Select Committee on Treasury Written Evidence

Memorandum submitted by Michael Saunders, Head of European Economics, Citigroup

  The BoE Inflation Report aims to gives a nuanced message: the MPC expects that the next move in rates eventually will be up, but does not expect to hike as aggressively as markets price in. If events play out roughly as the MPC forecast, then a 25bp rate hike will be needed in late 2006/early 2007 to keep inflation on target over time. But this is not a promise to hike. It is a conditional forecast, reflecting data available at that point. In the end, of course, the path of interest rates depends on the data and economic developments.

  My base case is for modest growth, subdued core inflation and a temporary nearterm energy-driven overshoot of the inflation target that gives way to a more lasting undershoot. Unless inflation expectations spike even higher, or clear signs emerge that the recent rise in inflation expectations is feeding through to pay, the MPC can afford to leave rates on hold for an extended period.


  The MPC's risk-adjusted growth forecasts are little changed, at 2.7%, 2.9% and 2.7% in 2006, 07 and 08 respectively, versus 2.6%, 3.0% and 2.7% respectively in the February IR. My own growth forecasts (2.4% in 2006, 2.7% in 2007, at the time of writing) are slightly below the MPC's but the gap is fairly small given margins of error. It could easily be closed, for example, through data revisions. Nevertheless, I would take issue with Walton's view that risks for growth are to the upside of the MPC's base case. [4]

  I share the MPC's view that consumption will recover only modestly, held back by high debts and modest real income growth. Nominal consumer spending growth in 2005 was the weakest since 1943. This year should be a bit better, but not great. In real terms, the growth of consumer spending in Q1 2006, at just 0.2% QoQ, was the weakest for a year, and unemployment is rising quite rapidly.

  However, (contrary to Walton) I doubt exports and business investment combined will be strong enough to produce above trend growth unless sterling falls sharply. The BoE agents' survey suggests that business investment will remain subdued. As Tucker of the MPC argues, investment may have been (and continue to be) capped by the surge in company contributions to pension funds, and risks of further increases. [5]The latest CBI survey shows better export orders, but, so far, the UK's underlying export trends (ex-MTIC-fraud) remain unspectacular. The Q1 GDP data show goods and services export volumes up 11.9% YoY, the best since 1976. However, roughly half that YoY gain reflects MTIC-fraud. This adds nothing to GDP and is matched by booming imports. Net trade deducted from QoQ and YoY GDP growth in Q1.

  I expect Q2 real GDP growth to stay at about 0.6% (as in Q1), whereas growth of 0.9% QoQ (or upward revisions to earlier quarters) is needed to hit the May IR forecast (which is for Q2 growth of 2.6% YoY). April retail sales suggest Q2 consumer spending will be stronger, but this is likely to be offset by flatter stockbuilding and slower government consumption (although strong public investment is likely to lift total investment).

  Moreover, the sharp tightening in financial conditions will cap growth and inflation further out. Compared to the levels used for the May IR, sterling's TWI is at the time of writing, 2%-3% up, UK equities are 8% down and 2-year rates are 10bp up. Although interest differentials against the dollar and euro have moved against sterling over the last year, it has benefited (and may continue to do so) from large inflows of FX reserves into sterling and large M&A inflows. If sustained, the swings in equities (down) and sterling (up) would be equivalent, in terms of the effect on GDP growth four to eight quarters ahead, to a rate rise of more than 100bp. That is already more restraint than the MPC judged would be needed to keep inflation on track over time.


  The more fundamental point is whether core inflation will really rise as much as the MPC expects, with either forecast for GDP growth—2.5% on average in 2006-07 on our forecast, 2.8% on the MPC's. Both forecasts imply growth around trend on average in 2006-07. And yet the MPC still expects capacity and non-energy cost pressures to build enough to keep headline inflation stable around the 2.0% target even once the energy effect fades in 07-08. This must require core inflation[6] to rise close to 2% YoY from 11/4% YoY now. Core inflation has averaged just 1.1% YoY since BoE independence, and indeed has been below 2.0% YoY in every month since then. The MPC's forecast seems to reflect a mix of pressures:

    —  Some upward effect from rising capacity use. The MPC seems to expect that some, but not all, of the slack accumulated in the recent slowdown will be exhausted: "there is a margin of spare capacity that has also restrained inflation recently. The economy is likely to grow at a firm pace during the next three years, but not quickly enough to erode that margin of spare capacity completely".

    —  Some anxiety about a feed through to pay deals from the rise in household inflation expectations in the Q1 BoE/NOP survey (to 2.7%, highest since survey began in late 1999, from 2.2% last November and average of 2.3% in 2000-04). [7]

    —  Less disinflationary effect from globalisation, with UK import prices lifted by strong gains in global commodity prices.

    —  Stabilising price-setting behaviour, whereby the inflation rate for non-energy items will rise—more or less spontaneously—to offset the expected slowdown in energy costs. "It is possible that producers and employees became used to setting prices and wages for their own industries in an economic environment that generated low CPI inflation| To the extent that the inflation target is credible, non-energy price inflation might be expected to pick up as energy price inflation abates."

    —  In Walton's case at least, a view that last year's slowdown in productivity growth implies that trend economic growth has slowed. [8]

  In my view, these inflation worries are less convincing. I expect that core inflation will remain quite subdued in 2006-08, and hence expect headline inflation eventually will converge down below 2%. The key issue is the lack of inflation pressures from the labour market, coupled with modest nominal GDP growth and the ongoing compression of consumer goods prices from cheap imports.

  1.  Labour Market Unemployment has risen from 4.7% in mid-05 to 5.2% in Q1 (LFS measure), the fastest rise in unemployment since 1992-93. The slack from last year's slowdown is being relocated from excess labour within firms (and hence a temporary productivity shortfall) to the recent rapid rise in unemployment. The mid-05 productivity slowdown cited by Walton was a normal side effect of the lag between GDP growth (slowing sharply at that stage) and employment. These lags are now unwinding. In Q4-05 and Q1-06, a modest pick up in GDP growth was accompanied by little growth in hours worked. As a result, YoY productivity (GDP per hour) in Q1 rose close to its longrun norm of about 2%. Productivity is (as usual) likely to rise further if GDP growth continues to pick up. Private sector productivity, of course, is higher with little or no measured public sector productivity gains.

  Rising unemployment has, in turn, helped slow pay growth. Private sector earnings growth ex bonuses are just 3.9% YoY (below the 1997-2005 average of 4.2% YoY), and the balance of consumers expecting unemployment to rise further is relatively high. Figures from Incomes Data Services suggest that 38% of pay settlements in 2006 to date are for less than 3%, the highest share since 2002 and versus 19% in 2005.

  It is important for the MPC to closely monitor household inflation expectations. But, there is no perfect measure. Other measures suggest that inflation expectations have picked up a bit less than the quarterly Q1 BoE/NOP survey indicates. The monthly YouGov/Citigroup survey shows a smaller rise (2.3-2.4% in Q4, 2.4%-2.5% in Q1, 2.4%-2.5% on average in April-May). This uses a sample of about 2,000 people each month, similar to the quarterly BoE/NOP surveys for Q2, Q3 and Q4, although the February BoE/NOP survey sample is about 4,000. The YouGov question is similar (but not identical) to the BoE/NOP one. It is published near the end of each month. The monthly Gfk/EC survey, which has a diffusion index on household inflation expectations, has been fairly stable in recent months.


2000-04 2005 2006
AvgeSep OctNov DecJanFeb MarApril May

BoE/NOP (Year Ahead)
2.3% nana2.2% Nana2.7% nanaNa
YouGov/Citigroup (Year Ahead)na nana2.3
YouGov/Citigroup (Longer Term)na nana3.5
EC/Gfk (Index for year ahead)19 16119 13141214 12na

  Note: Questions differ slightly. The BoE/NOP survey uses "How much would you expect prices in the shops generally to change over the next 12 months?". The YouGov/Citigroup Survey uses "How do you expect consumer prices of goods and services will develop in the next 12 months?" The longer term one refers to expected average inflation for the next five to 10 years. The EC/Gfk survey uses "In comparison with the past 12 months, how do you expect consumer prices will develop in the next 12 months?" with responses shown as a diffusion index between those expecting prices to rise more/less rapidly.

  Going forward, surveys suggest that private sector hiring plans are now improving. However, the labour market is subject to four large disinflationary shocks at present that will probably ensure that this pick up in job growth (and the rise in inflation expectations in the Q1 BoE/NOP survey) does not feed through to higher pay deals.

    —  Big inflows of low-cost migrant labour from Eastern Europe. The Q1 Accession Monitoring Report shows the number of new people approved to work in the UK under the Workers Registration Scheme (WRS) totalled 44,000 in Q1-2006, 6% up from Q1-2005. [9]Approvals have totalled 375,000 since EU Enlargement in May 2004. If this translated one for one into a net addition to the UK workforce, it would add about 0.6% to YoY workforce growth over that period—a significant addition given that workforce growth averaged just 0.6% YoY in 1997-2003. But this is quite uncertain. If some of the people registered under the WRS have since left the UK and not returned, then the net boost to the UK workforce would be less. But, since the WRS data do not count people from Eastern Europe working self-employed in the UK (eg plumbers, window cleaners), the boost to the UK workforce could be greater. No one can be sure of the precise addition to the UK workforce. But, it almost certainly is large relative to previous workforce growth. Having initially been mainly to London and the South East, the inflow from Eastern Europe has increasingly become spread across all parts of the UK in recent quarters. Moreover, the inflow is of low-cost labour. Of people working under the WRS, 79% have pay below £6/hour: only 25% of the existing UK workforce earn less than £6.25/hour. The average is £10.98 per hour.

    —  Rising participation rates among pensioners. This trend has been evident since the start of the decade, but gathered pace recently. People above the normal retirement ages account for only 4% of the level of employment, but have accounted for 39% of the rise in employment from Q4-2004 to Q1-2006. Several factors probably lie behind this: better health, longer life expectancy, less need for employers to contribute to their pension funds, willingness to work flexible hours, low annuity rates and the sharp rise in tax allowances for pensioners over the last 10 years. There is anecdotal evidence of a similar trend in some other G7 countries.

    —  Slowing demand for low skilled and unskilled labour, evident in recent quarterly surveys by the British Chambers of Commerce. This may reflect the use of offshoring/outsourcing/technology to substitute for staff in the UK.

    —  Slowing public sector job growth. Private sector job growth has lagged workforce growth for four years in a row, even in 2004 (when GDP growth was 3.1% YoY). Private job growth slowed to 0.5% YoY in Q4-2005 (probably lower in Q1-2006), remaining well below workforce growth (about 1.0% YoY recently). The fact that unemployment was stable/falling gently in 2002-04 reflected high growth in public sector employment, which is now ending. Public sector job growth averaged 2.3% YoY in 2002-04, but fell to 1.3% YoY in 2005 as a whole and 1.1% YoY (lowest since 1999) in Q4-2005. As a result, persistent sluggishness in private employment is finally pushing up unemployment. Looking ahead, the Government expects real public spending growth in fiscal years 2006/07-08/09 to average about 2.5% YoY, versus 5.3% YoY in fiscal years 2002/03-05/06. This will further slow public sector job growth. In turn, this implies that overall job growth will continue to lag workforce growth—lifting unemployment further—unless private sector employment accelerates really sharply.

  The first two factors are reflected in the relatively rapid growth of the workforce (0.6% YoY in 1997-2003 on average, 1.0% YoY in 2004 and 2005, 1.3% YoY in Q1-2006). The latter two factors will probably ensure that (even with the expected pick up in GDP growth) job growth does not systematically outpace workforce growth in 2006-07. Consequently, I expect pay deals to remain subdued.

  2.  Globalisation: The MPC has repeatedly forecast that the disinflationary effects of globalisation (weak consumer goods prices, sluggish business investment in the UK, high inflows of low-cost migrant labour) will soon fade. And, like many other central banks, this forecast has been incorrect. The same seems likely to happen again. The inflationary effects for consumer goods prices of higher commodity prices are being countered by the decline in labour costs as production shifts to low cost countries. Imports from developing countries (defined as those not in the OECD in 1990, plus Turkey) continue to account for a rising share of domestic demand, and the massive disparities in labour costs between the UK (and other EU-15 economies) compared to Asia and Eastern Europe suggests that this process will continue. As a result, BRC and CBI surveys suggest that consumer goods prices will continue to fall.

  3.  Self-stabilising price-setting: In my view, a key pre condition for inflation to be self-stabilising at around the inflation target is that (as well as having inflation expectations close to 2%) the growth of nominal GDP and nominal domestic demand should be roughly consistent with trend real growth plus target inflation. If these conditions are satisfied, then inflationary effects from swings in commodity prices will probably be balanced by either weak real growth or weakness in other costs.

  The Governor highlighted the importance of nominal aggregates growth in a speech in October 2003. In practice, since MPC independence, nominal GDP growth has averaged 5.2% YoY, while CPI inflation has averaged 1.4%. But, while nominal GDP growth is picking up, it remains quite low at 4.4% YoY in Q1. With such a pace of nominal GDP growth, the risks are that inflation will stabilise below 2%. Nominal GDP would need to accelerate quite strongly before it could pose a lasting risk of above-target inflation.

  4.  Q2 CPI Data Core inflation remained subdued in April, at 1.3% YoY. It is early days but, even with the further effect of rising gas prices, my forecast is for Q2 CPI inflation to average 2.1% YoY, 0.2% below the May IR forecast. That would be the biggest undershoot since Q2-2003 and should to an extent assuage the MPC's worries that the economy has become more inflation prone


  The Inflation Report has an intriguing two-page box on "excess money growth". The Report warns "broad money growth is currently well above its equilibrium rate. That excess money growth could indicate building inflationary pressures." The Report shows an apparent close link from "excess broad money" to MPC policy rates. It is not clear to what extent this measure of "excess broad money" is incorporated into the MPC's base case for growth and inflation. Nevertheless, the emphasis on money is greater than in earlier IRs.

  Analysis of money and credit should be an integral part of the MPC's forecast. However, in practice, the MPC's estimates of "excess money growth" are virtually identical to the contribution to broad money growth from deposits held by "Other (ie nonbank) financial institutions" (OFIs). OFI deposits in March (latest data) rose 24.4% YoY, adding nearly 4% YoY to M4 growth. Broad money growth excluding OFI deposits is 8.6% YoY, close to the BoE's view of "equilibrium" money growth, and actually slowed slightly in March.

  So, the MPC's warnings on "excess broad money" really boil down to a warning that rapid growth in OFI deposits has inflationary implications. However, there has been ample previous BoE research on links from the sectoral split of M4 to spending. [10]This has concluded that household deposits are a good guide to consumer spending, deposits held by non-financial companies are a good guide to business investment, and that OFI deposits are less useful, with only a loose link to business investment.

  This lack of a close link to the economy is not surprising. OFI deposits largely reflect deposits held by securities dealers, hedge funds, life assurance funds and pension funds. These recently have risen rapidly. These deposits are either savings held on behalf of others, or deposits held against other debts and assets. In either case, there is little or no direct link to the real economy. There could be an indirect link via strong growth in OFI deposits to strong increases in equity prices and hence to business investment and consumer spending. But, the trend in equity prices is already a key input to the MPC's forecasts for investment and consumer spending. The BoE will need to overturn its previous thinking if intends to establish an extra role for "excess money growth" in its inflation forecast. Otherwise, this worry about "excess money" is double-counting, which exaggerates upside inflation risks.


  To some commentators, Walton's vote for a hike at the May meeting is a precursor to a generalised vote to hike led by the Governor in the next few months. I do not view this sequence as inevitable or, given economic prospects, likely.

  First, the notion that minority votes to hike almost always lead to a majority does not hold. Indeed, to be bean-counterish, of the six Inflation Report meetings (before May 2006) when a minority voted to hike rates, rates rose in the next three months on one occasion, fell twice and were unchanged three times. After those six IR meetings, the next rate move was up twice, down four times. Similarly, while easing in 01/02, 2003 and 2005 was preceded by minority votes to ease, Nickell's recent votes for easing have not (so far) been the precursor to easing.



Voting for
A Hike
Policy Rate
Change Next
Three Months
Feb 984 (out of 8)0 +25bp (four months later)
May 984 (out of 8)+25bp +25bp (one month later)
Aug 981 (out of 8)-75bp ¸25bp (two months later)
Aug 004 (out of 9)0 -25bp (six months later)
Feb 051 (out of 9)0 -25bp (six months later)
May 051 (out of 9)-25bp -25bp (three months later)
May 061 (out of 9)na na

  Second, Walton is not an activist outrider for the rest of the MPC. The difference between his rate vote and the majority is not just a tactical issue of whether to hike sooner or later. The key difference is one of judgement over the economy's prospects. Walton expects growth to exceed the MPC's base case, thanks to buoyant exports and investment. In turn, he expects faster growth, an apparent slowdown in trend productivity, plus gains in inflation expectations and import prices, to lift inflation above the MPC's base case (and target). The rest of the MPC do not share that economic view: it is unsurprising that they are more cautious on rates.

May 2006

4   Last week, we tried to work out the BoE's growth forecasts from charts in the Inflation Report, and our calculation was a little too low. The MPC only publishes the exact numbers a week after the IR. Apologies for any confusion. Back

5   See speech to Association of Corporate Treasurers, 19 May 2006. Back

6   Core inflation is defined here as the CPI excluding food, drink, tobacco and energy products. Back

7   See Tucker's speech at the Chicago Business School, 25 May 2006. Back

8   See speech to the BoE Central Southern Agency, 18 May 2006. Back

9   These figures exclude repeat approvals for the same people. Back

10   See, for example, "Money, lending and spending", BoE Quarterly Bulletin, May 2002, "Money and Credit in an Inflation Targeting Regime", BoE Quarterly Bulletin August 2003, "Other Financial Corporations: Cinderella or ugly sister of empirical monetary economics? ", BoE Working papers No 151, 2001. Back

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