Thursday, November 13, 2008

The Bank’s self-falsifying projections

According to the Bank of England’s inflation report, we are projected to have a nasty but not horrendous recession over the next year or so. But the report also suggests that things won’t be as bad as projected.

Here’s the Bank’s projection for GDP growth, showing the economy shrinking around 2% from its peak (the darker area of the curve shows the central projection; the lighter bands show the range of outside possibilities):

It doesn’t look good. But you have to remember that this is not a prediction (‘we think this will happen’) but a projection (‘we think this would happen given certain assumptions’). And one of the key assumptions is what will happen with interest rates. As the report says:

This assumes that Bank Rate, following a path implied by market yields prevailing prior to the Committee’s November decision, falls from an average of 4% in the fourth quarter of this year to around 2.75% in the second half of next year, before picking back up to around 4% by 2011.

But this assumption is wrong. For one thing, rates are already lower than the assumed 4%, having been cut to 3% a week ago. For another, the Bank’s inflation projections suggest that larger rate cuts than those assumed are likely. Here’s the inflation graph:

So inflation is projected to fall very sharply, back to the Bank’s target of 2% by the middle of 2009, and then significantly below target – where it would stay for some time. This gives the Bank the opportunity – and indeed the mandate – to cut rates below the assumed level in order to avoid an inflation undershoot later next year and in 2010.

This projection makes it extremely likely that that the interest-rates assumption on which it is based will be false. So the unacceptability of the inflation projection makes it likely that the GDP projection is pessimistic. Rates will go lower, inflation won’t go so low, and the economy won’t contract quite so painfully.

That is, assuming that all the Bank’s other assumptions are right…


Anonymous said...

So if I'm reading that right, they reckon the most wildly optimistic projection is that we come out of recession before 2009 (seems a tad unlikely) and most likely is that we come out of recession half-way through 2009?

Tom Freeman said...

I think that's right - not counting the effects of bigger rate cuts (or any fiscal stimulus there might be).