Memorandum submitted by Mr Roger Bootle
1. As usual, the November Inflation Report
predicted that RPIX inflation would be very close to its 2.5 per
cent inflation forecast in two years' time, implying that the
current stance of monetary policy is broadly correct. Despite
this, financial markets scaled back their existing expectations
of further reductions in interest rates in response to the Report,
and in particular to the line that "the overall risks to
inflation are on the upside".
2. I believe that this judgement will prove
to be wrong, however, and that further interest rate cuts will
be required. Aside from the MPC's usual tendency to be too pessimistic
on inflation, there are several specific areas of the forecast
which are likely to overestimate the upward pressure on prices.
3. First, although the Inflation Report
contains downward revisions to growth, the central RPIX forecast
is still based on a very moderate slowdown in activity, with annual
GDP growth staying at or above 2 per cent right through the forecast
period. Yet forward-looking indicators currently warn of a significantly
sharper slowdown. Although it is true that domestic demand has
been stronger than international, it looks as though international
demand may weaken still further. Manufacturers have not yet felt
the full impact of the international slowdown on their exports.
Meanwhile, there are serious risks to domestic demand too. Consumers
have not yet felt the blow to confidence from a sharply slowing
housing market or a significant increase in unemployment. Yet
all these things seem to be in train.
4. Second, and in connection with the above,
the RPIX forecasts are based on the assumption that commodity
prices do not fall significantly. In particular, oil prices are
assumed to hold steady at around $20 per barrel. They have already
fallen by another 15 per cent (to around $17 per barrel) since
the Report was prepared, however, and further falls look likely.
(Kuwait has warned that the price may reach $10.)
5. Third, I suspect that the central RPIX
forecast underestimates the extent to which the falls in factory
gate inflation over the last year and any future falls are likely
to feed through to retail goods prices.
6. Taken together, I expect these factors
to result in a rather lower path for RPIX than that predicted
in the November Report. Indeed, depending on the behaviour of
some of the erratic items such as seasonal food prices, I believe
that RPIX could even breach the bottom of the 1.5 per cent to
3.5 per cent target range next Spring, triggering a letter of
explanation from the Governor to the Chancellor.
7. Both the MPC and the public need to guard
against the danger of being misled by the already apparently low
rate of interest. Rates in the UK are higher than in any other
G7 country and in real terms they are pretty high absolutelyalmost
3 per cent, when measured against the HICP, compared with 0.75
per cent in the euro-zone and minus 0.6 per cent in the
US. This leaves plenty of scope for further rate cuts if they
are needed. But if the public believes that rates are already
so very low that they must soon rise then the effectiveness of
rate reductions will be lessened.
8. The MPC takes the view that the risks
to growth are balanced while the risks to inflation are on the
upside (the latter arising from a fall in sterling or private
spending remaining stronger for longer than expected). By contrast,
I believe that the risks to both growth and inflation are firmly
on the downside.
9. The risk from a big sterling fall persists,
even though the record of the Bank's method of projecting the
exchange rate has continued to be poor. (See Chart.) (Incidentally,
under the current formula, if UK interest rates reached parity
with other countries, then the Bank would be obliged to assume
that the exchange rate remained unchanged over the forecast horizoneven
though it, or at least a significant body of opinion on the MPC,
clearly believes that the risks are strongly on the downside.)
10. The Report also confirms an apparent
departure in monetary policy strategy hinted at in speeches by
various Committee members over the past month or two. The November
rate cut was explicitly cited as intended to help keep private
domestic spending firm. In other words, fears about the need for
private spending to ease back in order to make way for faster
growth in public spending have been relegated to the back burnerrightly.
11. It is worth noting that some of my worries
about risks are incorporated in the alternative assumptions preferred
by some Committee members, the combined effect of which would
be to reduce the central RPIX forecast by 0.5 per cent at the
two year horizon (and hence imply the need for lower interest
rates). I continue to be puzzled as to why the views of some members
are apparently excluded from the central forecast upon which policy
decisions are made in this way, especially when they are not counterbalanced
by other alternative assumptions which might add to inflation.
16 November 2001