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The Quarterly Inflation Report makes for sobering reading.  The risks to both sides of the analysis have got worse.  The slowdown in economic growth will be both deeper and longer than previously expected.  The central forecast, based on the market’s assumptions that interest rates continue to be cut (of which more in a few lines), has GDP growth at barely 1% at the end of 2008 and not returning to 3% until 2011.  But even provided that the economy does slow, inflation continues to rise to around 3.7% at the end of 2008, doesn’t come back to even 3% until about a year from now and takes a further year to return to the 2% target.  That is an increase of 0.75% in the predicted peak and a delay of a further three quarters in returning to target since the last Report in February.  “Medium term” looks more like “long term” every time this report comes out.  The one risk that has fallen within this analysis is that of prices dropping below 2% any time soon.

Things only play out this well if two key assumptions are met.  Firstly, there must be a creation of spare capacity within the economy.  Fortunately that is happening, with plenty of evidence from the housing market and consumer spending (for those of us not cursed with rose-tinted spectacles) that things are getting tighter.  Banks are doing their bit by making sure that neither households nor companies have the cash to support them in lame decisions.  But it is the second assumption, that inflationary expectations can be contained, that is the really tricky one.  Faster inflation reduces real disposable income and real wage growth, so increasing the risk of bigger wage demands to compensate.  The Report makes it clear that employers must resist this, only conceding higher wage demands in return for reduced employment.  (As in Thatcher’s Britain, people can ask for what they want, but not all of them will have jobs at the end of the day.)  It is also essential that manufacturers and retailers alike are unable to pass on all their increased input and labour costs in the shape of higher prices to final consumers.  Because if inflationary expectations do rise and become embedded in the system, we’re in trouble.  “Reducing inflation expectations from persistently high levels has in the past required prolonged periods of tighter policy and subdued growth.”

  The full Report is an excellent piece of dispassionate analytical macroeconomics (http://www.bankofengland.co.uk/publications/inflationreport/ir08may.pdf).  There is no special pleading.  It tells things the way they are, no matter how outside observers may like them to be.  For those unable or unwilling to plough through it (and it does take several hours!) in his opening statement Mervyn King offered some helpful sound bites to focus the mind.  

“The balancing act faced by the Monetary Policy Committee is even more challenging than it was in February….. The possibility of more prolonged restrictions to the supply of credit means that the balance of risks to the outlook for growth is to the downside in the medium-term….. It is likely that, with inflation above 3% for several quarters, I will be required to write a number of open letters to the Chancellor over the next year.”

Now for the juicy bit.

  “The MPC is aiming to bring inflation back to target over a somewhat longer horizon.  That does not, however, mean it is ignoring the near-term rise in inflation.  The extent of the deviation from target this year is likely to affect the behaviour of those setting prices and wages.  For that reason, the Committee judges that a slowing of demand growth this year, reducing pressure on capacity, will be necessary to ensure that inflation settles around the target in the medium term….. We are travelling along a bumpy road as the economy rebalances.  Monetary policy cannot, and should not try to, prevent that adjustment.  The Monetary Policy Committee must focus on bringing inflation back to the 2% target in the medium term.  As our remit states, “the real stability upon which economic prosperity is founded requires that inflation remain low and stable for a long period of time.”  Inflation will return to the target and growth will eventually recover to a sustainable rate.  But we will need to be patient.”  Slower growth, smaller profits, rising unemployment, higher inflation, less scope for interest rate cuts.  All this may come as news to those who have celebrated the market’s 15% rise since the all the economy’s woes were “solved” in March.  By the close last night the interest rate swaps market was discounting that the next move in UK rates will be up.