Inflation report and forward guidance

Greater Manchester Chamber of Commerce’s Chief Economist, Dr John Ashcroft

Greater Manchester Chamber of Commerce’s Chief Economist, Dr John Ashcroft, gives his views on the latest inflation report:

The Bank of England today (7 August) released its quarterly inflation report, the first since Governor Mark Carney assumed the role of Governor.

The report presents a more optimistic view of the UK’s growth prospects following a batch of recent good news on the economy. The MPC increased the GDP growth forecast for this year to around 1.5% increasing the 2014 forecast to around 2.5%. Consumer price inflation is likely to fall back to 2.0% but not for some time yet. It could be 2015 before inflation falls back to target; 2.5% is the new threshold target for CPI inflation.

Governor Carney introduced the first ever version of ‘Forward Guidance’ linking a change in monetary policy to the rate of unemployment. In particular, the MPC intends not to raise Bank Rate from the current level of 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a level of 7%. On current projections, this is unlikely to occur until 2016, in line with forward market forecasts on base rates.

However, this isn’t an unconditional commitment. The Old Lady of Threadneedle Street will exercise the prerogative to change her mind subject to certain conditions. The guidance linking Bank Rate to the unemployment threshold would cease to hold if any of the following ‘knockouts’ were breached:

In the MPC’s view, CPI inflation 18 to 24 months ahead will be 0.5 percentage points or more above the 2% target.

Medium-term, inflation expectations no longer remain sufficiently well anchored and the Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability.

The intention is to suggest rates will be held until the recovery is well developed and “escape velocity” from recession has been achieved. The MPC would have us believe this is 2016. The risk is that inflation will remain above target as the recovery gains momentum and the MPC will be forced to raise rates before the suggested 2016 timeline.

It is a knock out start by Mark Carney. The economy is recovering and rates will be held for the next twelve to eighteen months at least. Forward guidance has made a promising start. Let’s hope it does not provide too much mis-direction. For now, enjoy the recovery.