The Bank of England Targets Inflation, Not Growth

Much of the recent commentary and analysis of upcoming Bank of England interest rate decisions suggests that on-going weakness in the growth of consumer spending will likely trigger rate cuts. What is interesting about much of this speculation is that it seems to reflect a view that the Bank of England should set interest rates so as to keep growth in demand and in output on an even track while also trying to stop inflation getting too far from the target. The emphasis placed on slow retail sales growth this year suggests that many take the view that the Bank should have a target for the growth in demand and output. Newspaper commentary and economists in the City often no longer bother to spell out the link between the pace of consumer spending and what that implies for inflationary pressures. The implication of much of the discussion is that the Bank should look to cut rates if the growth of spending looks set to stay below trend independently of whether that outlook also makes below-target inflation likely in the medium term.

In fact the Bank does not have two targets one for inflation and one for growth in demand and in output it only has an inflation target. Nor could it have two targets. The Bank has one instrument, the short term interest rate, so hitting two different targets is not possible unless both inflation and demand/output always moved together. In fact it is hugely unlikely that where inflation is heading and where the growth in demand and output are going will always be in the same direction.

Of course the Bank will attach a great deal of weight to where components of demand the largest of which is consumption are heading because the balance between demand and supply is a key factor behind inflationary pressures. But just as clearly there can be occasions where the short term direction of the growth in demand and the medium term direction in inflationary pressures can be quite different. This is what seems to have been lost in much of the current discussion of monetary policy in the UK.

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And this has particular significance at a time when retail sales growth has fallen very sharply while inflation has itself moved up significantly above target.

To make a sensible assessment of where monetary policy in the UK should be heading the inflation outlook is absolutely central; where demand is heading is relevant because it provides an indicator for inflationary pressures.

Let's take stock of where we start from. Spare capacity in the UK economy remains limited in our view, unit labour cost inflation has risen, inflation expectations look well anchored but are showing some tentative signs of picking up, and core inflation is rising.

What matters is where inflation is heading. We took two different approaches to projecting inflation. Our wider economy' model projects inflation at target only in 2008. (This model assumes that there are multiple interactions between inflation, unemployment, interest rates, consumption and wages. Each variable is modelled by the past history of all the other variables plus the oil price.)

Using the dynamics of the model and the Morgan Stanley oil price forecast to project forward, CPI inflation reaches 2.7% in the first half of 2006, and returns to the Bank of England's 2.0%Y target only in 2008. These are the central forecasts from the model consistent with no cuts in interest rates. On our RPI inflation model, it took a 1% negative shock in consumption growth to push annualised inflation 0.8% lower (after two quarters).

An alternative model just looked at the degree of inertia and mean-reversion in inflation based on the history of inflation. Our mean reversion' analysis suggests it is not a foregone conclusion that CPI inflation will revert back to its pre-shock level quickly or any quicker than it did in the past. Our mean reversion' model projects that (given the recent levels of actual inflation) CPI inflation will remain above target into 2008, and that underlying inflation edges above the 2.0% mark. This suggests that the recent rise in inflation is not a purely transient phenomenon and that part of the increase will result in an up-tick of underlying inflation for many quarters to come.

By David Miles, Melanie Baker and Vladimir Pillonca, Morgan Stanley economists, as published on the Global Economic Foru