Memorandum submitted by Mr Roger Bootle, Capital Economics
1. As usual, the February Inflation Report predicted that RPIX inflation would be close to its 2.5 per cent target in two years time, implying that the current stance of monetary policy is broadly correct. Note that the forecast was actually a touch below 2.5 per cent but the risks were perceived to be on the upside. These two observations probably neutralise each other.
2. RPIX is once again expected to stay below 2.5 per cent for the whole of the two year interim period, however, meaning that inflation would have undershot its target almost without interruption for five years by the end of 2003. This must surely increase suspicions that the MPC has a bias towards rather lower inflation than the 2.5 per cent targetwhich is supposed to be symmetric.
3. This point is supported by the effect of the alternative assumptions preferred by some members, which could reduce inflation by another 0.4 per cent at the two-year time horizon. It remains something of a puzzle why some members' views on certain aspects of the inflation outlook are left outside the central RPIX forecast and not incorporated within it, especially when the influence of these views on the inflation forecast works in only one direction (down). It is possible that the views of some of the outside members are not being given the same weight as those of the Bank "insiders".
4. More generally, it is perhaps surprising that the inflation forecast was left largely unchanged from that in the November Inflation Report given the changes in the assumptions underlying the forecast. Global growth was revised down by 0.25 per cent to 0.5 per cent in 2002, UK GDP growth was revised down significantly this year, oil prices were $1 lower than expected in November, and the pound was 1 per cent higher in trade weighted terms.
5. It is not clear which other forces provided the offsetting upward influences on inflation to leave the RPIX forecast broadly unchanged and there must therefore be a suspicion that the forecast was deliberately massaged higher to prevent the MPC from having to cut interest rates again and hence risk further unbalancing the economy.
6. It might be argued that these points are weakened by the January RPI numbers, which showed RPIX moving above its target to 2.6 per cent and which were not available when the Inflation Report was written. But I do not think that the January numbers would have had a big effect on the Bank of England's projected medium-term path for inflation.
7. In any case, I expect RPIX to fall back over the coming months as some of the erratic movements which contributed to January's rise are reversed and recent falls in output price inflation put renewed downward pressure on goods prices at the retail level. Provided that the sharp increases in food prices seen last spring are not repeated, there is even a chance that RPIX still breaches the bottom of the 1.5 per cent to 3.5 per cent target range. This would most likely occur in May or June.
8. As for the medium term outlook, the Bank was right to revise down its projected path of GDP growth in the February Reportthe profile in the November Report always looked too optimistic. But there remain considerable downside risks, not least the possibility that recent more encouraging signals from the US economy turn out to have been simply a near-term rebound from the extreme weakness in the wake of the September 11 terrorist attacks rather than a sustainable upturn in the economy.
9. In the other direction, it is notable that the Bank's expectation of some slowdown in consumer spending in the face of rising unemployment and falling wealth has yet to be met. Despite this, the Bank is right to recognise the risk of a sharp and sudden fall in spending at some point in response to the build-up of debt witnessed in recent years. The latter suggests that any rise in interest ratesor even the threat thereofcould have a major effect on spending behaviour.
10. The other main danger from the unbalanced nature of growth remains a sharp inflationary drop in the exchange rate, although my own judgement is that this is less of a concern than the drop in spending mentioned above.
11. Given these pointscoupled with the evidence of a systematic tendency for the Bank to over-estimate the likely path of inflationmy expectation is the RPIX will once again be rather lower than the Bank expects over the medium term.
12. Finally, I would make the point that the Inflation Report includes no mention at all of the single most important issue likely to face the UK economy in the next few yearsnamely the single currency and the question of UK membership.
18 February 2002