View From City Road: Bank suddenly sanguine on inflation prospects

As warnings go, the one contained in the Bank of England quarterly Inflation Report yesterday hardly chills the blood. 'If official interest rates were to remain unchanged over the next two years,' the Bank opined, 'then it is probable that inflation would gradually rise into the top half of the target range.' Well, I never.

The tone of the Inflation Report is so sanguine as to be barely worth the paper it is written on. Certainly it stands in stark contrast to its predecessors and to the frenzied speculation on an imminent interest-rate increase in the money markets last week. Despite the strength of economic recovery, the Bank is no more pessimistic about inflation for the first quarter of 1996 than it was in May. It might be tempting to conclude that the Chancellor, Kenneth Clarke, has finally got to the Bank. Don't cry wolf too often, he's been telling Eddie George, the Governor, or no-one will believe you.

If the Bank was keen to raise rates, it now seems to have backed off. Neither the Bank's latest comments, nor its forecast projection of inflation over the next two years, suggest much sense of urgency. This was reflected in the markets' reaction yesterday, with the short-sterling futures contract showing that significant rises in interest rates by the end of the year are now thought less likely.

The Bank said that the warning signals it had identified in May's report - rapid growth of the amount of money circulating in the economy, rising growth in average earnings and the high forecasts of inflation in the financial markets - now appeared either less threatening or little changed three months on. The Bank also appears less worried than in previous reports that retailers would be able to rebuild their profit margins and argued that the recent surge in commodity prices was unlikely to have an enduring effect on the rate of price increases in the shops.

So what has brought about this change of heart and is the Bank right? Certainly the Bank's record on predicting short-term inflation has tended to be overly pessimistic and this may be a reputation it wants to correct. On the other hand it may now be erring on the optimistic side on longer-term inflation, two years down the road. The market's appetite for an immediate rise in rates seems to have abated for the time being. But the likelihood is that it will return sooner rather than later. The Chancellor would be well advised to anticipate it.