Select Committee on Treasury Written Evidence

Memorandum submitted by Roger Bootle

  1.  The November Bank of England Inflation Report was a bit more dovish than the markets had expected. But while it suggested that interest rates are close to a peak in the current cycle, it left the door open to one more hike, probably early next year.

  2.  The forecast for consumer price inflation came down significantly compared to the August Report, largely reflecting the fall in oil prices. Inflation is now expected to return to target in mid 2007, a year earlier than previously expected, and remain there for the rest of the forecast period.

  3.  Note, however, that this forecast is based on market expectations of a further rise in official interest rates to 5.2%. Admittedly, this does not arrive in full until Q3 next year and rates are then expected to fall a bit thereafter. What's more, the alternative forecast based on constant interest rates of 5.0% also showed inflation very close to its target. This contrasts with the last two Reports, which signalled clearly that inflation would overshoot without a further rise in rates.

  4.  Given the apparent choice between leaving rates unchanged or hiking them again, I suspect that the Committee will want to err on the side of caution. As such, I think that a February hike to 5.25% is still rather more likely than not, though I concede that it is not a racing certainty.

  5.  I think that in current circumstances the Bank is right to be concerned about inflation. Inflation expectations must be contained and they are potentially febrile. Even if inflation does not rise much further, at a time of rampant asset prices and strong growth of the money supply the risks of inflation becoming ingrained at an above target level are significant. Accordingly, the policy risks facing the Bank are asymmetric.

  6.  That said, though, I think that in due course it will become clear that the MPC's projections for economic activity are simply too optimistic. Note that the Committee's GDP forecasts actually rose somewhat compared to August, with growth running at close to 3% per annum over the next three years. As such, for all Mr King's warnings that the NICE (non-inflationary consistently expansionary) period for the economy is over, the forecasts themselves could hardly be any nicer.

  7.   I expect growth to come in rather weaker next year, partly as a result of a major housing-led slowdown in the US. Mr King made the point that the housing slowdown has so far had little effect on US consumption, but I think that the adjustment has barely started.

  8.  This should mean that UK interest rates probably do not need to rise any further after February.

  9.  At a more conceptual level, there is a serious concern about whether the CPI is accurately reflecting inflationary pressures in the economy. In the latest month (October), whereas CPI inflation was 2.4%, on the headline RPI measure it was 3.7%, and on RPIX, the old target variable, it was 3.2%. At the time of the switch from RPIX to CPI it was understood that because the average gap between the two measures was 0.8%, a reduction in the target range of 0.5% (from 2.5% to 2%) implied an effective loosening of policy. That was all very well when inflation was low but now that it has been above the target for six months, it's more concerning. Indeed, this slippage may have contributed to the widespread suspicion of the CPI as an inflation measure.

  10.  In this regard, it is interesting that the Governor has recently mentioned that he hopes that Eurostat will incorporate housing elements (one of the main sources of discrepancy between RPIX and CPI) within the European harmonised measure of the CPI. At a stroke this would raise UK CPI inflation by between 0.2% and 0.3%. What is the appropriate policy for a central bank to follow in the circumstances? Should it proceed with the current definition unless and until the definition changes? Or should it, once it is pretty sure that Eurostat will soon make the move, take this into account immediately? The implication of the latter is that the MPC would regard inflation as even further above the target. This would strengthen the case for higher interest rates.

November 2006

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