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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