Select Committee on Treasury Minutes of Evidence


Memorandum submitted by Mr David Walton, Goldman Sachs

  The tone of the May Inflation Report was fairly hawkish reflecting the MPC's view that above-trend growth will be resumed shortly, leading to an overshoot in the inflation target in two years' time.

  The MPC's growth forecasts seem reasonable although there may be slightly more slack in the economy than the Committee believes. This gives the MPC time to assess the strength of the recovery before needing to tighten monetary policy. But interest rates are comfortably below any assessment of a neutral level and they are likely to reach 5-5.5 per cent over the next year.

  The recent weakening of sterling, if it continues, offers a chance to rebalance the economy.

A HAWKISH INFLATION REPORT

  The May Inflation Report had a fairly hawkish tone. Two factors were significant:

  1.  The MPC's forecasts for growth and inflation were both revised up—GDP is projected to grow by 3.1 per cent in 2003, up from 2.7 per cent in February; RPIX inflation is shown rising slightly above target at the two-year horizon (mode 2.6 per cent, mean 2.9 per cent).

  2.  The language of the Report was tougher. In February, the Overview ended merely by justifying the most recent rate decision (to leave rates at 4 per cent). In May, the MPC added a final sentence: "The Committee stands ready to act to contain any developing inflationary pressures ahead."

  There are likely to be several factors behind the MPC's more hawkish tone:

  1.  Business surveys point to a robust recovery in economic activity from 2002 Q2 onwards. The MPC expects the economy to grow at a 3 per cent annualised rate from now on. In the past, whenever quarterly GDP growth has picked up to a 3 per cent annualised rate or more, the MPC has tightened at the first opportunity.

  2.  The MPC has usually behaved in this way because it generally believes that the best way to keep inflation on target is to keep output at trend. Thus if the output gap is small and inflation is close to target, an early policy reaction is appropriate if GDP starts to grow much faster or slower than trend. The MPC appears to believe that there is not much slack in the economy at present. Despite the past six months of stagnating output, the Bank's Chief Economist, Charlie Bean, said in the press conference that—in the MPC's judgement—the economy would return to "around trend" early next year. The Inflation Report forecasts that GDP will rise by 2.9 per cent yoy in 2003 Q1. Working backwards from this, and noting that the MPC's estimate of trend growth is at least 2.5 per cent, it seems likely that, on the MPC's estimates, output is currently no more than 0.5 per cent below trend. On this reasoning, the MPC believes that output will run above trend in the final year of the forecast horizon.

  3.  MPC members have talked on occasions this year about the need for consumer spending growth to slow to make room for the recovery in global economic activity. There is no evidence of this. Consumer confidence is close to an all time high. This is reflected in the buoyancy of the housing market. The MPC noted that the measures in the Budget are likely to augment demand growth next year.

  4.  The MPC is concerned about the inflationary effects of the Budget, beyond its effects on demand growth. Unless it is offset by lower pre-tax wages, the planned rise in employers' National Insurance contributions will reduce margins, and firms may respond by pushing up prices: the central projection for inflation now incorporates "some pass through of higher NICs into higher prices". Even allowing for this, the MPC said inflationary risks from higher NICs were "on the upside".

  The recent recovery in the Euro will have added to the MPC's concerns about inflation. The Inflation Report assumed a gradual depreciation in the sterling trade-weighted exchange rate from 106.8 to 104.1; it is currently trading at around 103.

  My thoughts on the present situation are the following:

  1.  The MPC's growth forecasts seem reasonable. Monetary and fiscal policy are both stimulative and the global economy is recovering. Above trend GDP growth is likely to be resumed soon. However, there may be slightly more slack in the economy than the MPC believes. GDP did not grow in either 2001 Q4 or 2002 Q1. Capacity utilisation has fallen to the lowest level for nine years according to the latest CBI Industrial Trends Survey. Skilled labour shortages are below average and pay deals are running almost 1 per cent lower than a year ago.

  2.  If there is more slack in the economy than the MPC believes, then inflation pressures are likely to remain subdued. This gives the MPC time to assess how strong the recovery is likely to be before it needs to tighten monetary policy. But interest rates are comfortably below any assessment of a neutral level and they are likely to reach 5 to 5.5 per cent over the next year.

  3.  The recent weakening of sterling, if it continues, offers a chance to rebalance the economy. Consumer spending has grown by around 4 per cent a year in real terms each year since 1995 while net exports have been a drag on growth each year. This is unsustainable. A combination of a lower exchange rate offset by higher interest rates would help to turn around these trends. Arguably though, the MPC does not want to be seen to be reacting to the first signs of sterling weakness for fear that it pushes the pound back up.

10 June 2002


 
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