Memorandum submitted by Mr Roger Bootle,
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
2. Secondly, the final line in the Overview
sectionthat 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
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
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 Augustincreasingly
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
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