Commentary: Bank may be too gloomy on inflation

The Bank of England bills its inflation report as everything you wanted to know about inflation but were afraid to ask. It is hardly exaggerating. The 45-page report is a thorough, objective and intelligent summary of the prospects for inflation. Far from kowtowing to Treasury optimism, it is arguable that the Bank is a little too gloomy on the inflation outlook.

Like the Chancellor, the Bank focuses on underlying inflation (the rise in the retail price index excluding mortgages), the measure for which the Government has set a 1-4 per cent range and a 2 per cent target. The Bank's message is that, on all the present information, inflation is likely to be between 3 and 4 per cent over the next few years. Its central projection (shown in the graph) is 3.5 per cent.

Because the Bank feels that there is unlikely to be any further decline towards the Government's target, it believes that there is no further scope for a cut in interest rates. Although it argues that the past margin of error shows that inflation could be either higher or lower than the 1-4 per cent range, it also says that the risks are more probably on the upside.

The Bank worries about a further slide in sterling, the prospect of which, thankfully, seemed to be receding yesterday in the wake of President Clinton's US budget proposals. The 16 per cent drop in sterling since 16 September (on the trade-weighted index, which is what matters) is quite enough for any economy to absorb for now. It is also concerned that the impact of the recent devaluation could come through more quickly.

One reason for supposing that the Bank may prove to be too pessimistic is that its projections in October have already been revised downwards by more than half a percentage point. The latest inflation report was also prepared too early to take account of Friday's unexpectedly large drop in 'headline' inflation to 1.7 per cent and in underlying inflation to 3.2 per cent.

True, January's sales-related price fall may bounce back. But it is equally likely that the fall is a one-off that will leave the inflation rate lower for a year, in exactly the same way as cuts in interest rates will further reduce the 'headline' rate. If so, wage settlements could continue to decline. Inflation will then tend to stay low.

Policy-makers are probably still underestimating the potency of Britain's debt deflation. Debt as a proportion of income is barely lower than it was at the end of the Eighties, when people had far higher expectations of the future growth of their income. House and other asset prices have fallen sharply. It therefore seems likely that the long process of reducing debt to levels with which people feel comfortable still has some way to run. During that period, people will repay debt more willingly than spend.

There are no certainties, since there are no historical precedents for present circumstances. But it is not necessary to assume that the Government will behave irresponsibly to foresee another cut in interest rates. The power of debt deflation will be a perfectly legitimate justification.

(Graph omitted)