Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor Anton Muscatelli, University of Glasgow


  1.  The latest Bank of England Inflation Report presents some minor changes in the Bank's forecast for inflation compared to the August 2005 report. In contrast, the Bank's GDP projections based on market interest rate expectations show very little change. The main interest in the report lies in the Bank's assessment of the balance of risks for the inflation forecast. On balance, the latest inflation forecast suggests that the risk of inflation rising further above the 2% target is receding.

  2.  This note considers the key economic assumptions behind the Bank's current assessment for inflation. It highlights why, despite a slowdown in domestic consumer demand, the MPC may feel that the scope for further interest rate cuts is limited. The signal on interest rates from this Report is still quite neutral.

  3.  We also consider some downside risks for future GDP growth (on a six to 12 month horizon) which might lead to a reassessment of the Bank's policy stance in the next three to six months. These risks fall under two headings: a potential weakening of world demand and a further weakening of domestic demand. However, we stress that the Bank's ability to respond to any such weakening will be strictly conditional on a continuation of the current relatively benign outlook on the supply-side of the economy.


  4.  CPI inflation has peaked at 2.5% in September 2005, and has fallen back to 2.3% in October. Similar falls have been observed in RPI inflation, and in producer prices. The Bank's inflation forecast two years out (2007 Q4) is now centred on 2%, as opposed to 2.3% in August (cf. p 39, Charts 5.6-5.7 of the November Report). The November Report forecast also shows (cf Chart 5.3, p 38) that the MPC places a relatively low probability on the possibility that CPI inflation will rise again over the next six to nine months.

  5.  The Report also shows that, although subject to some uncertainty, the rise in oil prices during 2005 has had a significant impact on the CPI.

  6.  However, the most significant aspect of the last two Inflation Reports is that, to date, the oil shock has not had "second-round" effects by raising wage pressures. The November Report highlights some of the differences between this round of energy price increases and the experience of the 1970s and early 1980s (cf Boxed analysis on p 19 of the November Report). Some of this might be attributable to labour market reforms, and although formal econometric evidence on this is still lacking, it does appear that the increase in migration inflows in sectors which have seen skills shortages, has helped significantly to moderate the pressure on earnings. It should be stressed that what counts more here is not as much the aggregate net inflow of migrant workers (150,000-250,000 per half year), as the fact that it is will be concentrated in the sectors with the highest excess demand for labour.

  7.  The Bank is rightly cautious about attributing the lack of increased wage pressures to the anchoring of inflation expectations (p 25, November Report). The increase seen in CPI over the last year is probably not sufficiently large or persistent to have tested the credibility of the current inflation targeting regime. Measuring inflation expectations from financial markets or through direct consumer surveys is subject to considerable errors.


  8.  The economy has been experiencing falling domestic demand because of the interest rate increases in 2003-04. The rise in energy prices since last year represents an adverse supply shock, but came at a time when demand (and factor utilisation) was already falling. The evidence to date indicates that both consumers and the corporate sector seem willing to absorb the temporary increase in energy costs through reduced consumption and profit margins. However, the MPC will be cautious about lowering interest rates at a time when there is still some uncertainty on the balance between demand and supply pressures in the economy, and particularly the medium-run response of earnings to higher energy prices.

  9.  Below we argue that, on the assumption that the central forecast scenario for oil prices holds, with relatively stable prices over the next few months, the continued absence of "second-round" wage pressures will allow the MPC some room for manoeuvre should domestic or world demand conditions unexpectedly weaken. Until then, however, the MPC is likely to wish to maintain a cautious "wait and see" approach to setting interest rates, with limited scope for further cuts.

  10.  One point worth stressing on the scope for further interest rate cuts is that what affects domestic demand are real and not nominal interest rates. As a result of the recent increases in inflation (on all measures), both short and long-term real interest rates have been falling during 2004-05 (cf Chart 1.2, p 3 of the November Report). In other words, the MPC's policy during 2005 has been less restrictive than it might have been as inflation has risen. This in part explains why even on constant nominal interest rates the Bank's GDP forecast shows a steady recovery through 2006-07.


  11.  The MPC's forecasts for inflation and GDP growth are predicated on world economic (and trade) growth continuing at a level close to long-term average. A steady growth in world trade is one of the key assumptions which underlies the forecast. With UK consumer spending slowing since 2004, net trade (and in 2005 Q2, investment) has played an important part in maintaining UK real GDP growth.

  12.  How robust is this projection for world trade growth? There might be some downside risks which have not been fully factored in. Real consumer spending in the US has fallen back sharply in the last three months. Despite slightly healthier than expected headline retail sales in October (down 0.1%), this trend might continue. The pressure on consumption spending might be exacerbated by the large increase in natural gas and heating oil costs for US consumers, and by the expectations of future interest-rate increases by the Fed. Similarly, although Euro-area growth has picked up recently (0.6% in 2005 Q3), the ECB are increasingly expected to raise interest rates.

  13.  The general point is that it may be difficult for current forecasts to fully incorporate the impact of increased energy costs on consumer spending, both in the UK and in the world economy. The world economy is experiencing the first substantial and sustained major increase in energy and other imported (materials and metals) since the 1980s. This is happening in a regime in which inflation expectations are steady in the major industrialised economies and earnings growth is under control.

  14.  The recent increase in oil prices has also caused the return of current account imbalances between energy exporters and importers, and this issue has been highlighted in the November Report. OPEC countries, and other major net exporters such as Russia and Norway, have seen major improvements in their current account surpluses. A key issue in understanding the growth rate of world trade will be to understand how this growing trade imbalance will impact on savings and spending at the global level. Again, this is a relatively new scenario in a low inflation world, and the evidence from the 1970s and 1980s may be of limited help in understanding it.

  15.  Two broad scenarios are possible. The first is one in which these current account surpluses are channelled into spending by oil exporters, possibly in investment (eg to build infrastructure). In this case, this will assist growth in the world economy, and world trade (although there are distributional effects between the G7 economies). The second scenario is one in which the additional revenues are channelled into financial assets, thereby increasing world saving. The impact of this will be to reduce real interest rates, particularly in those countries whose assets are held by the oil exporting countries. In this case, the initial impact could be to reduce world trade growth.


  16.  The downside risks outlined above could yet provide an impetus for the MPC to cut rates in the current interest rate cycle, but only if inflation remains under control. In other words, provided that there are no further unexpected surges in energy prices, and provided that earnings growth remains subdued.


  17.  Although inflationary pressures seem to be subsiding, the MPC is likely to retain a cautious stance over the next few months as current real interest rates have fallen, and projected external trade and public sector spending sustain a gradual recovery in UK demand in 2006, keeping demand in line with potential output.

  18.  Throughout this phase, domestic consumer spending may remain weak, but unlike the last expansionary policy cycle in the UK, the current conjunctural situation is not one in which the MPC feels the need to stimulate consumer expenditure further. This is because the current projected GDP growth recovery for the UK is consistent with meeting the CPI target in 18-24 months.

  19.  If any downside risks to external trade occur, due to a slowdown in the world economy, or to domestic consumer or investment spending, due to the delayed impact of rising energy costs (with the benefits of past fixed-price contracts gradually unwinding for UK companies and consumers), the MPC's policy stance may yet have to loosen. But these downside risks are only a necessary, and not a sufficient condition for further interest rate cuts. Before loosening policy further, the MPC would need to be convinced that the risks of any impact on inflationary expectations of the recent inflation increases are definitely receding.

November 2005

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