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. 
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. 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
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
The more fundamental point is whether core inflation
will really rise as much as the MPC expects, with either forecast
for GDP growth2.5% 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
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).
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 risemore
or less spontaneouslyto 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
In Walton's case at least, a view
that last year's slowdown in productivity growth implies that
trend economic growth has slowed. 
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
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.
TABLE OF SURVEYS ON UK HOUSEHOLD INFLATION
BoE/NOP (Year Ahead)
|YouGov/Citigroup (Year Ahead)||na
|YouGov/Citigroup (Longer Term)||na
|EC/Gfk (Index for year ahead)||19
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. 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 perioda
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
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
growthlifting unemployment furtherunless 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.
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.
INTEREST RATE CHANGES AFTER PREVIOUS INFLATION REPORT
MEETINGS WITH MINORITY VOTES TO HIKE
|No Of MPC|
|Feb 98||4 (out of 8)||0
||+25bp (four months later)|
|May 98||4 (out of 8)||+25bp
||+25bp (one month later)|
|Aug 98||1 (out of 8)||-75bp
||¸25bp (two months later)|
|Aug 00||4 (out of 9)||0
||-25bp (six months later)|
|Feb 05||1 (out of 9)||0
||-25bp (six months later)|
|May 05||1 (out of 9)||-25bp
||-25bp (three months later)|
|May 06||1 (out of 9)||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
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
See speech to Association of Corporate Treasurers, 19 May 2006. Back
Core inflation is defined here as the CPI excluding food, drink,
tobacco and energy products. Back
See Tucker's speech at the Chicago Business School, 25 May 2006. Back
See speech to the BoE Central Southern Agency, 18 May 2006. Back
These figures exclude repeat approvals for the same people. Back
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