Select Committee on Treasury Written Evidence


Memorandum submitted by Professor Sheila Dow, University of Sterling

  1.  The May Inflation Report projects GDP growth to continue roughly at the current (healthy) rate, and for inflation to settle back to target, assuming that the MPC raises the official rate to 5.75% during the year, as markets were predicting at that time. On this basis, the rate was increased to 5% in May.

  2.  However the Report refers to the substantial uncertainties surrounding these projections, as reflected in the larger spread of the fan chart. The Report notes reasons for the MPC to be particularly unsure at this juncture about the future path of inflation, including how far inflation expectations might rise unduly with a prolonged period of inflation above target, how far firms will be more inclined to respond to moderating energy costs by moderating their product prices and how far they will respond to demand pressures by putting up prices. Particular attention is paid in the Report to consumer behaviour, noting that fixed-rate debt has protected consumers so far from the full effect of repo rate rises (something which will not continue) and that spending on durables has slackened. Both factors would suggest that there are particular risks attached to the consumer demand projections, which should go some way to allaying fears of demand-led price increases. So the MPC may be unduly pessimistic about inflation (and unduly optimistic about demand).

  3.  One continuing source of concern which the Report again highlights is the rapid growth of broad monetary aggregates, the significance of which continues as a matter of current controversy. Chart 1.7 shows how close the broad money supply and inflation series have been since the late nineteenth century. But the greatest divergences have been over the last twenty years, when, generally, monetary growth has run significantly higher than inflation. This implies that the relationship has been loosening in a systematic way. This does not mean that monetary growth should be ignored, but rather that its changing relationship with inflation be better understood. A major development over this period has been the tremendous global growth in activity in new financial instruments, particularly derivative products, as well as growth in merger and acquisition activity. This growth has been fuelled by a massive expansion of credit, and it is through credit that most bank deposits (ie money) appear. This has occurred alongside strong growth in household debt, which has contributed further to the growth of the money supply. If this liquidity is unwillingly held, then there is downward pressure on interest rates, which, other things being equal, fuels aggregate demand and thus, potentially, inflation. Table 1.B shows that the main growth in money holdings continues to be on the books of "other financial corporations" (rather than households or private non-financial corporations). There is a variety of explanations for growth in these holdings, some technical, some reflecting growing activity by these corporations, but others reflecting a defensive position against possible future market downturns. The question then is what the implications are for inflation—how far are these balances likely to fuel increases in demand, relative to any increases in capacity financed by the growth in credit?

  4.  But, rather than the implications for inflation, assuming the current financial environment remains stable, the more immediate question posed by this huge growth in money holdings is the fact that they reflect a growth in financial fragility, which threatens financial stability. Commentators are increasingly expressing concern as to what is seen as a rash increase in exposure to risk, which in the case of complex credit derivatives products is not properly priced. (Indeed, as Minsky's Financial Instability Hypothesis suggests, this is normal for asset markets at this stage in the cycle, but the character of this instability evolves with innovation in new products, with regulators striving to catch up.) Other signs of financial fragility are growth in liquidations, increasing difficulties of households in meeting debt payments, and so on.

  5.  The MPC have been very successful in preventing undue financial market instability so far, partly through transparency over their thinking, so that markets have only been surprised by monetary policy to a limited extent. They have also been successful so far in preventing undue instability for households, with gradual rises in interest rates helping households to adjust to an increasing debt service burden. This, together with the lag by which interest rates feed through into mortgage payments given the number of fixed-rate mortgages, has moderated the risk of a sharp downturn in the housing market and in retail spending. Further, inflation expectations seem reasonably well anchored. The Bank's Inflation Attitude Survey demonstrates a high level of awareness of current inflation, presumably from media coverage. The MPC is concerned with inflation over the next two years rather than current-month inflation. And the Governor took pains in a recent speech to emphasise this term of outlook. But the fact that the much-hyped rise in March to 3.1% was then reversed will have been a strong moderating influence on corporate and household expectations.

  6.  But this stability would be severely threatened if the asset price bubble were to burst, given the enormous degree of leverage among financial institutions. And the more interest rates rise the greater this risk, as the direct hit on cash-flow can itself prompt asset sales. Were there to be a dramatic downturn in asset prices, this would have its most immediate effect on output and employment, and any effect on inflation would be secondary (and arguably of secondary consequence). To the extent that monetary policy plays a part in asset price cycles, it therefore has real consequences even in the long-run.

  7.  Indeed there is increasing attention being paid to Keynesian arguments which suggest that monetary policy not only has only a partial impact on inflation, but also has real effects which are not just temporary. This is important in itself, but also in the context of discussion about whether monetary policy should target only inflation, or also output and employment. According to the supply-side reasoning employed by the Treasury, monetary policy does have real effects. A predictably low rate of inflation creates a beneficial environment for decision-making (ie successful monetary policy affects the real economy in a positive way). But monetary policy can have additional real effects. Thus, for example, if the MPC creates the expectation (as is currently the case) that interest rates are likely to rise later this year, then firms may be deterred from investing, thus dampening employment, output and long-run capacity, even if rates do not in fact rise. If the MPC is particularly uncertain about the future, so that the expectation of a rate rise is not held with confidence, then investors may defer decisions until the uncertainty clears, again with real consequences. Increasingly, deferring "real" investment decisions can encourage firms to invest in financial assets instead, further fuelling the strength in asset prices. In fact, business investment is currently strengthening, though the growth in investment in utilities and energy extraction is predicted to slow down, and the property-related investment, while currently strong, is vulnerable to any reversal of property prices, in which monetary policy may play a part.

  8.  Monetary policy has since 1997 been operating in a benign environment where high credibility over inflation targeting has succeeded in generating an outturn of low inflation. But this success is vulnerable to a change in environment, and the Governor has repeatedly emphasised the limits of monetary policy. The main challenge for the MPC therefore would seem to be to act in such a way as to promote as much stability as possible, not only in terms of inflation, but also in terms of financial stability. This is a difficult task, when further interest rate rises are contemplated in what many see as an overblown, and thus vulnerable, financial environment.

June 2007





 
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