–Analysts Expect CPI To Overshoot On Flat Rates
–Analysts Expect Modal Projection To Show CPI Undershoot
–BOE King Reveals Equal Chance CPI Above/Below Target 2 yrs Ahead

LONDON (MNI) – The Bank of England’s February Inflation Report, out
Wednesday, looks set to back the case for monetary tightening with
inflation shown overshooting the BOE’s target on flat Bank Rate and with
an equal chance of it being above or below target if markets’ implied
rate hike expectations are met.

The raft of inflation projections in the report are, once again,
likely to create confusion, at least initially. Analysts expect the
modal forecast, which is the one that tends to generate the first
headlines, to show inflation undershooting the target two years out.

King Reveals Key To Inflation Report

BOE Governor Meryvn King, surprisingly, revealed one of the
Inflation Report’s key conclusions in his open letter to Chancellor of
the Exchequer George Osborne published Tuesday.

“The MPC’s central judgement, under the assumption that Bank Rate
increases in line with market expectations, remains that … inflation
will fall back so that it is about as likely to be above the target as
below it two to three years’ ahead,” he stated.

Nick Bate, economist at Bank of America Merrill Lynch, said King
could be seen to be “front running” the Inflation Report.

King’s reference appeared to be to the market rate forecasts in the
Report – which are based on 15 day averages.

While markets have scaled back rate expectations, over the relevant
15 day period they were fully pricing in a May Bank Rate hike and at
least one more 25 basis point hike after that, based on SONIA (sterling
overnight index averages).

King’s comments suggest these market assumptions were about right –
they result in equal chances of above below target inflation.

The most recent, November, Inflation Report showed inflation was
more likely to be below target in two years’ time with the chances of it
being above or below target roughly equal three years ahead.

That report said the most likely (modal) outcome was for inflation
to be slightly below target by 2013 but the risks were skewed to the
upside.

The key fact is that November markets have ramped up their
expectations for rate hikes. The November Inflation Report was
conditioned on implied market expectations of just less than a single 25
basis point Bank Rate hike by the end of 2011.

The February Inflation Report will show the chances of inflation
being above or below target have changed little despite the sharp rise
in rate expectations. This, several analysts believe, is a pretty clear
endorsement of earlier tightening.

As ever, however, with the BOE’s Inflation Report there are
caveats.

The first is a technical one. While King makes clear the Inflation
Report will vindicate market rate expectations, it is a moot point
exactly what the BOE is going to say these are.

The BOE has in the past varied the ways it calculates implied
market rate expectations for the Inflation Report and come up with
assumptions that have, strangely, even surprised market participants.

Malcolm Barr, economist at JP Morgan cautions in a note that “the
Inflation Report tends to identify a lower market implied path of Bank
Rates than implied simply by looking at the OIS (overnight indexed swap)
for MPC meeting dates.”

The second caveat is that while all MPC members have to sign off on
the Inflation Report, their views at present are far from harmonious.

The central projections in the Inflation Report can be seen as a
compromise view.

“There is a great deal of uncertainty about the medium-term outlook
for inflation. And I do not wish to conceal that there are real
differences of view within the Committee, reflecting different
judgements about the risks to that outlook,” King said in his letter.

The stated views of individual MPC members in coming days and weeks
will still have to be watched closely, with the MPC split three ways at
its January meeting.

Near Term Inflation To Be Pushed Higher

The February Inflation Report will, inevitably, push up the near
term inflation forecast while the overall profile, of inflation staying
well above target throughout this year before falling back, is likely to
be retained.

In the November Inflation report CPI was forecast to average 3.55%
in the first quarter of this year and this was the peak on the modal
forecast.

Tuesday’s data showed CPI came in at 4.0% in January and analysts
expect it to rise further in February. King said it would be 4 to 5% in
coming months.

So both the peak for inflation and the Q1 average will be pushed up
in the February Report. Analysts at Capital Economics, for example,
predict the MPC will put raise its Q1 CPI forecast to 4.2% or above.

The November Report showed CPI on the modal flat rates forecast at
1.59% two years ahead, that is by Q4 2012, and at 1.99% on the mean
forecast.

This time around the two years ahead forecast, for Q1 2013, could
well be above target on flat rates.

Nick Bate, economist at Bank of America Merrill Lynch, says that
with the markets having priced in half a dozen hikes through 2012,
taking away the effect of those hikes for the flat rate assumption would
very likely push CPI above target.

–London Bureau; Tel: +44207 862 7491 email: drobinson@marketnews.com
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