(BOE) Quarterly Inflation Report August 2010
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Overview
The recovery continued in the United Kingdom, with output growth across the first half of 2010 close to its historical average. But the level of economic activity remained well below its pre-crisis peak. The revival in the world economy also proceeded, albeit unevenly. The UK recovery is likely to continue, underpinned by the considerable monetary stimulus, further growth in global demand and the past depreciation of sterling. But the risks to growth remain weighted to the downside. Spare capacity is likely to persist over the forecast period, although its extent will depend on the strength of demand and the evolution of supply, both of which are uncertain.
CPI inflation remained well above the 2% target, elevated by temporary effects stemming from higher oil prices, the restoration of the standard rate of VAT to 17.5% and the past depreciation of sterling. And the forthcoming increase in the standard rate of VAT to 20% will add to inflation throughout 2011. As these effects wane, downward pressure on wages and prices from the persistent margin of spare capacity is likely to pull inflation below the target. But the pace and extent of that moderation in inflation are impossible to predict precisely. Under the assumptions that Bank Rate moves in line with market rates and the stock of purchased assets financed by the issuance of central bank reserves remains at £200 billion, inflation is a little more likely to be below the target than above it during the second half of the forecast period, although those risks are broadly balanced by the end.
Financial and credit markets
Since the May Report, the MPC has held Bank Rate at 0.5% and maintained its stock of purchased assets at £200 billion. Financial market conditions remained strained, although they eased a little following publication of the results of the CEBS stress tests on EU banks. Market participants revised down further their expectations of the near-term path of Bank Rate. Ten-year gilt yields fell, as did equity prices, while corporate bond spreads widened. The sterling effective exchange rate rose.
UK banks continue to face a number of challenges related in particular to their need to refinance substantial levels of maturing funding. Credit conditions improved a touch, though less so than earlier in the year, while the stock of bank lending to companies fell further. Annual broad money growth remained weak.
Demand
The expansion in global demand and world trade continued, but the pace of recovery remained uneven. Growth was strong in Asia but was slower in the euro area, which is the United Kingdom's most important trading partner. The fiscal consolidation measures announced in some countries could dampen growth prospects unless accompanied by offsetting strength in private sector spending.
The United Kingdom's recent trade performance appears disappointing. Despite the substantial depreciation in sterling, net trade is estimated by the ONS to have reduced UK growth in each of the past three quarters, although business surveys and manufacturing output were perhaps consistent with a stronger net trade performance. The lower level of sterling should support an improvement in net trade but it seems to be taking time for UK companies to switch resources towards the production of tradable goods and services.
Both households and companies increased their saving net of investment sharply during the financial crisis, as the economic outlook deteriorated, uncertainty increased and credit became less available. The prospects for demand depend on the extent to which these high rates of net saving persist.
The level of households' consumption spending fell by 5% during the recession, but appears to have stabilised in recent quarters. Business spending rebounded in the first quarter of 2010. Business investment increased sharply and the pace of de-stocking eased. The level of capital expenditure remained substantially below its pre-recession peak, and the significant levels of corporate net saving over recent years suggest that many companies have funds available to invest, should they wish to do so. But weak orders and unused capacity are likely to deter investment and reports from the Bank's Agents are consistent with only a gradual recovery in capital expenditure.
A significant fiscal consolidation has begun. The Committee's projections are conditioned on the plans set out in the June Budget, which embodied a somewhat faster and larger reduction in borrowing than in the March Budget.
The outlook for GDP growth
GDP was provisionally estimated to have risen by 1.1% in 2010 Q2. The pattern of growth over recent quarters is likely to have been affected by a number of temporary factors. Growth across the first half of 2010 was close to its historical average. A number of surveys suggested that business and consumer confidence had softened recently.
Chart 1 shows the Committee's best collective judgement for four-quarter GDP growth, assuming that Bank Rate follows a path implied by market interest rates and the stock of purchased assets financed by the issuance of central bank reserves remains at £200 billion. The considerable stimulus from monetary policy, together with a further expansion in world demand and the past depreciation of sterling, should sustain the recovery. But the strength of growth is likely to be tempered by the continuing fiscal consolidation and the persistence of tight credit conditions.
There are some key uncertainties surrounding the prospects for demand growth. The strength of domestic demand will depend on the continuing impact of the highly accommodative monetary stance and on the behaviour of private sector saving, particularly in response to the substantial fiscal consolidation and the constraints on the supply of bank lending. Improvement in net trade will depend on the vigour of the global recovery and the degree of rebalancing prompted by sterling's past depreciation.
The Committee judges that the recovery is likely to continue. The most likely outcome for GDP growth is lower than in the May Report, reflecting the softening in business and consumer confidence, the faster pace of fiscal consolidation and a slower improvement in credit conditions. But the downside risks around this central projection are judged to be smaller than in May, due in part to the fiscal measures announced in the June Budget reducing the chances of a sharp rise in long-term interest rates.
Chart 2 shows the Committee's best collective judgement for the level of GDP, corresponding to the distribution of GDP growth shown in Chart 1. Output is likely to remain well below the level implied by a continuation of its pre-crisis trend throughout the forecast period.
Costs and prices
CPI inflation was 3.2% in June. That was well above the 2% inflation target and suggested that inflation in the near term was likely to be higher than anticipated in the May Report. The high rate of inflation reflects temporary effects stemming from increased oil prices, the restoration of the standard rate of VAT to 17.5%, and the past depreciation of sterling. The increase in the standard rate of VAT to 20% in January 2011 will add to inflation throughout 2011. Despite inflation being above the target for much of the past four years, measures of inflation expectations appeared broadly consistent with meeting the inflation target in the medium term.
Surveys continued to suggest that there was a margin of spare capacity within companies, although on some measures this gap was starting to close. Unemployment was stable but continued to point to a sizable degree of slack in the labour market. Despite above-target inflation, earnings growth remained subdued.
The outlook for inflation
Chart 3 shows the Committee's best collective judgement for the outlook for CPI inflation, based on the same assumptions as Chart 1. Inflation is likely to remain above the 2% target for longer than judged likely in May, in large part reflecting the increase in the rate of VAT to 20% in 2011. As the temporary effects adding to inflation drop out of the twelve-month comparison, downward pressure on wages and prices from the persistent margin of spare capacity is likely to bring inflation below the target for a period.
The Committee cannot be sure of the extent to which inflation will moderate. Businesses' costs and prices depend on the degree of spare capacity, both within companies and in the labour market, and therefore in part on the strength of demand. The impact of the recession on the evolution of supply will also be a key influence. Companies that temporarily adjusted their operating practices in response to the fall in demand may bring some capacity back on stream. But, over time, if weakness in demand were to persist, that might lead to some capacity being scrapped and individuals losing skills. Slack in the labour market will tend to bear down on earnings growth. But the size of that effect is uncertain, as it is also possible that earnings growth could recover as productivity picks up. Further out, inflation may remain higher than otherwise if the current period of above-target inflation causes medium-term inflation expectations to rise. Any further pressure on prices from the past depreciation of sterling, or substantial movements in energy prices, would also affect inflation.
There is a range of views among Committee members regarding the relative strength of these factors. Chart 4 shows the probability of inflation being above the 2% target along with the corresponding probability implied by the May Report projections. On balance, the Committee judges that, conditioned on the monetary policy assumptions described above, inflation is somewhat more likely to be below the target than above it during the second half of the forecast period, although those risks are broadly balanced by the end.
The policy decision
At its August meeting, the Committee judged that the recovery was likely to continue. The forthcoming increase in VAT was expected to keep CPI inflation above the 2% target until the end of 2011, after which inflation was likely to fall back, reflecting the persistent margin of spare capacity. In the light of that outlook, the Committee judged that maintaining Bank Rate at 0.5% and maintaining the size of the programme of asset purchases financed by the issuance of central bank reserves at £200 billion was appropriate to meet the 2% CPI inflation target over the medium term. But the prospects for inflation were highly uncertain and the Committee stood ready to respond in either direction as the balance of risks evolved.
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