MNI INTERVIEW2: BOE Too Optimistic On Inflation- Mortimer-Lee

Bank of England inflation models place too much weight on expectations and unjustifiably assume they are anchored on its 2% target, leaving officials over-optimistic that the rate of price growth will return to target, National Institute of Economic and Social Research Deputy Director and former senior BOE economist Paul Mortimer-Lee told MNI.

"Everybody's models say that what determines inflation is expectations. What they have in the model is that the economy believes the inflation target. So everybody's models will give you a convergence on target of inflation without the central bank doing anything because it is magnetic, it is gravitational," Mortimer-Lee said in an interview, in which he was sharply critical of the MPC's decision not to hike Bank Rate in November after signalling that rates are likely to head higher. (See MNI INSIGHT: Rates Pricing Races Ahead As BOE Sticks To Script)

"The Bank of England was hugely negligent because it needs to walk the walk as well as talk the talk. It didn't need to do much. Fifteen basis points wasn't going to kill the economy," he said.

The assumption that households, firms and financial markets base expectations on the BOE's 2% target is not credible, Mortimer-Lee said, pointing to the period following the global financial crisis when inflation in advanced economies got stuck well below target.

"People want to believe that this failure of the inflation target was a one-way phenomenon, that inflation targets don't work when you are below the target but that they will work when you are above the target," Mortimer-Lee said.

THREAT TO INFLATION FROM WAGES

"OK, where's the evidence? There is no evidence whatsoever, but people want to believe it because they want to believe that inflation expectations are everything, which is fine, but then the second step, which is not fine, is that inflation expectations will be formed according to the inflation target. That second step is wrong. That is a step too far," he said.

Mortimer-Lee also criticised projections in the BOE's November Monetary Policy Report, which cut the forecast for 2022 average weekly earnings growth to 1.25% from 1.75% despite labour market tightness, on the assumption that there will be no second-round effects from the current burst of inflation.

The fact that there has yet to be a widespread pick-up in pay settlements provides only false comfort, Mortimer-Lee said, arguing that employees were less likely to try and negotiate pay rises during lockdowns and high Covid uncertainty. Now, however, with unemployment falling and vacancies at record levels, pay rises are on the cards.

"The theology of central banks is you do not react to the initial price surge, that you can do nothing about because your policy can't change past price increases. What you do is respond to the second-round effects. So if you assume that the second round effect is zero then there is no reason to raise rates," Mortimer-Lee said.

"The question is, is it a reasonable assumption that the second-round effect is zero? I say absolutely no way is that reasonable," he said.