Select Committee on Treasury Written Evidence

Memorandum submitted by Michael Saunders, Citigroup


    —  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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