Memorandum submitted by Professor Anton
Muscatelli, University of Glasgow
INTRODUCTION
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.
THE INFLATION
FORECAST
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.
THE MPC'S
POLICY STANCE
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.
DOWNSIDE RISKS
ON FUTURE
GDP GROWTH
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.
IMPLICATIONS FOR
THE MPC'S
POLICY STANCE
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.
CONCLUSION
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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