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
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
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
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
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. 
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.
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, www.bankofengland.co.uk Back
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
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, www.bankofengland.co.uk Back