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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