Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor Anton Muscatelli, University of Glasgow



  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" during 2006.

  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 met.

  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.


  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.

February 2006

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