Look Out For The Bank of England Inflation Report
Some analysts are arguing that because the MPC left interest rates on hold
at
the November MPC, the Inflation Report, due to be released on Wednesday 10th
November will be "boring". We do not expect it to be at all boring and any
complacency that it will simply "rubber-stamp" the November rate decision is
a very risky assumption to make. As we predicted in our preview of the
November rate decision, even in the face of a "no change" decision at the
November MPC, Mervyn King has made it quite clear that the bank has a
tightening bias. We asked the question in that preview, how could the Bank
signal to the markets (and equally the audience is UK consumers and house
owners) that the tightening bias is retained? Our answer was then and
remains now that King will use the Inflation Report as a way of signalling
to the financial markets that the bank has some interest rate ammunition
left. King does not wish to be constrained by market expectations that the
next move is down, nor does he wish to invite a re-acceleration in house
price inflation.
So how can the Inflation Report be used to signal the retention of the
tightening bias? As we indicated in the MPC preview report, one option is
to use the Inflation Forecast Chart (the so-called "rivers of blood" chart)
to do the necessary work. If, for example the forecast (which is now based
on the assumption of market interest rates) shows a small overshoot of the
2.0% target at the two-year time-horizon, then this would signal that the
Bank considers that the market has assumptions for future interest rates,
which are (at least slightly) too low.
It would also be likely that King would wish to "finesse" the market's
reaction to such a forecast overshoot. He would likely stress that the
overshoot in inflation at the two-year horizon is "modest" and "within the
range of forecasting error" for example. So how could such an inflation
forecast be justified? To seek evidence for this we should note what King
and other MPC members have been saying recently. The most recent speech by
an MPC member was given by Richard Lambert ("Why Is Inflation So Low"). In
what was basically a "dovish" speech. Lambert conceded that there were good
reasons why inflation had been "so low" but he did point to some upside
risks to the inflation outlook.
These were firstly the recent depreciation of sterling and secondly, the
flattening in the yield curve, " ..both of which - should they persist -
could help to sustain the level of economic activity." We have noted many
times before how much primacy King gives to developments on the currency
front and that will be a pillar of the justification for caution on the
inflation outlook. However, it would also be wise for King to proceed
cautiously here. The intention is not to shock, it is to shape interest
rate expectations. There are plenty of arguments to counterbalance any
overly hawkish tone, which he will seek to avoid. After all, targeted
inflation is currently at 1.1% - much closer to the lower limit (1.0%) than
the 2.0% target. At the same time, we do not hear the "lack of slack in the
economy" argument so loudly since the below-trend 0.4% Q3 GDP number was
released. Wherever the lack of slack is in the economy, it is certainly not
in the recession-bound manufacturing sector.
Conclusion: Mervyn King will use the Inflation Report to create more space
for manoeuvre on monetary policy. He does not wish markets to come too
firmly to the conclusion that the next move in rates is down. It is also
important to note that this strategy is aimed at shaping EXPECTATIONS. The
threat of a rate rise is entirely different to that act of pulling the
interest rate trigger. Rates may well have already peaked but King does not
wish to be hemmed-in by that perception. |
