Martin said that while "it is likely that inflation will fall below zero at some point in the next six months" this is not something to which the MPC could or indeed should respond.
He explains:
"Our work suggests that a change to Bank Rate takes about two years to feed through fully to inflation. The implication of this is that we should not try to keep inflation very close to target all the time; if we did that, we could be sure that interest rates would be extremely volatile, in a way that no one would find very helpful."
Instead, he believes that the effect from oil will begin to drop out in less than a year and the rate of inflation will gradually recover towards target.
Martin explained that he is "confident that the Monetary Policy Committee can return inflation to target" given the tools at its disposal. The Committee has made clear that, should downside risks materialise, it could consider a further reduction to Bank Rate. It also has the option of making further asset purchases, a policy which Martin’s research suggests "remain a practical means of pushing inflation up towards target".
Nonetheless he discusses both the upside and downside risks to the current inflation target. On the downside there is a possibility that "expectations of low inflation may become entrenched" which would have consequences for both wages and prices. The most recent data did show a fall in inflation expectations but Martin argued that "it might simply be that expectations – even of inflation in two years’ time – are overly affected by the experience of current inflation". He added that we could reasonably anticipate that inflation expectations to pick up as oil and other commodity prices recover.
There is also a risk of further price shocks; "inflation shocks, even more than buses, rarely seem to come on their own". Martin acknowledges that "the recent recovery of the oil prices makes it perhaps less of a worry" than he may have thought in January. Nevertheless Martin’s view is it continues to pose a risk, and he wonders whether a rising exchange rate might be the next of these shocks.
The upside risk is provided by the recent performance of the labour market.
Martin continues:
"The unemployment rate has been falling rapidly, and we have also seen the employment rate reach a record high. Pay is now growing at its fastest rate since before the crisis."
Martin notes that while the effect of this on inflation may be ‘damped’ because of the make-up of the CPI basket and the response of firms’ profit margins, it is seen as the main upside risk.
These risks, both to the upside and the downside, make the situation "a finely balanced tug of war" in which "pulls in both directions have intensified".
Martin concluded by saying:
"Compared with the Autumn, when I was voting for an increase in Bank Rate, the fall in oil prices has certainly provided some unexpected breathing space. It is, however, at present no more than that.
"If wage growth continues to accelerate over the next few months, especially in the absence of a pick-up in productivity, then for me it strengthens the case for a rise in Bank Rate. As always, however, I will decide how to cast my vote in the light of economic developments."
