The Federal Reserve yesterday gave markets a strong steer that official interest rates will remain at rock-bottom levels for a further two years. Despite the Governor downplaying the suggestion, the Monetary Policy Committee has delivered a similar message in the August Inflation Report.

A key summary measure of the MPC’s policy intentions is its mean forecast of inflation in two years’ time based on unchanged policy. In May, this stood at 2.54%, representing the largest positive deviation from the inflation target in the MPC’s history – see chart. This gave a strong signal that the Committee foresaw policy tightening on a one- to two-year horizon, despite divisions over the timing of the first move.

In the August Report, the mean two-year-ahead forecast has been slashed to an estimated 2.1%, based on chart 5.13 (p.46). This projection, moreover does not incorporate the risk of “an intensification of concerns about sovereign debt” in the euro area, which the MPC judges “almost impossible to calibrate”, but will take into account in setting policy. Since this risk merited a separate box in the Report (p.38), it is, presumably, regarded as significant. The implication is that, were a full risk-weighted computation possible, the mean forecast in two years’ would be below 2%.

This, in turn, supports the prediction of the “MPC-ometer” that the Committee shifted to an easing bias last week. The model forecasts an “average interest rate vote” of -7 basis points, the most negative reading since November 2009, consistent with the two rate-hike proponents backing down and one or more members of the middle group joining Adam Posen in voting for more QE – see previous post for more details.

The cut in the medium-term inflation projection since May looks out of proportion with a modest downgrade to growth, raising further doubts about the Bank’s forecasting credibility. The suspicion is that the Committee has shifted dovishly in response to recent market turbulence and the inflation projection has been adjusted to be consistent with the new stance, rather than the forecasting process itself driving policy.
 
Surprisingly, the shorter-term inflation forecast is little changed from May. With commodity prices softening, CPI inflation may peak below the 5.0% level predicted by the Bank and fall more quickly into early 2012 while remaining above target further out, partly reflecting further exchange rate weakness promoted by the MPC’s dovish stance.