Select Committee on Treasury Written Evidence

Memorandum submitted by Professor Anton Muscatelli, University of Glasgow


  1.  The May Inflation Report presents a marked change in the MPC's assessment of the UK economy. The Report highlights a slight deterioration in projected GDP growth from mid-2007 onwards, with a more rapid return towards trend growth. More significantly for monetary policy, it shows a rise in the central forecast for CPI inflation for the remainder of 2006 and early 2007.

  2.  This deterioration in the picture for inflation explains the split in the MPC vote in May, with one member of the Committee voting for a 25 basis points increase in the repo rate. The member concerned subsequently explained this as being motivated by a shift in the balance of risks for inflation, with a slight upside risk following the latest inflation forecast. [1]

  3.  This note assesses this shift in forecast and analyses some of the main risks facing monetary policy. As far as the risks for inflation are concerned, as in the last two written reports to the Treasury Committee my focus is on the uncertainty surrounding the degree of spare capacity in the UK economy, and the persistence of the recent increase in energy prices. The risks for the demand side remain evenly balanced with the picture for different components of aggregate demand still somewhat uncertain. This will be discussed in detail below. Compared to my written evidence on the February Report, there are some additional concerns surrounding both the impact of energy price increases on inflation expectations measures (though this has not significantly impacted on earnings growth), and the evidence that concerns on international current account imbalances and inflation may finally be impacting negatively on financial and currency markets.

  4.  In the evidence I gave to the Treasury Committee on 7 March 2006, I was asked whether I agreed with the majority MPC view to hold rates. My response was that my instinct following the November 2005 Inflation Report would have been to favour a 25 basis point cut, but that following the publication of the February 2006 Inflation Report I favoured holding rates. That assessment has not changed. There appears to be sufficient momentum in the UK economy to sustain GDP growth. Although the situation for the demand side of the economy (particularly domestic expenditure) remains uncertain, the MPC's options have narrowed. The current evidence on expected and actual inflation suggests that it would be imprudent to stimulate domestic demand further. Whilst the evidence on the supply side of the economy is not sufficiently compelling in my view to argue for a repo rate increase, the potential for these higher inflation expectations to feed into earnings growth will need to be assessed very carefully over the next three months.


  5.  The uncertainty in the expenditure components of demand has been evident from the last two inflation reports.

  6.  Household consumption has been surprisingly resilient over the last two quarters of 2005, and grew 0.8% in the quarter to 2005 Q4. This was the strongest performance in 2005. This was also against a background of falling disposable income during the latter part of 2005. Retail sales have been volatile during the first four months of 2006, but given the trends in disposable income one would expect some moderation in consumer expenditure during 2006.

  7.  The puzzle regarding slow growth in investment expenditure seems to be resolving itself. Business investment had been very sluggish despite the recent growth in corporate earnings. This had been attributed variously to concerns about energy prices and about pension provisions and more generally about company balance sheets. The provisional estimates for 2006 Q1 show an increase in business investment of 1.7% on the previous quarter. Although the revisions in this series can be substantial, this is a strong indicator that investment is recovering the momentum it lost in 2004-05.

  8.  As indicated in the Inflation Report the contribution from net trade to GDP was strong in 2005Q4. This seems to have been sustained in early 2006. The MPC's central assessment regarding GDP growth therefore seems to have been validated, despite some unexpected compensating variations between the components of GDP. For this reason, and particularly in the light of some additional concerns about future inflation, an interest rate cut by the MPC seems unlikely in the near future.


  9.  One of the major risks highlighted in my recent written evidence to the Committee following the November 2005 and February 2006 Inflation Reports relates to the continuing imbalances in the world economy, how these might unwind, and the impact this would have on US growth and world economic growth more generally.

  10.  The last few months have begun to see renewed weakness in the US Dollar. Figure 1 shows that in nominal terms, the US Dollar is 23% below its peak in early 2002. We may finally be seeing some signs of adjustment to the growing imbalances which have characterised the world economy. As highlighted, much of the recent increase in the US current account deficit (which has grown from 1.6% of US GDP in 1997 to about 5.5-6% of GDP in 2005) has been linked to the increasing current account surpluses of the oil exporting economies, which amounted to 18% of GDP for these economies in 2005. There is no doubt that a return to fiscal discipline in the US would help this adjustment process, but the US structural budget deficit in 2006 is expected to increase to 4.2%. Figure 2 shows the current account imbalances for some of the main trading blocs (as a % of world GDP).

  11.  Many economists have expressed fears that the unwinding of these imbalances will create difficulties for the world economy, including greater volatility in asset and currency markets, and a slow-down in world economic growth. The dynamics and timing of this adjustment are difficult to forecast, for a number of reasons.

  12.  First, because the real effective depreciation required in the US Dollar is large: this has been estimated in various modelling exercises by Maurice Obstfeld and Ken Rogoff[2] to be as high as 34%, depending on assumptions about relative growth in US productivity and other factors. Although there has been a 12-15% decline in the real effective US dollar rate since 2002 [see Figure 1], it seems certain that a further major real exchange rate adjustment could not be effective without a slowdown in the US economy.

  13.  Second, because a major depreciation in the dollar will have a valuation effect on its net debt position. In the past these effects have permitted the US to borrow at low cost in the world economy, but the question is whether this will remain a stable feature of the world economic landscape and whether international investors (private and government lenders) will begin to price the risk of valuation effects into US dollar-denominated assets. Any moves in this direction could make world asset and currency markets far more volatile.

  14.  Third, because substantive US fiscal adjustment is more difficult to predict given the current political environment.

  15.  The risks to the UK (and the world economy) from this adjustment will depend on whether it is orderly or not. An orderly adjustment will result in possibly a minor slowdown in the world economy, led by the US, with much depending on the reaction to the slowdown in the oil-exporting and Asian economies. Higher public and private saving in the US could be offset to some extent by growth elsewhere in the world economy.

  16.  A disorderly unwinding of global imbalances could be much more serious as it would not only cause US demand to falter, but could see the re-emergence of large risk premia in world asset and currency markets. In such a scenario the world economy could slow much more rapidly and pose a real problem for European central banks in terms of balancing short-term liquidity needs and the need to stabilise asset markets through lower interest rates, and the need to keep an eye on price stability. Whether central banks in the UK and European economies have room for manoeuvre or face a difficult trade-off in such circumstances depends critically on the timing of the adjustment, and the extent to which inflation expectations remain under control over the next year.


  17.  The supply side of the UK economy saw some easing of labour market tightness and factor utilisation. This is one area where a difference in assessment emerged within the MPC, with the view expressed by one member that some of the recent increase in unemployment might have been due to structural and not cyclical factors. [3]

  18.  My major concern is instead focused on the latest evidence on inflation expectations, which both survey evidence (May Inflation Report, p.27, Chart 4.5) and gilts markets (Table 4.A, p.27) showing an increase to 2.8% or more. There is no evidence that this is feeding through into "second-round effects" as earnings growth remains relatively stable.

  19.  The main force behind the recent increase in the Bank's CPI inflation forecast is the rise in energy prices and import prices. But until there is evidence of any feedback into wage settlements, or clearer evidence regarding capacity utilisation, it would seem premature to raise interest rates.


  20.  Overall, I would stand by my assessment of the UK economy and the risks it faces as outlined in my written evidence to the Treasury Committee in November 2005 and February 2006. GDP growth retains sufficient momentum to suggest that a more expansionary monetary policy is not required at this time. The risks with regard to the growth of potential output and capacity which I highlighted in February may be beginning to emerge. The overall scenario is one where there will need to be a move towards gradual tightening of policy as clearer evidence on these emerging capacity constraints materializes. The biggest risk facing the MPC remains that of global economic imbalances: how they might adjust and over what time horizon: a disorderly adjustment would considerably complicate the picture for monetary policy.

May 2006

1   See A Shift in the Balance of Risks-speech by David Walton to a lunch organised by the Bank of England's Central Southern Agency, 18 May 2006, Back

2   See for example Obstfeld, M and Rogoff, K. (2005) "Global Current Account Imbalances and Exchange Rate Adjustments". Brookings Papers on Economic Activity, 1, pp. 67-123. Back

3   See A Shift in the Balance of Risks-speech by David Walton to a lunch organised by the Bank of England's Central Southern Agency, 18 May 2006, Back

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