The MPC claims that a Bank rate of 0.5% is necessary to prevent inflation from undershooting the 2% target over the medium term. Its recent forecasting performance, however, casts doubt on its ability to predict near-term inflation movements, let alone developments two years or more ahead. If the Bank's inflation model is broken, it is fair to ask whether the pseudo-science of the Inflation Report fan charts should be ditched in favour of an ECB-style judgemental approach, including increased emphasis on monetary analysis.
In its February Inflation Report, the MPC predicted that annual CPI inflation would fall to 0.8% and 0.7% respectively in third and fourth quarters of 2009. A post at the time argued that this was too optimistic, with the Bank underestimating the inflationary impact of sterling's plunge during 2008.
Despite upside surprises in early 2009, the Bank actually revised down its third and fourth quarter modal projections in the May Inflation Report, to 0.7% and 0.4% respectively. Further disappointing outcomes, however, forced a significant change in the August Report, with the forecast raised to 1.3% for both quarters.
Two months of data later, this no longer looks credible. With today's 1.6% August result following 1.8% in July, inflation would have to plunge to 0.6% in September to average 1.3% in third quarter, as projected. The overshoot is likely to carry over to the fourth quarter. Bank of England Governor Mervyn King is probably now regretting his statement at the August Inflation Report press conference that a fall below 1% was "more likely than not" later in 2009.
A puzzle for the Bank's forecasters is that core inflation remains sticky despite a weakening of import price pressures as sterling has rebounded this year – manufactured import costs fell by 5% between March and July, following a 14% surge in the prior 12 months. The CPI excluding energy, food, tobacco and alcohol rose an annual 1.8% in August and would probably have climbed 2.4-2.5% in the absence of December's VAT cut (based on a National Statistics estimate that the reduction lowered headline inflation by about 0.5 percentage points). This would be the highest in its 12-year history – see chart.
As well as the size and persistence of the exchange rate effect, the lack of response of core trends to rising economic slack is troubling for the MPC's inflation optimism. This could reflect longer-than-expected lags but the Bank's forecasts may have placed overreliance on highly-uncertain estimates of the size of the "output gap" and its influence on pricing decisions.
The 1.6% August headline rate is in line with the inflation profile forecast presented in a previous post, although the breakdown is slightly different, with core prices higher and food prices lower than assumed. Updating inputs to take account of recent information, CPI inflation is projected to fall to 1.2% in September as a result of favourable base effects before rebounding to about 3% in January as VAT is raised back to 17.5%. The implied first-quarter average of 2.75% compares with a forecast of 2.1% in the August Inflation Report.