Select Committee on Treasury Written Evidence

Memorandum submitted by John Butler, Chief UK Economist, HSBC

  1.  Although the May Inflation Report argued that the risks around the Bank's inflation and GDP projections were broadly balanced, the lack of clarity and extent of uncertainty were better illustrated by the fact the Committee was split in three directions at the corresponding policy meeting. However, given May's meeting was Professor Nickell's last, the MPC now probably has a bias towards tightening. The key aspect of the May Inflation Report was that CPI inflation was expected to overshoot the 2.0% target throughout the forecast horizon if interest rates were held constant at 4.5%.

  2.  The Inflation Report provides the Committee with an opportunity to explain how their views concerning the outlook and risks have changed from one quarter to the next. Yet it is still unclear what over the past six months, since the November Inflation Report, has shifted the MPC towards this tightening bias.

Deterioration in the GDP and inflation trade-off

  3.  The MPC's view concerning the GDP outlook has barely changed. Their latest central projection, using the assumption of constant interest rates, has annual GDP growth rising to 3.0% by Q4 2006 and slowing modestly to 2.8% by Q4 2007. That is very similar to the projections under constant interest rates—4.5%—in both the February and November Inflation Reports. Annual GDP growth in the November Report was slightly weaker this year—2.8% in Q4 2006—but stronger in 2007—3.3% in Q4 2007. Indeed, using the data available at the time, the level of GDP at the end of the forecast horizon was slightly higher in the November Report compared to May. Also, as in November, consumer spending was expected to grow steadily, investment to recover modestly and net exports were predicted to boost GDP growth slightly.

  4.  The real change in the MPC's view over the past six months concerns the relationship between GDP and inflation. In May's Inflation Report, inflation was expected to overshoot the 2.0% target throughout the forecast, under the constant 4.5% interest rate assumption. In contrast, in November's Report inflation was expected to consistently undershoot using the same interest rate assumption and despite an almost identical level of GDP. That growing pessimism about inflation is even more striking as it comes against a background in which CPI inflation in Q1 was 0.4% points lower than that predicted in the November Report.

Inflation remains well-contained

  5.  The growing nervousness on inflation has, it seems, been motivated, perhaps understandably, by the recent pick up in energy prices, input costs and, unusually, import prices. As yet, however, there has been very little evidence these higher costs are working their way through the supply chain or are having second-round effects through raising wage growth, as was the experience of the 1970s and 1980s. Non-energy CPI inflation, for instance, has actually dropped from 1.6% in November to just 1.2%.

  6.  To my mind there are three reasons why the inflationary risks may not have intensified over the past six months:

    —  There is little evidence to suggest the degree of spare capacity in the economy has changed. As the MPC argued in the May minutes, "changes in survey measures of capacity utilisation had not been large" (page 7).

    —  The labour market is now loosening. A combination of rising immigration and greater participation of those aged above the retirement age has meant the pool of available workers is far outstripping the rise in employment. As a result over the past six months the labour market has arguably loosened at its fastest pace since the previous recession.

    —  Sterling is higher implying the rise in import prices may be short-lived. The renewed concerns regarding the dollar have pushed sterling higher. Trade-weighted sterling (at 102.1 at the time of writing) is 3.2% higher than the starting point incorporated in the May Report and almost 2% higher than in November.

  7.  The Bank is predicting a worsening trade-off between GDP growth and inflation. However, the evidence to date has been the opposite. The evidence so far is that inflation in one part of the economy is causing disinflation elsewhere: energy prices rise and non-energy inflation declines; goods deflation eases and service sector inflation cools; import prices rise and labour costs correct. The rises in suppliers' costs are being treated as a relative rather than general price shock as the economy rebalances.

  8.  One new development that has clearly concerned the Bank of England has been the pick up in their measure of household inflation expectations. Inflation expectations on that measure are now at its highest rate since the survey began in 2000. But it is less clear whether the current expectation of 2.7% is high or whether expectations in the past were just too low. For a central bank with a symmetric inflation target that is an important consideration. The trouble is that other surveys of inflation expectations, with longer histories, point to something very different. The GFK/Eurostat survey, for instance, shows households' expectations of future price rises are very similar to the average of the past four years. The problem is that stabilising inflation expectations is critical for any central bank that is attempting to abide by an inflation target but unfortunately there is no single measure that the Bank can use. Hence, a rise in inflation expectations is a difficult peg to hang an interest rate move on.

Consumer spending, asset prices and personal insolvency

  9.  The Bank's relatively upbeat assessment of consumer spending depends in large part on the rise in asset prices and, hence, household wealth. As stated in the Report's overview "Real incomes are likely to be squeezed in the near term by higher utility prices and taxes, but past increases in equity prices and the continuing revival in the housing market should provide some offsetting support to consumption". Yet that link between wealth, asset prices and consumer spending has been questioned in recent years, not least by the Bank of England itself in past Inflation Reports—a point I made in my submission three months ago. Moreover, since the publication of the Inflation Report, equity markets have fallen sharply in the UK and globally. It would be interesting to hear whether this has softened the MPC's optimism about the consumer and investment outlook.

  10.  Finally, the Bank of England included a box on personal insolvency. The Bank is right to highlight this worrying trend. The puzzle is that typically mortgage arrears and personal insolvencies lag the pick up in unemployment but this time the relationship has appeared to be coincident: insolvencies have risen despite the still low level of unemployment. Part of this deterioration surely reflects the high level of household debt but part of move also seems to reflect a worrying trend beneath the surface. The unemployment rate of those aged between 25-49 years old is its highest since 2002 and it is often these people who have tended to take on much of the debt, particularly unsecured, over the past few years. Cleary, this is a trend worth monitoring, as it could have significant implications for the housing market and the outlook for consumer spending.

  11.  Overall, the MPC's expectation of a healthy GDP growth recovery is very similar to that published in both the February and November Inflation Reports, as is the source of that growth. During that period non-energy inflation has fallen, the labour market has loosened and sterling is now higher, but yet the Committee has become more pessimistic about the medium term outlook for inflation. It is still not entirely clear what has caused the MPC to switch from a loosening to tightening bias.

May 2006

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