Select Committee on Treasury Minutes of Evidence

Memorandum submitted by David Miles, Morgan Stanley


  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

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