Written evidence submitted by Roger Bootle,
Managing Director, Capital Economics
1. Press coverage of the November Inflation
Report focused heavily on the upward revision to the Bank's forecasts
for economic growth, and some commentators even suggested that
this presaged an early tightening of policy. I think that this
interpretation was completely wrong. Although growth was revised
up—and along with it the inflation profile—that profile
remained weak at the two year horizon. Moreover, the presentation
of the Report at the press conference was notably dovish.
2. The upward revision to the path of CPI
inflation since the August Report partly reflects higher energy
prices. Assuming that the amount of QE is limited to £200
billion and that interest rates follow the path expected by the
markets (which envisages increases starting in the spring of next
year and then taking rates up to 3% by the end of 2011) then inflation
is expected to rise to about 2.5% early next year. Beyond that,
though, inflation is expected to fall back quite sharply and to
be around 1.6% at the two-year policy horizon, comfortably below
the 2% target. Inflation then edges above the target in the third
year of the forecast. (On the assumption of unchanged interest
rates, the inflation forecasts are only slightly higher.)
3. But this profile is based on what looks
like a very optimistic path for the economy. GDP growth is expected
to average around 2% next year—well above the consensus
forecast—and to hit 4% early in 2011. Given the intense
fiscal squeeze likely to be underway by then—which is not
fully incorporated into the BoE's forecasts—I think that
such strong growth is very unlikely. (It is conventional for these
forecasts to assume that the announced fiscal plans remain in
force.)
4. Coupled with the effects of the enormous
amount of spare capacity in the economy, this suggests that inflation
could end up considerably lower than the Bank's current profile
suggests. Note that the Inflation Report itself acknowledges that
the required fiscal consolidation "will put significant downward
pressure on nominal spending and therefore inflation". This
point may well explain why Mr King's presentation of the Report
seemed much more dovish than the Report itself.
5. There is a debate about how much spare
capacity there really is since the financial crisis may itself
have destroyed some capacity. The Treasury has estimated that
this could amount to as much as 5% of GDP. But this number is
really an exercise in guessing in the dark. I am highly dubious
that much capacity has been lost at all. But even if the Treasury
is right that 5% has been lost, there should still be slack in
the economy.
6. The Bank is right to emphasize that this
overhang of unused capacity will exert downward pressure on inflation
long after the economy has started to recover. Even if the economy
grows at above trend rates for a couple of years this could still
be consistent with falling inflation.
7. Why did the MPC not extend its QE programme
by more? One issue which appears to have concerned some members
is the risk that QE will fuel an asset price bubble. Mr King himself
was dismissive of this idea in the press conference, suggesting
that it would be "peculiar to worry about asset prices now".
Nonetheless, this issue could prompt further division between
members in the coming months and the behaviour of asset prices
could have an important bearing on policy decisions.
8. Overall, the message from the Report
is that it is too soon to rule out the need for further monetary
policy action to support the economy, either in the form of more
QE or a further cut in interest rates, possibly into slightly
negative territory. At the very least, the MPC should not be contemplating
tightening monetary policy for a prolonged period.
13 November 2009
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