Thomson: We’re backing King on inflation

Mervyn King surprised the February inflation report press conference by categorically stating that “recover we will” and telling a few home truths about growth and inflation.

On growth, he noted that the very weak performance during 2012 was constrained by two sectors that together account for just 9 per cent of GDP, namely construction and North Sea oil output.

Excluding these factors, growth was 1.2 per cent (which he revised up to 1.5 per cent in the May press conference).

Likewise, concerns over inflation had been exaggerated by administered and regulatory price hikes in energy and education, which together had added 1 per cent to inflation over the past year (twice the average of the previous decade).

This forced the MPC to choose between hitting the inflation target and driving the economy back into recession or developing flexible inflation targeting. The Bank chose the latter, and as a reward has been able to have its flexible inflation targeting enshrined in a new mandate.

Sir Mervyn did not provide as pithy a sound bite in his valedictory press conference, but the message was clear – read my lips; the economy is recovering.

More importantly, faster growth is being achieved against a background of lower inflation expectations.

The Bank raised its growth forecast for 2013 and 2014 to 1.2 per cent and 1.9 per cent from 0.9 per cent and 1.8 per cent. The forecasts are consistent with our own views. Moreover, there appears to be greater certainty around these forecasts, with the governor noting that there were upside as well as downside risks to estimates.

Moderately faster growth will be accompanied by slower inflation. The improved growth/inflation trade-off is a growing phenomenon amongst the major industrialised economies as continued growth-recessions in emerging economies reduce inflationary pressures.

The MPC expects inflation to fall back to its 2 per cent target within the new, extended three year horizon.

Inflation is expected to average 2.9 per cent and 2.5 per cent respectively in 2013 and 2014, down from 3 per cent and 2.7 per cent. More importantly, the inflation rate is expected to slow close to target by the middle of next year.

The governor emphasised the distorting influence of government administered and regulatory price hikes, essentially indirect taxation, will continue to contribute 1 per cent to the inflation rate over the next couple of years.

Consequently, the underlying inflation picture is likely to be significantly weaker than the headline picture suggests. In particular, average earnings growth is likely to remain below headline inflation over the forecast horizon.

The doves have highlighted two elements of these forecasts. First that growth does not reach the Bank’s prior 2.5 per cent productive potential growth forecast, and secondly that these estimates are based on maintaining the current 0.5 per cent base rate and Asset Purchase Facility at £375bn throughout the forecast horizon.

The latter prospect clearly alarms the hawks. The leading hawk on the MPC, chief economist Spencer Dale, expressed disquiet at the consequences for risk appetite and the distortion of financial markets were policy to remain at emergency levels for such a prolonged period. This issue has also been highlighted in recent warnings from the Bank for International Settlement.

The new governor, Mark Carney, takes office on July 1st, and the new mandate has been tasked with providing intermediate targets for the next Inflation Report in August.

Expectations for the future

However, the old guard has sought to influence the debate with a very British interpretation of forward guidance.

Section 5.A provides a list of the assumptions underpinning the MPC’s key economic judgements. Rather than provide a set of conditions and numerical targets for unemployment and inflation that would prompt a change in policy as the Fed has done, this table lays out the events that the Bank of England expects to occur.

The presumption is that when the facts change, then policy will also change. The table provides more supporting opinion, which significantly enhances the Bank’s communication and transparency. We assume that Mark Carney has been consulted and cannot envisage any material change to this presentation in the August Inflation Report since it is a subtler, but superior version of forward guidance.

The current view is predicated upon four key judgements; international policy initiatives facilitate a sustained, but gradual, global recovery; the consequences of the financial crisis slowly fade such that consumer and business spending gradually recover; the recovery in demand is accompanied by a broadly corresponding expansion of effective supply; a revival of productivity growth curbs domestic cost pressures, meaning that inflation gradually returns to target as external pressures fade.

Mervyn King’s confidence in the recovery is based on the removal of last year’s distortions from oil production and construction. Indeed, the 0.5 per cent forecast for real GDP growth in the second quarter is probably predicated on higher North Sea oil output as well as better underlying growth.

The government’s Help to Buy programme for residential construction is likely to prevent a further large contraction in construction output (something that the Bank is suspicious about and partly explains why its forecasts assume upward revisions to prior GDP data). The governor viewed the Help to Buy and extended Funds for Lending programmes as incrementally positive, but not game changers. Moreover, he insisted that the Help to Buy programme should be temporary and that the government should not be permanently involved in subsidising mortgages.

However, he did not suggest time limits on Funds for Lending schemes to Small and Medium Sized Enterprises (SMEs), which provides hope that this programme may become permanent to offset the distorting preference for secured lending provided by the Basel banking accords.

Interest rates will rise sooner than expected

The growing conviction in the recovery means that the probability of further stimulus is greatly reduced.

The forecast of modest growth means that activity does not reach the prior estimate of productive potential during the forecast horizon. This means that the output gap remains wide and underlying inflationary pressures remain subdued which provides the central bank with an incentive to keep base rates on hold for a prolonged period.

However, the next move will be a hike and the upside risks to global growth suggest that this will come well before the end of the forecast period.

This does not mean that further stimulus is off the table. The MPC is expected to maintain its modest bias towards loosening and while Mervyn King’s assertion that arguments can be made for both adding and removing stimulus based on the current outlook suggests that he has reversed his vote for £25bn more QE at his penultimate meeting.

Although it should be remembered that he votes last and consequently this has been a signalling mechanism, that policy is biased towards easing rather than a vote for additional stimulus.

Mervyn King believes that there are limits to the effectiveness of further monetary stimulus. He also believes that the current growth rate is appropriate given the subdued recoveries in the rest of the world, particularly in Europe.

In recent speeches, Mark Carney has afforded greater credence to more activist monetary policy and has also endorsed King’s easier bias. It is possible that the new governor could satisfy his sponsoring chancellor’s desire for faster economic growth, but we view this as a low probability outcome, no more than 20 per cent, given the improved growth path and prospect for early tapering in the US.

The most likely outcome is that the current bias is maintained and base rates remain on hold for a significant proportion of 2014, but will belatedly respond to higher real rates by the second half of 2014.

This stance reflects the downside risks to the global economy, provided by Europe and the sub-trend growth in emerging economies (particularly the unbalanced Chinese economy).

Indeed, we believe that there will be further iterations of the European Crisis, Response, Improvement, complacency cycle, but these shocks are exogenous and cannot be timed.

Consequently, the best strategy remains to follow Mervyn King’s prediction that real interest rates must increase over the medium term, noting the average rate of 3 per cent over the past hundred years.