Bank warns on inflation and low investment levels

The Bank of England is to warn the Government this week that inflation targets will be missed and that investment is worryingly low, despite strong growth in dividends and profits.

The depressing outlook on prices and investment from the Bank, which will emerge in official publications due on Wednesday, will come hard on the heels of an expected recommendation from the Organisation for Economic Cooperation and Development that UK interest rates should rise to control inflation.

This would be the second time in just over a month the OECD has given the Government the same message.

The Bank's inflation warning will be contained in its Inflation Report, to be published on Wednesday.

It will confirm a widespread view in the City that Eddie George, Governor of the Bank of England, is refusing to back down from his claim that interest rates should rise to prevent inflation going outside the target range.

The Bank also hit back at attacks on its methods for forecasting inflation, which are pivotal in influencing the advice it gives the Chancellor on interest rates but which critics have said are too pessimistic. An article released ahead of publication of the Quarterly Bulletin on Wednesday mounts a vigorous defence of its methods.

The Bank has come under criticism for crying wolf on inflation since its current elevated role in policy began. In the majority of its predictions since the start of 1993, the Bank has been too pessimistic.

However, the Bank insists that the inflation projection "is not derived mechanistically", nor is it "simply extracted from a model of the economy". Leading indicators, surveys, information from the Bank's agents and judgement also play a vital role in arriving at the projection.

Another Bulletin article says there is a shortfall of investment in the current recovery compared with the upswing of the early 1980s. Business investment - defined broadly to include public corporations as well as private companies - has "recovered slowly and hesitantly". In real terms, it is still below the level reached at the low point of the cycle in early 1992.

But corporate profitability is not the problem holding back investment. Although it fell sharply in the first quarter of 1995, it grew rapidly in 1994. Dividends, too, "grew extremely strongly".

They were some 30 per cent higher in the fourth quarter of 1994 than at the beginning of the year.

For plant and machinery, the investment increase of under 5 per cent is modest in comparison with the Eighties, when by a similar point in the cycle, investment was 10 per cent up.

The Bank suggests there are some special factors that have depressed total investment in the current recovery.

The overhang of the property boom of the late 1980s is continuing to depress new construction. And the counter-cyclical investment in the utilities and oil industry, while welcome at the time, is now spoiling the investment picture in the recovery.

The Bank makes it clear that uncertainty may be constraining investment growth. Firms are still slow to adjust down their target rates of return because of fears of a return to high inflation - a concern raised by the Bank a year ago. Furthermore, companies may be worried about just how long the recovery will last.

"Firms have perhaps been willing to risk losing future output and perhaps sales, because they have believed the sunk costs of investing represented too big a gamble."

The export-led nature of the recovery may have contributed to this caution, says the Bank. "Exports tend to be more volatile than domestic demand and this may have added to producers' uncertainty."

Nevertheless, the Bank believes investment "is likely to strengthen during this year".