Hamish McRae: The Bank is too pessimistic on growth and not gloomy enough on inflation

So the risks were indeed on the downside. Back in August, when the previous Inflation Report was published by the Bank of England, it gave a relatively sanguine view of the future but warned that there were risks to that perspective. And so it has proved, for the new report revises its forecasts down for growth and up for inflation.

I always feel the Inflation Report does not reveal anything very new but is useful in two regards. It gives a feeling for what is going on in the Bank's corporate mind, which is different from what is going on at Monetary Policy Committee meetings. And it is useful for the rest of us to calibrate our own judgements about the UK economy and the global outlook. Some words about each.

As far as the Bank's mind is concerned, you see more from the choice of graphs and the way they are presented than from the carefully crafted script or the inevitably guarded comments from the Governor Mervyn King. Two graphs stood out for me – with one glaring omission.

The first that jumped out was one that gave a measure for the market disruption that had taken place since the summer, the one showing the gap between three-month interest rates and expected policy rates. It is shown above. Normally, you would expect three-month rates to be a bit above the projected policy rate (the official rate of the central bank concerned). During the early part of this year, that was indeed the case. Then came the catastrophic loss of confidence in the money markets and the gap, instead of about one-tenth of 1 per cent, shot up to more than 1 per cent. That happened in the US and the eurozone as well as Britain, and is still above half a per cent.

Now the three-month money market rate is the key one in banking for determining the cost of commercial borrowing and the return on spare cash. So you could say we have had the equivalent of a base rate hitting 7 per cent in August and now coming back to about 6.5 per cent. By next spring, the gap is projected to be back to around a quarter of 1 per cent but still above the "normal" pre-August spread.

So what is the Bank trying to say? One thing is that the US Federal Reserve and the European Central Bank have been wrestling with parallel problems and have not been significantly more successful in coping with them. The other is to bring home to people the scale of the squeeze that has happened. Earlier this year, I found myself warning that base rates might conceivably go to 7 per cent, although I could not see the circumstances under which that might happen. Well, it has happened. The central banks did not have the bottle to increase rates enough to check the excessive appetite for risk in the banks, so the markets did their dirty work for them. Bank of England staff could not, of course, put the point across in those terms but that is what has actually happened.

The second graph that I found fascinating was one on consumer spending in money terms, also reproduced here. The main thing here, surely, is just how resilient consumers have been, raising their spending at between 4 and 6 per cent in money terms for nearly a decade. True, the reports from the Bank's agents around the country show a somewhat more bumpy path, but I find (and I think the Bank finds) the resilience pretty remarkable. You start to wonder whether consumer spending might be able to weather a downturn in the housing market. The Bank's preoccupation with the link between the two is obvious because this is an enormously important relationship, but the thought that the link might be a little softer was a new one to me and an encouraging one too.

Now for the omission. The bank does its famous fan charts for expected inflation and growth, but the thing that is missing is any focus on inflation measures other than the Consumer Price Index. It is worth repeating that this is the European index that Britain adopted to harmonise its stats with those of other EU countries – it used to be called the harmonised index. It is not used for very much other than being the measure that the Bank targets, for government pensions, index-linked gilts and the like have all kept their link with the old Retail Prices Index.

As the Office for National Statistics says on its website: "The Retail Prices Index (RPI) is the most familiar general purpose domestic measure of inflation in the UK. It is available continuously from June 1947. The Government uses it for uprating of pensions, benefits and index-linked gilts. It is commonly used in private contracts for uprating of maintenance payments and housing rents. It is also used for wage bargaining."

So now with the CPI at an apparently acceptable 2.1 per cent, what is the RPI? Well, it is an absolutely unacceptable 4.2 per cent. It is pure spin to pretend that inflation is running at only 2.1 per cent when the key operating measure is running at twice that. I expect the Government to spin because that is what governments do. But the Bank ought to be intellectually honest and give at least equal prominence in its graphs to the more widely-used index. Further, it ought also to show the other two important measures of inflation, the RPIX (the X meaning excluding changes in mortgage rates) and the best overall measure, the GDP deflator – the amount that money GDP has to be reduced to allow for overall inflation in the economy.

The RPIX used to be the targeted indicator and it is shown here. It is running at 3.1 per cent, well above the old target of 2.5 per cent. The deflator is not shown because it can only be calculated after the event, but I looked up the numbers and the latest available is 2.78 per cent for the last financial year, 2006/7. That is not terrible but it is well above the CPI, and this year it is projected to be 3.25 per cent, which is not good at all.

To have a thing called the Inflation Report that does not focus on the projected deterioration of the most fundamental measure of the country's inflation seems a bit rum.

Some final thoughts on the Bank's big message: that there will be an economic slowdown and that inflation will deteriorate even on the CPI benchmark. It is helpful to have that on the record because it is what we all think. Now, by expecting a quite sharp slowing next year, the Bank is middle of the pack. My instinct (and this is what I mean about using it to calibrate one's own thinking) is that it may be a bit too pessimistic about next year and that the real downturn is more likely to come in 2009.

The second concern of the Bank is inflation, and here it shows some scary data on things such as global commodity and food prices. The great issue must be whether Chinese demand races on, supporting world economic growth but also piling on the pressure on global resources and, hence, on global inflation. Could it be that the Bank is too pessimistic on growth but maybe not quite pessimistic enough about inflation?