YESTERDAY’S Inflation Report presented a benign view of UK economic prospects. Economic growth is expected to continue at around 3 per cent or above, double the rate over the recovery so far. Yet sufficient spare capacity remains to prevent a rise in inflation. So interest rates can rise gradually and that can wait until next year.
This sounds reassuring. But the danger is that it is unrealistic. There are a number of features of the latest Bank of England forecasts which are at variance with our recent experience.
First, strong growth is expected to continue, but the fall in unemployment is expected to level off. Over the past year, the unemployment rate has fallen from 7.8 per cent to 6.8 per cent. At this rate of reduction, it is likely to be below 5 per cent in early 2016, contrary to the Inflation Report forecast that it will stabilise at around 6 per cent next year, helping to avoid upward wage pressures.
Second, strong growth is not expected to lead to a rise in capacity pressures or skill shortages. Yet over the past year, all the major business surveys have shown a sharp rise in the number of companies working above capacity as the economy has picked up. Unfilled job vacancies and reports of skill shortages are also increasing.
Third, inflation is expected to remain subdued at around 2 per cent or just below. This has been a characteristic of most Bank of England inflation forecasts since the financial crisis. Yet inflation has averaged above 3 per cent since the beginning of 2008 and peaked at over 5 per cent on two occasions.
The past is not always a guide to the future. But why is the Bank now so optimistic that the combination of growth, capacity pressures and inflation we will experience will be much better than before? The answer is a strong pick-up in productivity growth. To square the Bank’s forecasts of growth, unemployment, capacity pressures and inflation, we need productivity growth to pick up from the 0.5 per cent rate we have experienced over the past 12 months to around 2 per cent. This is also the key to avoiding rising skill shortages and wage pressures.
This is a big leap in the dark, because economists do not have a good understanding of changes in the productivity trend. If the current period of sluggish productivity growth persists for longer, either growth must slow down significantly or inflation is likely to pick up much more sharply than the Bank expects.
That should be a big worry in terms of monetary policy. If the Bank is too optimistic about productivity, it is also overestimating the underlying rate of growth of the UK economy. And it has probably been much too slow to raise interest rates.
If that is the case, we could face a much sharper rise in interest rates in the future than the markets currently expect, or a significant slowdown in growth driven by other factors. Either way, the real world looks much less rosy than the latest Inflation Report forecasts.
Andrew Sentance is senior economic adviser to PwC, a former member of the Bank of England Monetary Policy Committee, and author of Rediscovering growth: After the crisis (London Publishing Partnership).