Memorandum submitted by Mr David Walton
Surprisingly, the tone of the latest Bank of
England Inflation Report was mildly hawkish. The MPC now views
the risks to inflation in two years time as being on the upside.
The language in the Report is stronger than the MPC's projections
The MPC is relatively upbeat about economic
growth. After dipping in Q4 to around a 1 per cent annualised
rate, the MPC then projects GDP growth back to a 2-2.5 per cent
annualised rate during 2002. A more severe dip in economic growth
is likely in the next couple of quarters.
A MILDLY HAWKISH
The tone of the November Inflation Report was
mildly hawkish. Since the August Inflation Report, the Monetary
Policy Committee (MPC) has cut interest rates by 100 basis points
to 4 per cent. After stepping up the size of the interest rate
cut to 50 basis points at the 8 November MPC meeting, it was surprising
to read that "the overall risks to inflation are on the upside".
I have two major points of disagreement with
the Inflation Report.
On closer inspection, the language contained
in the Inflation Report is stronger than the MPC's projections
warrant. The quantitative assessment of the risks to inflation
are much more evenly balanced than the literary assessment.
2. Growth Projections
More fundamentally, the MPC's growth forecasts
can perhaps best be described as "rosy". They imply
a very short-lived downturn in global economic activity.
The hawkish tone accompanying the MPC's inflation
forecasts seems inappropriate for several reasons.
1. The mode and median forecasts lie slightly
below 2.5 per cent at the two-year horizon
I would not make too much of this since departures
from target are only ever very small but it is rare. Of the 16
Inflation Reports published since August 1997 (excluding the latest),
the MPC's two-year median inflation forecast was below target
(ie rounded to less than 2.5 per cent) on only three occasions
(November 1997, May 1998 and May 1999). Of the remainder, six
were exactly at 2.5 per cent and eight showed inflation slightly
2. The skewness of risk towards the "upside"
is negligibly small
The forecast implies that the probability of
inflation coming in above 2.5 per cent is 51 per cent, compared
with a 49 per cent chance of below-target inflation.
3. The dissenters to the published forecast
see the risks to inflation skewed to the downside
According to the Inflation Report, "some
members prefer alternative assumptions about supply-side developments
and international prospects that generate an inflation profile
that is either slightly higher or up to 0.5 per cent lower at
the forecast horizon".
4. Much of the upside risk in the inflation
forecast, such as it is, is related to the possibility of a larger
depreciation in sterling, presumably as a reaction to the "imbalance"
between domestic and external demand. This is a highly contentious
issue for the MPC, and one on which the majority view has usually
been wrong. It seems unlikely to be enough, on its own, to sway
policy decisions in coming months.
More important than the skewness of the inflation
forecast are the MPC's views about growth prospects. The MPC is
remarkably upbeat. The starting level of output in 2001 Q3 is
0.4 percentage points higher than the MPC assumed in the August
Inflation Report. This partly reflects slightly stronger growth
in Q3 but is primarily due to upward revisions to the past level
of output. Output is forecast to remain above the level projected
in the August Inflation Report.
The MPC expects the annual growth rate of GDP
to trough at around 1.9 per cent in 2002 Q1 and then to pick up
gradually to slightly above a trend rate of 2.7 per cent in the
second half of 2003. This implies a quarterly growth path of something
like 0.3 per cent in Q4 and then 0.5-0.6 per centreasonably
close to trendin the first half of 2002. On the MPC's latest
forecasts, the level of GDP is higher throughout the forecast
horizon than in the August Inflation Report (see Chart 1).
Curiously, Deputy Governor, Mervyn King described
the odds of recession over the next year as much lower than in
1998-99. Yet the international environment is considerably more
hostile than in 1998-99. The contrast is most marked in the US
where, during the 1998-99 slowdown, GDP growth never fell below
2.5 per cent at an annual rate. On Goldman Sachs' latest forecasts
US GDP, having already fallen in Q3, is likely to decline in both
Q4 and 2002 Q1, and fall by 0.2 per cent between 2001 and 2002.
Output is also set to fall in Japan and Euroland in the next couple
of quarters (see Chart 2).
Since the August Inflation Report, the MPC has
revised down its expectations for global GDP growth in 2001 and
2002 by half to one percentage points a year. At Goldman Sachs,
we have revised our global forecasts down by 0.5 per cent in 2001
and a full two percentage points in 2002. This more pessimistic
outlook for the world economy is reflected in our UK economic
forecasts. We expect quarterly growth in UK GDP from 2001 Q4 to
2002 Q2 to be 0.0 per cent, 0.2 per cent and 0.4 per cent respectively
and the trough in annual GDP growth to be closer to 1 per cent
than 2 per cent (see Chart 3).
There is little in the inflation outlook to
concern policymakers. RPIX inflation is back below 2.5 per cent
and forward looking indicators are consistent with an easing in
inflationary pressures. Producer price inflation, which surged
during the second half of 2000, has since come to a halt. Output
prices fell by 0.6 per cent in the year to October compared to
+2.7 per cent yoy inflation in the fourth quarter of last year.
Business surveys are also consistent with weaker price pressures.
The latest services PMI, for example, showed falling prices in
that sector for the first time in over two years.
Much of the pressure on firms' prices will be
felt in margins and profits. Unit wage costs, for example, grew
by 3.5 per cent in the year to 2001 Q2, compared to growth of
2.2 per cent in the GDP deflator. But labour income now appears
to be growing more slowly as well. Official data show that private
sector earnings growth has fallen sharply this year, from a peak
of 5.5 per cent in Q1 to 4.3 per cent in Q3. Most of this drop
is due to lower bonuses, arguably less important for firms' ongoing
costs of production. But more forward-looking indicators suggest
underlying pay growth will also slow in coming months. Basic pay
deals have fallen slightly, compared to the levels seen in the
spring and the latest Report on Jobs showed permanent staff salaries
amongst its respondents falling for the first time in four years.
RPIX inflation is likely to remain slightly
below the government's 2.5 per cent target throughout the next
two years (with the exception of a blip next spring as this year's
cuts in Budget excise duties drop out of the annual comparison).
MPC SENSITIVE TO
Inflation targeting has been a success. Since
1992, when the policy was first introduced, annual inflation has
averaged 2.5 per cent, in line with the government's target and
the average variation in inflation, from one quarter to the next,
has been 20 basis points, compared to 54 basis points over the
preceding 10 years.
This is a testament to the way monetary policy
has been conducted in recent years, but the success of policy
may have more to do with its response to output, rather than inflation
per se. The response of interest rates to changes in inflation
has been much the same under inflation targetingthe correlation
between them from 1993 onwards has been 0.32, not much different
than that over the preceding decade. The important change has
to do with how interest rates have reacted to variations in output,
to which policy has become much more sensitive.
At first sight they may seem strange, given
that the current regime has no explicit objective to stabilise
growth. But it makes perfect sense, given the way policymakers
view the inflation process. For the MPC, the single most important
determinant of future inflation is the level of aggregate output,
relative to potential. Thus as long as inflation is already close
to target, and as long as potential output growth is itself relatively
stable, the best way to smooth inflation is to smooth demand growth.
Policy should "lean against the wind". Indeed, the increased
sensitivity of interest rates to demand growth is the most direct
evidence that policy has become more forward-looking under inflation
The MPC has been particularly pre-emptive in
its most recent interest rate cuts. GDP growth was close to trend
in Q3 (+0.6 per cent qoq) and the 100 basis points taken off rates
since 11 September is consistent with the MPC's past behaviour
only if the Committee thought growth would slow sharply in Q4.
Further interest rate cuts will depend on growth remaining below
trend into 2002. If the growth projections in the Inflation Report
are correct, interest rates should trough at 3.9 per cent according
to our estimated policy reaction functionclose to the current
rate of 4 per cent (see Chart 4).
The next round of quarterly data are not published
until the New Year and, given the tone of the Inflation Report,
it is hard to see the MPC changing rates in at its next meeting
on 5 December. However, this does not mean rates have troughed.
If GDP growth is weaker than the MPC expects in the next couple
of quarters, interest rates will almost certainly fall further.
19 November 2001