Outlook: Bank may be getting it right after all

MERVYN KING, the Bank of England's Deputy Governor, gave his usual virtuoso performance at the quarterly Inflation Report briefing. Any reasonable person looking at the evidence, he argued, should not have been surprised by the Monetary Policy Committee's interest rate decisions. And indeed, Mr King made it seem very logical - with world growth even weaker and inflation incredibly subdued, why was anybody caught on the hop by last week's half-point cut?

Asked whether the steep drop in interest rates since October was not evidence that the Bank had earlier made a mistake in raising them too high and leaving them at that level for too long, Mr King pointed to the run of bad news about growth and good news about inflation since then. Perhaps other people felt they had been more far-sighted, he said, but the MPC had reacted to actual events.

It was a fair enough gibe. It is easy for pundits and pointy heads to have strong views about what the MPC ought to be doing, but many have made far bigger mistakes about what was happening in the economy. Their errors, unlike any the committee might make, can be quietly buried in the archives. What Mr King glossed over, however, was the fact that the MPC clearly has changed its mind quite radically about the degree of inflationary pressure in the economy. In particular, the wage inflation it thought was in the pipeline does not exist. The Bank's inflation forecast, for any given interest rate or growth rate, is lower than it was.

Whether or not this counts as a mistake, the financial markets were only too pleased to react to the forecast by pencilling in still lower interest rates. This is because many analysts in the City in their hearts believe the Bank is following a growth target rather than an inflation target - or if not, that it ought to be. They work backwards from the Bank's growth forecast, showing the economy pulling back from the brink of recession in the next few months if interest rates are unchanged, to the conclusion that rates therefore ought to be cut.

This would close some of the gap between the Bank's gloomier economic outlook and the relatively optimistic forecast that is the legacy of the Treasury's Pre-Budget Report. If rates fall to 5 per cent or lower, growth will be a bit better, though perhaps not as high as Gordon Brown hoped in November. The Chancellor, like the City, is depending on the MPC to cut interest rates again.

Yesterday's Inflation Report, stressing the downside risks to growth and inflation, certainly encouraged its readers to hope so. And, as Mr King said, the Bank has shown it will do what is needed to keep inflation from falling too low as well as climbing too high.

Whether interest rates drop to 5 per cent, or 4.5 per cent, or stay unchanged, it is important to keep the broader economic picture in mind. Inflation is low and is expected to stay low, while the economic downturn is sure to be the mildest since the 1960s. No doubt it could have been even better, but whatever the MPC's tactical mistakes, it is hard to fault the strategic results.

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