Blog: BoE inflation figures are barely credible

Bank of England governor Mervyn King yesterday set out his reasons for the overshoot of CPI inflation last month in a letter to new Chancellor George Osborne. They were all dubious, says Henderson chief economist Simon Ward.

Over the last year I have argued, probably ad nauseam, that Bank of England and consensus inflation forecasts were too low.

April figures delivered another unfavourable 'surprise', with the headline CPI and RPI rates moving up to 3.7% and 5.3% respectively. RPI inflation is now at its highest level since the aftermath of the late 1980s Lawson boom.

Governor King's latest explanatory letter claims the overshoot of CPI inflation relative to the 2% target is fully explained by higher oil prices, the rise in VAT and exchange rate weakness. This is dubious.

Energy and VAT are unlikely to account for more than one percentage point of the 3.7% April headline rate. Sterling's decline partly reflects monetary policy decisions so the Bank cannot absolve itself from responsibility for the impact on inflation.

The Governor also fails to acknowledge the scale of the Bank's forecasting error. The central projection in the May 2009 Inflation Report was for CPI inflation to fall to 0.7% by the second quarter of this year.

This incorporated the planned VAT rise and was based on a similar effective exchange rate level to today's. Higher energy prices can account for only about 0.5 of a percentage point of the 3 point forecast miss.

The Bank's error was to place too much weight on the 'output gap' as a driver of inflation while underestimating the impact of sterling's decline to significantly undervalued levels.

It also wrongly believed that low money supply growth would constrain price rises, neglecting that the demand to hold money had been depressed by its imposition of negative real interest rates. The lessons, however, have yet to be learnt, judging from the letter and the latest Inflation Report.

The updated CPI and RPI inflation projections incorporate, optimistically, a significant slowdown in core price rises from their recent pace in response to economic slack and smaller import price gains. A hike in the standard VAT rate to 20% is assumed in January 2011, possibly to be pre-announced in the June emergency Budget, while the RPI profile posits an increase in Bank rate to 2.5% by mid-2011.

Headline CPI and RPI rates may have peaked in April but are forecast to remain elevated, averaging 3.0% and 4.6% respectively between May 2010 and December 2011. The latest Inflation Report projections are barely more credible than those issued a year ago.