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Inflating expectations

The market reaction to the Bank of England’s latest Inflation Report was muted on the day. Nevertheless, the report has probably given economic optimism at least a short-term boost. The country needs a One Nation economic policy to make sure everyone benefits from rising economic growth.
The August Inflation Report was keenly awaited because it was the first such report published under Mark Carney, the new Bank of England governor brought over from Canada, at great expense, to lead the Bank over the next five years. The Inflation Report is produced by the Monetary Policy Committee, which sets interest rates. The MPC states that it will keep interest rates at the current 0.5 per cent level at least until unemployment falls from the current 7.8 per cent to 7.0 per cent. That implies 250,000 fewer people will be without work, which the Bank believes will not happen until 2016 (Carney said the Bank expected 750,000 new jobs to be created in that time, which implies half a million jobs will be lost in the next two to three years). Hence the headlines stating that interest rates will be held for three years.
There are, however, a number of caveats. The 7.0 per cent unemployment rate is only a ‘way station’, at which the MPC will review the situation. And the ‘forward guidance’ is subject to any one of three ‘knockouts’. Rates could rise sooner if the MPC believes inflation is likely to be above 2.5 per cent in 18-24 months’ time (it is currently 2.9 per cent), or if inflation expectations in the country rise significantly, or if financial stability is threatened.
I have wondered before if we have seen a turn in the growth forecasting cycle: as economic data exceed expectations, so forecasters conclude they have been too pessimistic and play catch-up with their GDP forecasts. The Bank provided some support to this view in that it increased its GDP forecasts for this year (estimated to 1.5 per cent from 1.2 per cent) and expects 2.7 per cent growth next year. Note that estimates of the trend rate of growth tend to be around 2-2.5 per cent; a recovery would see faster rates of growth than this at times. One reason the Bank has raised its forecasts is that it believes its Inflation Report will give people more confidence rates will be kept low for some time, so stimulating economic activity. The outlook for inflation, and therefore interest rates, is very uncertain, however, and there is a wide variety of opinion on when in practice the MPC may decide it has to raise rates. The outlook for unemployment is also highly uncertain. The jobs market is behaving differently in this recession and recovery to on previous occasions, and productivity is low (though may simply rise as GDP grows). As government spending cuts go deeper, so the public sector will make more people unemployed, so much depends on private sector jobs growth. The Bank believes the medium-term equilibrium unemployment rate should be around 6.5 per cent, or 400,000 fewer unemployed than now.
As thoughts turn to summer holidays, the economic picture at least in the short term appears clearer. The economy is growing across many sectors, and a little faster than people had expected. Interest rates are likely to remain low for some time and there are some signs lending to small businesses is picking up. At the beginning of the year I noted that with measures to boost liquidity what was needed for growth was an increase in confidence in the future. Confidence has increased it seems, at least for now, and that has been despite government policy (look at the poor attempts at growth plans and cuts to infrastructure spending for example). Many risks remain and the Conservatives will be hoping the fragile signs of recovery herald a couple of years of growth, even putting them in a position to promise tax cuts in the next parliament. The risk is that we see very little rebalancing and rely instead on higher household debt. A golden opportunity to promote a more sustainable economic future looks like it is being missed. The challenge for Labour is for us to show how our One Nation approach will make sure everyone benefits from recovery following years of falling living standards, rather than rising prosperity being focused on a minority. That means our message should focus on investment, and on being credible that spending will be effective.

This article was first published by Progress, on 8 August 2013.
Progress, 8 August 2013, 08/08/2013

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