May’s Inflation Report: The Bank’s still in a bind

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The Bank of England's May inflation report contains two similar messages to its previous report. They think that:1) Inflation is going to be higher, and2) Growth is going to be lower.

In other words, the Bank is still in a bind.

Despite forecasts indicating that inflation will remain high in 2011, potentially hitting 5%, the weak growth figures have meant that market expectations for when the Bank will finally take the plunge and raise rates have pushed out further.

The MPC must have hoped that the economic recovery would have gained more momentum by now. With fiscal austerity only just beginning to bite, the committee will be wary of rate rises that could further dampen growth in 2011. Growth is expected to come from investment and exports, so today's trade figures will not have provided any comfort. There are other risks too. The debt crisis in the Eurozone remains unresolved, and supply chain disruptions as a result of the earthquake in Japan could hit output in the coming quarter.

As for inflation, it is still well above target. One of the main contributors to inflation has been the rapid rise in costs associated with oil and commodities, some of which is still to hit gas and electricity bills. While last week's dramatic price falls will have provided some respite for the MPC, it is a little too early to tell if these will be maintained.

Other upside risks to inflation remain, and may become more pertinent. A survey released on Monday suggested that the general public's inflation expectations had reached a 29-month high in April. What is more, consumer surveys continue to show that households are feeling squeezed. Andrew Sentence – in one of his last speeches as a member of the MPC– made the comment that it may only be a matter of time before the Bank's continued accommodation of inflation hurts its credibility and leads to higher wage and price setting.

He said “It may be that indicators of an upward drift in inflation expectations are only flashing amber at present. But if the MPC waits until they are flashing red, and if other pressures continue to push up UK inflation in the meantime, the Committee could face a very difficult situation later this year or next.”

Spare capacity – in the form of high unemployment – should tend to keep a lid on wage pressure. Indeed, Mervyn King has said that wage growth is occuring at levels well below those that would be a concern to the inflation target. Whether this will continue is by no means certain, particularly when skills shortages are an issue. Wages remain a key point to watch: EEF's own settlements data for the busy April pay round will be released next week. This should provide some indication as to whether inflation expectations are impacting on wages.


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