Memorandum submitted by Mr David Walton,
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
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 upGDP 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
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 thatin the MPC's judgementthe 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
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
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
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