The May Inflation Report marks another step towards the demise of inflation-targeting. In a now-familiar routine, the Bank has been forced to raise its near-term inflation forecast significantly but continues to project an eventual decline to below the 2% target, based on a “neo-Keynesian” model emphasising the “output gap” and future fiscal tightening. A recent rise in inflation expectations is downplayed while the alternative “monetarist” view that persistent inflation overshoots reflect an excess of the supply of money over the demand to hold it – with demand depressed by the Bank’s imposition of negative real interest rates – is ignored. The message is that monetary policy, in effect, will be set to accommodate overborrowers, both private and public. Bank and building-society savers can expect a further erosion of their real wealth as post-tax deposit rates remain below "surprisingly resilient" inflation.
Key observations:
- The Governor suggested that the forecast was little changed from February but the inflation numbers are significantly higher out to the third quarter of 2011. The central projection for the current quarter appears to be 3.3%, up from 2.8% in the February Report, while the trough now occurs at about 1.5% in the second quarter of next year versus 0.9% in the first quarter previously (based on unchanged policy).
- The two-year-ahead projection, as in February, is just below the 2% target but with risks tilted slightly to the upside, signalling that the MPC remains firmly in neutral. The careful calibration suggests that this is more an assumption than an evidence-based forecast.
- The Bank remains bullish on the recovery, probably justifiably. The central projection is for GDP to rise by about 7.5% over the next two years (unchanged policy), although with downside risks, so the mean forecast is about 6.5%. On the defensible view that the "output gap" may be only 2% of GDP while potential growth may have fallen to about 2%, spare capacity could be eliminated by late next year. (The Bank, of course, refuses to disclose its own estimates of the "gap".)
- The chart compares quarterly inflation with the Bank's central projection a year earlier (unchanged policy). Since 2005, inflation has exceeded the forecast in 17 out of 21 quarters, with a mean error of 0.5 of a percentage point.
- The inflation target was switched from RPIX to the CPI in December 2003. Since then, the CPI has risen at an average rate of 2.5% per annum versus the 2% target while RPIX has increased by 3.1% pa versus the previous 2.5% target. Expressed differently, the level of the CPI today is 3.0% higher than if the 2% target had been achieved on average.
