Memorandum submitted by John Butler, HSBC
1. The February Report, like previous Reports,
provides the MPC with an opportunity to explain how their views
concerning the outlook and risks have changed. This note identifies
some of the key changes and raises some questions and a few concerns.
STILL OPTIMISTIC
ABOUT ECONOMIC
RECOVERY
2. As usual the Bank of England remains
optimistic about the GDP outlook, while their best guess is that
inflation would remain at target. Any other message and the obvious
question would be "why had they not adjusted interest rates
accordingly?". The central projection had annual growth at
or above trend throughout the forecast horizon, while CPI inflation
was expected to be at 2.0% hereafter. That price stability seems
to sit a little oddly with the recent volatility in inflation,
as CPI inflation has ranged from 0.6% to 2.5% since 2002.
3. The MPC also introduced in the February
Report a downside risk to GDP growth but still thought the risks
to inflation were broadly balanced. A healthy economic recovery
and stable inflation seems an extension of the nice period—a
period of non-inflationary consistently expansionary economic
growth. The Governor has frequently argued that the nice period
is "unlikely" to be repeated (see speeches 14 October
2003 and 11 October 2005). A general concern, therefore, is that
the Inflation Report, almost through construction, needs to send
a message that normal service has been resumed but that theme
does not seem to capture the most "likely" scenario
of some individual members.
ECONOMY TO
REMAIN UNBALANCED
4. Although the Committee's central projection
for GDP in February was little different from that published in
November, the source of the expected recovery changed. The November
Report predicted an investment and export-led recovery and the
theme of that Report was that the rebalancing of the UK economy
was underway. The February Report struck a different tone. The
Committee seem less confident about a "firm" investment
recovery and, instead, the recovery has fallen back on the consumer,
a shift that may have been influenced by the performance of the
economy in the final quarter of 2005.
BACK TO
THE CONSUMER
5. Interestingly the Bank's recent more
upbeat assessment of consumer spending comes against a background
in which employment is falling at its fastest pace since the previous
recession and disposable income growth has been squeezed, which
is partly a reflection of higher energy costs, as the Report itself
shows. The key driver of consumer spending in the Bank's latest
forecast appears to be higher estimates of household wealth, derived
from the renewed strength in house and equity prices. Yet that
link between wealth, asset prices and consumer spending has been
questioned in recent years, not least by the Bank of England itself
in past Inflation Reports. I would have two major concerns regarding
this shift in emphasis.
6. First, on housing, previous Inflation
Reports had argued that the link between rising house prices and
consumer spending was less powerful than in the past. The evidence
used to support that argument was a 10-year rolling correlation
between annual house price inflation and consumer spending growth.
That correlation had fallen sharply implying that the consumer
was less vulnerable than in the past to a housing market correction
and that households' balance sheets had not deteriorated as equity
withdrawal had been saved rather than spent.
7. Updating the correlation between housing
and consumer spending shows a similar result. So it seems there
has been a major shift in Bank analysis over the past year such
that rising house prices are now seen as a major driver of a stronger
consumer story. Has the Bank of England backed away from its previous
analysis or do members of the MPC believe the linkages between
housing and consumer spending will be renewed? In addition, basing
a stronger consumer outlook on the fact house prices have rebounded
seems to suggest the Bank of England is more confident that current,
and potentially higher, housing valuations are sustainable. Is
that the general consensus on the Committee?
8. Second, on equities, the experience since
the year 2000 seems to support the view that the link between
equities and consumer spending is not as great as forecast models
would suggest. Consumer spending, for instance, seemed to have
reacted little to the equity market crash. That is probably a
reflection of the fact few households owned equities directly
and that households are not inclined to adjust current spending
habits in response to a drop in the value of their pension holdings.
Since 2000, even fewer households own stock either directly or
indirectly (through pensions) so the linkages between consumer
spending and equities are even less clear.
9. In short, the Bank's renewed optimism
on the consumer appears to be based on channels in which higher
asset prices boost households' perceptions of their wealth or
provide households access to cheap finance. However, recent experience
and previous research suggest those links may be less powerful
than in the past, which in turn raises some major question marks
about the ability of the consumer to drive the economy again.
LOSING MARKET
SHARE
10. The Inflation Report also includes an
interesting chart that shows that the UK's export market share
has fallen sharply since 1996. The MPC expect that trend to continue,
albeit at a slower pace. The Bank offers some explanations for
this downward trend, such as greater competition from emerging
markets or the rise in sterling in the late 1990s. However, it
would be interesting if they could elaborate more on this worrying
feature of the UK economy. For instance, has the UK export share
fallen faster than in other G7 economies? If so, what does that
reflect? What weight would the MPC place on low productivity as
an explanation or is it symptomatic of an overvalued exchange
rate? It is worrying that the UK trade deficit has widened in
a background in which domestic demand has slowed.
11. Overall, the most interesting element
to this Report is the shift in emphasis away from investment and
exports back to consumer spending based on the role of higher
asset prices. I believe the risks to this outlook are on the downside,
that the consumer has not yet passed the worse, and that the recovery
in investment and exports will be muted. If that set of circumstances
develops, the downward pressure on inflation should intensify,
allowing interest rates or sterling or both to drop later in the
year.
February 2006
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