Back from holiday and nothing has happened which materially changes the British economic outlook. At its August meeting the vast majority of the Monetary Policy Committee (eight out of nine) thought doing nothing was the best option and “stood ready to respond in either direction as the balance of risks evolved”. The balance of risks has not changed, so we can be quite sure that, unless the Committee takes leave of its senses, monetary policy will remain unchanged on Thursday.
Michael Saunders of Citi put it well, writing:
“It is often tempting to stress uncertainties, but in our view this month’s MPC decision really is not a close call.”
That said, sensible economists continue to disagree about the next move for the Bank. That might be expected following Bank forecasts which we know contain no useful information at forecasting horizons of a year or more. But the following arguments are still interesting.
Why not hit the inflation target?
As Simon Hayes of Barclays Capital notes with the following nice chart, the Bank has persistently over-shot its 2 per cent inflation target of late and the aggregate price level is now 3 per cent higher than it would have been had inflation been on target since 2003.
The cost of such forbearance, he argues is lower household real incomes, equivalent to raising value added tax from 17.5 per cent to 25 per cent. it also risks undermining the credibility of the MPC’s ability to control inflation, making multi-year price and wage setting difficult. The reason the MPC has allowed the price level to drift higher is that it expects lower inflation due to continued slack in the economy and does not want to tighten policy when spare capacity is extensive. All this is reasonable but it is difficult for the MPC continue to allow around 3 per cent inflation with a 2 per cent target, Mr Hayes says. This is clearly correct and if we see signs that the economy is performing as well as the Bank’s central forecast, I am sure this concern will lead to significant tightening earlier than the markets expect.
The Bank is really quite bullish on nominal growth and more so than in 2009
We know the Bank had to revise down its growth forecasts and revise higher its inflation forecasts in the August inflation report. Given these trends, Michael Saunders of Citi has had the rather neat idea of putting these two together and looking at the evolution of the Bank’s nominal growth forecast to see whether the Bank thinks activity will be stronger or weaker than before. The implication being that if the Bank is revising higher its forecast for nominal activity, it is something of a signal of future tighter monetary policy.
As the chart shows, the Bank’s central nominal GDP forecast has been revised significantly higher at the same time as it has revised down its real GDP forecast. The result is that the Bank is expecting higher inflation than before but this has not been offset by lower growth. Surely a signal of tighter policy to come, again contrary to recent market movements.
But the Bank is still expecting an inflation undershoot on unchanged policies.
As Vicky redwood of Capital Economics points out, the August inflation report’s central forecast for inflation at the two year horizon is lower than in May and significantly below the 2 per cent target.
Although we should be extremely careful about putting too much weight on these forecasts, as Ms Redwood says, “The MPC seems genuinely still to believe that inflation will fall sharply in response to the large amount of spare capacity in the economy”. And if inflation does fall, the case for more stimulus will rise if it is accompanied by a renewed slowdown, she argues.
Put all this together and a confused picture emerges.
That seems about right. We don’t know where the economy is headed at the moment. Given this, doing nothing is not just an option in September. It is the only sensible option.