s forecasts, absurdly over optimistic – predicting 3.4 percent growth next year and 3.6 percent the year after. The Bank’s revisions needn’t trouble George Osborne, whose forecasts of 2.3 percent growth next year and 2.8 percent in 2012 were drawn from the OBR.

However, the OBR may have over-estimated recovery too. In the last week there has been grim news on the retail confidence front, on jobs and on house prices. Against that, the UK trade deficit closed by £600m in July despite the pound rebounding by more than 3 percent against major trading partners; this is welcome but the small amount of trade recovery is a reminder that global confidence, and particularly European confidence, remains depressed. In other words, the British economy’s regression might not just be the consequence of Osborne’s cuts. The opposition will bray that Osborne has inaugurated a double-dip, but if global recovery estimates for the second quarter were over-cooked, then a slowdown may have been unavoidable.

Of course, the Bank and the Chancellor must prepare to weather decline without curtailing the necessary task of limiting national overspend. As Pete has noted, the cuts are not yet deep – £8.1bn out of an economy of £1.4tr is minimal. And Peter Lilley is correct when he tells the Times (£):

‘In the last three recessions we were told not to cut spending because we were going to make things worse and in each case that proved to be wrong. The way to ensure confidence is to show that something is being done about the deficit which allows you to pursue a more relaxed monetary policy.’

How relaxed that monetary policy should be is down to the Bank. It is highly unlikely that interest rates will go up at this stage as that will damage consumer confidence and lending. But there are rumours that some are putting the case for more Quantitative Easing to boost demand. The consequence of such a move would be to increase inflation yet further, which would be a huge political risk given the VAT rise. But, the threat of deflation has abated and Osborne may now want to gently inflate his way out of a debt crisis that the nation’s finances can’t sustain.