Memorandum submitted by Professor Sheila
C Dow, University of Stirling
1. The inflation projection in the February
Report shows the central CPI projection to follow a remarkably
steady path along 2% to the end of the two-year horizon, and beyond
up to 2009. This is based on market beliefs about future interest
rates which likewise show a remarkable stability around 4.5%.
2. This inflation stability masks two opposing
trends which are judged to offset each other: the effect of continuing
spare capacity both on prices and wage settlements on the downside,
and rising energy costs and import prices on the upside. There
is also instability in the GDP growth forecast, which shows a
continuing upward trend during this year, before levelling off
around 2.5%.
3. This combination of forecasts raises
questions about the capacity for inflation to remain steady while
output is showing such strong growth over 2006. It is suggested
that there is sufficient spare capacity for this growth to be
non-inflationary. But, while it is argued that the deflationary
effects of spare capacity will be offset by rising energy and
import prices, creating the stable outcome, the uncertainty surrounding
the timing and effects of the two factors compounds the uncertainty
attached to the forecast. (Less favourable timing could create
a more unstable inflation pattern.) But the amplitude of the fan
chart is based on past errors, so cannot capture new sources of
uncertainty.
4. The growth forecast itself is also controversial.
The core forecast is for growth to rise to an annual rate of 3%
over the year. This is based on expectations of strengthening
consumer demand and reasonable total investment demand. The evidence
on consumption is however mixed. For example Chart 2.2 shows marked
differences in retail sales measures from the ONS and from the
Bank's own Agents (who are probably better able to capture the
real situation, given the range of types of evidence on which
they can draw), and these differences have been evident in a range
of other sources reported in the media. The fact that private
sector investment has been relatively weak (investment growth
primarily reflects public sector investment) does lend support
to the view that consumption demand is not perceived by producers
as buoyant.
5. Particular attention is paid in the Report
to the global rise in liquidity (Box, page 5), as well as to the
rise in monetary aggregates in the UK (Chart 1.5), on the grounds
that this could presage a trend to higher inflation if surplus
liquidity were spent (directly on goods and services, or indirectly
through wealth effects if spent on assets whose prices would then
rise). But the direct connection between monetary aggregates and
future inflation is highly contestable. On the one hand, it may
be felt that, while spare capacity can fend off an increase in
inflation as growth rises to 3%, there is not enough to accommodate
further growth in demand when money balances are released. On
the other hand, we would expect private sector investment to increase
if aggregate demand to increase, thus creating new capacity. The
important thing is to understand why both the demand for liquidity
and its supply have been rising.
6. The desire for liquidity stems from an
expectation that asset prices will fall (speculative demand) or
from a lack of confidence in asset price expectations (precautionary
demand). Any strengthening of the view that asset prices are too
high, or any further reduction in confidence in expectations,
would further increase the demand for liquidity, which would in
itself contribute to a fall in asset prices.
7. There has been widespread discussion
of the fact that asset prices are currently relatively high, and
yields low. It is suggested (Box, page 7) that low yields may
reflect a reduction in the risk premium, and one possibility is
that there has been a lack of appreciation of exposure to risk
(as tends to happen with the development of new products, like
credit derivatives). If this is the case, then the consequences
would be increased financial fragility, and the danger of a rapid
spread of asset price falls as defaults spread. Thus a turnaround
in asset prices would not necessarily encourage asset purchasesindeed
it could further encourage the preference for liquidity.
8. There is also the question of the source
of liquidity. Bank deposits generally come into being as the counterpart
to bank credit; and expansion of monetary aggregates therefore
implies an expansion in lending, something which is determined
by the banking system. The high current levels of liquidity reflect
past lending behaviour by the banks. If there were to be a weakening
of asset prices, and if this were accompanied by increased defaults
on loans, then banks would be less willing to lend, and the supply
of liquidity would fall back, at a time when demand for it could
be rising further, putting upward pressure on interest rates.
This would be the classic economic downturn scenario, accompanied
by weakening spending as household asset values weaken and investment
and employment prospects deteriorate.
9. This picture may be overly pessimistic,
but to assume that any weakening of asset prices would encourage
more expenditure on assets, and goods and services, would be overly
optimistic. There is uncertainty as to which direction the economy
will take, and the high holdings of liquidity are to some extent
a barometer of that uncertainty.
10. Two recent speeches by MPC members have
focused on addressing both the demand and supply conditions underlying
monetary policy. Stephen Nickell made a speech in January on "Monetary
Policy, Demand and Inflation" which emphasised the need to
consider aggregate demand in relation to supply (ie the output
gap, or the gap between actual and potential output). Indeed the
February Minutes reveal that he argued for a rate reduction on
the grounds that demand was now weak enough relative to capacity
that there was little inflationary pressure. David Walton also
spoke about the output gap in a speech last week on "Has
Oil Lost the Capacity to Shock?". He argued that, while the
effect of oil price rises was limited by a variety of factors
(not least the credibility of monetary policy), there could be
an inflationary effect through their effect on capacity: producers
might be holding back from investment due to uncertainty about
the outcome of energy price rises. His primary concern was with
the effect on capacity, but weak investment also has implications
for aggregate demand, such that the output gap could continue
to be present as demand weakened along with supply.
11. There is a general question, raised
by use of the output gap concept, about the extent to which demand
and supply are interdependent. If they are, then the relationship
between the output gap and inflation is a weak one. There is also
more scope for the economy, and monetary conditions, to be unstable.
Uncertainty on the part of producers encourages a holding-back
on investment plans (and a stock-piling of liquidity), which in
turn reduces demand for other producers and employment. The output
gap (and thus inflationary pressure) may not change, but the level
of output and employment may change.
12. Some might argue that the output gap
concept should therefore not be used for designing monetary policy
for inflation control (rather than economic stability). But it
can be argued that economic stability and monetary stability are
also interdependent. Uncertainty about asset prices (as part of
general uncertainty about economic conditions) can encourage a
building up of liquidity, which puts upward pressure on interest
rates, which discourages investment, weakening output and employment,
and discouraging bank lending. Here again supply and demand (for
liquidity) are interdependent, creating instability.
13. Do these speeches presage an explicit
discussion of the output gap in the Inflation Report? It would
be helpful to have a discussion in the Report at least of the
meaning and measurement of the concept and its relative usefulness
in monetary policy-making. But if indeed the output gap plays
an important part in MPC thinking, then some explicit indication
in the Report of the estimates used would help market understanding
of monetary policy.
February 2006
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