February’s Inflation Report – another hike to come, but greater uncertainty

The latest Bank of England Inflation Report shows that the MPC believes that one more rate hike (to 5.5%) should be enough to send CPI back down below the target (2%) by the 2009 horizon date. We know this because the Bank shows where it projects rates to be on the basis of both unchanged rates (5.25% – CPI slightly higher than target), and market expectations of rates (a hike to 5.5% by mid 2007 and then probably on hold, which results in CPI slightly below target). The Bank did state though that there is “greater-than-usual” uncertainty about their forecasts – not only thanks to energy prices, but also wages and inflation expectations. The Bank’s measure of inflation expectations has edged up lately – it’s worth remembering Paul Tucker’s comment about November’s rate hike – “I concluded that it was essential for the MPC to act in a way that was most likely to keep inflation expectations anchored”.
On a different, but related note, I found this quote in a recent UBS presentation fascinating: Professor Kenneth Rogoff of Harvard said that “as long as the central bank targets inflation in the overall price level, which it can over sufficiently long horizons, cheap goods from China simply imply that other goods must become more expensive. From this perspective, one might say that China is exporting inflation to other sectors of the economy”. In other words central banks have kept rates too low – the collapse in goods prices driven by China sent inflation rates down (for example in the UK, deflation in clothing and footwear was at one time running at 6% per year), but this was an exogenous shock, and out of the control of central bankers. In order not to have overall inflation rates fall below the bottom of their targets they had to generate higher inflation in the remainder of the inflation basket, for example in domestic services, by cutting rates. As they cut rates they stimulated already robust domestic demand, made mortgage finance substantially cheaper, and we can see the consequences in housing markets today.

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