Memorandum submitted by Michael Saunders,
Citigroup
COMMENTARY ON
NOVEMBER 2006 INFLATION
REPORT
— The Inflation Report projects an
extended boom, with strong real GDP growth—well above consensus—in
both 2007 and 2008, led by strength in domestic demand. The MPC
expects that (if base rates are stable at 5%), inflation will
slow close to target, but argues that there are many uncertainties
over the inflation outlook.
— The IR itself leaves the MPC with
a slight tilt to tighten again, but perhaps less clear-cut than
in August. Nevertheless, any notion that the MPC is signalling
that rates have peaked must be tempered by their robust growth
forecast. If growth in 2007 is as strong as the MPC expects, rates
are far more likely to rise than fall.
— We still expect another 25bp rate
hike in Q1. There is a significant chance that rates will rise
again beyond that in 2007 or 2008 if growth remains high or if
the MPC's upside worries on inflation expectations and pay materialise.
The MPC's base case, outlined in the latest
BoE Inflation Report, is for fairly strong growth in 2007-08,
with CPI inflation rising initially and then (if base rates are
stable at 5%) returning close to the target (but still slightly
above) further out. The Report leaves the MPC with a slight tilt
towards further tightening, but less clear-cut than in August.
Within that overall (and unsurprising) picture, there are three
interesting and important themes:
First, the MPC has now included the assumption
that inward migration—and hence workforce growth—will
stay high. "In the central projection, the growth in labour
supply is a little stronger than assumed in the August report,
raising output and employment growth somewhat and moderating the
upward pressure on wages and prices." In effect, the
MPC now accepts that the economy's potential growth rate is higher
than the usual estimates of 2 and a half % or so (it does not
say by how much). The MPC appears to have sidelined its previous
worries that potential growth might suffer if high oil prices
cause increased scrapping of the capital stock.
Second, the MPC believes that the economy does
not need lower interest rates to boost demand growth to meet the
elevated pace of supply (ie potential growth). The MPC's new forecast
for growth in coming quarters (assuming stable 5% rates) is a
little above that published in August (assuming stable 4.75% rates).
Indeed, the latest growth forecast is among the highest that the
Committee has published [see Figure 1: UK—MPC Forecasts
for Average GDP YoY Growth in Next eight Quarters, 1999-2006.
The chart shows the average of the MPC's forecasts for YoY growth
four quarters ahead and eight quarters ahead, taken from successive
Inflation Reports. We use the risk-adjusted (ie mean) forecasts,
and each forecast assumes base rates are stable at the prevailing
level (currently 5%)]. The MPC's forecasts for real GDP growth
in 2007 and 2008 (just above 3% YoY and just below 3% respectively)
are also well above consensus (2.4%-2.5% YoY in each year). Indeed,
the MPC's forecast for UK real GDP growth in 2007 is higher than
any of the 40-plus forecasts included in the Treasury's November
"Comparison of Independent Forecasts" survey (our forecast
is for 2.6% growth in 2007, highest non-MPC forecast is 2.9% YoY
in 2007, lowest is just below zero) [see Figure 2: UK—Forecasts
for YoY Real GDP Growth, 2006-08. For the MPC we use the forecast
based on market interest rates. This assumes slightly higher interest
rates than the consensus].
The MPC's optimism on growth partly reflects
some allowance for the boost to demand from high inward migration—in
other words, migration lifts both potential growth and actual
growth. For example, the IR notes that consumer spending will
benefit: "Increased inflows of migrants will also affect
demand in the economy." It cites a possible boost to
capital spending: higher labour supply lowers pay growth, thereby
lifting the rate of return on capital and "As a result,
firms are likely to invest more." It also cites a possible
boost to consumer spending "migrants will purchase goods
and services, including food and accommodation... Another possible
impact on demand is through the housing market. An increase in
population will tend to push up house prices and rents... this
could support consumption". It also cites the support
for demand from "slightly firmer growth in expected real
labour income, associated with a further rise in the size of the
workforce".
But, in addition, the MPC implicitly seems to
believe that financial conditions (including 5% interest rates,
as well as long rates and global asset price trends) remain supportive.
The MPC has revised up its central forecasts for both consumer
spending and business investment, notes that risks on domestic
demand still seem to be on the upside of its revised forecasts
and cites several times the strength of money, credit and assets.
The downside risks to growth are external not internal.
Third, the MPC remains more uncertain than usual
about the inflation outlook. "The uncertainties about
the outlook for inflation are judged to be somewhat greater than
normal, reflecting heightened uncertainty about the supply side
of the economy. In the August Report, that was reflected in a
widening of the bands in the inflation fan chart, and that judgement
has been retained in the current projection" [see Figure
3: UK—MPC Estimate of Uncertainty in Forecast for Inflation
9 Quarters Ahead. A higher figure implies that the MPC is becoming
more uncertain over its inflation forecasts, which would usually
be reflected in wider bands in the "rivers of blood"
forecast charts for growth and inflation.].
The MPC also appears more uncertain about inflation
prospects than outside forecasters. For example, the consensus
view among outside forecasters is that YoY inflation 8-12 quarters
ahead is roughly twice as likely to be in a range of 1.5%-2.5%
as outside that range. The MPC's view is that these probabilities
are much more evenly balanced, with roughly 55% of inflation being
in a 1.5%-2.5% range, and a roughly 45% chance of being outside
that range.
The MPC's uncertainties stem partly from migration.
No one really knows for sure what the recent pace of inward migration
(and hence workforce growth) really has been, how it will evolve
or the scale of the resultant boost to demand. In addition, the
MPC is worried about risks that high headline CPI and RPI inflation
will lift inflation expectations and pay deals in the next few
quarters. The Report highlights this latter risk several times,
noting for example "In the central projection, inflation
expectations are assumed to remain reasonably well anchored to
the target over the forecast period. But recent and prospective
near-term developments in price inflation—particularly of
the RPI—may pose an upside risk to this projection ahead
of the onset of the main settlements round in early 2007."
The Inflation Report forecast, of strong growth
and some overshoot of the inflation target (with stable interest
rates), implies that rates are more likely to rise than fall in
the next few quarters. The MPC's uncertainties over inflation
prospects also imply that the Committee will get decidedly more
hawkish if there are signs (in data and surveys on inflation,
selling prices, pay deals and inflation expectations) that some
of those upside price risks are materialising. Conversely, if
growth is anything like as strong as the MPC expects, then there
is little chance that rates fall even if wage growth is well contained.
Unusually, we currently agree with quite a lot
of the MPC's analysis. Surveys suggest that growth will stay buoyant
nearterm, and the MPC was much quicker than the consensus to appreciate
the pick-up of activity in 2006. The RICS survey and retail sales
data highlight the momentum in domestic demand. Indeed, given
uncertainties over inward migration, it is possible that inward
migration, workforce growth and job growth in 2006 really are
all markedly stronger than the official ONS data show. Our growth
forecasts for 2007-08 are also above consensus although (averaged
across the two years) not quite as high as the MPC's [see Figures
4 and 5: MPC and Consensus Forecasts for YoY GDP Growth in 2006
and 2007].
Similarly, the MPC's point about relatively
high inflation uncertainty seems valid, given the past year's
inflation overshoot, signs that the deflation in consumer goods
may be over, plus possibilities that pay and inflation expectations
are not well anchored on the 2% inflation target. Even after October's
softer price data, the YoY rates for CPI inflation and RPI inflation
are likely to rise further in coming months [see Figure 6: YoY
Inflation Forecast, 2000-07].
We continue to expect another 25bp hike in Q1,
and expect this to be driven partly by ongoing strength in real
activity but also by a desire among the MPC to ensure that inflation
expectations and pay are not destabilised by high headline inflation.
That may not be the last hike: the MPC's view that inflation uncertainties
are elevated implies that the interest rate outlook is more uncertain
than usual. If those upside risks on inflation, pay and inflation
expectations appear to be materialising, then it may take significantly
higher interest rates to return inflation to target.
Indeed, it may be useful for the MPC to stress
that the uncertainties are more in terms of how far interest rates
will have to rise to keep inflation on target rather than in where
inflation itself will be in two to three years' time. The MPC's
current habit is to present a fan chart of inflation forecasts
for a given path of interest rates. As a pedagogical device, it
might be useful to also present the same information as a fan
chart of the possible path of interest rates that might be needed
to keep inflation on target under different scenarios. That in
effect takes the same information as in the current inflation
forecast charts, but puts the uncertainty on interest rates rather
than inflation. This presentational addition could have three
advantages:
— It might help to anchor inflation
expectations on the target, by highlighting that the MPC is not
a passive observer in the inflation outlook, but (by its actions)
can return inflation to target.
— It might usefully remind borrowers
and lenders to allow for risks that interest rates might vary
significantly.
— It might help ensure that risk premia
in the interest rate curve and financial assets do not become
overly low and provide unneeded stimulus.
In other words, such a change might create less
inflation uncertainty and appropriately create more interest rate
uncertainty. Doubtless, there are some technical difficulties
in such a presentation. But, it does not appear impossible given
that the MPC already publishes inflation fan chart forecasts and
has well-established models for the effects of interest rates
on inflation. Indeed, the Norwegian and Swedish central banks
already publish indications of the path of interest rates that
appears needed to keep inflation on target over time.
November 2006
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