Judging the inflation outlook
economic growth
inflation
the MPC's growth and inflation forecasts
Much of the information the MPC studies tells it something about the economic outlook as well as current economic conditions. The MPC looks at a range of indicators of the growth in money, demand and output, and the extent of inflationary pressure in the economy in order to judge, as best it can, future inflation.
teams will have to judge future trends and how these
might impact on inflation
The Inflation section
explained that monetary policy has to be forward-looking because
interest rate decisions taken today only have their full impact
on inflation around two years ahead. The MPC is, therefore,
interested in the prospects for both economic growth and inflation.
Like the MPC, teams will need to form judgements about future
trends in the economy and how these are most likely to impact
on inflation.
economic growth 
If the growth in demand and output is currently strong or weak, teams will have to judge whether the recent trend is likely to continue or not. They will need to ask whether the current strength or weakness reflects temporary factors or more fundamental and lasting influences. In the case of consumer spending, for example, teams might look at information in the labour market - such as employment levels and wage increases - in order to judge the extent to which incomes are likely to rise and support future growth in spending. Are there factors which are likely to change recent trends in employment and the growth in incomes? This reveals something about the amount of spending power consumers will have at their disposal in the period ahead.
Survey evidence might also help teams to assess likely trends in future spending. Some surveys reveal how confident consumers are about economic prospects. And teams can look at how much money people are borrowing from banks and other financial institutions as an indicator of future spending.
In a similar way, developments in overseas economies, together with exchange rate developments, will largely determine the outlook for export demand. And future investment demand will be determined by factors such as company profitability and the outlook for the sales of firms' goods and services, as well as the cost of raising finance. Teams will have to look at trends in variables that tend to influence future demand in the economy.
has the MPC already acted?
Of course, the MPC may have already responded to strong or weak demand growth and the expected effect on future inflation, by changing interest rates. These changes in interest rates will take time to affect demand and output.
teams need to assess the impact of any
recent changes in interest rates
Teams will need to assess whether it is necessary to adjust monetary policy further or whether enough has already been done. Demand may have been rising quickly up to the period for which the latest data are available. But growth may already be moderating to the extent that another increase in interest rates may lead to even slower growth, with the result that inflation might fall below its target in the future.
inflation
Assessing the trend in inflation will depend both on current and future trends in economic growth and how these relate to the amount of spare capacity in the economy. Current demand conditions will tell us something about the likely future path of inflation. And much of the information that we monitor to tell us about current inflationary pressure in the economy is relevant to assessing the outlook for inflation. The aim is to spot early warning signals of higher or lower inflation within the production process and labour market, and evidence of spending exceeding the supply capacity of the economy.
These considerations provide clues about future inflation in relation to developments in the domestic economy. But the inflation outlook can also be influenced by changes in the exchange rate, particularly in the short run.
the exchange rate
The exchange rate is a key factor affecting inflation prospects, although it is very difficult to predict. There is, however, no mechanical link between a change in exchange rates and inflation.
A change in the value of sterling can have a direct influence on inflation through changes in import prices. An appreciation of sterling will tend to lead to a fall in inflation. But this is primarily a one-off impact on prices and so a temporary influence on the inflation rate. The exchange rate is also likely to affect prices indirectly, through its impact on the demand for exports and imports and, in turn, output.
there is no mechanical link between a
change in exchange rates and inflation
Importantly, the size of these effects will depend on why the exchange rate has appreciated or depreciated, not least because that will determine whether any change is likely to be sustained. The exchange rate is discussed further in The Economy section.
current inflation
Although monetary policy is the dominant determinant of the inflation rate in the long run, there are many other influences on the measured inflation rate over shorter time periods. This was discussed in the Inflation section.
Teams will have to monitor the current rate of consumer price
inflation and judge to what extent movements reflect temporary
influences or more fundamental factors, ie whether the current
rate of inflation is a guide to the future rate of inflation.
The current rate may be above or below the inflation target
but that may tell us little about its future direction. In
July 2003, the MPC reduced the official Bank Rate when RPIX
Inflation was above the then 2.5% target; the MPC increased
the interest rate in June 2004 when CPI inflation was below
the current 2.0% target.
Even the likely path of inflation in the immediate future may not be a good guide to its path further ahead. The immediate outlook might be for inflation to rise or fall, perhaps due to one-off factors such as a change in VAT and duties or a rise or fall in the exchange rate. But demand conditions might indicate that the underlying picture differs from this short-term prospect.
the immediate outlook for inflation may not be a
good guide to its trend over the medium term
You will want to judge whether inflationary pressures are
building or diluting over the two-year period, and whether
inflation is likely to be rising or falling once any short-term
influences on the measured inflation rate have dissipated.
It is not possible to do this with much precision. We cannot
say inflation will be 2.0% in one year's time and 2.5% in two
years' time. This kind of statement assigns too much certainty
to what is always a judgement about possible future outcomes.
the MPC's growth and inflation forecasts
- judgement and uncertainty
The MPC thinks about the economic outlook and future inflation with the help of an economic forecast. The MPC's forecast brings together into a quantitative framework all the key information on the economy and an understanding of how the economy tends to work.
the future will always be different
in some way from the past
Although teams will not have the MPC's forecasting framework,
the task, in many respects, will not be so different. The MPC's
forecasts involve judgements about a wide range of considerations.
The Committee does not just plug in a series of numbers and
wait for the forecast models to produce a mechanical answer.
Economic models are part of the monetary policy tool kit, but
they do not provide all the answers.
Given the size and complexity of the economy and the ever-changing
nature of the economic situation, economic models cannot possibly
incorporate all the factors that matter to monetary policy.
Most economic models are based on an understanding and an estimation
of what has happened in the past. Although this is often a
good starting-point for thinking about the future, the future
is never an exact repeat of the past. Forming judgements and
assessing their implications for interest rates are part of
the job of the MPC. So do not be put off by some of the more
technical aspects of the MPC's work. Teams will have to use
their judgement about future trends to help make their interest
rate decisions.
the MPC's 'fan' charts
One important characteristic of the MPC's forecasts is worth explaining. You will see that the forecasts are not presented in terms of a single number for economic growth and inflation in one or two years' time. The only certainty about this kind of 'single-point' forecast is that it will be wrong. The probability of inflation being a particular number in two years' time is almost zero.
So it is better to present a forecast as a range of likelihoods
or possible outcomes - what we call a probability distribution.
The MPC tries to judge the most likely outcome for inflation
and economic growth over a two-year period. But it acknowledges
that inflation might be higher or lower. This uncertainty is
reflected by the presentation of the forecasts as 'fan charts'.
These are shown in the Overview of the Inflation
Report . The central bands within the fans represent what
the MPC thinks is the most likely outcome for growth and inflation
over the forecast period. The outer bands represent other possible
outcomes.
The MPC's forecasts explicitly acknowledge that judgements about economic growth
and inflation in the future involve a great deal of uncertainty. So teams should
not feel they need to be too precise or exact. Like the MPC, they need to make
judgements about what is most likely to happen. And, like the MPC, teams should
acknowledge that those judgements will involve uncertainty.
Teams can look at the MPC's latest forecasts for economic
growth and inflation in the Inflation
Report. In addition, you can look in the newspapers
and other places to see what other organisations and economists
are forecasting for the economy.
This section has discussed, in general terms, the task
of forming judgements about demand conditions and inflationary
pressure in the economy. It has provided a foundation for
thinking about the task of setting interest rates to control
inflation.
©2000-2009 Bank of England.
