Memorandum submitted by Mr Roger Bootle,
Capital Economics
1. The November 2003 Inflation Report generally
supported expectations that November's interest rate increase
will be followed by further rises over the coming months. In particular,
the Monetary Policy Committee's central projection for RPIX inflation
remained slightly above the 2.5% target throughout the two year
forecast period and is rising towards the end of the period. This
has been seen as a strong signal that the MPC itself expects rates
to have to go up further.
2. However, it is worth bearing in mind
that this forecast is predicated on a very optimistic view of
the likely strength of the economy next year, with the MPC raising
its forecast for GDP growth in 2004 to close to 3.0%. This is
around 0.5% higher than the current consensus forecast amongst
outside forecasters and is in line with the Chancellor's own much-derided
forecasts. Admittedly, there have been signs of stronger activity
in recent months, but it is not clear why the MPC should be significantly
more optimistic than other forecasters.
3. My own view is that the MPC's optimism
will turn out to be misplaced. Although there have been signs
of an upturn in overseas demand, there are still major uncertainties
facing global activity and the UK's external sectors have yet
to show any visible improvement in response to stronger overseas
activity, or indeed to the depreciation of sterling since the
start of the year. Accordingly, while I expect the growth of net
exports to accelerate over the next year, it may fall short of
the MPC's expectations.
4. Meanwhile, I expect the growth of household
spending to slow more sharply than the MPC's latest projection,
which suggests that spending will continue to grow at its trend
rate. The result is that, while the MPC's optimism towards growth
will support further rate rises over the next few months, it could
soon become clear that growth itself is unlikely to meet the Committee's
expectations.
5. The MPC's upbeat growth forecast, together
with the concomitant increase in inflationary pressures means
that setting interest rates in accordance with the aim of hitting
the inflation target chimes in with the objective of cooling down
the housing market.
6. While targeting asset prices directly
is not part of the MPC's brief, it has become clear from the MPC
minutes and elsewhere that some members are very concerned about
the housing market and the associated build-up of household debt,
and the risk of a major downward adjustment to borrowing and spending
in the future.
7. If growth does disappoint next year and
inflation prospects look subdued but the housing market still
looks uncomfortably strong the MPC would face an acute dilemma.
The MPC needs to be asked how it sees its role in those conditions.
Would it put interest rates on hold even if this would cause house
price inflation to bowl along, thereby risking a serious adjustment
later? Would it be prepared to raise interest rates even though
the result would be inflation undershooting its target in two
years' time? Would this still be compatible with seeking to hit
the inflation target over a longer period? On this loose interpretation,
isn't a policy of targeting asset prices always expressible in
terms of an inflation objective over a longer time period?
8. Of course, the inflation outlook is muddied
by the forthcoming switch to the harmonised index of consumer
prices (HICP), likely to take place at the time of the Pre-Budget
Report on December 10th. With the target for HICP likely to be
set at 2.0% and the HICP currently at 1.4%, this is likely to
leave inflation comfortably below its target. This change could
well have no immediate impact on the path of monetary policy,
but it will surely have a significant impact eventually. At the
very least, the switch to HICP would be compatible with a lack
of urgency to push interest rates up aggressively.
9. Accordingly, it was disappointing that
the November Inflation Report did not include any analysis of
the likely effects and implications of the switch to the HICP
for monetary policy. The Inflation Report was written as though
the switch was not going to take place. Is this because the switch
has not yet been made and we still do not know the target? Is
there still some uncertainty about the new target? Or does the
MPC really believe that there are no implications from the switch?
Or does it believe that although there are possible implications
monetary policy should be set on broad lines and should not be
unduly influenced by technical considerations to do with the target
variable? The Bank should surely present a full discussion and
analysis of these issues—in the next Inflation Report, if
not before.
18 November 2003
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