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UK Inflation Report preview

Posted on Tuesday, August 10, 2010 at 12:47PM by Registered CommenterSimon Ward | CommentsPost a Comment

Inflation targeting supposedly involves the Bank of England using its huge intellectual capabilities to produce a forecast for inflation one to two years ahead and then adjusting policy to minimise deviations of the forecast from the 2% objective. This procedure has become meaningless, for two reasons.

First, the Bank's forecasts have little information content, as documented by an article in today's Financial Times. The chart illustrates the persistent tendency to underpredict inflation in recent years.

Secondly, the MPC appears to be more exercised by the "tail risk" of deflation than a persistent inflation overshoot, although such a bias is at odds with its remit. The Committee, in effect, is setting policy to avoid a deflationary scenario rather than taking into account the full probability distribution of future inflation outcomes.

A cynical view is that the emphasis on deflationary risks is a smokescreen to allow super-low interest rates to be maintained in order to meet objectives unrelated to the inflation target, such as providing cover for fiscal policy tightening and suppressing the exchange rate in the hope of promoting "economic rebalancing".

Against this backdrop, it would be a surprise if tomorrow's Inflation Report failed to follow the recent pattern of revising up near-term inflation projections significantly while forecasting a fall to below the 2% target in two years' time, with a sufficiently wide distribution around this forecast to allow MPC doves to continue to emphasise deflationary risks.

It would be even more surprising if markets reacted to the Bank's increasingly irrelevant musings.

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