Select Committee on Treasury Written Evidence


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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