In May 2009, the Bank of England forecast that CPI inflation, then 2.9%, would fall to 0.7% in the second quarter of 2010. The outturn was 3.5%. In the August 2010 Inflation Report, the Bank presented an analysis of this forecasting "miss". It concluded that one-third of the error reflected higher-than-expected energy prices, with the remainder due to a combination of underestimation of upward pressure from sterling weakness and rising VAT and overestimation of the disinflationary impact of the negative "output gap".
To make one huge forecasting mistake may be regarded as a misfortune; a repeat performance this year would seriously damage the Bank's credibility. Such an outcome, unfortunately, is probable. The same August Inflation Report forecast that CPI inflation would fall to 2.8% in the second quarter of 2011 on the way to 2.2% by the fourth quarter. Based on recent trends, these numbers may be overshot by 1.0-1.5 percentage points – the chart shows a possible profile.
What has gone wrong this time? The Bank cannot blame the latest VAT rise, the impact of which was supposedly incorporated into the August forecast. It will no doubt attribute a significant portion of the overshoot to higher commodity prices but were these really unpredictable? Commodity costs have been positively correlated with emerging-world growth in recent years and the latter was widely expected to remain strong. The Bank's default assumption of stable prices (or evolution as implied by futures markets) represents a dereliction of analysis.
Three more fundamental criticisms, however, can be made. First, the Bank, in time-honoured fashion, has misread monetary developments. Most MPC members pay little attention to the monetary side of the economy but those who do, including Governor King, have wrongly concluded that slow broad money growth precludes sustained high inflation. As argued in previous posts, however, this ignores the negative impact on the demand to hold money of the negative real interest rates imposed by the Bank. Weaker money demand has resulted in an inflationary monetary excess despite low supply expansion. (This argument has been ignored in the recent exchanges between Sunday Telegraph columnist Liam Halligan and leading monetarist Professor Tim Congdon about the inflationary impact of the Bank’s policies.)
Secondly, the Bank has continued to place unwise reliance on "output gapology" despite well-known difficulties in measuring economic slack and uncertainty about its disinflationary impact. A post in January last year presented evidence suggesting that GDP was then only about 2% below its trend or potential level versus an OECD estimate of a 7% gap – probably representative of the Bank's thinking at the time. The sensitivity of inflation to the domestic gap, meanwhile, may have fallen significantly since the last recession in the early 1990s, reflecting the globalisation of the economy.
Thirdly, the Bank has underestimated the impact on expectations of the inflation overshoot and its own failure to react. Judging by survey evidence, firms and retailers plan to pass on the bulk of recent cost increases and the VAT hike to buyers, suggesting confidence that the MPC will continue to accommodate above-target inflation. The Citigroup / YouGov measure of household longer-term inflation expectations (i.e. over the next five to 10 years), meanwhile, has surged to 3.8%, a level exceeded in only two months since the survey's inception in 2005. This pick-up appears to be feeding through to pay settlements, with private deals moving up towards 3%, according to research firm Incomes Data Services.
Current inflation difficulties would be less severe had the Bank raised interest rates in mid-2010, as suggested here; this would have boosted the exchange rate, thereby restraining import cost increases, while bolstering the MPC's inflation-fighting credibility and firing a warning shot across the bows of firms planning price hikes. With the relationship between banks’ funding costs and Bank rate much weaker than in the past, such an increase would probably have had limited impact on lending rates. The net effect, indeed, may have been to support economic growth by moderating the inflation squeeze on real income and money supply expansion.
The MPC's Andrew Sentance, who has voted for higher rates since June, is winning the argument and deserves greater support from his colleagues. The December minutes revealed a small shift towards increased inflation concern and the "MPC-ometer" model suggests that this will continue at this week's meeting, with a possibility of another member supporting a hike. Poor economic news (fourth-quarter GDP growth is released on 25 January) or a set-back in markets could intervene but Dr. Sentance may yet achieve his aim of moving rates higher before his second MPC term expires at the end of May.
