E is one thing that can be guaranteed whenever the Bank of England releases its quarterly Inflation Report – in two years’ time, its central projection for consumer price index inflation is at or very close to the 2 per cent target. Yesterday’s report was consistent with this tradition. Inflation is expected to rise to 3 per cent or so in the short term. But by 2015, it is forecast to be back around 2 per cent.
Recent experience, however, does not inspire much confidence that this will be the case. Since the onset of the financial crisis, the only time when UK inflation was close to the 2 per cent target was when it was artificially suppressed by a cut in the VAT rate to 15 per cent in 2009. Otherwise, it has been persistently above target, rising to over 5 per cent in 2008 and 2011, and averaging over 3 per cent.
There have been three main reasons for this persistent above-target inflation. First, surges in energy and commodity prices – including the price of oil – have pushed up the cost of imports. Second, the decline in the value of the pound has added to these imported inflationary pressures. And third, services inflation has remained stubbornly high – averaging close to 4 per cent in the past five years.
The Monetary Policy Committee’s (MPC) latest forecast of inflation coming back to the 2 per cent target requires all these sources of above-target inflation to subside. This seems quite unlikely.
First, the Bank of England forecast assumes that the world economy picks up over the next two years. When the world economy picked up in 2003-4, 2006-7 and in 2010, stronger growth was followed by a surge in energy and commodity prices. With strong growth expected to continue in resource-hungry emerging and developing economies, it is quite likely that a pick-up in global growth will be accompanied by a similar price surge in 2014-15.
Second, we cannot be sure that we have yet seen the full effects of the 20 to 25 per cent devaluation of sterling since 2007. As the UK economy recovers, importers and domestic producers may seek to pass through import costs to consumers, which they have been absorbing until now. And we cannot rule out the possibility of a further decline in the value of the pound if investor confidence shifts against the UK economy and sterling.
Third, it will be very difficult for consumer price index inflation to fall to 2 per cent if the prices of services – which make up around half of the consumer basket – continue to rise at close to 4 per cent. The MPC has been waiting for some time for low wage growth and spare capacity to feed through into lower services inflation. But this has not happened. One explanation is that inflation expectations in the services sector are running significantly above the target – which would point to services sector inflation remaining stubbornly high.
For all these reasons, it looks as if the inflation risks are still to the upside of the latest Bank forecast. The MPC will struggle to get inflation back to 2 per cent over the medium term without some change in monetary policy.
Andrew Sentance is senior economic adviser to PwC, and a former member of the Bank of England’s MPC.