MEMORANDUM BY MR DAVID WALTON, SPECIALIST
ADVISER TO THE COMMITTEE
The MPC has lowered its central forecast for
GDP growth and inflation since November and it judges that the
risks to inflation are "presently clearly on the downside".
The inflation projections and the MPC's assessment
of the risks are consistent with another cut in the repo rate
soon. The "hawks" may resist this, arguing that recent
data point to continued robust consumption growth and an upward
creep in average earnings growth in response to a further tightening
in the labour market. But these arguments need to be set against
the fact that inflation has been below target for the past two
years and is projected by the MPC to remain below target for the
next two years.
There is also a reasonable chance that inflation
will continue to undershoot the MPC's central forecast in coming
months. On Goldman Sachs' forecasts, RPIX inflation drifts down
to 1.5 per cent by mid-year and hovers around 1.5-1.75
per cent during the second half of the year. The 1.5 per cent
level is significant because of the need for the MPC to write
an open letter to the Chancellor if inflation moves more than
one percentage point away from target.
A DOVISH INFLATION
The February Bank of England Inflation Report
(IR) was one of the most dovish for some time. Compared with the
November IR, the MPC has:
(i) lowered its central forecast for GDP
growth and inflation; and
(ii) judged that the risks to growth and
inflation to be "presently clearly on the downside".
The downward revisions to the MPC's growth and
inflation forecasts can be seen in Charts 1 and 2. Annual GDP
growth is now projected to dip to around 2 per cent during the
second half of 2001 before recovering to slightly above trend
during 2002. RPIX inflation is forecast to run slightly below
2 per cent during 2001 and then rise gradually to 2.5 per cent
in two years' time.
The downward revisions to growth and inflation
are partly a reflection of the fact that recent outturns have
been lower than expected. Quarterly GDP growth slowed to 0.3 per
cent in 2000 Q4, which the IR described as "well below expectations
three months ago". RPIX inflation averaged 2.1 per cent in
Q4, 0.3 per cent below the expectation in the November IR. This
was the second successive IR in which inflation came in much lower
than expected (see Chart 3).
Several other factors are responsible for lower
GDP growth this year. The MPC expects a bigger drag on the economy
from net trade as a result of weaker growth overseas, particularly
in the United States. Lower share prices are likely to slow consumer
spending growth and keep business investment growth subdued. These
factors are expected to outweigh the stimulus from strong public
spending growth in 2001.
Not only is the central forecast for GDP growth
lower but "the MPC judges that the risks from the global
environment are weighted firmly to the downside". The MPC
is concerned that there may be a deeper and more prolonged downturn
in the United States. It also sees downside risks to consumption
and investment. The MPC believes that the probability of annual
GDP growth being less than 2 per cent in 2001 Q4 has now risen
from 36 per cent in November to 48 per cent (see Chart 4).
These downside risks to economic activity are
also reflected in the MPC's assessment of the risks to inflation.
Although the MPC notes that there is an upside risk to inflation
from tight labour market conditions leading to stronger earnings
growth than in the central projection, this is "substantially"
outweighed by the downside risks. The MPC judges that the probability
of RPIX inflation being below 2.5 per cent in 2001 Q4 has risen
from 68 per cent in November to 92 per cent now. For 2002 Q4,
the probability has risen from 47 per cent to 63 per cent (see
Furthermore, not all members of the MPC are
happy with the central forecast. Some Committee members consider
that the profile for inflation could be up to .5 per cent
lower than in the MPC's central projection.
There seems little reason not to expect another
cut in interest rates soon given that:
inflation is running at the lowest
level since the mid-1960s;
it has been below target for the
past two years and is projected by the MPC to remain below target
for the next two years;
the MPC believes that the risks on
inflation are skewed to the downside.
One reason for expecting an interest rate cut
sooner rather than later is that there is a reasonable chance
that inflation will continue to undershoot the MPC's central forecast
in coming months. RPIX inflation fell to a new low of 1.8 per
cent in Januaryslightly below the MPC's expectation for
Q1 as a whole. Moreover, the MPC's forecasts do not yet take into
account the proposals made by the Chancellor in the Pre-Budget
Report to cut 2p/litre off ultra low sulphur petrol and freeze
all other fuel duties. On Goldman Sachs' forecasts, RPIX inflation
drifts down to 1.5 per cent by mid-year and hovers around 1.5-1.75
per cent during the second half of the year before rising towards
the target in 2002 (see Chart 6).
The 1.5 per cent level is significant because
if inflation moves more than one percentage point away from target,
the Governor of the Bank of England is required to write an open
letter to the Chancellor explaining why it has occurred and what
the MPC is doing about it. If RPIX inflation were to dip below
1.5 per cent, the MPC would probably want to be able to demonstrate
that it had taken decisive action several months before it occurred
rather than waiting until the event itself.
The well known Taylor Rule provides a guide
to the appropriate level of interest ratesinterest rates
are set according to deviations in output from trend and inflation
from target. On Goldman Sachs' estimates, the Taylor Rule suggests
that three month interest rates will fall to 5.75 per cent
by mid-year, remain stable at this level during the second half
of 2001, and then rise gradually to 5.75 per cent during
2002. A similar path is suggested by a modified Taylor Rule, which
takes account of the past reaction of the MPC to economic data.
This is broadly in line with financial market expectations.
19 February 2001