Select Committee on Treasury Minutes of Evidence

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 purchases—indeed 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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