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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