BofE Inflation Report

 

WEEKLY COMMENT 2-11-2017

By Barry Edwards

BofE Inflation Report

 

The rise in bank rate to 0.5% by the Monetary Policy Committee (MPC) of the Bank of England (BofE) came as no surprise to anyone and the statement to gradually raise rates further to manage inflation was also expected. It is clear from the inflation report that the MPC are forecasting that inflation will fall back to the 2% target during the course of next year but they expect domestic inflationary pressures will gradually pick up as spare capacity is absorbed and wage growth recovers. If you click on the link below you read the full report;

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

If you do not have time to look at the report, below is most of the summary;

“CPI inflation rose to 3.0% in September. The MPC still expects inflation to peak above 3.0% in October, as the past depreciation of sterling and recent increases in energy prices continue to pass through to consumer prices. The effects of rising import prices on inflation diminish over the next few years, and domestic inflationary pressures gradually pick up as spare capacity is absorbed and wage growth recovers. On balance, inflation is expected to fall back over the next year and, conditioned on the gently rising path of Bank Rate implied by current market yields, to approach the 2% target by the end of the forecast period.

As in previous Reports, the MPC’s projections are conditioned on the average of a range of possible outcomes for the United Kingdom’s eventual trading relationship with the European Union. The projections also assume that, in the interim, households and companies base their decisions on the expectation of a smooth adjustment to that new trading relationship.”

“The decision to leave the European Union is having a noticeable impact on the economic outlook. The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly. And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.

Monetary policy cannot prevent either the necessary real adjustment as the United Kingdom moves towards its new international trading arrangements or the weaker real income growth that is likely to accompany that adjustment over the next few years. It can, however, support the economy during the adjustment process. The MPC’s remit specifies that, in such exceptional circumstances, the Committee must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity.

The steady erosion of slack has reduced the degree to which it is appropriate for the MPC to accommodate an extended period of inflation above the target. Unemployment has fallen to a 42-year low and the MPC judges that the level of remaining slack is limited. The global economy is growing strongly, domestic financial conditions are highly accommodative and consumer confidence has remained resilient. In line with the framework set out at the time of the referendum, the MPC now judges it appropriate to tighten modestly the stance of monetary policy in order to return inflation sustainably to the target. Accordingly, the Committee voted by 7–2 to raise Bank Rate by 0.25 percentage points, to 0.5%. Monetary policy continues to provide significant support to jobs and activity in the current exceptional circumstances. All members agree that any future increases in Bank Rate would be expected to be at a gradual pace and to a limited extent.

There remain considerable risks to the outlook, which include the response of households, businesses and financial markets to developments related to the process of EU withdrawal. The MPC will respond to developments as they occur insofar as they affect the behaviour of households and businesses, and the outlook for inflation. The Committee will monitor closely the incoming evidence on these and other developments, including the impact of today’s increase in Bank Rate, and stands ready to respond to changes in the economic outlook as they unfold to ensure a sustainable return of inflation to the 2% target.”

Overall, the depreciation of sterling and a satisfactory outcome from Brexit are the bases of the forecasts by the MPC. The currency is not expected to change much from the current level of around 1.30 to the US dollar which is a depreciation of 18% from 2015 level. Assuming that there is not further downward pressure on the currency most people agree that inflation will return to the 2% level next year. However, the assumption that there will be a trade deal that is acceptable for most businesses is something that many commentators will struggle to agree with.

The framework of the actual deal will start to become clear in about six months’ time since companies have to make decisions by then to prepare for Brexit. Most of the 27 EU countries have stated that they prefer as little disruption as possible to the way trade is conducted at the moment providing the UK makes a substantial contribution to the EU budget. Therefore, the main point of the negotiations revolves around the price the UK will pay to make this happen. The figure some commentators are suggesting is around €60 billion for a satisfactory deal is to be concluded. The payment of this sum would be spread over a period of about ten years which would be manageable for the UK economy.

It is clear this amount would be very contentious politically but the MPC must be basing their forecasts on something like this happening. Obviously they cannot make predictions about the outcome of Brexit and consequently can only assume a reasonable deal will be agreed. The significance of a bad outcome would be devastating for the UK economy and probably lead to a serious recession which would also have some negative impact on the EU. They would prefer that did not happen to interfere with their new found economic growth so assuming a deal will be found to suit everyone is not unreasonable.

The inflation report may turn out to be correct in its forecasts but how many people are confident that will happen? I would be interested to hear your comments on this very unpredictable subject. That’s all for this week.

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