LONDON (MNI) - Bank of England Monetary Policy Committee member Kate Barker said there are grounds for optimism in the recent data that the UK recovery is on track, and raised the possibility of the MPC allowing inflation to remain below the BOE's 2.0% target for much of the next two years.

In a speech Monday at the National Institute of Economic and Social Research Barker raised doubts about how effective quantitative easing would be if extended further and said the MPC should consider extending its policy horizon beyond its conventional two-year period.

Barker Says Seriously Underestimated Scale of Downside Risks

Barker highlighted some of the uncertainties surrounding the current economic conjuncture, with doubts over the size of the output gap. She also argued the MPC should think about extending its policy horizon, by placing more weight on the outlook further out than its conventional two year horizon.

In the speech, which could be Barker's last before she leaves the MPC, she admitted to getting policy wrong as the financial crisis kicked in.

"I seriously underestimated the scale of the downside risks from a potential financial crisis, and that implied overrating the ability of monetary policy to offset this shock," she said.

She also acknowledged the MPC's much criticized error of overestimating the likely pass through to wage growth from higher inflation rates.

"It is notable that despite frequently expressed concerns by the MPC about periods of higher inflation leading to higher wage inflation, the relationship between earnings growth and RPI has become weaker over time," she said.

At present, one large uncertainty facing the MPC is knowing how much spare capacity there is in the UK economy.

"At present, neither the extent of excess capacity nor the impact of capacity pressures on inflation are easy to assess," she said.

QE Could Be Less Effective If Extended

She said the MPC had been right to employ quantitative easing, but warned that it could become less effective if it is extended further.

"A significant part of the transmission mechanism (for QE) has been via the rise in the prices of riskier assets. As yet, I don't consider the evidence suggests that this rise in asset prices has gone too far, and therefore do not believe that this has become another risk to future economic stability," she said.

She added that her concern was rather "that this (asset price) channel might become less powerful if quantitative easing were to be extended, as confidence effects might be less apparent, and there might be reluctance to engage in further portfolio rebalancing as the price of risky assets rose."

"This could prove a concern, given that there are still some risks on the downside to the path of economic activity, including a continuing weakness in the world economy, particularly the EU. Credit conditions also remain a concern," she said.

Grounds For Comfort From Recent Data

While expressing concern further QE could be less effective, Barker drew comfort from recent economic data.

"There are grounds for optimism from recent data that the recovery is broadly on track," she said.

She noted GDP in the fourth quarter rose 0.3%, consumer spending is growing and "household balance sheets have already been strengthened. Employment trends have remained surprisingly robust, and firms' employment intentions continue to recover from the low point early in 2009 in the bulk of the business surveys."

"I don't think it is yet possible to be confident in the pace of recovery, and still expect the path to be bumpy. But some of the severe downside risks have diminished," she said.

Worth Considering Longer Policy Horizon

In the speech, Barker also set out a detailed debate over the policy horizons the MPC should employ in setting policy, and suggested the MPC could let inflation go below its 2.0% target and then allow it to take more than two years to get back up to it.

There has been a convention that the MPC focusses on a two year horizon with the BOE's unchanged policy forecasts only extending two years' ahead and two years' cited as the time it takes for policy changes to have maximum effect.

Barker, however, stressed that the policy horizon can, and should, shift according to the economic situation.

"It is worth considering whether, in present circumstances, there might be a case for considering a longer-term policy horizon," she said.

Among the reasons she gave for this were "quantitative easing might have longer lags before it reaches maximum effect than do changes in Bank Rate."

She also noted that inflation, at 3.5% in January, is well above the 2.0% target and "likely to remain above target for the first half of 2010."

This rise in inflation has been due in large part to sterling depreciation and the rise in the oil price and "some domestic inflationary pressures remain low," notably low rates of wage growth, Barker said.

The BOE's forecast is for below target inflation two years' ahead. Barker argued that there was a scope for the MPC to let inflation take longer than two years to get back up to target.

"The present above-target inflation background suggests little cause for anxiety about inflation expectations becoming deanchored on the downside if the MPC were to suggest it might take a little longer to move the underlying inflation trend back to target," she said

"Indeed, that might be one way to respond to the balance of risks the MPC faces, with inflation uncomfortably high in the short term, but medium-term prospects still likely to be on the downside," she said.

--London newsroom 0044 20 7634 1655; email: drobinson@marketnews.com