Inflation report and outlook for interest rates

Last time I was here I boldly forecast that base rate would increase in either February or May next year. Now we have the latest Bank of England Inflation Report, let’s see how realistic that prediction was.

Forecasts for growth this year have been cut, met with a resounding “told you so” from most economists, but hopefully we are still looking at some growth for the year as a whole. As far as the outlook for inflation goes, the chart below shows current expectations:

The thick, darker band shows the most likely outcome for inflation being above 2% for the next year or so before finally getting to or below target in the middle of 2013. This is a bit higher than February’s forecast but the pattern is pretty much the same.

But I would draw your attention to the header of that graph – particularly the “market interest rate expectations”. These rate expectations are derived from what the money markets currently expect base rate to be in the future. Here are the numbers:

They’re now showing the first movement in May 2013. Ordinarily I would look through 0.6% and 0.7% as meaningless (for 0.25% rises, we’re interested in 0.7% turning into 0.8% ) but there are other factors that come into play which are pointing to upward movement.

The notes alongside this table in the Bank of England's Inflation Report read “the path implied . . . was for Bank Rate to remain at 0.50% until Q1 2013 and increase gradually thereafter” and – much more importantly – the commentary gives a few more indications of shifting sentiment within the MPC.

First, it openly says that the risks are to the upside. I don’t remember them saying much before (though I could be wrong). I only remember much more pessimistic comments – generally the risks being of a major undershoot or, at best, being evenly balanced.

Second, one of the key expectations behind inflation coming down further is that “the utility price rises in Autumn 2011 drop out [of the calculation]”. And, since the energy companies have already been kind enough to warn us of another price rise due later this year,  that hope would seem to be doomed at the outset. The Inflation Report does acknowledge that “There may be further shocks to energy and commodity prices,” though I’d say it’s not so much shock as a certain inevitability.

Finally, we have the curiously honest statement that it’s so difficult to make a reliable inflation forecast the MPC “places more weight on the broad shape of the distribution than its exact calibration.” So it’s not that we think we’ll hit 2% inflation in early 2013, so much as we seem to be heading in the right direction so far, so let’s go with it.

Which brings me back to my gut suspicion; “what if inflation it holds up a bit higher, a bit longer?” Look at the inflation projection chart again: going into next year with inflation around or above 3% is barely outside the central forecast zone but would by that point give a very different “broad shape” – one in which inflation has bottomed out stubbornly high.

What then? – you have to think that base rate could gradually start to rise from Q2 2013, with a potential change in May.

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