Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Roger Bootle

  1.  In contrast to the rather ambiguous message of the last Report in November, the February Report made it pretty clear that the MPC expects to have to raise interest rates again. The CPI forecast based on market interest rate expectations showed inflation hitting its 2% target at the two-year horizon on the basis of a further rise in rates to 5.5% in Q2 and 5.6% in Q3. By contrast, the forecast based on unchanged rates showed inflation overshooting its target by around 0.2%.

  2.  Admittedly, the unexpectedly sharp fall in inflation in January has left it below the 2.9% average rate the Inflation Report assumed for the first quarter. Other things equal, this might have some downward effect on the forecast at the two-year horizon too.

  3.  But I doubt very much that this will remove the need for a further rise in rates altogether, particularly given the Committee's more general concerns about wider price pressures in the economy. Nonetheless, the fall in inflation has probably reduced the danger that interest rates will need to rise beyond 5.5%.

  4.  The Inflation Report brought the first hints that the MPC anticipates bringing interest rates back down again in the not too distant future. As the Chart shows, the forecast based on market expectations showed inflation dropping back below its target beyond the two-year horizon.

  5.  Of course, this profile could change over time. What's more, it is far from clear that the Committee would respond mechanically to the prospect of a slight undershoot of the target by cutting interest rates, particularly if it remained concerned about wider price pressures.

  6.  But on the face of it at least, it suggests that interest rates might need to fall a bit in a year's time in order to keep inflation on track to hit its target two years ahead. This is not yet a prospect being seriously discounted by the markets.

  7.  In fact, I believe that inflation will fall very sharply in the second half of this year. It could well be running at about 1.7% by end year. But this will be heavily influenced by movements in energy prices and may have little or no relevance to underlying inflationary forces.

  8.  More importantly, I see three major related structural challenges facing the MPC later this year. They go right to the heart of the inflation targeting regime. The first challenge concerns asset prices. In the long run you would expect there to be some sort of relationship between asset prices and consumer prices. Recently, consumer prices have been relatively subdued but asset prices have been rampant.

  9.  To re-establish some sort of normal ratio either consumer prices will have to rise more sharply or asset prices must fall, or at best stagnate for some while. The danger is that at some point the inflationary influence from surging asset prices will spill over into final demand and cause consumer prices to rise rapidly, thereby requiring the Bank to raise rates sharply, which could easily prompt an asset price collapse. In this way, the adjustment would involve movement in both variables. This could be the worst of all worlds.

  10.  In this scenario it would be better for the Bank to raise rates sooner and keep them higher for longer, even in the face of sub-target inflation, in order to cool asset markets. But to what extent would the current regime allow this approach to be taken by the Bank?

  11.  The growth of the money supply is the second, related, issue. Recent growth rates have been very high (13-14%). Some of this growth could be dismissed as technical in origin in that it corresponds to increased holdings of money by financial institutions which may have no relevance to economic activity.

  12.  But not all of it can be dismissed in this way. And even the part which is associated with increased activity by financial institutions may be relevant to asset prices, and hence ultimately and indirectly to aggregate demand in the real economy.

  13.  What should the MPC make of the growth of the money supply at a time when consumer price pressures appear to be ebbing? The money supply numbers are a proxy for the pressure on asset prices. That is why the ECB has retained them as its second pillar of monetary policy and why this idea is not so daft. Again, how is the MPC to give due weight to such considerations at a time when immediate inflationary pressures seem to be ebbing?

  14.  The third challenge concerns the limits to the MPC's own influence. The MPC has to contend with the fact that monetary policy affecting this economy is not only made here, but also in Tokyo and elsewhere. The huge growth of cross-border and cross-currency capital flows means that some of the upward pressure on UK asset prices comes from the fact that interest rates elsewhere, especially in Japan, have been kept so low. As rates rise in Japan, will this have a meaningful impact on UK asset prices which would temper the need for action on UK interest rates?

March 2007

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