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The February Inflation Report is more dovish than expected but the Bank of England has failed to provide an explanation of the significant inflation overshoot relative to its forecasts, casting doubt on the credibility of its current projections. The suggestion is that the forecast is being adjusted to fit the policy rather than vice versa.

Key points:

While forced to raise its near-term inflation profile, the Bank has revised down its medium-term forecasts: the two-year-ahead modal projection based on unchanged policies is now below 2% versus 2.35% in the November Report. It is difficult to believe that this change was warranted by the modest downward revision to its growth forecast, which continues to envisage a solid recovery.

Governor King's claim that the current overshoot relative to the Bank's forecasts can be explained by higher energy prices is unconvincing. The February 2009 Report projected inflation of 1.3% in the first quarter of 2010 based on unchanged policies. If the Bank had used its current energy price assumptions, the forecast would have been about one percentage point higher, i.e. 2.3%. Inflation is now expected to be about 3.3% this quarter, despite a much larger GDP fall than the Bank predicted last February. In other words, there is an unexplained forecast error of at least a percentage point.

The most likely explanation for this error is that the Bank overestimated the disinflationary impact of economic slack while underestimating upward pressure on traded goods prices from exchange rate depreciation. The cut in the medium-term inflation forecast, however, suggests that the emphasis on the "output gap" has, if anything, increased. The Bank, meanwhile, continues to assume that the impact of sterling weakness will be temporary; the alternative view is that the low real exchange rate will exert further upward pressure on UK goods prices relative to the global trend over the medium term.

A likely significant rise in indirect taxes after the election will boost inflation relative to the Bank's forecasts. In a recent speech, Governor King suggested that the MPC would ignore "temporary price level factors" – defined to include commodity price rises, sterling depreciation and tax increases – when setting policy. It is debatable whether such an approach is compatible with the MPC's remit, which is to achieve the 2% target, defined by the consumer price index without any exclusions, "at all times".

A previous post argued that how the MPC interprets its remit would be as important for the interest rate outlook this year as the evolution of inflation and output. Today's Report reinforces suspicion of a shift to "inflation targeting lite", involving downplaying "exogenous" upward influences on inflation and placing more weight on forecasts and discretion. Accordingly, any policy tightening is now unlikely before May at the earliest.