Memorandum submitted by Professor Sheila
Dow, University of Stirling
1. The November 2006 Inflation Report
forecasts inflation to continue to rise until the end of the year,
but then it is expected to drop back to the target rate by mid-2007. This
forecast is based on market rate expectations, while the forecast
based on a constant 5% repo rate suggests a slightly slower return
to target.
2. Countering the factors behind this reversal
are concerns about pay growth picking up, for a variety of reasons
which include the higher-than-target inflation feeding through
into indexed pay agreements and also into expectations. Against
this is the increase in unemployment, which should mute pay pressure.
3. The difference between price indices
continues to be relevant. While the inflation target is expressed
in terms of CPI, RPI is used for many pay settlements and also
for various benefit payments and tax allowances. Since RPI has
risen more sharply than CPI, this will have a relatively more
marked effect both on pay settlements and on the public finances
(the Budget calculations being based on a lower projected increase
in RPI). Further, since RPI is closer to direct experience of
inflation, there could be a more marked effect of recent experience
on inflation expectations. Charles Bean indicated in a speech
in October, not only that globalisation is meaning that larger
interest rate changes are required to manage inflation through
demand, but also that it was difficult to predict expectations,
and therefore that monetary policy should be risk averse when
contemplating inflation deviating from target. The credibility
of the target is itself an important element in meeting the target.
4. However, in considering a risk-averse
monetary policy, it is also worth bearing in mind that interest
payments themselves enter into RPI, so that tighter monetary policy
itself raises costs. There is also the risk that higher debt servicing
costs as a result of recent increases in mortgage rates could
turn what is presented in the Report (p 15) as still a
relatively benign financial situation for households into a more
vulnerable situation. The increasing incidence of mortgage lending
at multiples of five times earnings or more has also been increasing
households' financial vulnerability. A rise in property sell-offs
(eg to liquidate mortgage collateral) at some stage could cause
a serious reversal in house prices. David Miles' report earlier
this week concluded that housing is overvalued and a correction
is to be expected.
5. The increase in household debt is reflected
in a sustained rise in M4. How far monetary aggregates are relevant
for monetary policy has become a matter of increasing debate.
The ECB "two pillars" approach to monetary policy gives
prominence to monetary aggregates as well as to "real"
analysis, in marked contrast to the US approach, which downplays
the role of monetary aggregates. In the UK, there has been increasing
incidence of MPC members expressing concern with the strong rise
in M4 over the last few years, implying a veering towards the
ECB position. The summary statement on page 42 of the Report
for example refers to concern over "the outlook for wages
and prices in the light of rapid growth in money and credit".
6. In the 1980s, monetary targeting reflected
the Monetarist view that changes in the money supply caused changes
in the price level. This view fell into disfavour, not least because
of the difficulties in practice of controlling the money supply,
and the focus shifted to controlling interest rates. In the US
this has taken the extreme form of models for monetary policy
where money plays no part at all. The difficulty with controlling
the money supply stems largely from the fact that money (bank
deposits) comes into existence through the process of credit creation,
over which central banks only have some influence, but not control.
But this still means that the volume of credit, and thus of money
on the other side of banks' balance sheets, can still be important
indicators of spending plans. Even if there is no attempt to control
the money supply, the data arguably do provide useful information.
7. It is important however to try to understand
the forces at work behind the aggregates in order to decide whether
a rise in M4 does indeed pose inflationary dangers, or at least
be symptomatic of such dangers. Credit can be created for a variety
of purposes, including asset purchases, which may be speculative.
The effect then may be more on asset price inflation than inflation
in goods and services. Household borrowing is now increasingly
significant relative to corporate borrowing, for example. Increases
in mortgage borrowing reflect the significant speculative element
in the housing market, where purchases of second homes, buy-to-let
property and trading up are fuelled by expectations of continued
strong rises in house prices. So the credit increases behind the
increases in M4 will only partially reflect increased expenditure
on new housing (rather than the existing stock). Further, the
relatively weak investment by firms until recently, together with
their relatively healthy financial balances (Chart 1.12), means
that the steady increase in M4 does not reflect strong capital
expenditure by firms.
8. But M4 itself is on the other side of
the balance sheet (deposits), so we also need to consider the
demand for holding this broad money idle. The breakdown shown
in Chart 1.7 makes it clear that the relationship between M4 growth
and inflation is unlikely to be straightforward. Indeed it raises
serious doubts about the concerns being expressed about M4 growth.
Chart 1.7 shows growth in households' share of M4 as flat in recent
years, and only a modest increase in growth rates for private
non-financial corporations. The big increase is in money holdings
by other (non-bank) financial corporations (eg pension funds).
Increased liquid holdings for them reflect a variety of factors,
but one of these is a reaction to expectations about alternative
asset prices—either confident predictions that they are
likely to fall, or else a high degree of uncertainty about the
future direction of asset prices: money (deposits) is held as
a safe asset in times of uncertainty. While there may be a permanent
shift in relative expected returns and technical considerations,
as referred to on page 12 as an explanation for changes in money
holdings, a move to liquidity may well also reflect more short-run
shifts in expectations, and confidence in these expectations.
Releasing the liquidity as expectations firm up to encourage asset
purchases may well cause asset price inflation, but the connection
with goods and services inflation would then be very indirect.
9. This Keynesian analysis supports the
idea of paying attention to money. But the focus is more on composition
of credit and of money (and how that relates to expenditure, on
assets or on goods and services), and short-run changes in the
preference to keep assets liquid as expectations about asset price
movements change, rather than the long-run stable relationship
between money and prices of the Monetarist approach.
November 2006
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