Our central projection was for inflation to continue to rise during the second half of this year to a peak close to 4% and then – assuming that oil prices stabilised – to fall back towards the 2% target as the growing margin of spare capacity in the economy held back pay and price increases. Since May, inflation has turned out higher than expected and oil prices have risen further, notwithstanding some moderation in the past week or so. But the news on activity has not been very good either, with some distinctly downbeat business surveys, including yesterday’s Industrial Trends survey, further weakening in the housing market and continued fragility in the financial sector. All this points to a worse near-term prospect for both growth and inflation. The net impact of this on the outlook for inflation in the medium term is less clear, though for our considered view on that, you will have to wait until our August Inflation Report is published in a couple of weeks time. 6  BIS Review 95/2008  Moreover, there are considerable risks surrounding the central outlook. A particular risk on the upside is that the extended period of elevated inflation leads to an acceleration in pay and causes inflation expectations to rise. That could lead the higher inflation to become embedded. But on the downside, there is a risk that the credit crunch leads to a deeper and more prolonged slowdown, leading to greater slack in the economy and causing inflation to undershoot our target.
BIS Review 95/2008  5  I hope that this gives you a sense of the use we make of business surveys, and business intelligence more generally, in making our regular assessment of the state of the economy each month, before taking our decision on the appropriate level of Bank Rate. The timeliness of this information is particularly important at the current juncture, when the economic climate is changing rapidly. The global and UK economies have been subject to two large shocks of uncertain magnitude, duration and impact. The first is the continuing de-leveraging in the banking system and the attendant squeeze on the terms and availability of credit. The second is the fairly relentless rise in commodity prices, especially that of oil, driven in part by the robust growth in demand in the emerging economies. These two shocks both depress output growth, though they have divergent effects on inflation. In our May Inflation Report, our central expectation was for four-quarter GDP growth to slow markedly through this year, reflecting both subdued real income growth and tighter credit supply (see Chart 7, which also includes the same backcast information as Chart 6). It was then expected to gradually recover through 2009 as credit conditions slowly improved. The corresponding projection for CPI inflation is shown in Chart 8 (note that no uncertainty is shown for the past, as the data for CPI inflation are rarely revised).