Tim Pike, the Bank of England's deputy agent for the South East and East Anglia, explains the latest thinking of the Monetary Policy Committee (MPC) about prospects for the UK economy.

Since my last report, interest rates have remained at 0.5 per cent and there has been no change to the programme of quantitative easing.

Output in the UK economy was broadly stable in the second half of 2009. A recovery is now in prospect, driven by the considerable 'tailwinds' from monetary policy and supported by global growth and the past depreciation of sterling. But a number of 'headwinds' will restrain money spending in the economy in the short to medium term, including balance sheet adjustment of the damaged banking system and the need to strengthen public and private sector finances.

While the banking system reduces its leverage there will continue to be limited access to credit.

But, because asset purchases have injected additional money into the economy, money growth is stronger than it otherwise would have been. In addition, asset prices have picked up.

The economy

The preliminary estimate of GDP growth in Q4 was an increase of 0.1 per cent, following a decline of 0.2 per cent in Q3.

But output remains significantly below its previous peak, suggesting a substantial degree of spare capacity remains in the economy.

Households' consumption stabilised in Q3. Survey and monthly spending indicators suggest an increase in consumption in Q4. However, that may partly have reflected temporary factors, such as the restoration of the 17.5 per cent VAT rate in January that brought forward some spending ahead of the increase.

Overseas, there are signs that many economies are on the mend, although much uncertainty remains about the likelihood of a sustained pick-up in growth in the world economy as a whole.

GDP growth outlook

Going forward, the MPC expects that the balance between the substantial tailwinds and headwinds points to a gradual recovery in the level of economic activity.

Overall, the broad picture is little changed compared with the one I described last November. The Committee judges that while the most likely path for growth is somewhat weaker, some of the downside risks to the outlook are smaller now than in November.

The inflation outlook

Annual consumer price (CPI) inflation has risen sharply from its trough of 1.1 per cent last September to 2.9 per cent in December.

Although the exchange rate has been broadly stable over the past year, its sharp fall since the middle of 2007 is also still feeding through to consumer prices.

CPI inflation rose further, to 3.5 per cent in January as the effects of the restoration of VAT fed through. This is the third episode when inflation has temporarily moved above the target by more than one percentage point.

On both previous occasions the MPC said that inflation would come back down. On both previous occasions it did. And the Committee expects that to be the case this time too. CPI inflation is projected to fall back to below the target over the next year.

The Committee judges that inflation is, on balance, more likely to be below the target than above it for much of the forecast period.

In conclusion, a year ago I wrote about the asset purchase programme. That was a time of sharply falling output and collapsing confidence. Since then, the position has improved considerably. Output has stabilised and confidence has recovered.

The additional money created by the asset programme will continue to boost the economy for some time to come. But the nature of the headwinds means that the recovery is likely to be slow. And there is much uncertainty both about the outlook for the world economy and the strength of domestic spending. Although the MPC announced a pause in its programme of asset purchases, it is far too soon to conclude that no more purchases will be needed. So the Committee will keep its options open, and further purchases will be made if they prove necessary to keep inflation on track to meet the target in the medium term.

• To have your business financial questions answered, send them to Morag Welham atKent Business, Messenger House, New Hythe Lane, Larkfield, Aylesford ME20 6SG or email mwelham@thekmgroup.co.uk
• The Bank's latest Inflation Report, published on February 10, is available on the Bank's website at www.bankofengland.co.uk/publications/inflationreport/index.htm