The paradox is that the Bank foresees inflation rising above its 2 per cent target in 2018, but is in no rush to raise rates.
There's a simple reason for this. Its policy is based not solely upon its central scenario, but upon the distribution of risks. And as Bank governor Mark Carney said, the risks to economic growth are on the downside. The Bank is holding rates down in an effort to reduce those downside risks. It's especially important that it does this when rates are low, because there's an asymmetry in its ability to respond to risks: if inflation takes off the Bank can easily raise rates a lot, but it cannot so easily loosen policy if a recession begins. As MPC member Gertjan Vlieghe said recently, "we cannot respond to bad news as effectively as we can respond to good news".
There's an analogy here, says Oxford University's Simon Wren-Lewis, with walking along a dangerous cliff path. If you're doing so, you don't keep to the centre of the path because if you trip you might plummet to your death. Instead, you keep to the landside of the path so that if you stumble you'll land on grass.
If, however, the Bank's central scenario materialises, inflation will be above target in 2018. It will then look as if policy was too loose in 2016. We could then say that although the Bank was wrong, it was not irrational, as it was taking account of a reasonable risk - one that might have materialised, but happened not to do so.
But here's the thing. Investors face exactly the same problem as the Bank. We must base our asset allocation not just upon the most likely scenario - which is for modest but positive global growth - but upon the range of possible outcomes, one of which is that we might slip into recession. This risk means there is a case for holding cash and top-quality bonds even though their expected returns are low: interest rates might be lousy, but they look good compared with the 20-30 per cent loss we could suffer on equities in the event of recession.
And just as the Bank will look wrong with hindsight if the central scenario materialises, so too will those of us who have invested with regard to the risk of recession. We'll miss out on some big gains if shares soar as the chance of recession diminishes. Just like the Bank, we'll look wrong - even though our choice was reasonable. There's a big difference between wrong and being irrational.
Which leads me to an overlooked point. High returns can be a sign that you've taken too much risk. If you bet everything upon global growth picking up - say by buying distressed mining stocks - you might get lucky and make a fortune. But this will be only a reward for taking a lot of risk. Given that accurate forecasting is impossible, the choice to do this cannot be a well-judged one.
Just because you're right doesn't mean you were rational - a point which many wealthy people, and those who defer to them, are apt to ignore.
