Bank of England’s reputation at stake as inflation rises

17th January 2011

There is still plenty of debate as to whether that policy mistake will be through raising rates or keeping them at current levels and on this, economists are divided.

Simon Ward, chief economist at Henderson points out that in May 2009, the Bank of England forecast that CPI inflation, then 2.9%, would fall to 0.7% in the second quarter of 2010. The actual figure was 3.5%. To be fair, the Bank has explained this forecasting error – a combination of higher-than-expected energy prices, an underestimation of upward pressure from sterling weakness and rising VAT – but Ward believes another forecasting error is probable and a repeat could seriously dent the Bank's credibility.

CPI inflation is due fall to 2.8% in the second quarter of 2011 on the way to 2.2% by the fourth quarter. Based on recent trends, Ward estimates these numbers may be out by 1.0-1.5%. The VAT rise was well-flagged, so the Bank can't blame that. Higher commodity prices have been a factor, but Ward believes the Bank should have seen this coming. Emerging market growth always made this a probability.

Ward makes a number of other criticisms. Most importantly, he suggests that the Bank has over-estimated the extent to which GDP is behind trend. He also suggests that a pick-up in long-term inflation expectations is feeding through to pay settlements. 

He suggested a rise in mid-2010, believing it could have acted to support economic growth by moderating the inflation squeeze on real income and money supply expansion. He believes Andrew Sentance, who has voted for higher rates since June, is winning the argument and deserves greater support from his colleagues. In his view, rates may rise before the end of May.

His view is gathering force, with the most practical effects being seen in the mortgage market: 

However, it is by no means a universal opinion. Today, influential forecaster the Ernst & Young Item Club said that the risk of error by the Bank of England lay in cutting off recovery by raising rates rather than risking inflation through maintaining them at current levels. Peter Spencer, chief economic adviser to the Item Club, said: "If the Bank has been pushed into a rate rise this year it will find itself with a depressed economy, a low rate of inflation below target, and of course having to cut interest rates."

Mr Spencer was also reported attacking the Prime Minister , saying that his comments on inflation were ‘quite incredible and quite unprecedented' in the context of the VAT rises.

The Bank of England has steered the UK through a relatively steady course of recovery so far, even if its forecasting has been awry. It is entering a new and more delicate phase. With so many conflicting views, it is in an unenviable position and its reputation is at stake.

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