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