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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