–BOE MPC Wrestles With Uncertainty Over Spare Capacity Levels
–Policy On Hold Facing Downside Growth Risks; Upside Inflation Risks

LONDON (MNI) – Faced with persistently stronger-than-expected
inflation, and the risk of eurozone, and sovereign debt, turmoil
contributing to below forecast growth, Bank of England Monetary Policy
Committee members are offering no assurances that policy will be on hold
for a prolonged period.

The outcome of this week’s MPC meeting is a foregone conclusion,
with the committee sure to leave policy on hold ahead of the new
government’s first budget on June 22 and with the economic outlook so
uncertain. Recent comments by MPC members, however, have highlighted
both their uncertainty over the causes of the currently elevated
level of inflation and fears that events could spin out of control.

The MPC’s central view is that substantial spare capacity in the UK
economy will drive headline inflation back below the 2.0% target level
while the economy rallies. The BOE, however, is struggling to
get a clear take on how much spare capacity there really is following
the recession, and MPC members worry about second-round inflation
effects and downside growth risks.

Monetary policy makers around the world were widely criticized for
over confidence prior to the credit crunch but recent comments from the
latest batch of MPC members show humility.

“Are we … confident that we can go on, we can keep the economy
on track and hit the inflation target ? … Given the scale of the
shocks and challenges we face … I would be far from confident that it
will be easy to come across the right mix of policy to do that,” Kate
Barker said in her farewell interview in the Financial Times.

Barker, who left the MPC in May, and who has not been replaced for
the June meeting, offered no false assurance the committee would be able
to offset the impact of a widespread sovereign debt crisis.

“There are things where it’s very difficult for monetary policy to
mop up after. Both a debt crisis either that comes out of the banks or a
debt crisis that’s more based in sovereign debt would pose tremendous
difficulties for monetary policy to mop up after,” she said.

When headline CPI rose to 3.7% in April, 1.7 percentage points
above the BOE’s target, Governor Mervyn King’s attributed the rise in
his open letter to Chancellor of the Exchequer George Osborne to three
factors: higher oil prices, the rise in value added tax and sterling
depreciation.

His colleagues on the MPC, however, have said while these factors
go a long way to explaining high inflation levels, additional factors
appear to be at play.

The BOE staff are battling to assess how much spare capacity the UK
has left following the credit crunch and whether price competition has
diminished. There is a concern that with some companies pulling out of
markets, and the survivors looking to restore profit margins, price
competition has become less intense than it was in the pre-crunch years.

In an op-ed piece in the Daily Telegraph BOE Deputy Governor
Charles Bean explored the reasons why inflation has come in far above
the BOE’s forecasts, noting that just a year ago the central bank put
the odds on inflation exceeding 3% at only one in 15.

In his piece, Bean raised both the reduced capacity and price
competition fears.

“Part of the explanation could be that the credit crunch has
resulted in more loss of supply capacity than anticipated. Also,
businesses seem to have opted to maintain profit margins and cash flow
against a background of reduced credit availability, rather than cut
prices to boost sales,” Bean said.

Even if oil prices continue to ease back and sterling rallies,
the concern is that inflation will not fall back as far as expected.

The upcoming June 22 budget adds another layer of uncertainty to
the inflation outlook. Many analysts have been anticipating a rise in
value added tax, which would feed through directly into headline
inflation.

What is far less clear, and what has been widely debated in tax
policy making circles, is when a VAT should kick-in, and whether it
should be staged. Everything from a gentle 1 percentage point hike in
2011 to an aggressive 2.5 percentage point hike this autumn have been
rumoured. The latter would add somewhere between 0.6 and a full
percentage point to CPI, depending on the willingness of retailers to
pass it on.

The BOE has its hands tied in forecasting the impact of tax
changes on inflation: like other central banks it only plugs in
publicly announced policy changes into its projections.

While these upside inflation risks persist, the MPC is also
painfully aware growth could turn out to be a lot weaker than its latest
central projection in the May Inflation Report.

“There remain considerable downside risks to the recovery,
which have been brought into sharp relief by heightened concerns about
public deficits and sovereign debt,” Bean said.

MPC member Adam Posen believes that some of the downside risks to
eurozone growth have already become a reality.

“The UK’s major export market remains the Euro area … Let us just
say that the prospects for strong growth in most of the euro area are
rather dim for the next several years,” Posen said at a London School
of Economics event.

While the accelerated fiscal tightening plans to be unveiled in the
budget should ease the pressure for a UK sovereign downgrade, the MPC
will not be able to respond by loosening monetary policy – with Bank
Rate already at a record low 0.5%.

“Given where interest rates are now, there will be no bonus from
fiscal discipline. This is about pre-empting an interest rate rise,”
Posen said.

With inflation well above target it is unsurprising BOE researchers
are looking at the risks of higher inflation expectations feeding
through to higher inflation.

A BOE working paper found that back in the 1970s upward shocks to
inflation did have an important impact on actual inflation, but this
effect becames less significant in later years. Barker also pointed out
the correlation between inflation expectations and outturns in recent
history has been weak.

The BOE paper, however, contained one important caveat – the more
muted impact of higher inflation expectations in recent years compared
to the 1970s “seems to be mainly due to a relatively slower response of
monetary policy to these shocks in the 1970s compared to later years.”

The lesson MPC members could draw is if inflation expectations are
forced higher, and the latest survey by YouGov for Citi did show a
rise, a prompt policy response could well be appropriate.

“There is no room for complacency. Elevated inflation can persist,
even with a substantial margin of spare capacity, if businesses, workers
and households expect inflation to be high and set prices and wages
accordingly,” Bean said in his op-ed piece.

He added that the MPC would be watching these indicators carefully
and “We will not hesitate to act should they threaten the return
of inflation to the target.”

A growing number of analysts now back the view the MPC could, in
the absence of further downside growth shock, begin tightening policy in
the fourth quarter of this year. At the other extreme, there have been
some predictions it could be forced to restart quantitative easing.

MPC members themselves are expressing no great confidence about
how things will evolve.

–London newsroom: 4420 7862 7491; email: drobinson@marketnews.com

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