The forecasts in the latest Inflation Report are hard to square with the MPC's decision to leave Bank rate unchanged at its February meeting. This suggests that either rates will rise very soon or the Committee's commitment to achieving the 2% target over the medium term has weakened.
Bank of England Governor Mervyn King's interpretation of the MPC's remit is that policy should be set to achieve 2% inflation over the medium term, taking into account any skew of risks. A summary measure of whether the Committee is on track to deliver this objective is the mean two-year-ahead forecast based on unchanged interest rates and asset purchases. (The mean forecast, unlike the central projection, incorporates the risk skew.)
Chart 5.13 of the Report shows that, on this unchanged policy assumption, the Committee's central expectation is for inflation of 2.1-2.2% in two years' time but risks are judged to be skewed significantly to the upside. The mean forecast, therefore, is about 2.5% (estimated from the chart – the underlying numbers are released with a week's delay). The implied 0.5% overshoot of the target is the highest in any Inflation Report since 1997-98, when official rates rose by more than 150 basis points over 14 months – see chart.
Further information is provided by the alternative forecast in chart 5.1 based on market interest rate expectations, implying quarter-point rises roughly every three months starting in May. Even on this basis, the mean two-year-ahead forecast appears to be above 2%, taking into account the upward risk skew. The Inflation Report, therefore, is signalling a need for even faster tightening than the market now discounts.
The out-of-consensus view here has been that the MPC would use the February Inflation Report to signal a strong tightening bias, following through with a hike in March, barring data shocks. The new projections are consistent with this forecast but the balanced rhetoric of Governor King at the press conference is not. The February minutes will reveal more but, for now, the suspicion is that the Committee is split down the middle, with the Governor struggling to keep the hawks at bay.
