Bill Jamieson: King's faulty dials leave us blind to the true level of inflation
Last week the Bank of England lowered its forecast of 2011 economic growth, made just three months ago, from 3.4 per cent to a more realistic (though still optimistic) 2.5 per cent.
More notably, the Bank Governor Mervyn King also retreated from previous forecasts of moderating inflation in 2011 to a view that inflation would remain above 2 per cent throughout next year. It was as recently as May that the MPC forecast that inflation would fall below target in early 2011, and only in February that it forecast inflation would fall below 2 per cent this autumn. The CPI measure is currently rising at 3.2 per cent.
Since inflation watching is the primary remit of the Bank, this was quite an admission. However, since inflation has already exceeded the 2 per cent target for 42 of the past 51 months, that admission may not have come as much of a shock.
But it is a notable admission by the Bank that not only have its previous inflation forecasts been consistently over-optimistic, but also that the key plank of monetary policy - targeting a 2 per cent inflation rate - is effectively in abeyance for the foreseeable future. If the official target is not now to be bothered with for interest rate purposes, why persist with it? Indeed, why bother with regular monthly meetings of the Monetary Policy Committee if interest rates are to be kept ultra low?
When the MPC was set up in 1997 the operational target was an annual rate of 2 per cent "at all times". Brown did allude at the time to temporary circumstances and external events which might temporarily impinge on the pursuit of this target. Debate now rages on the interpretation of what is a temporary event and in particular the meaning of the phrase "at all times".
When do temporary conditions cease to be temporary? The financial history of the UK over the past decade could well be seen as an almost continuous series of unexpected circumstances. Says seasoned economist Stephen Lewis at Monument Securities: "'Shocks', perhaps, are no longer one-off occurrences but rather a regular feature of UK economic life."
But that in turn would create further problems for the Bank. "The MPC might then have a care," Lewis waspishly adds, "for the impact repeated 'shocks' are likely to have on inflation expectations. This should temper committee members' confidence in the latest Inflation Report's projection that the annual rate of CPI increase will fall well below 2 per cent within two years."
To be fair, such forecasting has never been an exact science. The first appearance of the Bank's famous fan charts depicting a wide range of possible outcomes, with the central forecast in darker ink, was a vivid visual admission as to the proximate nature of forecasting and the margin of error to be allowed for.
But the financial crisis and subsequent recession brought forth even more question-begging caveats. The first was the failure of both the Bank and Treasury forecasting models to predict either the banking crisis or its severity. The second was the vulnerability of official forecasting methodology to the sharply enhanced volatility in financial markets. And the third is the current inability to see through the aftermath or consequence of "outlier" events with any degree of clarity. Time after time over the past two years the despairing cry of experienced commentators has been "we are in unknown terrain" or, more starkly, "we are flying blind".
This matters, because in almost the same breath as Mervyn King signalled the abandonment of previous optimistic forecasts of inflation, he sought to reassure businesses and households that interest rates will remain at today's ultra low levels for an extended period. Yet how can we be sure this prognostication will prove any more reliable than the Panglossian ones just discarded? And given the policy concern to avoid a relapse into recession, any further resort to Quantitative Easing cannot but raise anxieties about an inflation surge a year to 18 months hence, and with it a sudden upward lunge in interest rates.
More worrying for the Bank is the heightened volatility evident in financial markets. A previous generation poured billions into long-term savings products. Who would dare risk such long-term commitments now? The life cycle of companies - not just their products and services - appears much shorter now than it did to earlier generations of investors.
We cannot be certain that the "new normal" is the period that awaits after this current volatility or whether it is in fact the febrile, apprehensive state we are now in. The rising school of behavioural finance would argue that crowd psychology has always played a major role in financial behaviour - only the crowd has got bigger and the means of spreading its mood changes more instantaneous and far reaching. Set against these heightened market mood swings, traditional methods of economic and financial forecasting may have an uphill struggle in influencing expectations.
For the moment, King's warning of a subdued and "choppy" recovery is well reasoned, though his continuing insistence on the temporary nature of upward pressures on inflation is less convincing. Similar arguments were being made ahead of the major inflation surge of the mid-1970s.
Citigroup economist Michael Saunders says the MPC is "probably wrong to dismiss the inflation overshoot as just a series of temporary one-off cost pressures". Inflation stickiness, he says, may also reflect the recent sharp pick-up in growth and that the economy has less disinflationary slack than expected. The result, he warns, is that inflation "will remain stickier than the MPC expect".
What monetary policy now starkly lacks is a credible targeting regime to monitor inflation now that the 2 per cent target has been left hanging in the wind. Perhaps the MPC can be put to work in devising a new inflation measure. It would certainly help to have one that takes account of changes in asset prices such as housing. It was arguably the absence of this, more than any other single factor, that accounted for the under-estimation of inflation pressures in 2003-07 and led us sightless into the financial storm.
Mervyn King is now the battle-scarred pilot of an aircraft bucked by turbulence, the instrument dials in either a maniacal spin or reading "flight path normal". But it is anything but. Hence that deeply uneasy feeling that, even after the policy admissions of last week, we are still "flying blind".