Select Committee on Treasury Minutes of Evidence


Memorandum submitted by Mr David Walton

SUMMARY

  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 warrant.

  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 INFLATION REPORT

  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.

1.  Language

  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.

"UPSIDE RISKS" TO INFLATION VERY SMALL

  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 above target.

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.

TOO OPTIMISTIC ABOUT GROWTH?

  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 cent—reasonably close to trend—in 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).

INFLATION PRESSURES SUBDUED

  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 GROWTH SHORTFALL

  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 targeting—the 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 targeting.

  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 function—close 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


 
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