By John Kemp
LONDON May 16 Governor Mervyn King has finally
admitted that the Bank of England can no longer accurately
forecast inflation, as the tremendous amount of uncertainty
renders the quantitative forecasting techniques employed before
"The difficulty of predicting the precise impact of these
influences means that the (Monetary Policy Committee) places
more weight on the broad shape of the inflation outlook than its
exact calibration," a subdued governor confessed at a news
conference to present the latest revisions to the bank's
inflation fan charts.
King urged a more qualitative assessment of the risks to
inflation and growth. While insisting the committee's decisions
about interest rates and quantitative easing are still guided by
the inflation outlook, he urged his listeners to focus on the
"Rather than focusing on quarter-to-quarter movements in
output or inflation which are impossible to predict, the MPC
focuses on the bigger picture," King said. "That bigger picture
is of a gradual recovery in output and of subdued domestic cost
pressures, meaning that inflation is likely to fall back as
external influences fade."
It ends a long period when the bank tried to justify all its
immediate policy choices through the twists and turns of the fan
charts, which proved about as accurate as a fortune teller's
WHERE DID THE SLACK GO?
Unfortunately the bigger picture is more gloomy than the
governor and his colleagues thought only six or twelve months
King dwelt on the external threat to the recovery from the
continuing crisis in the eurozone. Like other British
policymakers, King sometimes seems happier lecturing foreigners,
especially Europeans, about the inadequacies of their policies
than commenting on structural problems at home.
But it is the performance of the domestic economy which is
disappointing policymakers the most.
Until recently, a majority on the MPC seemed confident there
was substantial cyclical slack in the UK economy. If the bank
could only spark a recovery, the economy could manage a period
of above-trend growth without risking a pick of domestically
generated (as opposed to imported) price rises.
But even that is no longer certain. Pass-through from
commodity prices and the exchange rate has proved far greater
than the Bank expected. "We were too swayed by the experience of
the UK economy in the early 1990s, when sterling's fall did not
feed inflation," admitted Charles Bean, the bank's deputy
governor for monetary policy.
Domestically generated inflation is also proving stubbornly
high, leading the bank to ponder aloud about whether the
economy's supply side performance has deteriorated, leading to a
less favourable trade off between growth and inflation.
"There is no obvious reason to believe that we can't get
back to the level of output that we were on the pre-crisis trend
path," the governor said, "but it may take 10, 15 or maybe even
20 years to get there," which was not very reassuring.
"It doesn't follow from that that over the next two or three
years that there is a vast amount of spare capacity that you can
just put your foot on the accelerator (and) use up in order to
With that terse explanation, the governor buried four years
of bank forecasts, which assumed spare capacity could be relied
on to keep domestic cost and price pressures under control,
while the Bank could do nothing about the imported kind.
ENTRENCHED INFLATION PROBLEM?
The big problem for the Bank is that spare capacity (however
much there is) has not brought price increases under control
nearly as fast or as much as the members of the committee have
been forecasting for the last four years.
Even in the face of spare capacity and falling real wages,
businesses and retailers have proved surprisingly capable of
pushing through price rises.
Some have been automatic under Britain's system of
inflation-plus price regulation for utilities like water, rail
services, and other goods and services with administered prices.
But others are testament to the surprisingly strong pricing
power of the country's retailers and other businesses to push
through price rises to protect their margins.
The result is that inflation has consistently overshot the
Bank's forecasts since 2007 (with one exception in 2009).
"A gradual easing in the impact of external price pressures,
together with a continuing drag from economic slack, should lead
inflation to fall back to around the target," the governor said
in his prepared remarks.
The bank continues to blame external factors for most of the
inflation overshoot, though it has no ready answer about why
Britain has the worst inflation and growth track record of the
major advanced economies in the last few years.
But in a note of caution, the governor admitted "The
prospects for inflation remain uncertain, not least because it
is difficult to gauge with any precision the current strength of
underlying inflationary pressure."
"The path of inflation will also depend on the growth in
companies' domestic costs, which will be heavily affected by the
pace of productivity growth and the extent to which slack in the
labour market limits wage growth".
"The degree to which companies seek to restore their profit
margins by raising prices will also have an important bearing on
inflation," he added.
BEYOND THE INFLATION TARGET
With the quantitative forecasts thoroughly discredited, the
Bank has bowed to the inevitable and embraced a more qualitative
approach to presenting its policy decisions. It is at least an
honest acknowledgement that the old system was not working.
The bank should capitalise on King's new-found humility and
transparency to make one final admission: the inflation target
is no longer in effect, and has not been for some time.
Rightly or wrongly, the bank has made a conscious decision
since 2010 and especially 2011 that tolerating higher inflation
is a price worth paying to avert higher unemployment. In making
that choice, it has enjoyed quiet backing from most of Britain's
financial and political establishment, including finance
minister George Osborne and the opposition Labour Party.
In effect, the bank has substituted the "bigger picture" for
the narrower one of hitting a 2 percent inflation target.
King and his colleagues have sought to avoid formally
suspending or abandoning the 2 percent target by claiming their
mandate has always included an element of flexibility, to avoid
undesirable volatility in output, and means seeking a return to
2 percent over the longer term rather than immediately.
But rather like the inflation fan charts, it is a pretence
that has worn through. The bank has reverted to the more
discretionary approach which characterised policymaking in the
early 1990s and especially the 1980s and 1970s.
Building on its new spirit of openness, it is time for the
bank to concede inflation targeting has outlived its usefulness,
and will need to be modified in future. The question for
policymakers and economists is how to replace it with something