Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Mr Roger Bootle, Capital Economics

  1.  This was the most hawkish Inflation Report that we have seen for some time, in two respects. Firstly, RPIX inflation was forecast to be 0.1 per cent above its 2.5 per cent target at the end of the Bank's two-year forecasting horizon. This contrasts with the last two Reports, in which inflation had been forecast to undershoot its target by 0.1-0.2 per cent or so.

  2.  Secondly, the final line in the Overview section—that the MPC "stands ready to contain inflationary pressures further ahead"—was a clear break from previous statements that have balanced inflation concerns against the need to guard against continued weakness in activity. Taken together, the shift in emphasis is probably as close as the MPC gets to adopting a US Fed-style "tightening bias" without officially stating it.

  3.  On the face of it, this change of tone looks odd. Outgoing MPC member Sushil Wadhwani noted recently that the Committee has undershot its inflation target by an average of 0.5 per cent since its inception, so a projected 0.1 per cent overshoot in two years' time hardly looks like a compelling reason for a major shift in policy bias.

  4.  Moreover, much of the first few months of the year have seen MPC members trying to talk down financial markets' expectations of aggressive hikes in interest rates, yet this strategy now seems to have gone out of the window. So what might have brought about the change of view?

  5.  Ostensibly, the reason is the much more bullish forecast for GDP growth, with annual growth expected to accelerate sharply this year and finish 2003 some 0.7 per cent stronger than the MPC had assumed in its February forecast. Even before the downward revision to Q1 GDP announced by the Office for National Statistics (to 0.0 per cent quarter on quarter from 0.1 per cent), these numbers looked extremely demanding. Growth now needs to be well above trend rates for the next seven quarters in order for the Bank's projections to be achieved.

  6.  Much now depends upon interpretation of the ONS growth data. Before the last downward revision, the widespread view was that the figures were wrong and that growth would be revised up. If the official figures are to be believed then the economy has been at a standstill for six months. The Bank needs to be asked (i) does it believe that the official numbers are under-recording growth, and if so why? (ii) if it doesn't, why does it believe that the economy will move so quickly from standstill into overdrive?

  7.  One of the reasons the Bank cited for stronger growth next year was the boost to demand from the Chancellor's budget projections. On the face of it, this was surprising given that the cyclically adjusted fiscal stance was shown to be hardly changed, and was actually marginally tightened in the near term. At the post-report press conference, Mervyn King said that the boost to demand arose from "the balanced budget multiplier". This is the idea that even when government spending and taxation rise by equal amounts there is a net boost to demand because whereas all of the increased government spending boosts final demand, some of the reduction in income caused by higher taxes is financed by a reduction in savings, rather than a reduction in consumption. However, it did seem very odd for the balanced budget multiplier to be wheeled out in this way, after so long out of the spotlight.

  8.  So why are the MPC's growth forecasts so upbeat? One view is that the MPC has fallen into line with the optimistic forecasts of the Treasury. The Bank's growth forecast for next year is now just 0.1 per cent below the mid-point of the 3-3.5 per cent range now forecast by the Treasury, compared to 0.5 per cent below in February. The Bank even nudged up its forecast for trend growth a little, following the Treasury's lead. (By increasing the amount of spare capacity in the economy, however, this was in fact marginally helpful to the inflation forecast.)

  9.  The second possibility is that the MPC has been spooked by recent talk of a bubble in the housing market and was merely looking for an excuse to raise interest rates even though such a move is not necessarily justified by its own inflation forecast. Clearly, the longer the current bull-run in the housing market goes on and the longer current imbalances are allowed to develop, the greater the chance that there will be a major readjustment, which could mean that the MPC will miss its inflation target by a large margin outside the two year forecasting horizon. However, the possibility of deliberately allowing the inflation target to be missed in the short term in order to rebalance the economy was discussed and ruled out by the Committee a few months ago for fear of the damage that could be done to its credibility and transparency.

  10.  Overall, although the Report makes the possibility of imminent interest rate hikes more likely, I am still not giving up on the idea that there may well still be a protracted period of inactivity on interest rates, for two reasons. Firstly, although inflation is projected to be above target in two years' time, it is expected to spend all but the last two quarters of that time below target, so the MPC has plenty of time to wait and see what happens. This point is even stronger if, as is possible, the lags between changes in monetary policy and its effects on output and inflation have shortened in recent years. Secondly, in taking what is an optimistic view on growth over the next couple of years, there is a good chance that the Bank will be forced into revising its forecasts for growth and inflation back down at the time of the next Report in August—increasingly regarded as the most likely trigger point for an interest rate hike. Since raising interest rates whilst simultaneously revising down its forecasts for activity and inflation would be rather difficult to explain, I think an August rate hike would be difficult to justify.

  11.  I remain of the view that the financial markets' expectations that interest rates will rise to over 5 per cent by the end of the year are too pessimistic. Given my rather pessimistic view on activity over the next two years and the systematic tendency for the Bank to over-estimate the likely path of inflation, I believe that inflation will continue to come in rather lower than the Bank anticipates over the medium term.

27 May 2002

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