MNI INTERVIEW: BOE Too Reliant On Output Gap, Ducks Trump
MNI (LONDON) - The Bank of England's November forecast for inflation to eventually fall back below target relies on a hard-to-justify assumption of the appearance of an output gap, National Institute of Economic and Social Research deputy director and former senior BOE official Stephen Millard told MNI.
While the balance between aggregate supply and demand is impossible to measure, key components in its calculation are estimates of unemployment and the natural jobless rate, and these currently show little sign of tending in directions compatible with an output gap, Millard said in an interview.
"The labour market, as far as I can tell, still looks pretty tight, and even in the Bank's forecast where they ... a very similar unemployment forecast to us, where it's rising to something like four and a half percent, which is our view as to where the natural rate is. So, all that time, unemployment is around about its natural rate. It's again not clear that you have an output gap opening up.”
The Bank's central projections showed government spending pushing up growth in 2025 to 1.5% from 1.0% this year, before easing back to 1.25% in 2026. CPI inflation was seen running above the 2.0% target, peaking at 2.8% in Q3 2025 and dropping below it in Q3 2027.
The Bank is probably right to assume that higher public spending would boost near-term growth before it is eventually sapped by the negative effects of tax rises, but its inflation projection is based on tenuous assumptions, said Millard. (See MNI POLICY: Budget To Push Up BOE Growth, Inflation Forecasts)
"What makes less sense ... is that they're saying, 'Well, what's happening is that, because of the timing of fiscal policy, and indeed, the fact that monetary policy is still tight, you have an output gap opening up.’ And it's that output gap, actually, that is pulling inflation back down," Millard said.
"There are so many other things that affect inflation in an open economy that concentrating on the output gap is probably not the way to go.”
DUCKING U.S. SCENARIO
The Bank has begun implementing recommendations of former Federal Reserve head Ben Bernanke, including providing alternative economic scenarios. But, Millard noted, in November it offered no scenario examining the effects of plausible changes to U.S. trade policy or any other geopolitical risk.
This was probably due to fear of being dragged into political debate, he said.
Instead, the BOE's published alternative scenarios were limited to one in which inflation stays under control as previous economic shocks fade and another in which core inflation is stickier than expected.
"What would be more interesting ... would have been to have chosen a specific event that may or may not transpire and say, 'Okay, if this event transpired, this is how we would respond'," Millard said.
One scenario could have been the effects of tariffs which could be imposed by U.S. President-elect Donald Trump. NIESR ran tariff figures of 10% across the board and 60% on China through its model and found a hit of 1.3 percentage points on U.S. GDP growth in the first year after the tariffs were imposed and then 1.1 percentage points in the second year. There would be a cumulative 2.7% hit to UK GDP after three years.
"It would have been good to see the Bank do a similar scenario … and then see what they feel that would mean for interest rates and inflation," Millard said, noting however that the Monetary Policy Report came out only two days after the U.S. election. “They probably didn't want the political flack that would have come from publishing such a scenario.”