More unfounded optimism from the Bank of England?

The Bank of England has produced its latest inflation report and the Governor, Sir Mervyn King, believes that there is “grounds for optimism”.  The problem with this is that the Bank has been consistently overoptimistic about the prospects for inflation and output since the financial crisis and the onset of recession.  Is this time different?

Prospects for Inflation

The Bank has an inflation target of 2%.  Its latest forecast suggests that this target will not be hit until the end of 2014 (see chart).

Inflation 2 v2

But as the chart shows, the Bank’s recent record suggests that this is unlikely, as it has consistently overshot its target.    How has the Bank reconciled its loose monetary policy with high inflation?    The frequent refrain is time lags – that monetary policy takes two years to have an impact on inflation.  Another excuse prominent in the latest report is that there are many inflationary pressures that the Bank cannot control – such as university tuition fees and domestic energy bills.  Simply, the Bank is now acknowledging that it can only influence core ‘demand pull’ inflation and has little influence on cost-push inflation.

Prospects for Output

The Bank expects the economy to remain weak in the near term but with return to normal in 2014. But the Bank has an appalling record on forecasting output.  Look at the chart:  it had no idea that the crisis was coming and it missed the double dip – but it continues to forecast a return to normal.

BoE GDP Forecasts 2

In many ways this is product of the weaknesses of macroeconomic modelling – with virtually all macro models, a shock has a temporary impact and then the economy returns back to ‘equilibrium’.  But this is reflection mainly of mathematics rather than economics.  On the notion of a long-run equilibrium, Keynes got it right when he stated that: “The long run is a misleading guide to current affairs. In the long run we are all dead.”

About mk242013

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