Economists have challenged the Bank of England’s projection that inflation will fall below target next year, leaving question marks over the expectation that interest rates will remain low for some time.
The latest quarterly inflation report, released last week, rev-eals that consumer price index inflation rose to near two-year highs of 3.7 per cent in April. The report forecasts that inflation is likely to stay above the target 2 per cent for the rest of 2010 before dropping back to target next year and then falling below target.
The monetary policy committee’s minutes for its May meeting, also published last week, echo these inflation forecasts and reveal that members voted unanimously to hold bank rate at 0.5 per cent.
Bank of England governor Mervyn King says: “Inflation is likely to remain above target throughout 2010. The near-term outlook is higher because of further increases in the oil price and falls in sterling since February. Looking into next year, inflation is likely to fall back towards the target as the temporary effects of the factors pushing up on inflation wane.
“It will then probably fall below target as the substantial degree of spare capacity pushes down on prices. But the pace and extent of the fall in inflation are highly uncertain and recent experience suggests that there are substantial risks in both directions which the committee will monitor carefully.”
But economists are unconvinced by the arguments put forward by King in the report.
Henderson chief economist Simon Ward says King’s explanation of increased inflation due to rising oil prices, falling sterling and the December VAT increase is “dubious”.
He says: “King’s latest explan-atory letter claims that the overshoot of CPI inflation relative to the 2 per cent target is fully explained by higher oil prices, the rise in VAT and exchange rate weakness. This is dubious. Energy and VAT are unlikely to account for more than one percentage point of the 3.7 per cent April headline rate. Sterling’s decline partly reflects monetary policy decisions so the bank cannot absolve itself from responsibility for the impact on inflation.
“The governor also fails to acknowledge the scale of the bank’s forecasting error. The central projection in the May 2009 inflation report was for CPI inflation to fall to 0.7 per cent by the second quarter of this year. This incorporated the planned VAT rise and was based on a similar effective exchange rate level to today’s. Higher energy prices can account for only about 0.5 of a percentage point of the three-point forecast miss.”
BarCap UK analyst Simon Hayes says: “The MPC judged that inflation was likely to drop substantially below target next year and to remain there for some time.
“We are surprised that the MPC is so relaxed about the medium-term inflation outlook and that although there are differences in view across the committee, there have been no signs of major dissent. Inflation has been consistently stronger than the MPC’s forecasts and we expect this pattern to continue.
“We do not share the MPC’s confidence that the mediumterm outlook is for inflation to slump persistently below target. Nevertheless, the MPC’s recent communication has made it clear that it believes the current ultra-loose policy stance is appropriate and a near-term tightening in policy app-ears unlikely.”