The UK government keeps insisting that inflation will fall below its target of 2%. Yes, inflation is falling, but it remains well in excess of the 2% target, and we aren’t quite seeing the sharp declines in inflation whereby observers can comfortably proclaim that the target will be met.
Instead, we’re always told that target inflation is just around the corner. Well, Morgan Stanley thinks it’s time to come to terms with reality… the target is bunk:
Morgan Stanley’s Melanie Baker, CFA:
Inflation outcomes continue to broadly surprise us on the upside – inflation did not decline as much as we’d expected in June. We assume that not all of the June surprise is reversed. We formally update our forecasts for the impact of the Budget and recent forecast changes from our currency team. After a detailed look at the inflation outlook for the next 18 months, we continue to argue that the balance of risk to our forecasts is on the upside.
August’s BoE Inflation Report may well reveal an increased balance of upside risk to the MPC’s central inflation forecast. It is not at all clear that, in the light of fiscal austerity measures announced in the Budget, the MPC will substantially revise lower its medium-term inflation projections.
Near term, there is plenty of scope for further inflation shocks – more on the upside. Longer term, we remain concerned about higher inflation outcomes and the potential for the 2% inflation target to become untenable.
Here’s their chart showing how inflation could remain well above the target level (dotted line) until 2012, below.
What’s the broad relevance? Higher than target inflation restricts the amount of monetary stimulus the UK can deliver to its economy. In this sense, the UK is more ham-tied than the U.S., where inflation has been underwhelming to say the least.
(Via Morgan Stanley, Global Monetary Analyst, 14 July 2010)