Three issues should dominate tomorrow’s Bank of England inflation report: changes to the Bank’s economic forecasts; the implications of these changes for monetary policy; and the degree to which the Bank is confident it can offset further fiscal tightening with looser monetary policy.
Will we get clear indications of the Bank’s thinking on these three areas? There is no good reason why not, but a lack of justification for obfuscation doesn’t usually prevent the practice. All three are related so I have used the following decision tree to help my thinking.
In the diagram negative numbers represent the degree of policy loosening implied relative to November, while positive numbers indicate a degree of policy tightening and:
If, as most analysts expect, the Monetary Policy Committee sees slower demand growth than in November, the implied process of tightening monetary policy should be delayed, other things being equal. That is the expectation of financial markets. Investors in the Overnight Index Swap market – the best estimate of future policy rates – expect the average official interest rate over the next two years to be 1.18 per cent, compared with 1.41 per cent at the time of the November inflation report meeting.
But if The MPC also thinks the damage to the supply potential of the UK economy is worse than in November, that assumption does not hold. The monetary policy stance should be close to unchanged. And if the MPC still sticks to its very bullish demand forecasts, then there is a good change that it will give a signal that policy tightening will come earlier.
Fiscal policy tightening also depends on the degree to which the Bank and the government believe monetary policy is effective and can offset harsher spending cuts or tax increases. The less effective monetary policy is – and the inability of the MPC to point to obvious successes for quantitative easing should give everyone pause for thought – the greater the required role for fiscal stimulus remains.
What’s my best guess? I think the inflation report will have a slightly weaker demand forecast; it will express greater concern about the supply capacity of the economy than in November and the MPC will insist monetary policy is effective. That gives an inconclusive implication for monetary policy and a moderate call for greater fiscal tightening. We shall see.
