The BoE’s Inflation Report is out and Mervyn King is making an appearance to explain himself.
Of interest, particularly, is King’s reference to the broadening shape of its CPI fan chart:
A note on how fan charts work from the BoE:
Nobody can predict the future evolution of the economy with absolute certainty. It is more realistic for forecasters to recognise that uncertainty when describing their projections. Consequently, the forecasts for GDP growth and RPIX inflation described in the Inflation Report are always presented in probability terms. And the fan charts are graphical representations of those probabilities.
And specifically:
The fan chart depicts the probability of various outcomes for CPI inflation in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation over the subsequent three years would lie within the darkest central band on only 10 of those occasions. The fan chart is constructed so that outturns of inflation are also expected to lie within each pair of the lighter red areas on 10 occasions. Consequently, inflation is expected to lie somewhere within the entire fan chart on 90 out of 100 occasions. The bands widen as the time horizon is extended, indicating the increasing uncertainty about outcomes. See the box on pages 48–49 of the May 2002 Inflation Report for a fuller description of the fan chart and what it represents. The dashed line is drawn at the two-year point.
But what does it really mean?
The BoE is forecasting inflation could go anywhere between from +3 per cent to a deflationary -1 per cent in the next year or so.
Explaining himself, King referred to the unprecedented turnaround in commodity prices (not expected in August) and the biggest banking crisis since the outbreak of the first world war.
King cites the BoE’s oil-price expectations chart in defence.
The central bank governor now says, if necessary, the BoE is prepared to cut rates again.
Of course one of the key measures that can predict a deflationary environment is a fall in average earnings growth. The Bank notes wage pressures have remained subdued:
Both the average earnings index (AEI) and average weekly earnings (AWE) measures suggested that annual earnings growth weakened in August, and remained lower than over the past eight years on average.
And interestingly, the BoE says in 2008 Q3 the proportion of pay freezes in the private sector also picked up.
That pickup could reflect the extent to which demand for some companies’ output has fallen: the pay freezes were disproportionately concentrated in housing-related industries.
Regarding risk of deflation, King says in these (current) circumstances it’s very difficult to calibrate the risks. But, RPI is very likely to go negative, as for CPI - who can tell.
Either way, a very defensive King reassures: The BoE is now prepared to move the bank rate to whatever level so CPI returns to 2 per cent in whatever term. “We looked at the balance of risks, it was perfectly reasonable to take a different judgement before September,” he says. “The world changed in September.”
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