Memorandum submitted by Professor Anton
Muscatelli, Heriot-Watt University
INTRODUCTION
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.
THE DEMAND
SIDE
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.
INFLATION, INFLATION
EXPECTATIONS, AND
WAGES
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.
OTHER SUPPLY-SIDE
DEVELOPMENTS
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.
ASSET AND
FINANCIAL MARKETS
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.
CONCLUSION
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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