Memorandum submitted by Anton Muscatelli,
University of Glasgow
Introduction
1. The MPC has increased Bank Rate by 0.25%
during their meetings in August and November 2006, in correspondence
with their quarterly inflation forecast cycle, and the publication
of the last two Inflation Reports. The MPC's judgement
following the November Report seems to have been driven
largely by considerable uncertainty over the supply side of the
economy, at a time when CPI inflation was already above the 2%
target rate.
2. In my last written evidence to the Committee
in May 2006, I suggested that Bank Rate had probably bottomed
out, and interest rates would need to rise as capacity constraints
emerged; I noted (HC 1185 i-ii, Ev 37, par 20):
"... The risks with regard to the growth
of potential output and capacity which I highlighted in February
may be beginning to emerge. The overall scenario is one where
there will need to be a move towards gradual tightening of policy
as clearer evidence on these emerging capacity constraints materialises...
"
3. Although I was expecting the evidence
for an interest rate increase to emerge in autumn, these capacity
constraints have now materialised, and this has happened at the
same time as CPI inflation has been above target for most of 2006. The
Bank's inflation forecast in August even put a small, but not
insignificant, probability on CPI inflation rising to 3% in the
current year.
4. In this note I will focus mainly on an
analysis of the supply side, and on the uncertainties in this
area of the economy which seem to be dominating the MPC's current
decisions. I will also discuss the extent to which the Bank's
current inflation forecast provides useful information on the
likely path of interest rates in 2007.
The Supply-side of the UK Economy and Inflationary
Expectations
5. The November Inflation Report
highlights that, although UK GDP is growing at close to its average
rate for the last decade (0.7% in 2006 Q3), a majority of the
MPC believes that there is little spare capacity in the economy.
With growth expected to continue at a similar rate in 2006 Q4,
this leaves little margin for manoeuvre. Of the two MPC members
voting against a rate increase in November, one focused particularly
on a more optimistic view for potential output and supply.
6. The picture on the supply side is mixed:
surveys of business capacity utilisation suggest that there may
be little spare capacity (see Table 3.B, p 21 November Inflation
Report. The recent upward movement in labour productivity
(Chart 3.3, p 21, November Inflation Report) also suggests
that labour hoarding is unwinding.
7. In support of the more optimistic supply-side
view, unemployment is increasing, reaching 5.5% in the latest
LFS statistic. Private sector earnings also seem to be relatively
stable, despite the recent increase in CPI and RPI inflation (see
chart 4.5, p 28, November Inflation Report). As highlighted
in my written evidence following the May Inflation Report,
a rise in unemployment may indicate an increase in wage pressures
as opposed to a reduction in excess demand. The analysis on p
30 (Charts A and B) of the November Inflation Report is
rather worrying in this regard: the real product wage has been
increasing in recent years, ahead of productivity and both the
real consumption wage and the profit share have suffered. These
structural supply effects, driven by higher energy prices, increased
taxation and pension contributions, suggest that the increase
in unemployment is not being driven solely by cyclical factors.
8. One positive supply-side effect, which
has undoubtedly kept inflationary pressures at bay in the labour
market, is the growth in labour supply. Net inward migration is
one of the main forces driving this. Notwithstanding some of the
problems in measuring net inward migration flows accurately, the
Labour Force Survey data shown in Chart 3.5 (p 22, November Inflation
Report) shows a clear increase in available labour.
9. On the balance of the available evidence,
I would concur that the supply-side evidence pointed to a need
for a tightening of monetary policy at this stage. Whilst there
is some uncertainty, not least about the ongoing dampening impact
of net migration on skills shortages and wage pressures, it would
be surprising if firms did not attempt to restore profit margins
at a time of continued economic growth. There is also a risk in
allowing inflationary expectations to increase. The price of a
delay in increasing interest rates in 2006 might have been that
a more substantial policy tightening would have been required
in 2007. This will be discussed below in par 15.
10. The most positive impact on the supply
side has come from the recent reduction in oil and gas prices,
and the fact that households' inflationary expectations still
seem reasonably well anchored (Chart B, p 32, November Inflation
Report).
11. This does suggest the possibility that
the current monetary policy cycle could be relatively flat: unless
we begin to see any signs of "second-round effects"
in earnings, as wage setters seek to increase their real consumer
wages and a wage-price spiral ensues, the recent interest rate
increases will begin to slow the economy in early 2007, and there
may only be the need (at most) for one further 0.25% increase
in Bank Rate. On the Bank's central case forecast, this policy
stance will also be validated by a reduction in inflation in 2007. In
fact, comparing the Inflation forecast in the August and November
Inflation Reports (Charts 5.3 and 5.4) one sees that at
the same time as monetary policy has been tightened, the upside
risks for inflation have been slightly reduced: the Bank now believes
there is little chance of inflation approaching 3% in 2006-07. This
was not the case in August.
12. All this of course assumes that energy
prices do not begin to increase again as we move into 2007, and
that world economic growth continues to moderate in response to
tighter monetary conditions in most industrialised economies.
If some further exogenous inflationary pressures emerge from outside
the UK economy, due to energy price increases or a more rapid
than anticipated phase of world economic growth, there will be
further pressures on the MPC to tighten UK monetary policy. We
now analyse what may happen if such a scenario develops.
How quickly will the current policy tightening
impact on Inflation?
13. One of the most striking aspects of
the current Inflation Report are the current forecasts
for GDP and CPI inflation based on market interest expectations.
Given that money markets are only pricing a small probability
of a further 0.25% increase in Bank Rate in 2007, Charts 5.1 and
5.3 show the Bank's forecast for GDP and inflation if Bank Rate
were to remain at or close to 5% into 2007.
14. What is striking is how slowly the central
forecast for GDP growth comes down during 2007-08. On the
mean of the forecast, GDP growth settles to just below 3% and
CPI inflation converges to 2% by the middle of 2007. In essence,
by raising interest rates since the summer, the Bank has taken
the UK's monetary policy stance close to neutral. In the central
case forecast the inflationary "blip" caused by faster
growth in 2006 and higher energy prices in 2005-06 is unwinding
and working its way out of the economy, without generating any
sustained inflationary momentum.
15. One important issue is also the extent
to which, should inflationary expectations increase well above
the Bank's inflation target, monetary policy would have to be
tightened in order to bring inflation back towards 2%. As recently
pointed out by the Bank's Chief Economist[1]
this may be resulting in a very flat short-run trade-off between
output and inflation. Thus, if inflationary expectations were
to rise, bringing inflation down towards target might require
a substantial tightening of monetary policy.
Conclusion
16. The overall situation for UK monetary
policy is therefore carefully balanced. Providing there is no
resumption of the upward trend in energy costs, and domestic and
external demand evolve as predicted in the November Inflation
Report, the current monetary policy cycle could be very flat,
with interest rates peaking at 5-5.25%.
17. However, any deviation from this relatively
benign scenario, either due to exogenous inflationary pressures
(energy and commodity costs), or rather more resilient domestic
demand (eg due to household consumption and investment), or external
demand (eg due to economic recovery in the Euro-area), might require
a further tightening of policy. Even more seriously, any evidence
of inflationary expectations increasing and feeding into wage-setting
would probably require a substantial tightening in policy to bring
inflation back towards the 2% target.
November 2006
1 See Bean, C "Globalisation and Inflation",
available at www.bankofengland.co.uk/publications/speeches/2006/speech287.pdf Back
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