The latest Inflation Report from the Bank of England is notable for a number of reasons. It could be seen as the Bank coming to terms with the reality of the world as we know it in 2015, while still being somewhat starry eyed about the prospects for next year.

The Bank now expects productivity to increase by just ¼ percent over the course of the current year – an estimate that is down from ¾ per cent in the previous Report. This adjustment aligns with continued pessimism surrounding the UK’s failure to resolve the productivity puzzle of recent years. The ¼ percent figure is not the result of any sophisticated modelling – rather it is an assumption that is used to produce model forecasts of other variables. So alongside the cut in its assumption of productivity growth, we see a consequent fall in predicted wage growth – the forecast for 2015 is now 2½ per cent, down from 3½ per cent in the last Report. The Bank’s revised expectations for both productivity and wage growth in 2015 certainly make a lot more sense than those reported in their previous Report, just three months ago.

The Bank remains very bullish about productivity (and hence also about wage growth) looking further ahead. On the back of productivity growth of 1¼ per cent next year, they expect wages to grow by some 4 per cent. Meanwhile they expect price inflation to rise to close to 2 per cent by the end of next year. Now, while the deflation that we are currently experiencing is likely to be short lived – the price of oil has been increasing since March – the Bank’s premise that inflation will so quickly rise to 2 per cent seems to have more to do with its desire to hit its target than anything else. And, crucially, it is not clear that productivity will grow to meet the Bank’s expectations. It might, but then again, it might not. One of the determinants of productivity is business investment. The Bank has revised its projections for the growth of business investment in 2015 down from 6¼ per cent to 2½ per cent, and has revised down its projections for 2016 and 2017 as well. For sure, we need business investment to grow rapidly – otherwise the current recovery is likely to stall as has been the case with consumer led booms in the past.

The longer term optimism of the Bank may turn out to be well founded; we should certainly hope so. Like many forecasters, there is a lot of mean reversion in the model that the Bank uses. This means that, after a year or two, the answer is always 2.5. (The question is: at what percentage rate will we grow?)  Whether this modelling approach is really appropriate in the aftermath of the type of shocks that the economy has experienced in recent years is somewhat moot.

All of this is important in the context of the government’s desire to close the budget deficit (and indeed to generate a surplus) by the end of this parliament. Productivity growth is needed to generate wage growth, which in turn is needed to boost tax revenues. Unless productivity makes a remarkable recovery, the fiscal plan is at risk. Yet -  as I have noted elsewhere – the government seems to have little idea about what to do to stimulate productivity. For sure, it requires conditions to be put in place to encourage business investment (some tax breaks might help). It also calls for a reinvigoration of the innovation landscape, and in this context a re-engineering of the patent system to provide greater incentives to successful research and development would be useful. The last Budget contained little, nothing really, to help. Hopefully the next, on 8 July, will.