–Inflation Projections Higher Near Term Than In August Report
–Chance of CPI Being Above/Below Target “Roughly Equal”
–Report Projections Not Compatible With Early Tightening Nor More QE
–King: BOE MPC Stands Ready To Act In Either Direction

LONDON (MNI), Nov 10 – The forecasts in the Bank of England’s
Monetary Policy Committee’s latest quarterly Inflation Report show
inflation, at least in the near term, will run higher than previously
predicted.

The chances of inflation being above or below target in two years
time are skewed to slightly below, but this is based on market rates
which show a gentle tightening profile over the next year to 18 months.
Even in three years the chances of CPI being above or below are assessed
as being “roughly equal”.

The BOE’s assessment of market rate expectations shows rates rising
from 0.5% to 0.7% by Q4 2011 and at 1.2% by the end of 2012.

The projections in the November Inflation Report suggest that the
MPC has current got policy about right. When compared with those in the
previous report in August, the latest report is less compatible with
more quantitative easing but nor does it make the case for early
monetary tightening. The projections put no great pressure on the MPC to
end its prolonged policy pause.

At his press conference following the report, BOE Governor Mervyn
King also emphasised that the latest forecasts hardly compelled the MPC
in any direction.

“Towards the end of the forecast, the Committee judges that it is
about as likely that inflation will be above the target as below it. But
at both the two- and three-year horizons, there is only a one-in-four
chance that inflation will be within 1/2 a percentage point of the
target.”

As King added: “That underlines the uncertainty faced by the
Committee”.

The Inflation Report contains a raft of ways of looking at how
growth and inflation will evolve. The modal, or the most likely,
projection tends to attract most attention and this showed inflation
clearly below target two years’ ahead. Near-term, however, this
projection shows inflation coming in markedly higher than expected in
August, in part because the MPC has doubled the predicted size of
domestic gas price hikes.

That longer and higher near-term hump in inflation increases the
risks that inflation expectations could become unhinged.

The numbers underpinning the report can only be estimated, but
Nomura economist Philip Rush reckons in all the CPI inflation for 2011
is around 0.6 percentage points higher than August’s, and the MPC says
its latest projections for gas price rises would alone boost CPI by 0.2
percentage points.

Another of the key views on inflation is the ribbon chart showing
the probability of inflation being above target through the next three
years.

This chart shows, in the words of the report, “the chances of
inflation being above or below target by the end of the (3-year)
forecast period are roughly equal.”

On that view, the MPC’s policy settings are not far from where they
should be to meet the target.

Any market participants hoping the Inflation Report would add to
the case for more quantitative easing were disappointed. The MPC stuck
with unchanged policy at its three monthly meetings when policy was
informed by the August Inflation Report, and compared to August the
November Report’s inflation profile is clearly higher, at least near
term.

In the November forecasts “the overall distribution for inflation
is higher than in August in the first half of the forecast period, but
by the two year point the distribution is broadly similar.”

While the modal projection shows inflation falling below target in
2012 and staying there – the risks on this forecast are skewed to the
upside.

For the majority on the MPC to back a shift in policy, the upside
or downside risks are going to have to materialize. There is a good
chance of that, but the MPC will be in wait and see mode.

“At present, there are large upside and downside risks to
inflation. Monetary policy has to balance these risks. Only with
hindsight will it be clear which has predominated,” King said.

The MPC itself is split. We know that in October while seven
members voted for unchanged policy, one voted for more quantitative
easing and another for a hike in Bank Rate.

King said “there is, as you would expect … a vigorous debate
between members, and a range of views that is wider than usual, about
the weight to attach to those different risks.”

The Inflation Report reflects the collective judgement of the MPC.
In other words, it shows how things would evolve if the views at the
centre of gravity in the MPC held true.

The projections, when compared to those in August, do little, if
anything, to justify any MPC member changing their policy stance.

There had been speculation recently that King himself could have
joined the dovish camp and he has made several comments which seemed to
put him in the faction which saw a rising risk that further QE might be
needed. However, the tone of his comments today seemed much more
balanced.

The growth projections are not vastly different from the August
ones. Growth two years ahead appears to be running at close to 3.0% on
the year, almost identical to the 3.1% expected in August. As in August,
the rate of growth is expected to ease back next before rising back to
3.0% and then holding around 3.0% into the third year of the forecast.

The MPC looks set to stay in wait-and-see mode, or as King said –
“We will monitor what happens and take action if necessary.”

The high near term inflation, which King says be easily explained
by a “sequence of price shocks”, such as sterling’s fall, rises in
commodity prices and the rise in value added tax, will not in itself
force the MPC to tighten.

“It doesn’t make sense to respond to price-level shocks in that
way. What we have to do, and the test of our credibility, is to explain
to people why we think inflation has been high and why we think it’s a
reasonable judgement that – on the balance of risks – inflation will be
where we think it’s going to be in the medium-term,” King said.

The uncertainties are high, from the MPC’s perspective, in
particular over the key question of how much spare capacity has really
been left in the wake of the financial crisis.

“You get very conflicting views, depending on which piece of data
you look at,” King said.

Unemployment data supports the view firms have hoarded labour and
have the spare capacity to up output without new hiring, but business
surveys suggest there is less capacity than expected.

These uncertainties, however, are not going to be resolved any time
soon.

Market participants took the view the Inflation Report lowered the
likelihood of more QE, with sterling rallying and Gilt futures taking a
hammering. Dec 2012 short sterling was down some 20 basis points.

Analysts said that the market is now fully pricing a full quarter
point hike by the end of next year whereas something just less than that
had been discounted before.

The MPC has had policy on hold since November 2009 and a year on
the November Inflation Report suggests this pause is unlikely to end any
time soon. Analysts median forecast in a Market News survey prior to the
MPC’s November meeting was that there would not be any monetary
tightening until Q4 2011 and the market has moved in line.

Glacial as these rate expectations seem, today’s report still marks
something of a landmark in that it is the first time since May 2008 that
an Inflation Report has led to the market revising up its rate
expectations. The BOE MPC has delivered a hawkish surprise to the
markets – be it ever so slight and highly nuanced.

Based on this Inflation Report and King’s note of the “vigorous
debate” taking place within the MPC it is likely that next week’s
publication of the MPC’s November minutes will show MPC member Andrew
Sentance still backing a 25 basis point rate hike and Adam Posen a stg50
billion addition to QE.

The minutes may well also show that the group of members who had
seen a heightened risk of further QE at the September and October
meetings has rethought its view.

–London newsroom 0044 20 7862 7491; email:
drobinson@marketnews.com/dthomas@marketnews.com

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