Memorandum submitted by Professor Danny
Quah, London School of Economics
THE FEBRUARY 2006 BANK OF ENGLAND INFLATION
The Bank of England's February 2006 Inflation
Report makes the case that, should fundamentals remain unchanged,
over the next two years the (greatest probability) modal outcome
1. inflation remaining on track at 2% and
2. output growth rising to a high of 3% in
late 2006 before easing to 2½% in 2007.
The 90% confidence region is symmetrically distributed
around this mode, increasing gradually to around 2 percentage
points in either direction by two years out. Given this, it is
unsurprising and well-justified how the Bank has kept interest
rates constant at 4.5% for December through February.
This nice outcome has emerged from a conjunction
of two sets of opposing forces. On the one hand, somewhat unexpectedly,
relatively weak business investment (not just in the UK but in
most of the West) and significant increases in global oil and
energy prices have not perturbed a stable UK growth and inflationary
equilibrium. On the other hand instead, positive factors-strong
domestic consumption demand, robust service sector output, a somewhat
resurgent housing market, subdued pay pressures-have dominated.
Such a delicate balance of forces guides our
attention to possible future risks. Any change, either strengthening
or weakening, on one side of this mix can disturb the current
outcome. The Inflation Report discusses some obvious risks, with
great depth and clarity. Here, I seek clarification on three others,
that I feel might be usefully expanded on from what's already
in the Report.
The US term structure of interest rates has
threatened to invert for several months now, to some journalistic
fanfare on its economic significance. Popular view and weak statistical
evidence has it that an inverted yield curve presages economic
downturns. On the other hand, the UK term structure has already,
quietly, gone ahead and inverted (and, indeed, has been inverted
for years now) [p 6 of the Inflation Report, and that today below].
One reason observers find this inversion interesting
is that some evidence (not absolutely ironclad but then not casually
dismissed either) suggests its predictive power for economic downturns.
The relation in the US is illustrated in the following graph:
(In regressions, other variables outperform
the yield curve spread for predicting output growth [Ang, Piazzesi,
and Wei, 2006]. The Chart is meant only to be suggestive.) Practically
every time the term structure rotates sharply clockwise, recessions-the
shaded vertical bars-follow.
I cannot tell from the February Inflation Report
if this enters the MPC's current thinking or how this relation
has been dealt with. Perhaps it needn't be considered now, but
some (ongoing) clarification might be helpful. On the other hand,
the Bank's analysis [pp 4-7] of why, internationally, long-term
interest rates are so low is certainly insightful and, to my mind,
correct. But then put these two ideas together. Let long yields
indeed be determined by some combination of global savings (from
East Asia and the oil-exporting economies), a reduction in long-term
risk and risk premia, and global pension funds' demand. Let short
yields, subject to very small adjustment, be fixed by monetary
policy. This then explains the inverted yield curve. It does not,
however, say that that curve's predictive relation for future
output growth has changed, that "things are different this
time." Indeed, the Inflation Report's own analysis of the
possible unwinding of long rates provides a description of how
a recession and deflation might indeed occur as a result.
I suppose the question then is, is the MPC's
analysis of low long-term interest rates already sufficient for
evaluating the MPC's prediction of inflation and growth prospects?
Or does the inverted yield curve contain further information that
might be usefully exploited? Has the MPC done so explicitly?
To repeat, the MPC's concern is inflation, not
output growth and not recessions. But in the short run these macroeconomic
variables are usually statistically related, and output stability
does enter the ancillary part of the Bank's remit.
2. GLOBAL IMBALANCES
Longer term and more generally observers have
noted for a while now the large global anomaly of poorer economies
saving to send capital to the richer economies. Typically, this
is the concern of real-side analysis of longer-term economic growth,
not of shorter-run monetary policy. And, of course, plausible
explanations of these global capital flows abound.
The link from those flows to more immediate
inflation and growth outcomes, in most of the Western economies
not just the UK, turns on what might happen to the US dollar and
its current account deficit, should the current global situation
reverse or, put bluntly, should global savers stop investing in
Such concerns are implicit in the MPC's analysis
of the impact of external trade, long-term interest rates [as
described in 1. above], and so on. All that analysis is rigorous
and compelling, taken on its own. I wonder, however, if thinking
about global imbalances and their possible unwinding have been
factored in sufficiently. I'm not sure how I would formalize this.
Since nothing has happened yet, any econometric or statistical
reasoning runs into a version of the so-called "peso problem".
But I would like to know how the MPC and the Bank have thought
3. GLOBAL LIQUIDITY
International observers have remarked how the
global economy's successful recent growth performance is akin
to an airliner, flying on just one engine, namely the US economy
and its consumers. The situation, in the minds of these observers,
In this regard, Chart A. on p 5 is striking.
It is the Euro area's broad money contribution to global liquidity
that is by the largest. The US, by contrast, barely shows, while
Japan despite remaining the world's second largest economy and
trying its hardest to pump liquidity into the system provides
a contribution less than half that of the Euro area's.
Perhaps that global economy airliner is using
more than just one engine. Or, alternatively, perhaps the risk
of global imbalances unwinding is more profound and pervasive
than everyone had previously thought.