Memorandum submitted by David Miles, Morgan
Stanley
MONETARY POLICY OUTLOOK—NO CHANGE IN
SIGHT
The Bank of England's quarterly Inflation Report
is the clearest statement of the collective judgment of the Monetary
Policy Committee (MPC) on the outlook for the economy and for
monetary policy. The message from the February report—published
earlier this week—was very clear: at unchanged interest
rates the Bank's best guess is that inflation stays right on target.
Risks of inflation being above or below the target—again
at unchanged rates—are evenly balanced. It would seem to
follow naturally that if the monetary policy committee behaved
in a risk neutral way, so that it was content to adopt a stance
that on average meant the target for inflation was hit, then our
best guess should be for no change in rates. Yet the weight of
market opinion is still that rates are more likely to be cut than
held at 4.5%. To our mind this has led to yields on short dated
gilts all being driven down to levels that are hard to reconcile
with the message in the Inflation Report.
The Bank of England's February Inflation Report
and press conference was consistent with our view that further
rate cuts in coming months are not the most likely path for monetary
policy. Our central expectation is that interest rates remain
at 4.50% through most of 2006 (and we tentatively anticipate a
rate rise in Q4 2006).
If the economy moves in line with the MPC (Monetary
Policy Committee) central projection (of course the chances of
this happening exactly are very small), then there would be no
need to cut rates again: inflation would be very close to the
target rate of 2% for the whole of the next three years.
In this latest report the MPC revised both their
central inflation and growth forecasts. The central inflation
projection (based on "market expectations" for broadly
unchanged interest rates) shows inflation close to the 2% target
for the whole of the forecast horizon. The Bank's central profile
is now flatter than in November's report which showed inflation
dipping below the target and then rising two years out.
They describe risks to their inflation profile
as substantial, but balanced. The Bank continue to ascribe a large
degree of uncertainty to their central projection. On GDP growth
they now see the balance of risks to their central projection
as a little to the downside.
Our central forecasts are not very different
from the Bank's. With GDP growth likely close to potential growth
this year and with unit wage inflation above the 2.0% CPI target
rate, however, our central case remains that a rate rise will
look likely by the end of the year.
The Bank's new inflation forecast is much flatter
than the one in the November Report. This is not a profile which
suggests that the Bank are feeling complacent on risks to inflation,
rather that the path remains quite uncertain but that the risks
are evenly balanced. The Bank see the main risks as being the
outlook for growth, the margin of spare capacity (energy prices
may have shrunk potential supply) and the evolution and effect
of energy prices. On the latter, the Bank point out that while
there is a direct impact on inflation from higher energy prices,
the indirect impact can be positive or negative. Pricing pressures
can build along the supply chain as input prices rise or companies
may squeeze other parts of their cost base, eg wages.
The Bank's central projections for inflation
assuming unchanged rates look somewhat similar to our own, though
our central profile is a little more volatile. On growth, the
Bank remain, if anything, a little more optimistic than us, though
our estimate of potential growth is likely to be a little lower.
Nevertheless, if the economy evolves in line with either set of
central forecasts, a rate cut does not seem the most likely outcome.
Many commentators continue to stress that what
might appear to be weak consumer spending figures suggest a rate
cut in the UK is imminent. This view is at odds with our own interpretation
of the latest data and also with what the Bank now says. The Inflation
Report notes: "Retail sales indicators suggest that consumer
spending growth was firm in Q4", though this is based on
partial information. At the Press Conference for the publication
of the Inflation report Governor King gave very measured responses
to questions on the outlook for consumer spending, again stressing
that retail sales only account for about a third or so of household
consumption. He described how consumer spending growth had remained
below its average growth rate in the past year having previously
grown at an unsustainably high pace. He attributed the slowdown
in spending to a rise in taxes relative to disposable income and
a relative rise in the prices of "boring" items (such
as utility bills and petrol) relative to more "fun"
items (the items more related to much high street spending). After
accounting for the "boring" items, "discretionary"
income growth was negative in the second half of last year. This
is similar to what we found using our own measure of discretionary
income (see for example "UK Consumer: Bills, Bills, Bills
. . ." 13 June 2005). Our own analysis also suggests that
this measure has since shown positive growth. The Bank's central
profile has consumer spending growth edging up "towards its
historical average" this is in line with our own projections
of a marginal increase in consumer spending growth in 2006 and
2007.
January 2006
| 
