Inflation Report post mortem

The Bank of England’s decision to keep interest rates on hold today may have been what the markets were ultimately expecting – after having been conditioned between February and late-April to expect a rise – but I can’t help thinking that the late change of mind has caused more problems than was strictly necessary.

The forecast upon which the decision was based was not hugely different from that presented in February. Growth is a bit weaker this year but that is primarily due to the weakness of Q1 GDP. Inflation is moderately lower, but we are only talking about a few tenths of a percent. However, the BoE did go to great lengths to persuade us that some things have changed – notably the fact that the pass-through from sterling’s depreciation in 2016 has operated more quickly than expected, and as a result CPI inflation does slow more quickly in the early part of the forecast period than in February. As they pointed out, the March inflation figure (2.5%) turned out some 0.4 percentage points lower than expected three months ago (when the last observation was the December inflation rate of 3%).

As noted a couple of weeks ago the weakness of Q1 GDP, which at 0.1% q/q undershot even the most modest of expectations, was the key factor in the decision. In the past, the Bank has tended to raise rates only when quarterly GDP growth is at 0.5% or higher, so the majority of MPC members were clearly uncomfortable with tightening policy when growth is so far below this threshold.

Questions are increasingly being asked as to whether this slowdown is a one-off triggered by weather effects, or whether it marks something more serious. The ONS reckoned that the impact of the snowstorms in early March explained only part of the weakness. They may be right, but apparently this deduction was derived from a survey it sent out asking firms whether output had been affected by the snowstorms. When relatively few firms responded this was the case, the statisticians deduced that the weather effect was not so significant. In my view, and one which the BoE shares, the impact of the snowstorm was greater than the weight attributed to it by the ONS. Indeed, survey-based estimates suggest that Q1 GDP growth was higher than the initial estimate of +0.1%. The Bank believes that the figure will be revised up. That being the case, why did it simply not look through the temporary distortion? Presumably, the decision was partly based on how raising rates when the economy is going through a soft patch would play with the wider public. Or it could be that the BoE believes underlying growth is slowing.

Across the channel, we have already seen signs that the euro zone economy has lost momentum. And there is a school of thought which suggests the slowdown in UK monetary aggregates is a sign of weaker growth to come (see this FT article by Chris Giles).  It is always difficult to disentangle the direction of causality between monetary growth and real economic activity. But as Giles notes, “simple correlations show that measures of money have moved closely with the cycle this decade, raising the possibility that monetary indicators are due for a revival in economics.” But the slowdown evident in the money data is not yet evident in survey-based estimates (although last month’s retail sales activity was weak according to the British Retail Consortium). Consequently, the jury is still out on where the economy goes from here, but it seems set to continue growing much more slowly than prior to the EU referendum.

Not surprisingly, the big issue at the Inflation Report press conference was the BoE’s communication strategy. Having built markets up to expect a rate hike in May, only to backtrack in the face of the data, has led to accusations of inconsistency in expectations management. The BoE will point out, of course, that the decision was conditional – in this case on the data – so that a change of heart was the rational response. And there was a sense of testiness on the part of Bank officials when faced with intense grilling on the subject. Governor Carney sought to deflect criticism of misleading markets by referring to the fact he is trying to appeal to firms and households rather than just markets. But since markets set prices which impact on the decisions of firms and households, I am not sure I fully buy it.

However, I can see both sides of the debate. The BoE makes conditional forecasts and when the conditioning assumptions change it is entitled to change its view. The press in particular may not always understand the nature of a conditional forecast. Arguably, however, the BoE has to work harder to make sure that the conditional nature of its forecasts is better understood.If the BoE wants to improve its communication strategy, this might be a good place to start. But there is a wider problem. The MPC is comprised of nine members, each of whom is independent. Given the tendency of economists to disagree on any given issue, one could be forgiven for suspecting that it will prove almost impossible to get the MPC to speak with one voice, thus reducing the effectiveness of the forward guidance strategy.