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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