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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