Memorandum submitted by Professor Anton
Muscatelli, University of Glasgow
BANK OF ENGLAND INFLATION REPORT, FEBRUARY
1. The Bank of England's Inflation Report
for February 2006 shows some important changes in the MPC's assessment
of the UK economy's prospects over the next 12 months.
2. Since the November Report CPI inflation
has fallen back towards the 2% target as anticipated in the MPC's
central projection (cf. p 36 of the February Report, Charts 5.3
and 5.4). However, the MPC feels that some of the short-term uncertainty
surrounding the impact of higher energy prices has been reduced.
Hence the fan chart for CPI inflation has become "tighter"
3. Also, since the November Report, the
MPC's central forecast for GDP growth has firmed up in the short
term (cf. p.32 in the Report, Chart 5.1). This has been largely
driven by the improvement in domestic demand in the UK, fuelled
by consumer spending and government investment. In contrast, business
investment remains soft, and net trade made a negative contribution
to UK growth in 2005 Q3, but has recovered in GDP Q4 data published
since the February Report.
4. The key issues for the MPC appear to
be the following. The immediate dangers of `second-round effects'
by which higher energy prices might feed into inflationary expectations
and wage settlements appear to be receding. Although this might
ordinarily have allowed a further (and final, in the current cycle)
reduction in the Bank's official interest rate, the strength in
domestic demand (except business investment) has probably convinced
the majority of the MPC that GDP growth will remain sufficiently
strong in the short to medium term to allow output to move into
line with potential output, allowing the inflation target to be
5. However, the situation in terms of the
UK's potential or trend rate of output growth seems more uncertain.
Business investment has been weakening throughout 2005, despite
lower real interest rates. This may simply be a reaction (with
a lag) to the weakening economic conditions in 2004-05, but we
might also be witnessing the impact of higher energy prices not
being passed onto consumers, and depressing business profitability.
This makes the medium-term scenario more complex for the MPC.
Their assessment of the path of potential output over the latter
part of 2006 and 2007 will be the key to determining the extent
to which interest rates can continue to be maintained at current
levels. The extremely flat yield curve at the short end of the
money market (cf. February Report, p 33, Table 1) probably reflects
this (balanced) uncertainty on inflation over the next 2 years.
6. In this note we focus both on the short-term
prospects for domestic demand, and the medium-term impact of higher
energy prices. We consider some of the main risks facing the MPC
as it considers its policy stance during 2006.
FOR UK GDP
7. At the time the February Report was written,
real GDP figures for 2005 Q3 showed a 0.4% increase over the previous
quarter. Since the publication of the Report, this has been revised
upwards to 0.5% (mainly due to an upward revision within services).
More significantly, the figures for 2005 Q4, released later in
February, show that the MPC's expectations of a continuing recovery
in consumer expenditure were fully validated.
8. The first release of 2005 Q4 GDP data
shows an increase of 0.6% over the previous quarter, with GDP
1.8% above its level a year previously.
9. It is interesting to note that, within
this GDP figure, consumer spending continued to recover, rising
by 0.7%. After a poor quarter in 2005 Q3, highlighted in the February
Report (p 16), UK net trade once again made a positive contribution
to UK GDP growth, with net exports in goods and services increasing
by 0.8%. Government expenditure also continues to make a significant
contribution to the UK recovery, with an 0.8% increase on the
previous quarter, 2.8% above the level in the previous year.
10. The weakest element of domestic demand
continues to be business investment. As noted in the February
Report, in 2005 Q3 business investment only rose by 0.3%. Business
investment actually fell by 1.0% in 2005 Q4.
11. The latest data shows a rather mixed
picture for the MPC. On the one hand, world trade growth and the
recovery in consumer expenditure (together with the planned UK
fiscal expansion) are helping to ensure that GDP growth recovers
as expected. However, business investment has moved from being
"lacklustre" (February Report, p 14) to decidedly weak.
Already in the previous quarter the Bank had pointed to a weakening
in corporate liquidity, if one focused only on non-oil companies.
Given the recent evidence on prices, there are grounds to believe
that the recent energy price increases are being absorbed by companies.
12. The weakness in business investment,
whatever its cause, may pose greater problems for the MPC in the
medium to long-run as it depresses the competitiveness of the
UK economy and its potential output growth. In terms of managing
demand, as long as there are no unexpected reverses in consumer
spending in the next few months, it is unlikely that the MPC will
wish to change its policy stance.
13. In my written evidence to the Treasury
Select Committee following the November Inflation Report I highlighted
the fact that the most significant aspect of the current oil shock
is that it had not had "second-round" effects by raising
wage and price pressures. Above we have already seen that one
impact of the low pass-through to prices may have been that of
(temporarily) depressing company profitability.
14. The latest data on the three-month average
earnings index to December 2005 was 3.8% (including bonuses),
the same level reported in the February Report for the three month
average to November 2005. Hence there is no evidence as yet of
any impact of higher domestic energy costs on average earnings.
Although the next three months will be crucial, it does appear
at this stage that the increase in oil prices and the spike in
gas prices are being absorbed by firms and households.
15. The absence of a pass-through from oil
and energy prices to prices and wages is less surprising than
may first appear. There are a number of explanatory factors. First,
the new monetary policy framework in the UK and many other economies,
which through central bank independence and inflation targeting
has ensured that inflation expectations are firmly anchored. Second,
the fact that both UK firms are less dependent on oil and energy
than they were in the 1970s and early 1980s, and UK households
spend a smaller proportion of their total income on fuel and energy.
Third, the fact that labour and product markets are more flexible
in the UK than they were at the time of the two major oil shocks,
ensuring a lower degree of pass-through. Fourth, the relatively
smaller size of the current shock in real terms. Finally, the
fact that the economic cycle was more volatile in the 1970s and
early 1980s which made it more difficult to manage a supply shock
which was superimposed on an already difficult conjunctural situation.
16. One key issue for the MPC will lie in
assessing the impact which the energy price increase might have
on the growth rate of potential output. Although oil price futures
do not show any expectations of major increases, and indeed may
suggest a slight decline, the price of oil is sensitive to political
instability. In addition, there are concerns about gas wholesale
prices. We recently experienced a major price spike, which could
be repeated in future.
17. The major risk for the UK economy lies
in the possibility that energy price developments reduce the trend
growth rate of investment and potential output. (It is worth noting
that labour productivity growth has recently been declining, although
there are difficulties in disentangling cyclical effects in this
data series). This would not have an immediate impact on MPC policy
as at this point in the economic cycle the MPC will not have concerns
about potential supply (cf. p.20-22, February Report). However,
there would be an impact on the extent to which the economic recovery
predicted during the latter part of 2006 and into 2007 (cf. Chart
5.1, p.32, February Report) will require interest rates to rise.
18. The other major area of uncertainty
is the extent to which world trade will continue to grow on its
current path. I discussed this fully in my written evidence to
the Treasury Select Committee following the November Report and
will not repeat this here, except to observe that there has been
further tightening of monetary policy in the US and the Euro-zone.
19. The period since the November Inflation
Report has seen a consolidation of the initial recovery in domestic
expenditure and GDP which has ensured that, on current projections,
the MPC has kept interest rates on hold. Although there remain
downside risks on the short-term path of domestic demand, the
greater risks to policy relate to the path of potential output
over the medium term ie the next 18-24 months. The recent continuing
decline in business investment and productivity may, if confirmed
by future data, represent the major risk to policy. The current
projected recovery in GDP growth (over 3% in the MPC's central
forecast for early 2007) might not be consistent with the growth
of potential output in the UK.