Although Bank of England Governor Mervyn King, did not use the ‘S' word during his speech yesterday, Ted Scott, Director, Global Strategy at F&C, believes the details of the three-monthly inflation report were an implicit admission that stagflation (rising inflation combined with low growth) is the prospect that faces the UK economy.
"In the report, the Bank once again raised its inflation forecasts and now believes it will peak at around 5% in the fourth quarter of 2011, up from 4.5% in the third quarter in the last inflation report in February. Furthermore, the longer-term forecasts have also been increased so that now CPI is not expected to return to the Bank's 2% target until the second quarter of 2013. The pessimistic inflation forecasts are combined with equally downbeat revised growth forecasts, which leads to the inescapable conclusion that stagflation will become entrenched if the Bank is correct," Scott commented.
Following earlier downgrades to GDP forecasts, the Bank now expects growth of just 1.9% in 2011, a cut of 0.3% from February, and it has also reduced its forecast for next year to 2.5%.
In Scott's opinion, the BoE has been rightly criticised for its failure to manage an inflation rate that is not anywhere near its mandated target of 2%, stating: "This report will do nothing to enhance its credibility with the admission that its forecasts for both growth and inflation are, once again, way behind the curve. The usual litany of excuses are given for underestimation of the inflation rate (commodity and energy prices featuring prominently) and, while it is likely that inflation will fall back as the effects of not only higher energy prices but also indirect taxes and the decline in sterling fall away, the forecasts for GDP growth are still vulnerable on the downside."
The BoE's Monetary Policy Committee has been characterised by a lack of consensus that has also undermined its authority in recent months, with a clear division between members wanting to increase interest rates and a diminishing majority, including the Governor, resisting the calls for a rise. Yesterday's report added to the confusion as it was more hawkish than expected, intimating that the first rate rise will be likely later this year to be followed by further increases next year. This is at variance with what the market had been expecting on the back of improved inflation data (a decline of 0.4% to 4%) and weaker economic data.
Scott concluded: "One of the main problems has been the poor communication from the Bank, which has failed to deliver a consistent message and given the impression that it is behind the curve. I believe that it is correct in its view that rates should not be raised but has failed to communicate effectively the reasons why and incorporate those reasons into its forecasts. As a result, it runs the risk of higher inflationary expectations becoming embedded, manifested partly through higher wage demands, that would force the committee’s hand in raising interest rates faster and higher than it would like and, more importantly, than would be good for the UK economy."
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