Why has the outlook deteriorated so quickly? The banking crisis dealt a severe blow to the availability of credit. Growth in secured lending to households fell to an annualised rate of 1.9% in the three months to August, its lowest level in more than a decade. The Bank of England’s survey of credit conditions suggests that the terms on which banks provide credit to companies have tightened even further. And, on some estimates, the supply of finance to the UK corporate sector has ground to a halt. This credit shock has come on top of a fall in real disposable incomes resulting from the rise in energy and food prices earlier in the year. So, taken together, the combination of a squeeze on real take-home pay and a decline in the availability of credit poses the risk of a sharp and prolonged slowdown in domestic demand. Indeed, it now seems likely that the UK economy is entering a recession. At the same time, consumer price inflation, our target measure, has risen from around the 2% target at the beginning of the year to a worryingly high rate of 5.2% in September. Oil and other commodity and food prices have all been rising very rapidly. In those circumstances, it was sensible to allow those price changes to be absorbed by movements in consumer prices. The alternative would have been an even sharper slowdown in the economy. Central banks in other countries also find themselves in a similar position.
The Committee must balance the risk that a prolonged slowdown in domestic demand pulls inflation materially below the target against the risk that today’s high inflation rate becomes embedded in inflation expectations. During the past month, the balance of risks to inflation in the medium term shifted decisively  BIS Review 128/2008  3  to the downside. And the MPC – in an action co-ordinated with six other major central banks – cut Bank Rate by half a percentage point to 4.5%. Looking ahead, the outlook is obviously very uncertain – both for the world as well as our own economy. The MPC cannot simply extrapolate the past into the future. The prospects for oil and other commodity prices are difficult to assess. So too are the period over which bank lending will return to normal and the extent of the damage to business and consumer confidence. Moreover, the credit crunch affects not just demand but also the supply potential of the economy, complicating the assessment of the inflationary impact of changes in the level of demand. The associated shift of resources away from those parts of the economy that have flourished in recent years towards other areas of economic activity will moderate the increase in potential output while that adjustment is taking place. The MPC must monitor carefully all the available evidence about fast-changing patterns of spending, supply and prices. It will act promptly to ensure that inflation remains on track to meet our target.