Four lessons from today's BoE Inflation Report

By Edmund Conway Economics Last updated: August 12th, 2009

I’ll be doing a few pieces of news and analysis for the paper this afternoon, but before I get onto them, here are a few thoughts about the Bank’s Inflation Report today.

1. The market had overstepped itself with its expectations for interest rate hikes.
The report said that according to the markets, traders were pricing in that the Bank would start raising interest rates from their current level of 0.5pc as soon as in the first quarter of next year, lifting them pretty quickly towards over 4pc by 2012. These assumptions were clearly wrong, or so we can judge from a quick look at the inflation projections. As I explained briefly this morning, the key thing here is to compare two charts - the first being the one which shows what the Bank thinks would happen to inflation if rates followed market expectations. This is reproduced below.

The key question is whether the level of inflation in two years’ time is at, or above or below, the 2pc level the Bank’s Monetary Policy Committee targets. As you can see, if the Bank did what the market expected and hiked rates up towards 4pc, inflation would come in well below target (NB in this chart the two year point is represented by that vertical broken line).

Does that mean we shouldn’t expect any increases in rates whatsoever over the next two years? Not necessarily. To see why, look at the chart which sets out where inflation will go if rates were kept constant at 0.5pc.

This chart (the timescale is slightly different, in that it ends where that broken vertical line was on the one above, ie in two years’ time) shows that inflation would be ever so slightly above target in by mid 2011. The message, then, is that at some point monetary policy will certainly have to tighten, but not by half as much as the market is anticipating.
Whether this implies interest rate increases or plain withdrawal of quantitative easing is another good question. The answer is we simply don’t know, though the Bank has indicated that the process could involve a combination of selling back gilts into the market and raising rates (though it is well aware that pumping back gilts when the Government is already selling so many of them in the coming years could cause unwanted indigestion).

2. The Bank was worried about the threat of deflation and the risk of Britain “becoming a Japan”
As we wrote in a couple of stories over the past days, the rationale at the Bank for pumping extra cash into the economy really did surround these prospects. As the report says: “At its August meeting, the Committee noted that the immediate prospect was for CPI inflation to fall substantially below the 2pc target…. the margin of spare capacity in the economy was likely to continue to grow for some while, bearing down on inflation.” This was its broad rationale for pumping an extra £50bn into the economy - though we’ll learn more in next week’s minutes.

King also admitted, tellingly, that he had consulted with his counterparts in the Bank of Japan specifically about how to avoid making the same mistakes, saying it is essential for policymakers to do so, as “we definitely do not want a wasted decade.”

He then added that he thought the UK had responded better in two ways: the BoE had cut rates sooner and the Government had done a better and faster job in cleaning up the banking system. More precisely, he said: “The banking system has to be fixed. The banks will end up with much higher levels of capital than they had going into this crisis. We’re very conscious of the Japanese experience. We do not intend to go down the same road.”

On deflation, it was telling that he warned that although inflation will pick up this year, price growth is more than likely to drop down below the 1pc level, meaning he is forced to write a letter of explanation to the Chancellor this autumn.

3. Banks remain in deep trouble.

Another part of the rationale for pumping more cash into the economy, and for this gloomy outlook, is that the financial sector is still far from healthy. Indeed, King said it would be a number of years before it recovers fully, saying: “What we have to do is to recognise that the banking sector is still in a very bad way, and it will take several years for it to repair its balance sheets, to get back to the point when it will be weaned off very large amounts of public support and in a position again to lend normally.”

This has significant consequences: if banks are still charging high mark-ups on their loans, it will make the BoE more reluctant to raise rates sooner, since even 1.5pc Bank rate will translate into a painfully high mortgage rate. The problem, he indicated again, is that banks are too undercapitalised to be able to lend out money at a reasonable rate. However, he denied that this was anything the Bank can do much about. Indeed, it is the Government’s responsibility to decide whether it needs to pump more capital into their accounts (and given this would imply possible wholesale nationalisation of some banks, one hardly suspects it would be likely).

4. Watch out for the fiscal squeeze

Bear in mind that neither the inflation or growth forecasts factor in the likely scale of tax rises/spending cuts that will come into force after the election. The projections are based on the plans laid out in the Budget, plans which according to almost every economic authority, including King himself, are not ambitious enough. But if, as most expect, the next Government does indeed tighten their plans, it will imply weaker economic growth and weaker inflation as this feeds through to the wider economy. Therefore it is probably fair to assume that the inflation projection is a wee bit higher than it should otherwise be. This supports the view that the Bank will almost certainly be loth to raise borrowing costs ahead of the next election - because there is a large chance that what follows the election will be a pretty horrendous bout of government austerity.