LONDON (MNI) - It is "far too soon" to say the Bank of England's quantitative easing is over, despite the decision to pause it in February, with the BOE expecting inflation to return below target after a near time spike, Governor Mervyn King said in his Q and A following the publication of the February Inflation Report.

The report showed inflation undershooting its 2.0% target two years ahead on both flat and market interest rate assumptions, raising the question why the BOE's Monetary Policy Committee did not extend QE at its February meeting.

King made clear the MPC has not shut the door on further QE.

He said that despite the pause in QE - "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."

Spare Capacity May Not Have Been Lost

A key assumption underpinning the BOE's view that inflation will return to well below target is that the UK economy may well experience persistently high levels of spare capacity.

The Bank of England's Monetary Policy Committee does not subscribe to the view the UK economy has necessarily lost substantial amounts of supply capacity as a result of the recession.

King said if growth picks up strongly much of the so-called "lost" spare capacity could return, helping curb inflation. His comments come with the BOE projecting inflation to be below target in two years time on both flat Bank Rate and on market rate expectations.

Asked about the BOE's views on spare capacity loss, King said "We are more uncertain about how much spare capacity there is. It's an extraordinarily difficult judgement to make."

"We (the MPC) had a long discussion of this. We were more inclined to think that this is a reduction in effective supply in the short run that could be reversed," he said.

"I don't think we are confident that this reduction in supply capacity will necessarily persist. And indeed, we are in a position where if growth in demand were to be rapid I suspect much of the capacity which has been 'lost' would come back and would be able to be used again, whether in the labour market or capital stock," he added.

"On the other hand if growth in demand is weak, and persists, then much of that lost capacity may turn out then to be a more permanent loss of capacity," King said.

"In that sense, I don't think it is easy to make a judgement about how much has been lost. How much will prove to have been lost will depend very much on the path of demand," he added.

The BOE's view suggests the evolution of spare capacity could have a damping effect on both inflation and disinflation.

The BOE's assumptions "suggest that if demand (growth) is particularly rapid then it may not be the case that inflation will pick up quickly because the supply capacity will come back on stream," King said.

"It also suggests that if demand was particularly weak then maybe inflation would not fall necessarily so far below target as one might fear because the supply capacity will be contracting at the same time," he added.

Inflation Rise Due To Temporary Factors

The rise in inflation is due to only temporary factors and it is expected to fall back below target as a result of high levels of spare capacity, King said.

Asked why inflation has come in stronger than the BOE forecast, King said it was due to temporary factors and the big picture, of inflation heading below target due to spare capacity, remained in place.

The spike in CPI in Q4 and Q1 is due to "shorter term factors to do with the beginning of the forecast horizon," King said, citing two key factors, the VAT rise and petrol prices.

"One is higher petrol prices, so there is much inflation that has actually occurred and that will carry through to the beginning of this year," King said.

"The other thing is our agents, when talking to business contacts around the country, have come to the judgement, which the committee has incorporated into its forecasts, that somewhat more of the increase in VAT, back up to 17.5%, will be passed through in prices at the beginning of this year than we had previously assumed," he said.

The BOE expects inflation to return back below target once these temporary factors have evaporated.

"Looking further ahead the position is really pretty much unchanged from November which is that for much of the forecast inflation coming back to below the target because of the impact of a very large amount of spare capacity (then) returns to target at the end of the forecast horizon, with the risks pretty broadly balanced around that," King said.

UK Structural Deficit Needs To Be Eliminated

The BOE Governor trod carefully on the politically charged issue of deficit reduction.

Asked about comments for the leadership of the opposition Conservative Party about co-ordinating fiscal policy with the BOE King said "I don't know what this proposal means."

He said the current system, with the BOE getting briefed by the Treasury on fiscal policy measures, worked well.

"The key thing is that monetary policy is something that can be changed every month whereas fiscal policy is not. In that sense monetary policy clearly has to bear the burden of steering the economy," King said.

"I don't think it is sensible to regard fiscal policy as something which is fine-tuning, but the scale of the deficit now has got nothing whatsoever to do with fine-tuning the economy," King said.

"It is a very large structural deficit which needs to be eliminated," he added.

Credit Raters Shouldn't Lower UK's AAA If They Have Sense

King did weigh in on the question of whether the UK's top AAA rating is at risk.

Despite the historically large size of the public finance deficits, King said as long as the UK acts sensibly in tackling the deficits there would be no 'sensible' reason for the rating agencies to cut their ratings.

"I cannot think of any reason why the UK should lose it and it would be most peculiar if this were to happen," King said.

"We now await announcements by Government before the election and after the election about the precise measures that will be implemented to bring down the deficit," he added

"But ... the UK has a very good track record over a long time. There is a wide political consensus in the UK, right across parties, on the need to reduce the deficit," he said.

King noted that UK debt has a longer maturity structure than almost any other country, including the US, thereby reducing rollover risk on refinancing.

The AAA rating "is ours to lose. All we have to do is behave sensibly and I am sure we will and I think if the rating agencies, if they have any sense, will see that," King said.