The Bank of England must get it right soon
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Associate Editor
David Stevenson Aug 12, 2010
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The quarterly Bank of England Inflation Report isn't really the sort of tome to set the pulses racing.
And normally, ploughing through 54 pages of heavy-duty text, tables and charts would be more than enough to test the staying power of even the most diligent of economic students.
But…these aren't exactly normal times. The country has just about emerged from the worst recession in living memory. There's a likely 'double-dip' on the way. The base rate is still at its lowest-ever 0.5%. Yet house prices are now falling again. As for stock markets – they're flying all over the place. The FTSE fell almost 2.5% yesterday.
So the Bank's views matter much more than usual. But the trouble is, can we believe anything it says? And what could then go wrong?
Is the 'recovery' nearly over?
This has been the most eagerly awaited Bank of England Inflation Report for ages. That's because the UK economy is at a crossroads.
The 'recovery', such as it is, looks like it's about to go into reverse again. The government is set to slash its spending, which will mean lots of public sector work, and jobs, being lost. Consumer confidence is crashing, says the latest Nationwide survey. People are starting to worry about how much, if any, spare cash they'll have left when things get tougher. And the global picture is looking grimmer by the day.
Meanwhile, the cost of living is climbing at 3.2%, well above the official 2% target. Yet average wages are growing at less than half that. This is already putting a big spending squeeze on many Brits.
So the base rate being held at the current all-time record low level of 0.5% is just about the only bit of cheer around for lots of us right now. That's because it's keeping down the cost of variable rate home loans. Without this, many more families would be on the edge of a financial cliff, while plenty would already be right over it.
Normally, with the cost of living climbing at over 3%, you'd expect interest rates to be much higher than at present. Yet the Inflation Report includes a hint from Bank Governor Mervyn King that the base rate will stay where is for longer than had been expected. That, you'd think, must be more good news for borrowers.
Except that there are two big snags.
Two big problems for the economy
The first is that the Bank now reckons growth will now be weaker than it had forecast before. In other words, this means more job losses, and less spare cash around, than had been expected. And while it sees inflation eventually falling further than previously predicted, this will take longer to happen because of the likes of VAT hikes.
This nasty mix of lower growth and higher inflation is often called stagflation. In short, this means more pain all round for even longer.
Then there's the second catch. This is even worse – the base rate could be forced up anyway. For its forecasts, the Bank has always produced its infamous 'fan' charts. With these, the range of possible outcomes is so wide you'd imagine they must cover almost any result.
What's more, these predictions are always tempered with a swathe of health warnings. With almost every forecast there's a major caveat added about the "high degree of uncertainty" surrounding it.
Yet the Bank has just admitted it has no more idea than the rest of us about what's going to happen in the economy. Not in as many words, mind you. Central bankers don't do that. But actions speak louder. Threadneedle Street is now spending a total of £3.5m overhauling its forecast model – because the previous one just didn't work.
Of course most of us had worked that out already. In 2007 the Bank proclaimed that: "this is not an international financial crisis". Ouch. In August 2008 it said its "central projection" was for "broadly flat GDP over the next year or so". In fact, the economy soon shrank over 6%.
Since then, the forecasts for the recovery have consistently been too bullish. On top, the Bank said in August 2009 that inflation was "more likely to be below target in the medium term than above". Yet the cost of living has been over the 2% target in 42 out of the last 51 months.
That may be the past, but it's also crucial for the future. Our government still has to sell a shedload of its bonds – gilts – to fund the budget deficit – the difference between its spending and tax take.
Gilts look set to become awful investments
Yet investors in ten-year gilts are currently getting less than a 3.2% yield, which is no higher than our inflation rate. In 'real' – inflation adjusted – money terms, these investors are merely breaking even.
In my book, that makes gilts a poor value investment. But they could become a downright bad one. "There are few worse sins in central banking than falling "behind the curve" and the consequences can be dire", says Philip Aldrick in the Telegraph. "Should the market lose faith, institutions would sell sterling and ten-year yields would rise".
In other words, investors would demand more for their money. So gilt prices would automatically fall. In turn, a falling pound would push up the cost of imports. Companies would be forced to pay higher interest rates on their debt. So consumer prices would rise. "The Bank would then be forced to defend the pound by lifting rates", say Aldrick.
"Alternatively, business would assume the Bank had lost the ability to rein in inflation", he says, "and start lifting prices accordingly – again creating a vicious circle leading to rate rises".
In other words, the Bank is now very much under the microscope. If it's too optimistic about its inflation forecast yet again, and the markets panic, that vicious circle could kick in fast. And not only will gilt investors get hit, the whole country will be in even more trouble.
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