Earlier today the BoE released its February Inflation Report; as expected the big theme was deflation. The Governor of the BoE Mark Carney said that inflation is more likely than not to go negative in the coming months but underplayed fears of persistent deflation in the UK.
The Inflation Report is overwhelmingly positive about the prospects of the UK economy not withstanding risks coming from abroad. The BoE is optimistic that falling inflation will give a boost GDP growth through stronger demand and an increase in real incomes. Key to this argument is that deflation is imported – through the collapse in oil prices and deflation in the Eurozone – rather than a reflection of domestic economic conditions which allows the BoE to look through such large one-off falls in prices.
This means that while inflation will go negative in the coming months it should edge up towards the latter half of the year as these effects drop out of the annual rate and slack in the economy is absorbed. The pickup in inflation should be supported by real wage growth as falling unemployment and an increase in average hours worked are exercising upward pressures on wages.
An increase in earnings combined with falling inflation will also give a further boost to consumption growth while the Bank also expects robust business investment. Productivity growth is also predicted to underpin growth in the medium term but there remains considerable uncertainty around that forecast. Based on this outlook the Bank judges that inflation expectations remain broadly consistent with the 2% target within the next two years. However, the MPC considers that inflation is as likely to be above as below the target risks are moderately skewed on the downside.
The fall in oil prices coupled with expansionary monetary policy throughout the globe should also support global demand. The Bank’s projections assume that world GDP growth will recover gradually this year, supported by the fall in oil prices.
There are notable downside risks to this forecast however; persistent sluggish growth in the Eurozone, potential market disruptions when US interest rates rise, and economic challenges in major commodity exporters put a dent on this positive outlook.
The Eurozone is seen as a particularly acute risk with discussions on a new program for Greece currently on-going. The Governor said that direct exposure to Greece is minimal but its indirect impact on the Eurozone’s growth prospects will have consequences for the BoE’s forecasts. On the upside, the ECB’s launch of QE should provide some growth stimulus to the Eurozone.
Falling inflation means no rush to increase interest rates and the BoE voted to maintain the Bank rate at 0.5% and the stock of purchased assets at £375 billion. The Governor also said that the most likely next movement in the Bank Rate remains upwards.