Bank of England November 2009 Inflation Report - Treasury Contents

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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