Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor Sheila Dow, University of Stirling

  1.  Inflation is projected to approach the 2% target in two years, based on market expectations that the repo rate will continue to be around 4.5%. This compares with the August projection, which was for inflation to be comfortably above 2% by then; but then that projection was based on market expectations of a fall in the official rate.

  2.  The weaker inflation projection is consistent with a weaker projection for output growth than in August, again reflecting among other things a market expectation that the official interest rate will not fall over the period. But the projected growth may still be overoptimistic, given the various indicators of weakening demand, and falling productivity. Indeed many commentators judge this growth forecast still to be optimistic; if they are right, then, other things equal, inflation will end up below the 2% target in two years.

  3.  The precise details of the inflation forecast are clearly important for market expectations, for example whether the core forecast is expected to be above or below the 2% target in two years, since this is taken as a signal for a rise or fall, respectively, in the repo rate. This forecast is now for CPI rather than RPIX. The change is addressed again in the November Inflation Report, which includes a discussion of how the difference between the CPI and RPI (NB not RPIX) has behaved (pp 29-30). Steve Nickell also returned to the issue in a speech in September to the British Academy.

  4.  The fact that the target for CPI was 2% rather than the 2.5% RPIX target meant a loosening of monetary policy, since the average difference between the two (in terms of the "formula effect" and the inclusion of house prices in RPIX) was about 0.8%. Otherwise it has been presented as neutral for monetary policy, which is addressed to the actual inflation experienced in the economy, for which these measures are only proxies. But there were other differences between the two series due to other differences in weights and coverage which mean that this 0.8% difference is only a long-term average. Chart 4.8 (p 27) shows that the weights and coverage differences have actually been eroding the wedge between the CPI and the RPI over the last two years, implying that monetary policy is actually becoming tighter. It should also be noted that these additional differences reached 1% earlier this year, and are still close to 0.8% (Chart B p 29). This is a huge difference relative to a 1% inflation target, where markets are sensitive to much more minor changes in forecasts. There is some inconsistency between, on the one hand, arguing that, as Nickell suggests, the change in measure has had "minimal effect on monetary policy" and, on the other hand, presenting the forecast by one measure in such a precise way as in the fan chart, when the fan would look quite different for different measures. Further, has the Bank's core model been recallibrated for the change in measure used?

  5.  The comparison in this Inflation Report has been between CPI and RPI, not RPIX (ie RPI excluding mortgage interest payments). The comparison at the foot of p 27 is between CPI inflation rising from 1.1% to 2.5% over the year to September 2005, as against RPI inflation falling from 3.1% to 2.7%. But RPIX inflation rose from 1.9% to 2.5%. This highlights the cost role of mortgage payments, such that a fall in mortgage rates has a significant impact on inflation measured as RPI. This can also be seen from the yellow portions of Chart A, p 29. While a rise in mortgage rates now would not show up in CPI, it would nevertheless add to household (and corporate) costs.

  6.  Financial instability does not appear to be regarded by the MPC as a significant threat. The next Financial Stability Review is not due until December, and there may then be a review of this stance. But a survey is reported (p 7) which concludes that, while there has been a small rise in financial pressure on households, most are experiencing no difficulty in servicing their debt. But the June Review noted developments, such as rising debt write-offs and insolvencies, for which the Inflation Report provides evidence of continuation. These require attention, given the scale of outstanding household debt. Mortgage repossessions have been rising, as has the incidence of personal insolvency (although that is due in part to regulatory change). Net lending to individuals has been falling, and effective borrowing rates on unsecured debt rising relative to the repo rate. A major element here must be a growing reluctance on the part of lenders to extend credit where the risk of default is now seen to be higher than before, as much as a reduced willingness on the part of households to add further to their debt. The effect of reduced availability, and increased cost, of unsecured credit will affect mostly those households with greatest risk exposure, which need to continue borrowing to meet debt service payments. The weakening of demand for borrowing will be most evident among those households with scope to reduce expenditure (on consumption and assets) in order to service their debt.

  7.  The argument that the scale of debt will not in the future pose financial stability problems is (a) that a high proportion is secured by property and (b) that the growth in debt has proceeded alongside a growth in household holdings of financial assets. Any problems with servicing the debt then can be resolved by the sale of assets. In fact this indicates the fragility of the financial structure. The housing market seems to have stabilised and the stock market is reasonably strong. But were there to be any development which increased the need to liquidate holding of these assets to meet debt commitments on an economy-wide scale, then these markets would weaken and could indeed go into marked decline, increasing the risk exposure of borrowers and lenders. This heightens the importance of avoiding increases in the repo rate as a central factor in the ability of households to continue to service debt (along with the growth in income). The June Financial Stability Review drew attention to the excess liquidity of the banks, which should provide protection from bad debts. But for the banks any significant fall in the value of collateral and/or a large increase in bad debts could also prove problematic.

  8.  The scope for markets to vary cyclically is an important element in the argument that short-term movements can bring about outcomes which have long-term consequences. Thus anything which increased financial instability in the short-run could bring about an increase in debt default and an associated downturn in asset markets, and thus in aggregate demand. There has been debate as to the existence of the business cycle, as well as to the appropriate response to it. But the Governor of the Bank of England stated (in a speech to the North-East CBI in October) that "the business cycle has not been abolished, although monetary policy can affect its amplitude". This suggests a recognition that monetary stability and financial stability are not independent, and thus that the MPC should be paying attention to asset prices.

21 November 2005

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