Inflation Report, May 2008, Bank of England

Report - Finance

Inflation Report, May 2008, Bank of England In the United Kingdom, output growth moderated and surveys point to further easing. Indicators of household spending were mixed, while the investment climate worsened. International prospects deteriorated, especially in the United States. Stresses in global financial and credit markets intensified in March but latterly there have been signs of improvement. Sterling depreciated further and in April the MPC cut Bank Rate by 0.25 percentage points.

Under the assumption that Bank Rate moves in line with market yields, the Committee’s central projection is for output growth to slow further over the next year and then recover. But there is a risk that the slowdown may be more prolonged.

CPI inflation was 2.5% in March. Energy and import cost pressures increased. Pay growth remained muted but measures of household inflation expectations rose. In the central projection, higher energy and import prices push inflation up sharply in the near term. The emerging margin of spare capacity, together with a declining contribution from energy and import prices, then brings inflation back to around the 2% target in the medium term. The conflicting risks to inflation from a more prolonged slowdown in demand growth and from the impact of persistently elevated inflation on inflation expectations have both increased since the February Report. Overall, the balance of risks is presently judged to lie to the upside.

Financial markets

Financial markets remained under stress. The dislocation in global wholesale funding markets intensified in March but conditions improved a little thereafter, in part reflecting central bank initiatives, including the introduction by the Bank of England of a long-term facility to swap liquid assets for high-quality, but presently illiquid, collateral.

Even so, funding costs for banks remained elevated. These stresses in funding markets, coupled with the need to reduce balance sheet exposures to risk, were reflected in a further tightening in credit supply by UK banks, with higher premia charged, particularly to riskier borrowers, and the withdrawal of some products. As a result, mortgage approvals fell sharply, while loan growth to non-financial companies also slowed.

The MPC cut Bank Rate to 5% at its April meeting. Forward market interest rates imply less further policy easing than at the time of the February Report. The effective exchange rate for sterling depreciated by 31/2, leaving it some 12% lower than at its peak last July. Only a small part of that fall can be directly attributed to movements in expected interest rates here and overseas. The remainder may indicate a reassessment by investors of the sustainable value of sterling or an increase in the risk premium required for holding sterling assets. ...

The outlook for GDP growth

According to the ONS’s preliminary estimate, GDP growth in Q1 eased to 0.4%, on the back of slower growth in the non-distribution services and energy sectors. Business surveys and reports from the Bank’s regional Agents point to a further moderation in growth in the second quarter.

Chart 1 shows the Committee’s best collective judgement for four-quarter GDP growth, assuming that Bank Rate follows a path implied by market yields. In the central projection, output growth slows markedly through 2008, opening up a margin of spare capacity. Sluggish real income growth and tighter credit supply dampen consumer spending, while the weaker demand outlook and lower property prices also weigh on business and residential investment. Growth then recovers, as credit conditions ease and the lower level of sterling continues to feed through to net exports. The outlook is somewhat weaker than in the February Report over the first part of the projection.

Costs and prices

CPI inflation was 2.5% in March, some 3/$ of a percentage point higher than six months earlier, reflecting higher energy and food price inflation in particular. Higher energy and import prices are expected to exert further upward pressure on inflation through the rest of this year. Oil prices have risen by a quarter since the February Report, reflecting both continued growth in the demand for oil and constraints on oil supply.

There was an equivalent movement in wholesale gas prices and a further round of domestic energy price increases over the summer seems probable. Price inflation of imported goods rose to its highest since 1995, in part reflecting the substantial depreciation of sterling.

The scale and persistence of the projected rise in CPI inflation is uncertain, however. Businesses early in the supply chain appear to have passed some of the cost increases through into higher output prices, and survey measures of businesses’ pricing intentions have remained elevated. But a survey by the Bank’s regional Agents suggested that many consumer-facing businesses were not in a position to pass on cost increases to their customers, perhaps on account of the weaker outlook for consumer demand.

Those businesses not able to pass on cost increases may instead attempt to push down on other costs, especially pay. But the past and prospective pickup in consumer price inflation may also lead employees to press for higher wages to compensate. So far, pay growth has remained subdued, despite quite strong employment growth.

Easing employment intentions point to a weaker labour market in the future, which is likely to add to the downward pressure on wages.

Both pay and prices are likely to be influenced by expectations of future inflation. Measures of short-term household inflation expectations rose again, broadly in line with the recent and prospective movements in consumer price inflation. But some longer-term indicators of inflation expectations have also edged up. If expectations were to remain elevated, then that would pose an upside risk to inflation in the medium term.

The outlook for inflation

Chart 2 shows the Committee’s best collective judgement of the outlook for CPI inflation, assuming that Bank Rate follows market yields. In the central projection, higher energy and import prices push inflation further above the 2% target, to a level requiring a number of explanatory open letters to the Chancellor. The margin of spare capacity, together with waning contributions from energy and import prices, then brings inflation back to around the 2% target in the medium term. The profile is higher than in the February Report for most of the projection.

As usual, there are substantial uncertainties surrounding these projections. The key risks to inflation are: on the downside, the possibility that a more prolonged period of subdued demand opens up a larger margin of spare capacity; and, on the upside, the possibility that the persistent period of above-target inflation leads to a lasting increase in medium-term inflation expectations. Both risks are judged to have increased since the February Report. Overall, the risks around the central projection to growth lie to the downside in the medium term, while those to inflation are to the upside.

There is a range of views among the Committee on both the central projection and the balance of risks.

The policy decision

At its May meeting, the Committee noted that the immediate prospect was for a sharp increase in inflation, which was already above the target, and sluggish output growth. The latter would open up a margin of spare capacity, but that was likely to be necessary in order to return inflation to the target in the medium term. There were particular uncertainties relating to the severity of the slowdown and the future path of inflation expectations. The key challenge for policy was to balance those conflicting risks.

The Committee judged at its May meeting that it was appropriate to leave Bank Rate unchanged in order to meet the target for CPI inflation over the medium term.

Download Inflation Report, May 2008, Bank of England

PDF format, 2.88MB, 56Pages.

Contents:
Overview 5
1 Money and asset prices 9
1.1 Financial markets and asset prices 9
1.2 Credit conditions 13
1.3 Monetary aggregates 18
Box Monetary policy since the February Report 10
Box How far along the risk spectrum has secured credit supply tightened for households? 16
2 Demand 19
2.1 Domestic demand 19
2.2 External demand and net trade 24
Box The implications of recent falls in consumer confidence for spending 22
3 Output and supply 27
3.1 Output 27
3.2 Capacity pressures and capital 29
3.3 Pressures within the labour market 30
Box The impact of the dislocation in financial markets on potential supply 28
4 Costs and prices 33
4.1 Near-term outlook for CPI inflation 33
4.2 Global costs and prices 34
4.3 Inflation expectations 36
4.4 Labour costs 36
4.5 Companies’ pricing decisions 37
5 Prospects for inflation 39
5.1 The projections for demand and inflation 39
5.2 Risks to demand 41
5.3 Risks to inflation 44
5.4 The balance of risks 47
5.5 The policy decision 47
Box Financial and energy market assumptions 40
Box Other forecasters’ expectations 49
Index of charts and tables 50
Press Notices 52
Glossary and other information 53

Inflation Report: May 2008

In order to maintain price stability, the Government has set the Bank’s Monetary Policy Committee (MPC) a target for the annual inflation rate of the Consumer Prices Index of 2%.

Subject to that, the MPC is also required to support the Government’s objective of maintaining high and stable growth and employment.

The Inflation Report is produced quarterly by Bank staff under the guidance of the members of the Monetary Policy Committee. It serves two purposes. First, its preparation provides a comprehensive and forward-looking framework for discussion among MPC members as an aid to our decision making. Second, its publication allows us to share our thinking and explain the reasons for our decisions to those whom they affect.

Although not every member will agree with every assumption on which our projections are based, the fan charts represent the MPC’s best collective judgement about the most likely paths for inflation and output, and the uncertainties surrounding those central projections.

This Report has been prepared and published by the Bank of England in accordance with section 18 of the Bank of England Act 1998.

The Monetary Policy Committee:
Mervyn King, Governor
Rachel Lomax, Deputy Governor responsible for monetary policy
John Gieve, Deputy Governor responsible for financial stability
Kate Barker
Charles Bean
Tim Besley
David Blanchflower
Andrew Sentance
Paul Tucker

The Overview of this Inflation Report is available on the Bank’s website at
www.bankofengland.co.uk/publications/inflationreport/infrep.htm.
The entire Report is available in PDF at
www.bankofengland.co.uk/publications/inflationreport/2008.htm.
PowerPoint™ versions of the charts in this Report and the data underlying most of the charts are provided at
www.bankofengland.co.uk/publications/inflationreport/2008.htm.

Glossary of selected data and instruments

AEI – average earnings index.
AWE – average weekly earnings.
CDS – credit default swap.
CPI – consumer prices index.
CPI inflation – inflation measured by the consumer prices index.
ERI – exchange rate index.
GC – general collateral.
GDP – gross domestic product.
LFS – Labour Force Survey.
Libor – London interbank offered rate.
M4 – UK non-bank, non-building society private sector’s holdings of sterling notes and coin, and their sterling deposits (including certificates of deposit, holdings of commercial paper and other short-term instruments and claims arising from repos) held at UK banks and building societies.
PMI – purchasing managers’ index.
RPI – retail prices index.
RPIX – RPI excluding mortgage interest payments.
SVR – standard variable rate.

Abbreviations
A8 Accession countries – the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia.
BCC – British Chambers of Commerce.
CBI – Confederation of British Industry.
CIPS – Chartered Institute of Purchasing and Supply.
FTSE – Financial Times Stock Exchange.
GfK – Gesellschaft für Konsumforschung, Great Britain Ltd.
HBF – Home Builders Federation.
IMF – International Monetary Fund.
ISA – individual savings account.
LTV – loan to value.
M6 – Canada, France, Germany, Italy, Japan and the United States.
MPC – Monetary Policy Committee.
MTIC – missing trader intra-community.
OFCs – other financial corporations.
ONS – Office for National Statistics.
OPEC – Organization of the Petroleum Exporting Countries.
PNFCs – private non-financial corporations.
PwC – PriceWaterhouseCoopers.
R&D – research and development.
RICS – Royal Institution of Chartered Surveyors.
S&P – Standard and Poor’s.
TFP – total factor productivity.
UIP – uncovered interest parity.