Select Committee on Treasury Written Evidence

Memorandum submitted by Professor Sheila Dow, University of Stirling

  1.  The May Inflation Report shows more short-run volatility in its inflation forecast than in February, but again settling around the 2% target in the medium-run. The GDP forecast is for growth to settle rather lower than the February forecast, below 3%. These forecasts are conditioned on the rise in the repo rate to 4.75% forecast by markets; if the rate remained unchanged, the core forecast is for both GDP and inflation to be higher. These forecasts in large part reflect concerns for both output prices and final demand arising from high energy prices.

  2.  There are continuing signs of uncertainty being an influence, both on financial variables and on final demand. As in February, growth in monetary aggregates has been highlighted in the Report. In spite of all the misgivings about broad money as an indicator, the discussion concludes by noting "the possibility that estimates of excess money growth may contain useful information about future inflationary pressure" (p.7). One factor explaining the build-up of liquidity, particularly in the corporate sector, is continuing uncertainty (as discussed in my memorandum on the February Report). This is consistent with the CBI investment intentions survey which predicts continuing decline in investment (Table 2.C); the Report only notes the much more optimistic intentions (for investment increase) coming from the BCC data (p.14).

  3.  "Moderate growth" is predicted for consumer demand, in spite of relative weakness in earnings growth, and increasing unemployment concerns. This forecast refers to the healthy state of aggregate household finances and the moderate pick-up in the housing market. At the same time, the increase in personal insolvencies is noted in the box on pages 8-9. It is concluded that these insolvencies affect only a small proportion of households, and do not seem to have markedly affected credit conditions, and so have limited macroeconomic significance. In the meantime, there has been a marked reduction over the last year in unsecured lending (Chart 1.5), and it is likely that this reflects more a supply constraint than a fall in demand, with banks becoming more cautious.

  4.  On the face of it, the fact that an increasing proportion of borrowing is secured, and that households hold significant stocks of financial assets, implies that households and financial institutions are protected against any spread in financial distress which might arise from weak earnings growth and possibly higher interest rates. But the protection comes from the capacity to sell property and financial assets. Were this to be required on any significant scale, then the downward pressure on asset prices would have macroeconomic consequences, with household and corporate spending plans likely to be revised downwards.

  5.  The Inflation Report was published before the recent instability in stock prices, affecting particularly emerging markets, but also global markets more widely. If there were to be a further fall in asset prices, then a much wider range of households will be faced with deteriorating wealth, with likely cut-backs on consumption plans. As the Governor has noted with respect to the issue of household debt, the cure at the household level lies in cutting back on consumption. But this cure reduces final demand. To the extent that weakening and/or volatile asset prices continue as a global trend, the same would happen to export demand. Further, forced asset selling would add fuel to a bear market.

  6.  There has been much discussion in the media as to whether the equity market has simply been undergoing a correction, or whether this is the beginning of a more long-lasting bear market. One consideration is the possibility that risk has not been "correctly" priced in derivatives markets (particularly credit derivatives), and that the required correction, together with the degree of leveraging in derivatives markets, will spark off a major downward movement. How this kind of situation is analysed depends on the basic view taken of how markets function. If the view is taken that markets are basically stable, then the focus is on corrections and short-term turbulence. However if markets are viewed as having the inherent possibility of instability, then the potential is there for a major fall in equity prices, with the possible effect of a major downturn in the global economy. Along with this view goes the doubt that it is feasible to identify "correct" prices when there is significant unquantifiable uncertainty. The LTCM debacle occurred because trading was based on a model which presumed inherent market stability. Such models break down when there are structural shifts in markets, as in 1997-98 (ie risks which could not feasibly have been "correctly" priced). According to this view, rising asset markets and confident expectations that such rises will continue, easy credit, and a high degree of leveraging, all create vulnerability to anything which causes a reversal which can feed on itself. Indeed a recent BIS Working Paper (no. 205) suggests that success in promoting price stability can have the unfortunate long-run side-effect of stoking up the financial conditions which cause financial fragility and thus the potential for a significant downturn. Rising market conditions can last a long time, and it cannot be predicted what will cause the reversal, or when. But the conditions are there for a financial and economic turnaround.

  7.  What has been critical for financial markets has been changing expectations about US inflation and thus interest rates. The current design of monetary policy in the UK (just as in the US) is based on the "New Keynesian" view that transparency, about the MPCs policy goal and the thinking behind the MPCs forecasts and thus policy actions, will help achievement of the goal. If markets price the MPC inflation target into contracts (debt, labour etc), then that will contribute to the target being met. The Bank has built up a lot of credibility in terms of keeping inflation close to target. It is therefore rather worrying that the public's expectations are shown to be for increasing inflation (Table 4.A). It is suggested in the Report however that the public are overly reliant for their forecasts on recent experience (Chart 4.5), and even misunderstand the price index relevant to the survey question (p.27). (Indeed the precision implied by the point forecasts for RPI and CPI is somewhat spurious, not least given the significant, and unpredictably variable, gap between the two.) It is concluded that household inflation expectations are not significant for wage and price setting, and therefore the expectations data gathered are not significant. This conclusion challenges the conventional idea that workers supply more labour when real wages (as measured by expected inflation) rise. Overall, the implication of the analysis is that monetary policy is transmitted to households, not so much by inflation expectations, as by employment expectations, disposable income (after interest costs), ease of credit availability, and perceived wealth.

  8.  The expectations gleaned from financial market prices are however for stable RPI and CPI inflation over the forecast period (for CPI, very slightly below target). For financial markets, the precise inflation forecasts are more important for what they imply about monetary policy (rather than what exactly is being measured). The events of the last two weeks have shown that financial markets react very speedily, directly, and globally to changing inflation expectations and what that implies for interest rates. These expectations in turn respond to interpretations of public statements by policy-makers, which may in fact be misinterpreted. While asset markets react in part to the expected real consequences of inflation and interest rate changes, they also react to expected immediate consequences for asset prices, something which may be compounded by the scale of operations in derivatives. When the economy is highly leveraged, as now, and if confidence is punctured, then movement trading can create significant instability in financial markets, which then weakens spending plans and growth prospects. The awareness of these relations, which is evident in much of the media coverage, can only serve to increase the fears of a downward spiral. It should be noted that, while the width of the "fan" is said to be a measure of forecast risk, in fact it is derived from past forecast errors, and so cannot reflect new structural change (as in major shifts in equity prices). Many commentators agree that there is currently a high level of risk of volatility in financial markets, particularly given global structural imbalances.

  9.  Financial regulation and sensitive monetary policy action can go a long way to protect the financial system. And the state of market confidence is critical; belief that the market will stabilise quickly can encourage stabilising behaviour. Indeed the UK market has rebounded to some extent. However, the developments of the last two weeks are a hint at the possibility of the MPC forecasts being confounded by events, and the importance of the MPCs efforts in calming fears.

May 2006

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