Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Roger Bootle, Managing Director, Capital Economics Ltd

  1.  November's Bank of England Inflation Report suggested that the Monetary Policy Committee's concerns over the inflation outlook have eased somewhat in recent months and therefore left the door open to further cuts in interest rates next year.

  2.  The Committee's CPI inflation forecast based on market interest rate expectations was pulled down to slightly below the 2.0% target at the two-year horizon, having been at around 2.2% back in August. (See Chart.) The forecast based on unchanged rates is a touch lower still, apparently implying that the markets have become over-pessimistic in recently starting to factor in higher interest rates.

  3.  What's more, the inflation forecasts are still based on a pretty optimistic outlook for economic activity, with GDP expanding by 2.5% odd next year compared to the consensus forecast of 2.1% and my forecast of 2.0%.

  4.  Part of this optimism reflects the MPC's suspicions that the published GDP numbers have been understating the true strength of the economy and will therefore be revised up at some point.

  5.  The Committee's apparent reluctance to reduce interest rates is partly associated with its belief that potential supply may have been damaged by the rise in oil prices. But the argument is a theoretical one and the Bank is yet to produce any convincing evidence of it working in practice.

  6.  The August Inflation Report put much emphasis on asset price movements in the preceding months, in particular sharp falls in market interest rates and the sterling exchange rate, as a "significant impetus to demand growth in the medium term". The fact that those movements have since been largely reversed suggests that the impetus to demand will now be much weaker unless the MPC both signals and delivers lower official interest rates.

  7.  The overall impression is that the Committee remains reluctant to cut interest rates again at a time when inflation remains above its 2% target and there are lingering concerns about second round effects on wages and inflation expectations. In the press conference, Mervyn King again stressed his new-found reluctance to change policy in response to "short-term" fluctuations in output.

  8.  Nonetheless, if, as I expect, concerns over inflation continue to ease over the coming months, then the excuses not to cut interest rates will weaken and the Committee will become more willing to respond to the weakness of economic activity. I continue to expect a 25bp cut in rates in February before they head back towards their 2003 low of 3.5% later in the year.

18 November 2005

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