BofE Inflation Report

 

WEEKLY COMMENT 2-02-2017

By Barry Edwards

BofE Inflation Report

 

The Bank of England’s inflation report is a very different document from the previous ones since the referendum. It is strikingly positive compared to the pessimistic outlook that was the theme of the others. Despite all the warnings the British economy refuses to react in the way predicted by many economists and commentators and consequently the BofE has forecast a much more encouraging future for the UK over the next two years. If you click on the link below you can read the report (45 pages);

http://www.bankofengland.co.uk/publications/Documents/inflationreport/2017/feb.pdf

The following are extracts from the summary of the report which outlines the policy of the MPC;

“The MPC has increased its central expectation for growth in 2017 to 2.0% and expects growth of 1.6% in 2018 and 1.7% in 2019.  The upgraded outlook over the forecast period reflects the fiscal stimulus announced in the Chancellor’s Autumn Statement, firmer momentum in global activity, higher global equity prices and more supportive credit conditions, particularly for households.”

“CPI inflation rose to 1.6% in December and further substantial increases are very likely over the coming months.  In the central projection, conditioned on market yields that are somewhat higher than in November, inflation is expected to increase to 2.8% in the first half of 2018, before falling back gradually to 2.4% in three years’ time.  Inflation is judged likely to return to close to the target over the subsequent year.  Measures of inflation compensation derived from financial markets have stabilised at around average historical levels, having increased during late 2016 as concerns about a period of unusually low inflation faded.”

“As the Committee has previously noted, however, there are limits to the extent that above-target inflation can be tolerated.  The continuing suitability of the current policy stance depends on the trade-off between above-target inflation and slack in the economy.  The projections described in the Inflation Report depend in good part on three main judgements:  that the lower level of sterling continues to boost consumer prices broadly as expected, and without adverse consequences for expectations of inflation further ahead;  that regular pay growth does indeed remain modest, consistent with the Committee’s updated assessment of the remaining degree of slack in the labour market;  and that the hitherto resilient rates of household spending growth slow as real income gains weaken.  In judging the appropriate policy stance, the Committee will be monitoring closely the incoming evidence regarding these and other factors.  For instance, if spending growth slows more abruptly than expected, there is scope for monetary policy to be loosened.  If, on the other hand, pay growth picks up by more than anticipated, monetary policy may need to be tightened to a greater degree than the gently rising path implied by market yields.  Monetary policy can respond, in either direction, to changes to the economic outlook as they unfold to ensure a sustainable return of inflation to the 2% target.”

The extracts above sum up their views concisely and need no further explanation which is fine if you agree with their summation. I and quite a few others believe their forecasts will prove to be too optimistic and as the negotiations get underway in the latter half of this year you will probably see the pessimism return affecting the confidence that has prevailed so far. In the end, it is how confident companies and people feel that determines the decisions that are made and I believe that will suffer as the detail is fully comprehended.

The elections in France and the Netherlands will have been held by then giving us a clue as to the extent of anti EU sentiment which could turn out to be much greater than many expect. That could influence the German elections in September and if that shows an unexpected result the whole EU question is up in the air. How that would affect the Brexit talks is the big query making progress unpredictable. That big doubt and the discussion about the cost of Brexit could together affect the economies of both the UK and EU who will miss the financial contribution from the UK. This is of great concern for France and Germany who will have to make up the difference if expenditure is not curtailed.

That would be unpopular politically in those countries increasing anti EU sentiment even further which would make the EU commission determined to seek the maximum compensation, which is estimated to be about €60 billion, showing their determination not to give in to the UK. If there was no flexibility in that figure it would have a big impact on the UK budget maybe causing a recession. All this has to be decided before any talks about tariff free trade and access for the UK services sector, the mainstay of the British economy.

In my view, there is a false sense of optimism that is unjustified when the uncertainties about the Brexit negotiations are assessed which will change people’s views on the potential outcome. The BofE is taking a big risk in presenting a positive forecast although this may be alleviated by the very expansionist policies of Donald Trump which could positively influence the UK economy as it has in the past.

That’s all for this week, more observations next week.