Sean O'Grady: Wrong inflation forecasts and mixed messages can lead to dizzying confusion

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The Independent Online

Outlook This week, the Bank of England will present its latest Inflation Report to the world. Now, obviously, I haven't seen the document – the bank is a remarkably unleaky institution – but I've got a pretty shrewd idea what it will say, because Bank officials have been dropping some broad hints about it for a while.

The Governor, Mervyn King, told the Treasury Select Committee a couple of weeks ago that inflation would stay above the official 2 per cent target for "much of next year"; the Bank's chief economist, Spencer Dale, told this newspaper before that that the target would be missed for the "whole" of 2011.

So, you get the picture. Both also indicated that the growth forecast for next year will be downgraded. Mr King told MPs the Budget had made little difference to the outlook; Mr Dale said the forecasts would be lower "partly" because of the Budget. Again, the broad view is similar, and similarly unsurprising. What I also expect to see is a fan chart of unprecedented width. The individual folds of the fan are supposed to show degrees of uncertainty about an outcome alongside a central path (the Bank doesn't publish a bold central forecast figure or short range).

Adam Posen, one of the external members of the Bank's Monetary Policy Committee, made a thoughtful speech a few weeks ago, saying: "The MPC's current forecast is that we are far more likely to have an economy with less than 1.5 per cent inflation or with greater than 2.5 per cent inflation over our target horizon than an outcome close to our target." Frank, but hardly reassuring.

So, as everyone at the Bank says, with entire honesty, there's a lot of uncertainty about. Just think for a moment about the increase in VAT on 4 January next year. That is pretty much the reason why inflation will stay above the 2 per cent target for longer than the Bank thought before, and such political decisions cannot be foreseen by the Bank, it is fair to allow.

Yet, as any sixth-form economics student will tell you, raising VAT also reduces inflation. It has a disinflationary effect because it takes spending power out of the economy. But which effect will prove stronger? And how will a rise in VAT affect pay-bargaining? We cannot know: the last time the economy faced such a VAT-inflation conundrum was after 1979, when the then Tory chancellor, Sir Geoffrey (now Lord) Howe, almost doubled VAT to 15 per cent as part of a package to, ahem, rebalance the economy and reduce inflation. The world was different then.

Another problem for policymaking is similarly apparent; while the Bank may be trying to stoke the economy's fires towards the end of this year, if the double dip gathers strength, the Treasury is busily dampening the economy through savage public spending cuts and tax rises.

It may or may not be the best way to proceed; but it will take a hellish amount of skill on the part of everyone to make it work and to explain it. And that's before the Bank starts toying with the third pedal in the car – the new macro-prudential policy tools discussed in this space last week. Consumers and businesses may end up with a dizzyingly mixed set of messages.

Which just leaves us the slightly awkward question of why inflation is quite as high as it is. By three key benchmarks, inflation is too high.

First, by recent UK experience, during the so-called "nice" decade (non inflationary continuous expansion), ending in 2007. Second, inflation is high by international standards. As the chart shows, underlying CPI is much higher in the UK than in comparable economies. If it goes on like this it will lead to a cumulative loss of price competitiveness.

Third, of course, inflation is high in relation to the official target of 2 per cent, and has been for most of the last three years.

Anyway, it is too high. And, at the Bank's Inflation Report press conference this week, the Governor and his senior colleagues will once again explain why, and why their past forecasts were errors.

This time last year they told us it would be about 0.7 per cent now, rather than above 3 per cent (and round 5 per cent on the Retail Price Index, used for wage bargaining). There will be the familiar litany of one-off causes: the depreciation of sterling by more than 20 per cent since 2007; commodity price inflation, with the wheat spike a very uncomfortable reminder of its resurgence this year; the hike in VAT back to 17.5 per cent last January, and so on.

Mr King will sound once again a little like a guilty schoolboy giving excuses about why his economics homework hasn't been handed in: the dog ate it; "I left it on the bus"... whatever. Now the problem for the teacher – us – is that in this case Mr King's excuses really are correct. The dog did eat it, and so on. Yet that still leaves us with the problem of the missing homework, i.e. of inflation being above target.

Behind the bike sheds on Threadneedle Street, some of Mr King's school chums are a bit more sceptical about his excuses. Mr Posen, for example, in that thoughtful speech, effectively said that, while true, all those one-off reasons are not the whole answer as to why inflation is higher here than abroad, and that another factor is a modest creep upwards in inflationary expectations. Slightly confusingly, Mr Posen added such a modest creep was nothing to worry about.

Or take Mr Dale. Mr Dale, too, is a little impatient with the "one-off factors". As he said last month: "Now, we can come up with all sorts of clever and legitimate reasons to explain our view but at some point people will say 'inflation just seems higher than it used to be' and that is a very substantial risk. We're aware of that."

Mr Dale suggested the slackness in the economy wasn't sufficient to prevent firms passing on rises in input costs because they simply needed the funds to protect cash flow. Both Mr Dale and Charlie Bean, the Deputy Governor, have said that inflation is also higher than they thought because the feed through of higher import prices has been faster than previous experience told them, maybe part of a faster-moving economy generally.

The bigger picture is that the Bank has been extremely lucky to have got away with inflation being quite so high for quite so long without an even bigger impact on wages and price setting behaviour, and the beginnings of an inflationary spiral. The Bank will argue that there is little sign of that even now; but how sure can we be that the Bank is right this time round? Where do you think inflation will be this time next year?