Select Committee on Treasury Minutes of Evidence

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.


  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.


  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.


  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.


  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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