Select Committee on Treasury Written Evidence

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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