King Says Bank of England Will Act as Recession Seems Likely

By Brian Swint and Jennifer Ryan

Oct. 22 (Bloomberg) -- Bank of England Governor Mervyn King said Britain's worst banking crisis since World War I is likely to push the economy into a recession, requiring policy makers to act ``promptly'' to prevent inflation from slowing too much.

``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,'' King said in a speech to executives in Leeds, England yesterday. The Monetary Policy Committee ``will act promptly to ensure that inflation remains on track to meet our target.''

King said house prices will continue to fall and the pound may depreciate further in his first explicit acknowledgement that a U.K. recession is likely. The financial crisis led Gordon Brown's government to bail out the British banking system and will push the economy to its first full-year contraction since 1991, the National Institute of Economic and Social Research said today.

``We are far from the end of the road back to stability,'' King said. ``But the plan to recapitalize our banking system, both here and abroad, will I believe come to be seen as the moment in the banking crisis of the past year when we turned the corner.''

Manufacturing confidence is at the lowest since 1980, the Confederation of British Industry said yesterday, and house prices fell at the biggest annual rate in at least six years this month, Rightmove Plc said Oct. 20. Gross domestic product will fall 0.9 percent in 2009 and consumer spending will drop 3.4 percent, Niesr, whose clients include the central bank, said today.

Recession `Likely'

``Over the past month, the economic news has probably been the worst in such a short period for a very considerable time,'' King said. ``Indeed, it now seems likely that the U.K. economy is entering a recession. The balance of risks to inflation in the medium term shifted decisively to the downside.''

The fastest consumer-price gains in a decade, spurred by higher utility bills, are adding to the squeeze on consumer spending, King said. Still, the 50 percent drop in oil prices since July and the recapitalization of banks are two pieces of ``good news'' about the outlook, he said.

King cautioned against expecting borrowing costs to rebound to levels before the credit freeze took hold. The gap between the three-month London interbank offered rate and the base rate was 1.6 percentage points yesterday. The last time the benchmark rate was 4.5 percent, in July 2006, the gap was 0.29 percentage point.

`Age of Innocence'

``The age of innocence -- when banks lent to each other unsecured for three months or longer at only a small premium to expected policy rates -- will not quickly, if ever, return,'' King said. ``I hope it is now understood that the provision of central bank liquidity, while essential to buy time, is not, and never could be, the solution to the banking crisis, nor to the problems of individual banks.''

Brown's government took controlling stakes in Royal Bank of Scotland Group Plc and HBOS Plc as part of a 37 billion pound ($64 billion) bailout. It also promised 250 billion pounds in interbank loan guarantees to help unfreeze money markets after Lehman Brothers Holdings Inc. filed for the biggest bankruptcy in history, destroying confidence among banks.

``Not since the beginning of the First World War has our banking system been so close to collapse,'' King said. ``It would be a mistake, however, to think that had Lehman Brothers not failed, a crisis would have been averted. The underlying cause of inadequate capital would eventually have provoked a crisis of one kind or another somewhere else.''

Investor Confidence

The decline in credit-default swaps for U.K. banks is ``the single most important diagnostic statistic'' for investor perceptions of bank solvency, King said. He said bank credit derivatives have fallen ``markedly'' since the government announced its bank stakes plan, suggesting the measures are having a ``major impact'' in restoring confidence.

Contracts on Royal Bank of Scotland Group Plc have dropped to 103 basis points, falling 203 basis points since Oct. 7, the day before the government announced its bailout plan, CMA Datavision prices show.

King said that higher national debt incurred by the bailout ``need not prove inflationary'' and that the government may be able to reduce its stakes in banks ``within a reasonable period.'' He said one method would be ``by selling units in a bank reconstruction fund.''

Investors overseas may also be less willing to put their money in the U.K., King said. ``Unless they are replaced by other forms of external finance, the adjustments in the trade deficit and exchange rate will need to be larger and faster than would otherwise have occurred, implying a larger rise in domestic saving and weaker domestic spending in the short run.''

Economists including Citigroup Inc.'s Michael Saunders and UBS AG's Amit Kara predict that the Bank of England will follow the Oct. 8 emergency interest-rate reduction with another half- point cut at the next scheduled meeting on Nov. 6. Minutes of last month's meeting, showing how each of the nine panel members voted, will be published today.

To contact the reporters on this story: Brian Swint in London at bswint@bloomberg.net; Jennifer Ryan in London at jryan13@bloomberg.net.