The Bank Of England’s Inflation Forecasts Are Too Complacent

The Bank of England has dramatically upgraded its UK growth predictions. Just like HM Treasury, the International Monetary Fund and all those other official bodies that took an astonishingly pessimistic view of Brexit, the “Old Lady of Threadneedle Street” has somewhat changed her tune.

Ahead of last June’s referendum, Bank Governor Mark Carney warned of “a technical recession” – two consecutive quarters of shrinking GDP – if we voted to leave the European Union. Even in August, as the economy remained buoyant despite the Brexit result, the Bank was forecasting growth of just 0.8pc in 2017.

That prediction was raised to 1.4pc in November – since when we’ve seen figures pointing to 2pc GDP growth in 2016, with unemployment hitting an 11-year low. The latest survey data suggests continued expansion into this year too, the January PMI manufacturing index registering 55.9, where 50 indicates growth.

With Carney now describing the UK economy as “resilient”, the Bank last week forecast 2pc growth in 2017. While we could dwell on earlier analytical failures, bemoaning again the overtly political behaviour of our central bank, I’ll focus on the inflation numbers instead.

The Bank estimates CPI inflation will peak at 2.8pc during the first half of next year, remaining at 2.4pc in three years’ time – still above the 2pc target. So why isn’t the Bank raising rates? If inflation is projected to stay above target beyond the forecasting horizon, rates should go up.

One reason is that rates were only recently cut, the Bank shifting from 0.5pc to 0.25pc in August. This was apparently designed to address a post-referendum slump that didn’t materialise. The idea a quarter point reduction instantly “saved” the economy by boosting consumer confidence – when just 30pc of UK households have a mortgage, half of those on fixed rates – is nonsense.

Whether motivated by genuine concern, or a need for the Bank to “explain” why growth hadn’t in fact tanked after our Brexit vote, the August cut was counter-productive. It makes it almost impossible for the Monetary Policy Committee to volte face and now raise rates, even though inflation is looming into view.

The Bank’s reluctance also reflects concerns about the fragility of financial markets. A “bold” hike now, following the Federal Reserve’s December increase, could convince international investors the global interest rate cycle has finally turned, raising difficult questions about the sky-high valuations of both equities and bonds.

Keep in mind, also, that the UK hasn’t seen an interest rate increase for almost a decade. The last one was in mid-2007, predating any of the nine current members of the Monetary Policy Committee. The Bank then, for a variety of reasons, will find it tough to raise rates any time soon.

While good news for indebted consumers and home-owners, that’s unfortunate for the broader economy as the Bank’s inflation forecasts strike me as too complacent. The CPI’s recent rise from 0.5pc in June to 1.6pc in December was partly due to the post-referendum fall in sterling, but that was only part of the story.

Factory input prices have been rising since last April, with input inflation hitting a 25-year high last month, according to PMI surveys. A lower pound was a factor, but so too was the spiraling cost of fuel, steel, plastics and – ultimately – crude oil.

The Bank of England has to navigate Brexit-related uncertainties throughout 2017, and their impact on currency markets. But a potentially more serious complicating factor is the oil price. This time last year, crude was $38 a barrel. Now it’s close to $57. A chunky 40-50pc rise in oil prices, then, will feed into the January and February inflation numbers, with further large increases hitting CPI data throughout the first half of this year.

That’s if oil stays put. It’s quite possible, though, crude could keep rising, driving further inflation, and putting more pressure on the Bank to start raising rates. That depends on the ensuing battle between the Opec exporters’ cartel, which controls a third of global production, and the US domestic oil industry.

In November, Opec agreed its first coordinated production cut since 2008, pledging to reduce daily supplies by 1.8m barrels to prop up prices. The deal seems to be holding, with survey data pointing to 80pc compliance. Non-Opec member Russia, which backed the November initiative, also slashed production by 100,000 barrels a day in January.

Iran, meanwhile, tested a ballistic missile last week, leading to renewed tension between Washington and Tehran. That added to mounting speculation President Trump may renew sanctions – which would stem the flow of Iranian crude onto global markets. All this points to lower supplies and a higher oil price.

Meanwhile, rising crude prices have galvanized the US energy industry into pumping more. Dearer crude helps, in particular, the hard-pressed shale producers, who suffered most when Opec flooded global markets from 2014 onwards, in a bid to push such upstarts out of the market.

This new US supply response is seen in a higher “rig count” and surveys suggesting a 6pc production rise during the last two months of 2016. That’s feeding into official US oil inventory data – which rose 6.5m barrels last week, almost twice industry expectations. Petrol stocks were meanwhile 3.3m barrels higher, more than three-times the average forecast.

While Opec is cutting output, then, the US oil industry is raising. For now, Opec seems to be winning, which is why, since the November deal, oil is up around $10. Who prevails in this geological and geopolitical battle is, quite possibly, the most significant issue facing the global economy during 2017. The oil price should certainly loom large in the Bank of England’s thinking.

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