The chart shows an update of a monthly CPI inflation profile presented in a previous post together with the Bank of England's mean forecast based on unchanged policy, estimated from chart 5.13 of the May Inflation Report. Assumptions underlying the profile include:

• "Core" prices – defined here as the CPI excluding unprocessed food and energy – rise at a 2.25-2.5% annualised rate, in line with an estimate of the trend leading into the recent VAT hike.

• 90% of the VAT rise has been passed onto consumers, consistent with evidence from the Bank of England agents' survey – higher pass-through implies a larger mechanical fall in inflation next year as the impact drops out.

• Household energy bills rise by 7.5% over the next 12 months.

• Unprocessed food inflation peaks at an annual 6% in mid 2011 and slows to 3.5% in 2012.

• Bank rate is raised to 2% next year, contributing to core inflation remaining stable despite a further rise in capacity utilisation as the recovery continues.

• Undergraduate tuition fees add 0.2 percentage points to inflation from late 2012, as discussed in a previous post.

On these assumptions, inflation is projected to peak at 4.6% later this year before falling back below 3% in early 2012. The average between April 2011 and June 2012 is 0.6 percentage points lower than in the Bank's forecast, showing a quarterly peak of more than 5%. The profile, however, is higher from late 2012, with inflation stabilising at about 2.75% versus the Bank's 2.5%.

Reasons for these differences include:

• The Bank's forecast incorporates a larger rise in household energy bills, of about 12.5% rather than 7.5%. The latter takes account of the recent correction in wholesale energy prices and assumes that slower emerging-world growth will relieve upward pressure over the remainder of 2011.

• The Bank assumes lower VAT pass-through of about 75% rather than 90%, despite the evidence from its own agents, resulting in a smaller favourable base effect on inflation in 2012.

• The Bank's lower forecast from late 2012 reflects its view that spare capacity remains significant and will bear down on core inflation, despite limited evidence of such an impact to date. The Bank's medium-term numbers would be closer to 2% if based on the assumption of a rise in Bank rate to 2% in 2012.

While inflation is likely to remain well above the target for the foreseeable future, a significant fall next year should contribute – with rising wage growth and employment – to a rebound in household real income, in turn supporting prospects for consumer spending and GDP expansion.

Japanese bank reserves surged in the wake of the 11 March earthquake / tsunami as the Bank of Japan supplied emergency funds and, later, intervened to suppress the yen. Some investors speculated that the tragedy had triggered a major policy shift and further Japanese liquidity injections would supercharge global markets already boosted by the Fed's QE2 largesse.

These expectations seemed hopeful at the time – see previous post – and the BoJ has duly disappointed. Reserves have fallen back as lending has normalised and f/x intervention has been sterilised. As of today, they were ¥10.7 trillion ($132 billion) below the late March peak and half-way back to the pre-earthquake level – see chart. The liquidity withdrawal is boosting the yen and has probably contributed to recent commodity price weakness.

What is the UK’s non-inflationary trend rate of GDP expansion? The Office for Budget Responsibility (OBR) suggests 2.35% per annum. The Bank of England, naturally, refuses to reveal its estimate. The view here is that trend growth is below 2%, possibly 1.8-1.9%.

The OBR bases its 2.35% figure on trend productivity expansion of 2.0% and a projected rise in hours worked of 0.35%. On first inspection, the 2.0% productivity assumption looks reasonable. GDP per hour rose by 2.0% per annum between 1997 and 2008, years in which capacity utilisation in the economy was probably similar – the unemployment rate averaged 6.4% in 1997 versus 6.2% in 2008.

Measured productivity expansion over 1997-2008, however, is likely to overstate future potential, for two reasons. First, growth was artificially boosted by an outsized contribution from “financial intermediation” due to the credit boom. Financial intermediation accounts for 8% of GDP and productivity in the sector rose by 5% per annum over 1997-2008 versus an increase of 1.75% in the rest of the economy.

Financial intermediation GDP correlates with inflation-adjusted bank lending to the private sector. Output has slumped with credit since the financial crisis and – in contrast to the rest of the economy – has yet to recover, consistent with the view that part of the prior increase represented a bubble. Despite a larger cut in hours worked than in other sectors, productivity in financial intermediation is now a drag on the economy-wide trend.

A reasonable – optimistic? – expectation is that credit will revive and expand in line with overall GDP over the next 5-10 years. In that case, productivity growth in financial intermediation might converge with the rest of the economy, suggesting a trend rise in output per hour of 1.75% rather than the OBR's 2.0%, based on experience over 1997-2008.

A second reason for doubting the OBR's extrapolation is the recent revelation that the Office for National Statistics (ONS) underrecorded clothing inflation over 1997-2009, implying that it may have overestimated real GDP expansion. According to the Bank of England, the increase in the CPI for clothing may have been understated by 5.5 percentage points per annum, with double the impact on the RPI. With the RPI used to deflate consumption, this suggests that GDP growth was overstated by up to 0.4 percentage points, based on a 3.5% share of clothing spending.

In practice, the distortion should be smaller because the ONS calculates GDP incorporating output and income as well as expenditure data while its real GDP calculation is based partly on volume information, not only nominal inputs deflated by prices. A plausible guess is that GDP growth was overstated by 0.2-0.3 percentage points over 1997-2009, an error that will have fed into estimates of trend productivity expansion by the OBR and others.

The underrecording of clothing prices coupled with “phantom” financial-sector output gains due to the credit bubble, therefore, suggest that current trend GDP expansion is 1.8-1.9% per annum rather than the 2.35% estimated by the OBR. This would be consistent with recent evidence: unemployment has fallen slightly over the past year while survey-based measures of capacity utilisation have risen despite GDP growth of only 1.8% in the year to the first quarter, or 2.0% excluding volatile oil and gas production.

This is bad news for policy-makers. Trend expansion of 1.8% rather than 2.35% implies a GDP “pie” that is 5% smaller in 10 years’ time. Future economic expansion, in other words, may contribute less than hoped to reducing the fiscal deficit and consumer gearing. The inflation-growth trade-off, meanwhile, is likely to be less favourable than the MPC has assumed – consistent, of course, with recent experience. Interest rates may need to be raised despite “unsatisfactory” economic expansion – if the Committee wishes to adhere to its remit.

The May Inflation Report confirms that the MPC is no longer setting monetary policy in accordance with its remit.

The key measure of whether the MPC is on track to meet its target is the mean inflation forecast based on unchanged policy. The mean forecast takes account of the balance of risks around the mode or central projection – as should the MPC if it is doing its job. The mean forecast, in other words, summarises the whole fan chart*.

The Bank withholds its forecast numbers until a week after publication of the Inflation Report. This results in media attention focusing on the central projection, which is easier to estimate from the fan chart than the mean and has been significantly lower in recent Reports.

In February, the mean forecast for inflation in two years’ time assuming unchanged policy was 2.48%, representing the largest overshoot of the target since February 1998 and clearly signalling the need for higher interest rates.  Based on chart 5.13 on p.47 of the May Report, the current two-year-ahead mean forecast remains at about 2.5%. The central projection is again below the mean but has risen from 2.08% to about 2.25%. So neither measure is consistent with the 2% target.

The chart below compares the path of the mean forecast estimated from the May fan chart with the published numbers from the February Report. The forecast has been raised in every quarter until the end of 2012 – average inflation over the next two years is now 3.5% versus 3.3% in February. The MPC's remit is 2% inflation “at all times”, not just at the two-year horizon.

A year ago, the view here was that inflation, far from heading for an undershoot as the MPC claimed, would remain above 2% for the foreseeable future, implying a need for policy tightening. The Bank now accepts this prospect but still the MPC remains inert. Many, including the Chancellor, will support the Committee’s approach but the pretence that policy is being set in accordance with "inflation targeting" should be abandoned.

*The Bank’s own advice is that “it is more appropriate to compare outturns with the MPC’s projection of the mean, rather than the mode or median”. See “Assessing the MPC’s fan charts”, Bank of England Quarterly Bulletin, Autumn 2005, p.332.



UK economic news remains reassuring and at odds with the unremitting gloom purveyed by the media and propaganda organisations such as the British Retail Consortium (BRC).

The Monster index of online job vacancies rose by an annual 14% in April, up from 9% in March, despite a fall of 8% in public sector openings. A seasonally-adjusted version of the index tracks combined output of the services and industrial sectors (which account for 93% of GDP) and remains on an upward trend, implying that the economy is continuing to recover despite data volatility caused by the weather, holiday effects and unreliable ONS estimates of construction output – see first chart.

Rising employment is also suggested by last week's Royal Institution of Chartered Surveyors (RICS) commercial market survey, showing an increase in demand for space in the first quarter – second chart.

The RICS housing market survey for April, released this morning, reported a rise in both activity and price balances. The net percentage of surveyors expecting higher prices remains heavily negative but – at least when asked by their industry body – estate agents have a surprising tendency towards pessimism: the current reading has been associated with inflation historically – third chart.

Reflecting holiday effects, BRC retail sales soared by an annual 6.9% in April, a figure as meaningless as the 1.9% March slump, which was a cause of much celebration by the gloomsters when reported a month ago – see previous post. The average of the current and year-before annual changes strips out holiday distortions and is a better guide to the underlying trend: April's 3.3% result was in the middle of the recent range, consistent with a subdued but not suicidal consumer – fourth chart.

The OECD's leading indices for March confirm a loss of global economic momentum suggested much earlier by monetary trends – see January post.

The first chart shows the six-month growth rate of combined industrial output in the G7 and emerging "E7" economies together with a forecasting indicator derived from the OECD indices, which incorporate a wide range of economic and financial inputs. The indicator peaked in December and fell again in March, suggesting that output will slow into the summer, based on the usual 3-7 month lead.

Monetary trends are signalling a slowdown rather than anything worse. G7 real narrow money is still expanding and the lower rate of increase recently reflects higher inflation, with nominal growth boosted by the Federal Reserve's QE2 securities purchases – second chart. A reversal is possible after QE2 ends at mid-year but this would affect the economy only from early 2012.

Interestingly, the recent decline in the forecasting indicator has been due to the G7 rather than E7 component – third chart. Within the E7, the OECD indices are signalling a slowdown in Brazil, India and Russia but continued strength in China. Chinese resilience, however, is at odds with recent monetary trends and, if correct, implies further policy tightening, which would increase the risk of a "hard landing" later in 2011.