Select Committee on Treasury Written Evidence

Memorandum submitted by Professor Anton Muscatelli, Heriot-Watt University


  1.  The May Inflation Report, together with the Minutes of the MPC meeting held on 9-10 May, and more recent communications by Bank officials[1], clearly highlight what the Bank perceives as the main risks to the achievement of the inflation target, and which particular indicators have been important in validating its recent interest rate decisions.

  2.  Although considerable attention has been focused in recent months on inflation breaching the upper limit of the inflation target range, reaching 3.1% in March, the Bank continues to state that it remains focused on the path of future inflation, at the 6-8 quarter horizon over which interest rate policy is usually seen as having an impact.

  3.  Having said this, it seems likely that recent policy decisions may have also been affected by the recent surge in inflation, and the associated risk of a possible increase in inflationary expectations. This is discussed further below.

  4.  This note also highlights that actual GDP growth over the last year has been well in line with the Bank's central prediction for GDP growth a year ago (cf. Chart 1, p. ii in the May 2006 Inflation Report, based on market interest expectations). This is in contrast with the Bank's prediction for CPI inflation 12 months ago, which failed to predict the inflationary surge of 2007 until rather later in 2006. It is interesting to note that, despite the recent monetary policy tightening, GDP growth remains at its average rate for the last decade. The resilience in aggregate demand in the economy, combined with the MPC's concerns about the degree of capacity utilisation in the economy, has probably made the MPC more cautious about the future path of monetary policy.

  5.  We will focus on the fact that this assessment of the supply-side of the economy, the resulting output gap, and capacity utilisation is based on some indicators which are notoriously volatile.

  6.  We will also focus on recent events in asset markets and on trends in financial aggregates which may create further uncertainty for the MPC in the next few months.


  7.  In his recent speech to CBI Wales, the Governor of the Bank highlighted the role played by output growth in recent monetary policy decisions, and the fact that " ...these upside demand `shocks' have not -at least so far—been offset by a slowdown in consumer spending..."[2].

  8.  It is true that consumer spending in the UK has been volatile during 2006, and has remained robust on average, despite the recent increases in interest rates and a reduction in real take-home pay. However, as noted above, GDP growth in recent quarters has been generally in line with the Bank's own forecast 12 months ago. It therefore seems puzzling that this is identified as a significant element in recent interest rate decisions.

  9.  Business investment has continued its strong recovery, as I predicted in my evidence to the Select Committee in May 2006. This has helped to sustain growth, as well as rather more resilient growth in the Euro-area and Asia.

  10.  The main issue on the demand side is related to the recent volatility in consumer expenditure, rather than with total demand, whose path was largely as predicted during the last 12 months. It is likely that this unpredictability in consumer spending is what is making the MPC more cautious about the future path of interest rates.


  11.  The path for CPI inflation in the last six months has taken the Bank (and many other observers) by surprise. The May 2006 Inflation Report saw the Bank attach a negligible probability to CPI inflation rate reaching 3% or above in early 2007 in its inflation fan chart prediction. Even in the November 2006 Inflation Report, inflation was expected to peak in late 2006 and then fall back. We now know that this prediction was wrong. The recent surge in inflation was mainly due to increases in the prices of energy and food. These effects seem to have been temporary, and are now unwinding. CPI inflation fell to 2.5% in May, with similar falls in RPI and RPIX. As the current Inflation Report highlights (p.27), even if gas and electricity prices do not fall further, as last year's price increases drop out of the index, CPI inflation will fall by about 0.5% by 2007Q3.

  12.  Given that the recent surge in inflation seems to have been due to a temporary supply shock which has been quickly reversed, and not to inflationary pressures within the UK, did it play any role in the Bank's recent decisions to increase interest rates? The Bank usually insists that it focuses on the impact of interest rate decisions on future economic conditions, given the usual lags with which monetary policy affects the economy. By this rationale, the recent surge in inflation should not have impacted on monetary policy decisions: it was unexpected by the MPC, it was temporary in nature, and by the time it was observed it was too late for policy to impact on it.

  13.  However, my view is that the recent inflationary shock, despite its temporary nature, has affected recent decisions on interest rates. The main reason is the MPC's concern for the impact of the recent increase in inflation on inflationary expectations, particularly when the economy is operating at close to trend growth.

  14.  The concern is that, although long-term inflation expectations as measured in financial markets are well anchored at 2%, survey evidence shows a slight increase in households' inflation expectations.

  15.  Again, however, the precautionary principle seems to have been applied here. There is no evidence that higher inflationary expectations are feeding onto second-round effects in wage settlements. Whilst average earnings (including bonuses) grew at 4.4% in March 2007, this has since fallen back to 4% in April. If one excludes bonuses, earnings are growing at a slower rate in March 2007 than in March 2006.

  16.  The only evidence of any potential tightening in labour markets seems to come from some surveys of labour markets, particularly in some service sectors, which suggests a shortage of skilled workers. However, these shortages are not showing through in official earnings data, and the labour market still seems to be enjoying the benefits of inward migration into the UK. A small reduction in labour participation does not change this overall picture.


  17.  The main evidence of any tightness on the supply side seems to have been a recent increase in real product wage, driven mainly by non-labour costs, which seems to have been accommodated through lower take-home pay.

  18.  The one area of concern for the MPC seems to have come from business survey data. The May 2007 Inflation Report shows that recent surveys put capacity utilisation in the UK above its average since 1999, and it has surged recently. This seems to have been a major consideration in the MPC's collective judgement[3].

  19.  However, it is important to stress just how volatile the business survey series are. The MPC is acting on evidence which is probably less robust than one would wish, partly because the starting point is one in which inflation is already well above its target. It is reacting to a perception about the balance of risks for inflation as opposed to predictable inflationary pressures as might be evident from, say, labour market data.


  20.  Recent events in asset markets are worthy of comment, particularly as the last two weeks have seen interesting events in bond markets. Long-term bond yields have risen sharply in recent months, with the US 10-year Treasury bond yield reaching 5.3-5.3% at the time of writing.

  21.  Normally these increases in bond yields are caused by an increase in inflation expectations, but in fact the recent increase in long-term rates seems to have been largely driven by real yields. In turn this may have been driven by expectations of tighter monetary policy around the world, or, more likely, the recent switch by Asian central banks (eg China's sovereign wealth fund) away from US bonds and towards equity investments.

  22.  Whilst this may simply be a portfolio adjustment at global level, there is some possibility that increases in long-term risk-free rates will raise financing costs and exert some downward pressure on world economic growth. It will be interesting to observe if these recent trends are reversed.

  23.  Turning to UK financial markets, one factor which was cited as motivating the recent increases in Bank Rate by the MPC was more rapid monetary growth. M4 growth in the UK has remained at high levels (Table 1.B, p.13, May 2007 Inflation Report). The Bank's concern seems to be that this high growth is so sustained that it might signal a potential increase in future demand in the UK economy and hence that it carries risks for inflation.

  24.  However, this is an argument which has not been advanced to date by the Bank. It does seem curious that after sustained growth in M4 in the last two years this indicator is only now causing alarm bells to ring. It is true that the recent behaviour of M4 is not well understood: the recent growth has largely been due to the demand for money by "other financial intermediaries" (which include housing credit corporations and special purpose vehicles), but there is little evidence that it is likely to fuel expenditure in the economy as opposed to it being simply a portfolio shift which has increased the overall demand for broad (M4) money.


  25.  It seems clear that the MPC faces a more uncertain environment than it had anticipated 12 months ago. The recent inflationary surge, which has not been due to UK domestic factors or to the Bank's own actions, and which has been temporary, has arguably impacted on current MPC decisions largely because of its potential impact on inflationary expectations.

  26.  The MPC has also had to face more resilient growth in GDP, and particularly consumer expenditure, in the face of more uncertain supply-side conditions than it anticipated at the start of the contractionary policy phase in August 2006. This lies behind the use of rather less precise evidence such as business surveys to understand the real extent of spare capacity in the economy.

  27.  Both with regard to inflationary expectations and to capacity utilisation, the MPC seems to have applied the precautionary principle: there is little concrete evidence of domestic inflationary pressures or wage pressures, but given the starting point of an inflation rate already well above the 2% target, a variety of indicators suggesting potential risks on the inflation front, and the consequent possibility of awakening inflationary expectations, monetary policy has been tightened by more than some analysts anticipated even 12 months ago. Financial markets have been completely surprised over the last year: market expectations in May 2007 suggested that Bank rate would be 4.75% in May 2007.

  28.  In my written evidence to the Treasury Committee in November 2006 I took a cautious view on interest rates, with a rather flatter profile for Bank Rate in this contractionary phase, suggesting that rates might peak at 5.25%, suggesting that we might face a period of sustained, but moderately tighter policy.

  29.  Market expectations of future interest rates are now also flat (see May 2007 Inflation Report, p. 41, Chart A and Table 1), with a peak at 5.7% around late 2007-early 2008 (implying a peak Bank Rate of about 6%) and a very slow reduction into 2009.

  30.  Such a flat interest rate profile would seem to require a very resilient path for UK GDP growth in 2007 and 2008, together with continued tight capacity constraints. Although the Bank is predicting reasonably steady GDP growth in 2007-08, and continued strength in consumer spending, it is anticipating CPI inflation dipping below its 2% target in 2008 in its central case scenario. If interest rates are raised further during 2007 in line with market expectations, one would expect a relatively flat Bank Rate profile into 2008-09 to be less likely.

June 2007

1   Speech by Governor of the Bank of England to CBI Wales, 11 June 2007. Back

2   Speech by Governor of the Bank of England to CBI Wales, 11 June 2007, p.5 Back

3   Speech by Governor of the Bank of England to CBI Wales, 11 June 2007, p.5-" ...A position in which growth is above its long-run average and businesses are already operating on capacity is unlikely to be one without inflationary risks..." Back

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