The August minutes contained yet another surprise for MPC-watchers, with three members voting to expand asset purchases by £75 billion rather than the £50 billion favoured by the majority. The difference, however, should not be exaggerated: the Committee agreed that the new purchases should be spread over three months and the size of the programme is unlikely to be revisited before the November meeting, when the MPC will update its quarterly forecasts. If the economy evolves in line with the projections in the August Inflation Report, there will be no justification for continuing gilt-buying and by early 2010 the Committee will be under pressure to start withdrawing monetary stimulus.

A useful summary measure of the implications of the Inflation Report for future policy direction is the MPC’s mean forecast for inflation in two years’ time based on unchanged policies. This forecast fell to a record low of 0.38% in February, signalling that the Committee judged significant further easing to be necessary – the gilt purchase programme was announced the following month, along with a half-point cut in Bank rate. In the May Report, the two-year-ahead forecast was raised to 1.71% but the shortfall from the 2% target indicated that the MPC retained an easing bias. This residual bias partly explains the decision to expand asset purchases further in August.

The August Report, however, suggests that the £50 billion expansion was larger than strictly necessary because the two-year-ahead forecast is now above the target, at 2.17%. This is the first positive deviation since last August and the largest since August 2007 – the MPC last raised Bank rate in July 2007. The Committee’s decision to adopt a looser policy than warranted by its projections appears to reflect a judgement that the economic costs of inflation undershooting the target would exceed those of an overshoot. It has, in effect, taken out temporary insurance against worse-than-expected outcomes.

The emphasis, however, is on “temporary”, since such an approach risks damaging inflation-fighting credibility. Moreover, if the economy performs in line with the MPC’s mean expectations, the deviation between the current policy stance and one calibrated to achieve 2% inflation will widen. The August Report shows mean inflation climbing by 0.2 percentage points between the third quarter of 2011 and the first quarter of 2012 in the forecast based on market-implied interest rates; the increase would be greater if rates are unchanged. So the two-year-ahead projection based on unchanged policies could rise from 2.17% currently to about 2.5% by early next year. A 0.5 percentage point excess over the target would be at the top of the historical range.

Taken at face value, therefore, the August forecasts seem to lay the foundations for a withdrawal of monetary stimulus in early 2010. Of course, with economic recovery at an early stage and unemployment possibly still rising, any such action would be controversial. Moreover, some MPC members may argue for a delay to monitor the impact of the January VAT rise, although an assessment has already been built into the projections. The imminent general election may also affect the Committee's willingness to follow the logic of its forecasts – political sensitivities may be heightened by the Conservative proposal to transfer responsibility for financial regulation from the Financial Services Authority to the Bank of England.

While the likelihood of policy tightening in early 2010 can be debated, the August Report appears to rule out further loosening unless growth and / or inflation fall significantly short of the MPC’s expectations. This seems unlikely. The GDP forecast based on unchanged policies shows a mean rise of only 1.1% in the year to the second quarter of 2010 but purchasing managers’ indices have recovered close to long-term averages, consistent with annualised growth of more than 2%, while an end to destocking alone will give an arithmetical boost of 1.4 percentage points.

The MPC has revised up its short-term inflation projections significantly since the May Report, now expecting an annual CPI gain of 1.3% in the third and fourth quarters, but this is possibly still too low in light of July’s higher-than-expected outcome of 1.8%. While food price trends are favourable, core inflation may remain disappointingly sticky, reflecting lagged currency effects and – perhaps – a smaller "output gap" and / or lower sensitivity to economic slack than widely assumed. Also worthy of note is a likely strong rebound in retail price inflation from late 2009, which may boost measures of household inflation expectations monitored by the MPC. (See previous post for more discussion of inflation prospects.)

An eventual withdrawal of monetary stimulus is likely to take the form of a rise in Bank rate rather than a reversal of quantitative easing. The Bank of England could drain banks' excess cash reserves, by selling bills or reducing repo lending, but such action would probably have little economic impact. A run-down of the Bank's gilt portfolio is unlikely to be possible next year given forecasts that fiscal funding needs will remain gargantuan – unless officials are prepared to risk triggering a major rise in yields. With "quantitative tightening" off the agenda, and given the historically low starting level, rises in Bank rate, when they begin, could be larger than in the initial stages of prior cycles.