1.  The inflation projection in the February Report shows the central CPI projection breaching 2% in 2007 Q1. This was anticipated in the November Report for the same quarter, but there has been a slight edging up of the central forecast. Nevertheless, as in November, the downside risks are shown as being much greater than the upside risks. Since CPI has been so persistently below the 2% target for such a long time, and since the target is symmetric, it is not at all clear that a low-probability forecast of breaching the target should prompt a rise in the repo rate. And indeed, with one exception, the MPC voted not to change the rate in February.

  2.  A significant downside risk noted in the Report is that household consumption will weaken. There is particular uncertainty about consumer demand, not least because of uncertainty about house prices and how any sharp reversal might affect consumption. While the current indications are that the housing sector is slowing down without a sharp reversal, any rise in the repo rate has the potential to hit consumption, both indirectly through downward asset price movement in the housing sector, as well as directly through reductions in disposable income.

  3.  Uncertainty about consumer demand in the meantime has real consequences in that the CBI report this as being a significant factor inhibiting investment (Chart 2.D, page 14). Although real long-term interest rates are low, this is not enough to encourage investment unless there is confidence in demand. The argument (foot page 13) that the business investment recovery will improve rests primarily on an assessment that capacity utilisation is high (pages 24-5).

  4.  The Report cautions against drawing quick conclusions from data which may well be revised. And since the Report was published, the various pieces of evidence coming in have sent further mixed signals about inflationary pressures. But since the Report was published, the Minutes revealed that Paul Tucker had voted for a rate rise in February, and his speech on 1 March outlined his reasons. This has contributed to a growing expectation among market-watchers, as reported in the press, of an early rise in the repo rate. As a result, while market expectations reported in the Report were on balance for no change in the repo rate, these now appear to be moving towards an expectation of a rise.

  5.  Since market expectations in turn are an important input into the repo rate decision, the additional information provided by speeches by MPC members is becoming an important tool of monetary policy. But the potential conflict continues to hold, between sending signals to the market so that any rate change does not take it by surprise, on the one hand, and actively increasing the risk of weakening demand by bringing forward expectations of rate rises, on the other.

  6.  The inflation expectations of employees are particularly important for the inflationary process. A survey was conducted by the Bank's Regional Agents into sources of pressure on private sector labour costs (Chart 4.6, page 30). The greatest pressure was reported as coming from inflation expectations of employees, dominating productivity growth, even though that is reported (in Chart 3.5, page 21) as being historically high. The survey was conducted before recent concerns about inflation building up. And external forecasters were almost exclusively reported at that time to have been expecting inflation below 2.4% in 2007 Q1 (page 45).

  7.  The MPC thus has high credibility among professional forecasters, but apparently less among the general workforce. Nevertheless, greater monetary policy credibility is given as one reason that there appears no longer to be a tendency for inflation to rise when capacity utilisation rises (Chart 4.1 page 26) or for earnings to rise when unemployment falls (Chart 4.2 page 27). (This was discussed in more detail in a speech by Charles Bean on 22 February.) So it may be that the Agents' survey result should not be taken at face value.

  8.  But if it is indeed the case that there is no longer a positive relationship between aggregate demand and inflation, then monetary policy cannot rely on raising interest rates to reduce inflation by reducing demand (or vice versa), although this has been the tenor of much of the history of monetary policy-making. Indeed, while the increase in inflation projected in the Report is substantially due to capacity constraints, Chart 4.1 needs to be borne in mind. If demand is less significant for inflation, the focus shifts to costs. And indeed import prices are picked out as the other major factor behind the inflation projection. But then, since interest payments constitute a cost to indebted firms, and income gearing is currently high (Table 2.C, page 13), a rise in interest rates could for that reason add to inflationary pressure.

  9.  Several members of the MPC have made speeches lately reflecting on the success of the UK monetary policy framework in achieving low inflation and macroeconomic stability. Success indeed may breed success. If central bank credibility in inflation control is high, then this will ensure that low inflation is incorporated in private sector expectations, and thus in prices for goods and factor services (notably labour and capital). The frequent references by MPC members to uncertainty reflect the fact that it is now widely accepted that the actual transmission mechanism at any time from monetary policy to inflation is not fully understood (which in fact reflects an improved understanding at another level). Nevertheless the role of inflation expectations is widely accepted to be crucial, and the Bank appears to have been highly successful in encouraging expectations that inflation will be kept close to target.

7 March 2005