Outlook: Too optimistic on inflation

It should probably come as no surprise that the Bank of England's Inflation Report should start to show inflation hitting its target for the foreseeable future. The obvious question, if it did not, would be why had the Monetary Policy Committee not done something about it. For the report is no longer a critique of the Chancellor, but rather a justification of the new committee's decisions.

The trouble is, as Mervyn King, the Bank's chief economist, admitted yesterday, that the Bank is being unusually optimistic in its inflation forecast, which is predicated on interest rates staying at 7.25 per cent. The prediction assumes a convenient and sharp slowdown in growth, but one that keeps it below trend for only a few quarters before taking off again. What if the economy enjoys a few more quarters of boom before starting to slow significantly? Or what if other economists are right that inflation will not remain at 2.5 per cent without a more sizeable dip in growth?

In either of these scenarios, the Bank will find itself having to react month by month to the economic statistics. Take retail spending. Yesterday's report placed a lot of weight on a Mori survey showing that most of the pounds 36bn free share windfalls would be saved, and said the effect was therefore fading. However, the survey was conducted in August and asked people whether they had spent or saved their windfall. Many who were saving it this summer could be spending it before Christmas. Even without the windfalls, incomes and wealth have risen strongly in the past year and will encourage consumers to have a very jolly festive season.

There are caveats, of course. World stock market turbulence casts a shadow over growth, as does the fear that the strong pound will eat into exports. Few would challenge the notion that the economy is going to slow next year.

There are also a lot of uncertainties in world financial markets which might spill over into growth. The Bank is therefore right to keep an open mind on interest rate moves. By the same token, however, it was also right to raise rates last week. More likely than not, the Bank will have to opt for another modest rise in rates before putting them on a downward path. The Bank has been consistently over-optimistic about inflation. If it is wrong again, interest rates will have to climb quite a lot higher. Eight per cent begins to look a more plausible peak than 7.5 per cent.