Bank of England Inflation Report
November 1993 Inflation Report
November 1993
SUlllllHlry
Recellt price developments 5 1.1 Rclnil prices 5 1.2 Output prices 6 1.3 Domestic defl ators 8 1.4 'Core' inflation 8 1.5 Summl.lr), 9 Box Rebasil/g and H ' I'iJioIlS- IIOII' /ias hisrOlY changed? 7
2 j\lonehlr~ and fi scal policy 10 2.1 MOnChlr)' conditions 10 Interest rates 13
Exchunge nltc:-; I ~
2.2 Fiscal policy I ~ 2.3 Sumll1:u')' 15 Box MO \ /IIollitoring ral/ ~e 12
3 Demand and oulput 17 3.1 Ocmand 17 Personal spend ing 17 Investment and stockbuilding 18 Overseas trade 20 3.2 Output l.md the outlHlt g.lp 22 3.3 SUm lmlr)' 24 Box CSO rnule figllres: I/e ll' colleCTioll methods 21 Box UK comperiril'elless 23
4 The labour market 4.1 Earnings :tnd settlements 25 4.2 Eml)loymenl and unemployment 25 4.3 Labour produclivit)' and unit wage costs 27 4.4 SUlllnll.lry 28 5 Price dynamics 29 5. 1 External inrluences 29 Pri rnary product prices 29 Overseas inflation and im port prices 30 - ,.-, hllHlt prices 30 5.3 Uusincss prolih,bility 31 5.4 Summary 33
6 Pmspccts 1'01' inflation 34 6. 1 E,'id cncc from timllldal markets 34 6.2 Pri".ltc sector forecasts 34 6.3 Survc~' s of inflation eXI}cctations 35 6.4 Bank projections 36 The shorHun out look 36 Longer-term projections 36 Uncertainties 38
7 Conclusions 39
Re,,"nl~d f,om 11", N,)\~",I>,'r I<)IJJ Il:on~ "' Engla"J Q,,,,,.,n-/, /1"1/,.",,
1'"IIlcJ b} ll" rrHp' Lld. SI 'vc, plc Cl I l:I,,~ " I I' ''gl;o "d 1';<)1 ISIlN I H57.1() (JJ2 4 Summary
The illjJmioll Report cons i dc r ~ recen t dcvcloplllcnb. in inflation an d puts forward the Bank of England"s all a Jy~i~ of future prospects. [\ corllain s seven sections covering:
(i) recent price developments:
(i i) monetary and fiscal policy:
(i ii) demand and output:
(iv) the labour market:
(v) pri ce dynamics:
(vi) the prospects for inflation: and
(vii) conclusions.
Underlyi ng inflation- defined ilS the \wclvc-momh c han ge in the Rel.\i! Prices Index cxclu dlllg mortgage interest paymenb (RPIX)-has risen si nce the last 11I{(tllioll Report. I! was 2.89'(' in June. but has increased in each of the la~1 three Illonth~. (0 reach 3.3% in September. The headline rat e of inflation has abo ri sen.
RPI X inflation has heen affected by the ~wilC h fromlhc Community Charge to the Council Tax. To disentangle the impact of such tax changes on the price /{".", from the 'underlying' rate of illJ/(I{ioll. it is useful to examine a price index which exclude~ not only mortgage in tere",t payments but a[",o indirect taxes and local authority taxes. Inflation mca~ured in th i", way ro~e from 2.8q. in June to 3.5% in September. the same as a year ago before sterl ing's depreciation began to affect import pri ce~.
Some increase in inflation between June and September had seemed likely at the time of the last Rt,porI. Sales discounts wcre unusuall y widespread in June. !:!uggesting that a ri!:!e in the inflation rate would fo ll ow post-sale price rises. In addition. seasonal food prices fell by more than is usual in JUlle.
In fact. RPIX inflation has risen a liule more than projected last time: to 3.3% compared with 3. 1%. Th is difference partly refl ects sma ller than expectcd falls in food prices in Jul y, and partly the larger than expected recovery in the prices of household goods and clothing and footwcar associated with the end of the summer sales.
To conduct monetary policy effectively, it is necessary to form a view aboul the likely course of inflation over the longer term. Given current policies. Ihe Ba nk's vicw of lhe most likely outlurn is Ihal inflation- both hcadline and RPIX-will ri se untillhe middle of 1994 and then start to decline again . The new information avail'lble since the August Report has led to a small upward revision in Ihe Iwelve-month inflation 1"<1I es expected over Ihe nex l few mont hs. but it has nOI prod uced any signi ficant change to the expected rat e of inflation Iwo years from now. The central projec ti on remains with in the target range for RPI X inflation. BUI there is a slight possibility that in the first ha lf of next year inflati on wi ll brie fl y rise above the top of the target range. Th is is panly because of changes in indirect and local au thority taxes. Excluding those taxes. inflat ion is expected to start f'llling in early 1994. and could reach a level close to the middle of the target range in 1995.
But there arc considerable uncerwi nties. The fi rst concerns the exchange rate. If attempts to stimulate recovery lead to bi gger than expected cuts in in terest rates abroad. this would be likely to push up the sterl ing exchange rate and reduce inflationary pressures in the short run.
A second source of uncertai nt y is the behaviour of wage bargainers. If the short -ruIl increase in infl ation is simply extrapolated forward and earnin gs start 10 rise more rapi dl y. then more of the growth of nomi nal demand whi ch is expected over the next year or two will take the form of higher prices rather than hi gher output and empl oyment. But Ihe continuing output gap. moderate growth of nominal demand. and slow growt h in broad money and credi t. all po int to the possibility of bringing in fl at ion down fu rt her at the sallle time as output growth picks up. Recent price developments 1
l.l Retail prices
Underlying inflation- defined m. the twel ve-month change in the Retail Prices Index excluding mortgage in terest pay ment s (RP IX)- bas ri sen ~ince the last Chart 1.1 /njl(l/ioll Report. It was 2,8 % in June bUI has increa:.ed Inflation in each of th e last three months to reach 3.3% in September (Chart 1. 1). The headline rate of inflation has also risen. Three mOllth s ago it had fallen to 1.2%. Ihe lowest rate for nearly 30 ye'lrs. but by September it had increased 10 1.8%.
Headli ne inflation has been lower than RPIX inflation since the middle of 1991. The difference between it and RPIX pri marily reflects changes in mortgage interest payments d uring the prcv i ou~ twel ve mon th ~. The gap wi ll narrow in thc ncxt fcw month ~ a:-. the reduction ... in interest rates which took place la:-. t aulumn fall out of the twelve-month calculation.
Du ring the coursc of thi s year. RPIX inflation has been
'" 11 .... ,."""","-"«1",, ""...... ," '"' v ... ·, ..... , ,,,,,., ..... 1 ..-"' ..... NI', affected by the switch from the Community Charge to """"' ..." . . the Council Tax. The c han ge lowered the twelve-month ri se in RPIX. an e ffect whic h will persist until the second quarter of next yea r. At th at point the increase in VAT announced in the M,lrch Budget wi ll enter the index. To disent angle the impact of such tax c han ge~ on the price lel'e! from the 'underlyin g' rate of ;lIf/alioll. it Tllhlc I.A is useful to examine a price index which excludes not Contrihulinlls to HI'IX inllalion onl y mortgage interest payments bu t also indirect laxe:-.
G,.",h 01 "h"'h S«'k"" C""",,,I I(I'IX,,, (VAT and excise duties) and local authorit y !;lxes. Sc~"M,.1 CIooh,"$ Tu (",od, and Chart I. I shows inflation measured in thb way f. _ " ,, ~ .. denoted by RPIY- since Ihe beginning of 1990. RP] Y Se", IW ~ 1 62 ·0 11 ·01)2 O .~l ~. O M", 1991 I n .(1 16 0 02 O ~\ J~ inflation rose from 2.8% in June to 3.5% in September. Junt I99J I ~~ I) 10 ·(P O ~ 8 x'" 199' I <15 I) I1 I) I ! ·(n o .H the same as a year ago before sterl ing's depreciation .., 1'<"" ...,.,"-""".) .... , .. ,.... began to affect import price:-. . C._ ... ,""') ... ",m •• M'" "" ...... "...... ' _ Short-run infl ation measures can often give an earl y indicatio n of a change in inflation. Table I.B shows the three-month in fl ation rates for a number of indices. The fi gures have been seasonally adjusted and annualised, to Tahll' I.n allow comparison with conventional twel ve-month Shurl-rul1 nH.' a~III· I" of inl1aliun mcasures. Short-ru n measures need to be interpreted I'",,,,,,,"~" ,ha,,~", ", with particular care in o rder to distinguish changes in the RI'I NI'IX RI'I) normal seasonal pattern (such as the early start of \'1',",,,1>0, I 'J'J! ! ~ l" I .! 4,~ summer sal es in Ju ne), from persistent c hanges in the D.. ·c ",nl>o,IWo! lit) "l.7 ::: ~ 51 'I, ,,'h I'JOB , " ) ~ III inflation rate. The table shows that. follow ing a sharp J" ,.... I'Nl '", U'J" ,,9" .! I l .b Sq''"'''''''' I 'JOJ 1 " " " 44 S.I fall in short-run RPI X inflation between March and June '" ' ..... ,... ,"" '", ..... ,"<,, n ... ,h ,., H,,,,,, ",.. ", <-""". ",,,,,",,n, ..... !"."d ,,'" """,,"«>1 as a result of the int roduction of the Council Tax, the rate ,'''' """,.,1<1;""""" <. ,I>< f"~< ,."... , _m "'" ....' .11, .-1,.,«" . "n~ • K,I",<.n li l"', rebounded to 4.5% in September. "'...,"""f" .... ,I>< .... ,""'.. ',"'od, ".lul ,""",,., ...... ""'"'" ...... ,...- .. , Tb< .... ,", ',K ,.."" ....1 ""," ~<, "", ... " ...... 'h< 1\1'1\ ...... ' """,,,,,,, "'" ,.",.. .1", "~, .... ,""'( ., ..., ... ,, 0 .... 1'<, 1'"...... 1 .. ',,"', ""'~~,"".~ ,n",'"".. , Table I.A shows the main c han ges to the components of RPIX inflation sinee sterl in g left the exchange rate mechanism in September 1992. RPIX in fl at io n fe ll by 0.7 perccntage points during this period. But if the impact of the switch from the Community Charge to the Counci l Tax is removed, the inflation rate was broadly unchanged. Within the total. the contribution of services to inflat ion has tended to diminish and that of goods has increased. Pet ro l. clothin g and footwear, and seasonal foods arc a ll contributing significantly more. For petrol and clothing and footwear, this reflects the impact of C harl t.2 depreciation on import prices. By contrast, retail I'l'IIdUl;cr uulpul prkl' intlaliun non-seasonal food prices contributed no more to ,".. "", '" 1""<",,, ,< .. ,... 1", inflation during the past year than in the year before 1'<,,",", sterl1l1g's withdrawal from the ERM, despite sharp ri ses in farm gate pri ces caused by a net devaluati on of the - , g reen pound. 1.2 Output prices - , - , Manufactured output prices have accelerated since the last Inflatio/l Report. In the year to September, prices - , rose by 4.2%. up from 4.0% in the year to June. The -. manufacturing sector has been redefined by the CSO , ,I. since the last Repon. and the pri ce series has also been I. "'" " """, ,~ .. " .. " rebased to allow for changes in the composition of '" r""" ".... "''""'"""~, I~"" 100, ,~Il' 81" output in the late 1980s (see the box on rebasing on .b, roc.l ...... f ... '",,"•• ,'I\IO<-IOOI'Sl("q~, page 7). T he new series, which now includes petroleum re finin g. shows that output prices rose more slowly during the past two years than when they were measured by the old series (Chart 1.2). Bu t it a lso means that the rate of inc rease of prices has ri sen since a year ago, a c hange which was less obvious in the earl ier data. 6 Rebasing and revisions-how has history changed? The UK national accounts statistics [HIve recentl y potential ou tput- and its deflati onary impact may been ["cbased on the year 1990. This means that all now be smaller. Real GDP (at factor cost) is now the expenditure components of GDP are now thought to have risen by 2.0% in the year to 1993 expressed in terms of average [990 prices and new Q2, compared with a previous estimate of 1.5%. aggregate measures have been c:l1cul:lted. Similarly, The recovery :Ippears steadier. rising gentl y through the detailed components of output. which were 1992. increasing less rapidl y arou nd the turn of the previously weighted together usi ng 1985 values fo r year. net output, have now been rewcighted according to val ues of net output in 1990. Together with other Manufacturing on its revised definition- it now data revisions and methodological changes. rebasing incl udes coke, ovens. mineral processing and :Litcrs recorded hi story. nuclear fuel production- has gl"Ow n more slowl y Hn'lIkdown of ' lIlonc)" GDI' J: 1'o\\th si nce the beginning of this yellT than o ri gi nally l 'c ' "c n" ~c ch;,ngc recorded. In the first six months of 1993 ' Moocy' (i1)P K,· .I (jDI' l)on"".. ", manufacturing output is estimated 10 have grown by ~< ~< Infla""" ~, 1.5%, compared with an earlier estimate of 2.7%. 0'" N~ ..· "" Nc .. 0," N~ .. IW801 This downward revision to manufactu ring output 1990QI 18,4 lK2 H 1.l9 '" large ly reflects a reassessment of the movement of 199001_ " 1992QI .., " ." . \~ ". 11.3 prices and volumes in this sector. In pltrticular. 1992QI ex port prices. which have grown sharply since last 19'13Q2 ,. . 211 2.5 2') " ", "~ - '00 - '00 .... - " - . - • - . - " - . - • _ I I I ! I ! I 1 I 1 I ' , 1 I - , ~l •.1 , ~ •. " • " •. "" .. .' " " , If the more volati le prices of petroleum refi ning, and food. drink and tOb'1CCO, are excluded, the rate of increase of outpu t prices is a liule hi gher than three months ago. In the year to September, prices rose by Chart t 3 2.9%. up frOIll 2.4% in the year to June, Moreove r. in \ tanuf:I\'turinJ.! l'Xllllrt and twodu('cr pricc intlalion the latest three months, prices have risen at an annualised rate of 3.7%. , ~._« ''''ruo r-"'" «dod,"" ~ ...... , ..... "". ""nolt.", , .... """'''' ...... ~ ....u) 0.1,.,1('<1 """"'.. " .."'~ <'I'''' r-.<.., ..... , t· "'>CJ dou Some rise in the rate of increase of producer output """'"E"'''' "k'lo... ~ .."" .... ,·c,_",,,,,, I,<","",t< ,"' , '~" .... y... " •• 1,« prices du rin g 1993 had seemed likely at the time of last _1'i autumn's deprec iation. Chart 1.3 shows that, although -" manu fact urers' prices in the home market have risen by - 11 slightly less than 3% over the past year, the sterling - 'O! prices for manufactured export s to the non~EC economies have risen by more than 14%, durin g which ~~~-. ' time sterl in g fe ll by a similar amount against the non-EC ~ -. cUITencies. Both the speed and the extent to which export prices have responded are surprisi ng. Past -'" experience suggested that export prices would ri se by -" only about half the extent of the devaluation. I"" ""I, , ",.1", '"', QI Q! Domestic deflators • ___ ""'. "", •• ",.h"~ "'''''''''.... ''' 1.3 The GOP defl ator provides a broader measure of domestically generated inflat ion. This series too has been affected by the rebasing of the national accounts since the last Rep0 l"' , The new data show that the factor cost GDP defl ator (whi ch excludes indirect taxes and subsidies) was unchanged between the first and second quarters of thi s year. In the year to Q2, the deflator rose by 1.5%. This was much lower than in the year to Q I; that increase is now put at 3. 1%, against the 2.0% that Chart t .... GDP della!or was reported in Au gust (see Chart 1.4). 1'<<<< ...... , ~ •••"<, nO • )<'" , .. I",. -" The hi gher estimates of the increases in the recent GOP defl ator are largely the resu lt of a downward revision to the import price deflator in the fi nal quarter of last year. - . This showed a sharp ri se following sterl ing's depreciation. The revision has revealed that a larger fraction of the increase in expenditure deflators has been -. the result of domestical ly generated inflation. Some _. uncertainty remains because of the difficulty of estimating price deflators ror trade with the EC under -, the new reporting system. 1 ' , , t , ' U QI (}2 0' {Jot QI 02 0' {Jot 01 Ql (}l Q-< QI Ql 1.4 Core inflation ,~, " Changes in the measured rate of inflation can result from movements in relat ive pri ces as well as from changes in underlyi ng inflation. But it is not always easy to distinguish relative price movements from • changes in the gene ral price level : he nce the development of indicators that try to identi fy 'core' inflat ion. Most 'core' inflation measu res ! Chart 1.6 shows two o ther useful measures: the housing adj usted (HARP index) RPI and the Tax and Price Index (T PI). The HARP index has an estimate of the user cost I, I .. ", I, ,I, .. " of housing in place of mortgage interest payme nts (and 1_, NI'I ..' ...... -J.'l<" ,_ .. ~ 1"')_0" . 10001.0001, ..1-.1 h~hI . was discussed in the Febnwry Report). O n this measure, "".01 ""''''''~) ....' -.I "",",<11.,,,, inflatio n has risen more steeply, part ly because ho use prices rose o ver the last twelve months (whereas interest rates. whic h affect headline infl atio n. fe ll ). The Tax and Price Index is an index of the gross taxable income needed fo r tax payers to mai nta in their purc hasing power: it increases if di rect tax rat es or the RPI increase. The T PI has followed the RPI c losely. re fl ectin g the Charl t.6 absence of substantia l direct tax changes in the last IU)1. '1'1'1 and lI ,\Itl' i"nal i(l ll rail'S twe lve months. "KJ<"" ;" "'''', .." ,),,,,,... 1,,,, 1'<<<,,,, -11 1.5 Summary -m Infl ation is a litt le higher than at the time of the Aug ust Report. This is true not j ust fo r the headline rate. - . Excludi ng mo rtgage interest payments, indirect taxes - . and local autho rity taxes. the rate is also hig he r. and alternative measures such as the TPI and the HARP index - , confirm thi s. The median in flation rate shows a slight fall. But it excludes items discounted in the earl y \_n~J.- summer that are now back at no n-sale prices. Much of the rise in inflat ion can be accounted fo r by a reversal of _1,.", " "I" " ,,- 0 discounts starting in June, plu s a return to a mo re normal ,~ ~I 9l .. pattern of seasonal food prices. 2 Monetary and fiscal policy 2. 1 Monetary conditions The growth of both narrow and bro ad money has ri sen slightl y since the last Heporl (Chart 2. 1). So the Chart 2.1 monetary aggregates are showing a greater degree of I'll tt, t-Illllnlh 10:1'1)\\ Ih raIl" of '10. ' I ~. I)h j .. i;1 :111(1 thl' l'1"l-d ilcmmtcrllurt to ~14 consistency than was the ca.se in the first half of this ye ar. However. MO renl ('hart 2.2 A large part of the strength of MO is attributable to the " •• d'c-nU/nth j.:ril\\ Ih ralc~ nf noll'" and increase in liquid ity and the reduction in velocity growth l',lill and \ atul' and. nlU rlJl" of retait .. ale .. brought about by lower interest rates over the last year. "«""' There is uncertainty aboulthe precise size of the interest - " ~<1."I_",'.., nHe effect on MO in the shon run. However. over the • medium term. thc present monitoring range of 0%-4% for MO remains broadly consistent with the inflation • target (see the box on page 12). Broad money growth has picked up a liu le. its ..:..-"'<-.J\--N+t-IJ----.' , twelve-mont h growth ratc rising to 3.9% in the third quarter. The an nual growth rate of bank and bui ldi ng society sterl ing lending to the rest of the pri vate sector the ma in credit counterpart to M4-also rose in the th ird quarter. With both the three and six- momh annualised _I " L L" q " .t ,.. • growth rates of M4 and M4 lending above their annual growth rates, this suggests th at the trough in broad money and credit growth may have been reached in the last quarter. However, thi s growth is occurring from an already low base. '" Recent work by the Bank on the role of banks and building societies in the transmi ssion mcchani sm (~ee the article on pages 478- 91 of thi s November's Qllarlerly Bllllelill) hi ghlight:. the ~ i gn iri c anc e of sectonll measures of Illoney and credit. Empirical evidence suggests that the characteri stics of the demand fo r both money and credit (ban k and building .'.ocicty lending) vary sector by sector. Large rirms (part of the e lmrtl.] 'industrial and commercial companies' grouping) are Estimatcd lulal ((lIarll'r') lo ll'rlin)! hornming b,\ able to switch both their assets and liabilities relati vely I CCo; easi ly between banks and non-banks, Looking just at their bank deposits and borrowings wil l thu s provide r-;" ",,", ,. "",,,,_ ""'""' < " " "'~' " ""..o!".,,,, N" ",, ',," "'I"'" "'''''. un""J"'~" only a partial , and poss ibl y mislead in g, view of their B.. "m,,'~ ""'" '"'''' .,," ,,",~h" , ~'.""' , "" " .., lI y ""I""'" financial decision-making and thus of their potential spending, - . This is important when interpreting recent monetary trends. Industrial and commcrcial companies have - . repaid borrowing from banks and building societies in - , each of the last three quarters (.'.ec C hart 2.3). But al the same time companies have taken advantage of buoyant capital markets to isslle shares and bonds: though capital issues were lower in the thi rd quarter than in the second quarter. they were still hi gher than in any qual1er last year. So the pattern of financing among industrial and commercial companies appears to represelll balance sheet restructuring, rat her thall balance sheet contraction. They may be reducin g bank debt either to increase the maturity of their liabi lities through longer-dated bond iss ues. or to reduce their indebtedness more generally by increasing equity capital. Neither is necessarily a Charl 2..1 harbinger of weak spending, I'I'i\atc SCl" tur lIel ~ll' rlinJ.: hnrrowin:.: frum Imnks and build in)! sUl"ictics Credit frol11 the bank .~ and building societies constitutes 01' 1, ,et'< ,~''' .. , • ,... , 0 0 a much larger proportion of the tOlalllabilities of small t " ,""." firms and households than of companies. because these . ~. agents are typically less able to draw upon the capital . II - 1Of markets for funds. So in principle credi t ~ h o llld provide -" a better indicator of the personal sector's actual and -,. potential spending patterns, -" - f 1 -'" Bank and bui lding society lendi ng to the personal sector - • increased by £5.5 billion in the third quarter. against - • - , £4.2 bill ion in the second quarter (Chart 2 ....1 .). Within - , thi s, lending for house purchasc rose by £4.9 billi on. I~ -+, from £4.3 billi on in the second quarte r. This is consistent with the modest reeo"ery in activity in the , , , , - , ,m ., ., ., housing market. But lending for conslI mption remains broadly unc hanged frolllthe second quarter. The relatively modest ri se In borrowing is. by it self. probably insufficie nt to account ful ly for the recent fall s in the personal sector saving ratio. This would imply that " MO's monitoring range In the la:. t Budget. fi xed monitoring ranges were different MO equat ions. The equations shown are :.et for both MO and Mol (0% to 4% ,md 3% to 9% the Treasury eq uation (from the January 1993 annual !!,I"owt h re:.pecti vely) for the whole period Public Release of the Treasury macroeconomic covered by the Medium Term Financial Strategy model) the current Bank of England equation (until 1997/98). The Fin.mcial Statement and (described in a fo rthcoming Bank of England Budget Report contai ned an annex on MO's working paper) and an earlier equation estimated monitoring range wh ich described how MO has by the Bank in 1989 (described in 'The long-run recently been growing faster in relation to determination ofthc UK monetary aggreg:lles' nominal GDP than in the past. In other words. the Bank of EJlg/ond D;sC:IIs.\·;on Paper No. 41). The growth rat e o f MO' s ve locity of circu lation has estim;l\es shown in the chart include only the slowed (see the box on page 299 of the last direct effect of interest ra tes on MO for a given QI/flrter/y BIII/t,till). The annex noted that if thi s level of nomi lllll de mand. The mosl noticeable were more than a temporary phenomenon. MO's fe ature of this chart is that the est i m The chart shows estimates of the effect of a Ol1e percentage point reduction in short -term interest rHte ~ on the rate of growth of MO using three " indi viduals are financ ing a grealer proportion of thei r spending ou t of income. through a slower accumu lalion of savings. Pa rtly. thi s wi ll be reflected in sluggish bank and bui ldi ng society deposit growth. Equal ly. however. it may be reflected in slower accumulation of non-bank Tabl... 2.A assets. such as equities. whic h- unlike non-ban k Oflici:11 inl ... r ...... 1 rail's o\crW:I' liabilities-make up a signiricant proportion of the l'co «n, PC' "n""", personal sector's balance sheet. 1992 1'I'1l I StP' I ~ I " 7 M~l ' !Aug_ 2700::, Un "cd S,",", Borrowing by unincorporated bu sinesses rose by 1'",,,<,,, ,d, "'''''''HI, '" ""'" ""," ""'" "'H) £0.4 billion in the third quarter. following a net Jap"" '-ep"yme nl ofm.8 billion in the nest half of thi s year. If D,,,'!)"'" In 2.'IU 250 250 CJIi"" ) 20 12U UO ,~'" sustained. th is ri se in borrowing would suggest that Ihe (;e ",,",, )" "" scal ing back of these businesses' liabilities has been 1),,,,,,,,, ,, 05 X'X) 725 6.75 1.75 I.<,," ..... ,J '1.00 X_.\O 7.7~ b_7S completed, Future income lllay be used for spending. I'r..... ' o· "" rather than to repay ex isting debts. I",or' ~ """" 6.75 6.45 S- IO do) ropo 10''''1 12U" '""" IOfoO,b) 725 1 1~ly The Bank's Divi sia index rose by 1.1 % in the thi rd [>r",,,,,,,, j12~ ,\d.. ",,", Ins '"' 2 _5 1""2_0 100"' """ quarter. compared with an increase ofO.9% in the .", ...... oI"r" .. """" previous quarter. On an mumal basis it s growth rate '",M 1... _",,," increased fo r [he third consecut ive quarter from its trough of 2.8% in the fourth quarter of 1992 and currently stands at 4.2%. Consistent with the signals given by the sectora! a!lalysh-. the growth in Divisia was large ly re lated to personal sector activity, The personal sector index increased by 1.3% in Ihe third quarter. rai sing it s annual growth rate to 5.0%-the hi ghest since 1990 Q4. The corporate sector index, on the other hand. Charl2.5 grew by on ly 0.5% and it s annual growth rale fell EXP"'l'lcd Vrcm'h'(;("'nwn intcrl'~1 rail' dilTl'l"l'nlialr.\ further to 1. 1%- the lowest since 1985 Q3. ',<,,<0' ".. IlIfcre.\·' I"{I(('S 11«<..... " "m '" Although offi ci;ll interest rates in Ihe Uni ted Kingdom "' have nOI changed since the last Report. rates in "' continental Europe fell after the widening of the ERM .+uo"' bands on 2 August. though not by as much or as quickl y "' as some were expecting. The Japanese discount rate has " also been reduced (sec Table l.A). The European "' "' sequence of changing expectati ons is best illustrated by "' changes in the differential between French and German ". three- Illon th interest rate futures (Chart 2.5). The - " differential widened significantly in earl y August as the :t \(I " I':!O 11 , 10 11:. , ~ IJ 11 " i00i) ""I"" "'...... ' o.:~""" market expected large and rapid French interest rate ." C"","lMal ... ,... '"'1'1 ..... , _h ""'''''' _. ' ...."""" I-.-h ""'" r.r-:. """".,;h ..,"". "" <"""'1'-"' IlM I ...... , .... cuts. but has since ret urned to lie above it s level at the end of July. The reducti on in German interest rates on 21 October was fo ll owed by most other EC countries. Market ex pecliltions of the level of UK interest rates at the end of the year fell by two thirds of a percentage poi nt after the widening of the ERM bands. The market seemed 10 be expectin g sterling to appreciate . thereby L"thuon Rq>llrl Nm~",bcr L,),) l Table 2.11 offering scope for an interest rate cuI. These Ster ling (,\l' h ~lII J:l' rate' expectations receded as the anticip ",<,Imf I'RI Latterly. however. interest rate ex pectations in the United VS - S.9 Previous Report.l· have compared the short-tenn yield - H curve for the United Kingdom wi th that fo r ' world ' in terest rates. At the tillle of the last Report the - 5.1 di fferential between these curves was around -0.52% fo r three-mon th interest rates and -0.13% fo r twelve-month rates. Since then, the di fferentials have been reversed. UK rates stood at a pre mium of 0.26% -" duri ng September at the twelve-month hori zon (Chart 2.7). Thi s impl ies that the sterl ing effecti ve index is expected to depreciate slightly over the next year, compared with an expected appreciation at the time of - 0.: the last Report. - 0.1 + - 00 2.2 Fiscal policy --,=,----;c:::;;,--"-::::;;-- 0.1 - 1 " . ..h b . "-",th 11 ,.. .. "h In the Budget on 30 November, Ihe Government will be announcing a new rorecast of the public sector borrowin g requirement ('PSBR ' ) for the 1993/94 fi scal " year. The current fo recast. made at the time of the March Budget. is £50 bill ion. At the halfway poin! in the fi scal year (taki ng account of the monthl y oult urns to end-September) both government ex penditure and receipts. particularly those 111 0st directly dependent 011 economic acti vity, were broadly in li ne with the March fo recast. In each fiscal year since 1988/89, general government expenditure CGGE') has increased as a proportion of Tablt' 2.C GDP (Tabl e 2.C). Over the same period. the publ ic Gencral J,!U\'t'rnlllt'nt cxpt'lIditUrl'''' as a fin ances ha ve moved froln a surplus (of 3% of GDP in Il c .. n~nlagl' of 1Il0lll'Y Gill' 1988/89) to an ex pected defi c it of 8% of GDP in T",. I(b' 1'0",,1 Sub,,",e' Cu"e"' G",,, I)" b, 1993/94. The share of current grants (wh ic h include C""W' ''P'''''' ~ r, u ' " ' "I",al ""e,,,,' f''''''"'''", social security pay ments and unempl oy ment benefi t) in 19 ~ t.'g 7 JJ.H 1.9 spending increased durin g thi s period, refl ectin g the 191171118 "" "'21), ~" " " 1 ~~IIIll~ '"38.2 111.7 " "" '" ",.. 'automatic stabili sers'. Expendit ure related to the ,~"" 39 4 " ""11 '1 22" ,-, ." 2'"0~ " 122 " general govern ment pay bill has remained at around 1991191 ~ 2 0 2 1 9 " 133 "1.2 19" 1'),)2193 21.2 " 22 30% of total expend iture throughout th is pe riod. but h a ~ ~" '" '" ,,, N. """", A"'-I' ...... ' " increased as a proportion of GDP since 1988/89: ill llo< dolk"''''''' Il Since 1991 /92 the publi c fi nances have been in deficit and the value of oUlstanding government dcb! has increased sharpl y. albeit from a low base. In previous periods when the government has borrowed heavily. infl ati on was hi gher, and the real increase in government indebtedness was less (see the ;Irti cle on pages 5 12- 20 of thi s November'S Qlfar/erly illllle/in). The fi ve percentage poi nt increase in the net debi to GDP rati o in 1992/93 was excepti onally hi gh by histori cal standards. In spite of the measures announced in the 1993/94 Budget. the net debt to GDP rati o is forecast by the Treasury to incre.lse by a fu rther 16 percentage poi nts bet ween 1992/93 and 1997/98. alt hough it s rate of increase shou ld decline. 2.3 Summary The il nnua l growth rates of bot h broad and narrow money rose in the third quart er. alt hough MO remains above it s monitoring ran ge and M4 remains close to the fl oor of it s moni toring range. The existing monitoring ranges would seem appropriate ovcr a medium-term horizon. The term structure of interest rates- a! both long and short mat urity- has shift ed downwards. So expected interest rate reducti ons have had no adverse im pact upon longer-term infl at ion ex pectati ons. The conti nui ng rapid increase in the ratio of public debt to GDP need not jeopardise this development. as long as the efforts of the Government to reduce the PSBR retain credibility. ", Demand and output 3 The pat h or inflation IOward~ it s tong-run rate depends on demand relative to the economy's pOlential OLltpu t and on the demand for labour re lative [0 labour supply. Thi s secti on examines the recent behaviour of aggregale demand 10 ilssess whethcr there wi ll continu e 10 be downward pressure on the inflation rat e in the short rUll . Taille 3.A Expl' ndillll'l· l·tJmponcnl.~ 01" t; 1)1' :lll'(lIlsl .. nt 3.1 Demand prircs. PJ'}} Q2 The rebased figurcs on demand and ou tput show a Qu' '' Chart 3. 1 Personal SCCIHI' .,avinJ.,: lllld hOl'r'llIIing Personal .~p l' lIdil/ g 1''' '''0' " Consumption turn ed up at the sa mc lime as GDP; 111 1992 Q2 it rase for the firsttimc in two years. Since - , then it has increased slightly marc slowly than GDP: by 1.6% in the year to 1993 02, comparcd wi th a rise in Il_ - . GDP of 2.0%. At firs\. the recovery in consumption al so 00- lagged behind that in real personal disposable incomes ,- ," (RPDI ), so that the savi ngs ratio rosC. to 13.3% in 1992 .- " Q3 (see Chart 3. 1), Since then, RPDl has fa llen . -... ,.... ,., - " Income from wages and salaries, now comprisingjusl '..... -..-.... <-, over hal f of personal income, barely rose bctween the ,- - " first and second quartcrs. 0-, .. .1"" .. · 1".1 .. *,,, 01,, I" I " I " I" I .. I .. I. _ 11 1"lI01, il •• ~ ss 116 ~1 "* aq '10 91 ~l ~, ,., ~ ...... t.. " The fa ll in the savings rati o to 10.1 % in 1993 Q2 has reflected stronger consumer confidence: the Gallup index has improved from a low of -26.3 in 1992 Q4 to ·8.6 in 1993 Q3. The ri se in confidence probably Chart 3.2 re fl ects reduced income gearing (brought about by lower "l' p,onal 'l'l'IOr j.!l'aring :lIld finand,,1 dl'licit interest rates). better employment prospects. and some r."'<"'''f<'" ... m .." (a)!' I.... ,'.. stability in the housing market. The sharp fal l in in terest - " rates si nce sterl ing le ft the ERM last year has - " substantiall y eased the sq ueeze on the di sposabl e income l ....'" ~'·"' '' .. i ,. , of indebted households, while reduci ng the income of "'i'" h...... "' ... , J"V''' " ,, ' ----,-'"---,---j----'\- households wi th net financia l assets. Chart 3.2 shows '" that the income gearing of the personal sector has - . returned to the same level of the mid· 1980s and is about i - , hlllf its peak in 1989. I",,",,,, ~, ... "."'h' 1,, ~ hllunJ~""\ - . Borrowing by the personal sector has remained light. so 1,""""I ""f~" , ,, - 0 indicated by particulars delivered to Land Registries. was higher in the third quarter than in the first half of 1993, II/W:.\fIIJ(! /lf (/I/d ,HocklmilditlM ,,-"', ...... ro"<' . ,..,...,""'"',~ '''''''''''..... ".. I <\. Ult ,(,It , _ '''''''"i' """J< ~« ~ I) ".'.• n_ ...... 1 .1t_ " _~ ... I,,,. N,. 1;.n" I' Since total investment stopped falling in 1991 Q3. it has \u,,<) "ro" flucluated within a narrow range arou nd 15% ofGDP. But there ha ve been some sharp scctoral differences: real manufacturing in vestment fell by over 10. 3% between 1991 Q2 and 1993 Q2. whereas in vestment in electricity, gas and water supply rose by over 16%. 18 Between the first and second quarters of 1993. whole economy invesllnenl fe ll by 2.9%. close to its level a year earlier. Manufacturing investment fell by 3'/1% in the second quarter. Charl3.4 Chart 3.4 shows how in vestment changed in three Whole economy rh-ed imestment ill threi.' recessions. Total investment fell less in the most recent rel'cssions and rccolcrics recession than in the early I 980s. but at an earlier stage _I~ of the downturn. perhaps as a reaction to bigger company _ "8 deficits. and then level led out barely a year after the _ IJ (. recession started. The fl atness of investment since thc _ 114 trough of the recession more than a year ago is si mil ar to _ JJ2 the pattern aft er the previous two recessions. - "" - ,. _ If., Compared wi th the last recession. in vest ment has fall en -,. relatively more in non-manufacturing and relatively less in man ufacturing. Investment in commercial construction has fa llen particu larly fa r. In 1993 QI the _w value of new construction work for the private L..~-'-'W-~'--',~'o-'-...L...:i~_ % -QII Q6 -04 Q2 00 0 2 0' Q6 commercial sector was only two thirds of its level a year ,.) 0...... ,"'_"""...... 1'1.,..,....-....10\1. earlier. and litt le more than a third of its peak in 1990 Q3. The CB I's quarterly survey for October shows a balance of I % of manufacturing firms expecti ng to reduce investment in plant and machinery over the next year. compared with balances of 3% in July and 8% in April. The balance of firms planning to reduce investment in buildings was 18%, compared with 20% in Jul y. The Chart 3.5 Relailll'd earnings and i1 U'cs lmcnt CBI su rvey shows that uncert ainty about demand remains the most import ant constrain t on investment: l """."', the cost of finance is seen as the 1110st important - Ib,OOO const raint by only 4% of firms. compared to an average - ...wo ofl2% in 1992. - 12.000 Chart 3.5 shows that most investment used to be - 10.000 financed from retained earnings. but that in the late - 'M 1980s and early I 990s external finance increased its share. Recent data show a sharp increase in company profits since the recovery began. In 1993 Q2the gross tradi ng profi ts of companies (excluding the North Sea - ~_OOO sector and net of stock appreciations) were 1.6% higher _ I" I" J"",,, J "1,,,1,,01,,01 J, I,,, ,I,,, 0 than in the prev ious th ree months and more than 13 % up ,_" 12 t.' ~. III lib ,1 II!j IN on 9, 92 vI on a ye,lr earlier. Over the same year. company interest payments fell sharply. taxes remained fI;u and di vidends increased less than profits. so Ibat companies' undi stributed income rose by over a third. In the near term . some compani es Illay want to use surpluses to reduce debt- company capital gearin g is still hi gh rather than for more investment. " In the economy as a whole. stocks are estimated to have falle n by some £1.300 million ( 1990 prices) in each of the first and second quarlers of this year. In only one of the last twelve quarters has stockbuilding been positive. and stock/output ratios have fa llen. The change has been helped by new technology. which allows easier and more accurate stock control. In addition. firms have wanted to contain costs, though the cost of stockholding has fallen as interest rates came down. Monthly CB I surveys suggest that the balance of manufacturing firms Table ,tu with more than adequate stocks of finished goods fell to (/ 11)1)2 h;.huln ' of l)lI) m~nt s data- rt'\ i s iol1 ~ 9% in September, the lowest since June 1990: in some Il sectors there may have been some unplanned destocking P"""" ""H" Po, ...,·, ",M, in recent months. The change in stockbuilding from V , ,,~1c ...,1," "," 11.77 1 · I .I. ~06 period to period can have a powerful effect on GDP I " \ "\~k , growth: an end to destocking, even if there were no ~< " "" ' ... ,1"",," 3.7(,) ~.O&) 1"1 Data revisions have substanti all y changed the picture fo r last year's current accou nt. while a new system for estimating trade with the EC (VAT returns rather than customs forms) makes the data for the fi rst half of 1993 difficult to interpret. Table 3.B shows the revisions to the 1992 balance of payments data. producing a deficit of 1.4% of GDP compared with earlier estimates of 1.9% of GDP. About 0.4 percentage points of this revision is the result of new estimates of interest, profits and dividends: the rest reflects revised estimates of Tllhle 3.C trade. U K tnldc \ lIlumc' in non-oil gouds (excluding erratil:!» The balance of trade deteriorated during 1992, as the hl"Hh In,,,,,,,, economy began 10 pick up, increasing the demand for I'NI Q.l 1'1\12 0 '- 199 I Q.I.--- 19\1203- imports. Bul. since sterling's depreciation late last year, 1 1992 QJ 1993 0 1 199! QJ 199 O.! and despite the UK recovery coinciding wi th recession >C ,. ·6.1> ., -9.5 ~on· £ C in many of our main export markets, the balance of real -r",. 1 !" 2 " " ·"U M,,,,,, " " net trade has improved significantly. Between 1992 Q4 T",.' !ood, ."" and 1993 Q2, trade's contribution to growth, 1.5 ·4.7 "'"''C''' " 0.' " percentage points, more than accounted for the overall ex pansion in GDP. Trade's contribution so fa r this year has reflected a larger fall in imports than in ex p0rls: between 1992 Q4 and 1993 Q2 the volume of exports fen by 0.7%, whil e imports fell by almost 5.4%. The figures show that the apparent falls in imporl and export volumes refl ect movements in trade with the EC (Table 3.C). Between the third quarter of last year and the second quarter of this, the vo lume of goods imported from the EC fel l by nearly 10%, implying a fa ll in 20 /)"""" ,,1 I",d ",1/ ,," cso trade figures: new collection methods With the completi on of the EC single market at the Ch:lrt A end of 1992, dala on EC trade flows can no longer UK iml)Orl pl'nt' lration h.' an':t'" be obtained from customs declarlltions as in the past. Since the beginning of the year, data on EC trade values have been based on the IntraslaI system, which is linked to the collection of VAT. In " the press noti ce accompanying the release of the " latest world trade stat isti cs, the CSO acknowledged ii that 'the EC component of the fi gures has a greater ", margin of error and is more subject to rev ision than Il the non-EC component'. Only partial information on the prices of goods " imported from and ex ported to the EC is availllble - '" from the lntrasta1 system. As a result. EC prices ~ ... I ( are calculated by adjust ing non-EC prices in an ;ltIempt to reflect the divergence in price movements between the two regions. The CSO's latest estimates indicate that the prices of non-oil These charls suggest that, on economic grounds, goods imporlcd from the EC rose by 14.4% we would expect any future revi sions to cause both between 1992 Q3 and 1993 Q2; non-EC imporl import and particularl y export volumes to be prices, over the same period. rose by 13.4%. The revi sed upwards. Any undcrestimat ing of net prices of non-oil ex ports to EC countries rose by export volumes would have a different im pact 9.5% between 1992 Q3 and 1993 Q2, compared dependi ng on whether it is the result of;m with an increase of 7.3% in non-EC export prices. undcrrccording of trade v.. lues or an overrecording Given sterli ng's substantiall y greater depreciation of prices. If it is purely because of an against non-EC currencies than EC currencies, underrecording of total values. the trade de fi cit will these import and export price movements arc be overstated but real G DP (as measured by the surprising. and may suggestlhal. as a result of the OlLt pu t index ) is li kely to be unaffected. By limited information available from Intrastat, the contrast. if export pri ces are overestimated this will prices of UK export s to and imports from the EC mean th;lt GDP would be ullderrecorded. because have been overstated. However, although the new export deflator~ arc now used to deflate estimates of prices could be revi sed when more manufacturing output va lues when measuring information is Hvailable from the lntrastat system, manufacturing output. the CSO arc unaware of any reasons why future revisions to prices should necess:Lrily be ChOIr! n Trt'nds ill UK l" purh'" downwards rather than upwards. Trade vO/llmes arc calculated by using the price ltu data to defl ate the value data. Chart A shows that. while import vol umes from the non-EC relative to " "" ,~ UK domestic demand have cominued to increase ,. since the beginning of the year, published data imply that EC imports have dropped off sharply. ,~ Similarly, Chart B shows that. despite sterling's depreciation following the suspension of the ".• United Kingdom's membership of the exchange % ",.. · I{" rate mechan ism, UK exp0rls as a share of EC " domestic demand have fallen sharply. This is ., particularly difficult to explain, given the United ., ~ Kingdom's inlprovement in price competitiveness .. , UK "f"'01 "~""""", IV Duri ng the recent recession. the ba lance of payments dcficit was largcr as a proportion of GDP than in most earlier rcccssions. Chart 3.6 shows that. during the boom of the late I 980!';. the main counterparts to the initial deteri oration in the current account were sharp moves into deficit by households and companies. The - - ., persistence of the deficit during the recession has partly - , reflected the change in the pol icy mi x towards - , monetary restraint and fiscal ease. Since sterl ing's ex it - , from thc ERM. the balance of policy has changed. The \fC------'~~--- -., fa lls in interest rates and the exchange rate are sti mulating overall demand and improv ing - , competiti veness: and tighter fiscal policy will serve to - , - , restrain domestic demand relative to output. The evolut ion of the cu rrent account wi ll depend on the balance between these various effect!'; . and on how ex ternal dcmand change!';. The box on page 23 discusses thc measurement of competitivencss. wh ich should be thought of as an ou tcome of the interplay of these macroeconomic factors. Tahlc 3, IJ Scctoral llcI'till'm;III ce in Ihe rerolcr) I,..,,,,", 3.2 Output and the output gap \\ c , ~l " Onc ....n« Ch,"!:" on dt,"go on on GI)I> ,h.;o n ~< '" ""'1"'" ,n "."1"" ixl"O<" pe.lOR I'NU Q2 1l'NU1 '''''1'''' on }"'" to 19'11Q2 19'HQ~ .od 1993 Q2 The rates of recovery in output in manufacturing and services have been sim ilar. Manufacturing production Ind~"<} ,., ,\ ~o< uIIU'" "' rose by 0.6% in 1993 Q2. for an increase over four \1,n,ng ,," " ,I " " 6.2 ·2.1 quarters of 2.3%: fo r service industries, the ~"" ~"I 2 ! I',,,u'''''"''''' 217 " n corresponding figures were 0.6% and 2.4%. But the IJ« """).I" " " " 2 2 early stages of this recovery have not been reached by T 01.. .. "" 1 r".jucoo,," " " " ,ndu,",e- 2 ~ 1 2.7 all sectors of the economy. Construction output has ·02'" -4.l ·11"' 1 Co""""""" continued 10 decline- by 4.3% in the year (Q 1993 Q2- l)""'''''",KI ",~cl, " • .-.1 ,"'co"S. "'PO'" n · 5.0 and is only abollt five six ths of its peak in 1990 (see Tra'''I><.>t1.1nd '" .:<,,,,,,,,,",e.l"vn " ·0.7 Table 3.D). ho,,",,,.1 ",O 22 / J{'IIIU"'/ ,,,,d "''' >111 UK competitiveness Competitiveness is usua ll y measured by relative produce. Although cost measures mi ght therefore prices or costs. expressed in a common currency. be preferred conceptuall y, they arc typicall y based Competition in international markets tends to on relative unit labour costs or relilti ve unit wage eqUlllise these prices and costs, but in the short costs (which do nofiinclude non-wage labour term changes in exchange rates can allow them to costs). These vary with the cycle, and do not diverge. Differences in the product mix and include non- labour costs. such as the cost of ra w non-pri ce fa ctors, such as product specification milterial inputs ilnd capi ta l. Ultimately, the choice and reliability, can al so affect indices of of which measure of competitiveness to use is an competitiveness in the longer term. empirical questi on. Chart A The charts show movement s in the UK reil I I' I 'in' k, ()~t t'(lInlldith· t:IIl'~ S in a ('lIInnWI1 eurrtlwy'" effective exchange nne agilin st the other G7 , ~ countri es on a re lat ive unit wage cost and a relative price basis. As a result of sterling's , " depreciation, both the price llnd cost measures of \ competiti veness hilve significantly improved since - ,~ sterli ng's suspension from the ERM (see Chart A). But the improvement in UK competitiveness has _ 110 not depended ent irely on exchange rate movements: in the year to 1993 Q2, unit wage costs in the Un ited Kingdom fell by around 4% relalive to other G7 eountrie ... (see Chart B). An incfCase in competitiveness liS a result of lower _ 111 ,1" oJ ,,11 lid '" I, "I, Id,,, I Iq I "' h " I , ,, I, _ 101 domesti c costs is like ly to be regarded as more ''''IKl~'~' ~\ Ill> ~1 ~~ 11'1 'Kl 9, ~~~J permanent than a change in competitiveness ,., ( K_'''''"''"~''~'''''~<''"'''''''''''''''''''''',<",""".,,, ';1,,_,"',. ...,..<0«1 1.0<',,,".1>"-"'''''''''''' caused solely by flu ctu:llions in the nom inal exchange rate, so it is more li kely to lead to a sup pl y response. Measures of competitiveness based on prices and costs do not always move toget her, Market P:lrt of the difference in (local currency) cost structure is an important influence on their relative performance refl ects cyc li cal producti vity effects. movements. In a competitive market, where goods The United Kingdom is emerging fro m recession and services are perfectl y substitutable, finns will before the major cont inental economies. be unable to influence the world price. A fall in the exchange rate wou ld be reflccted fully in Chart n higher sterling ex port prices. $0 this increased l{tI;lth t: prk c";c tl ~t ..... illtu l' al l' t1 r r t n l'~ ;1Il!J tht: incenti ve to suppl y for the export market would tnc..:lil t: t \ tlmn).:t !'att not be reflected in (common currency) relative ''''''_11''- ,>I, prices, wh ich would remain unchanged. However. measures of (coml11 on currency) relative cost competitiveness would show an improvement. In imperfectly competitive markets. finns will be able to vary their prices in foreign currency terms: a fall in the exchange rate in thi s case would then lead to an improvement in both relati ve costs and relati ve prices. Price mellsures have the advantage of measuring the prices that consumers nctually face, while 1. ,, 1, I. I, 1 .. ,1" I. I, I",t "I I" I measures based on costs attempt to cnptu re the I.~' ~! ~, ~~ ~~ M. ~1 "~ " ~ .. , ~ I ~! ~, impact of competitiveness on the incentive to muc h as in the previous recession: and capacity utilisalion has risen in recent quarters. Table 3.E shows Ihal in October 199360% of manufacturing firms rep0l1ed that their capacity was underu ti lised. compared lahle J.E with a mean of 60% in the previous two decades. Capadl~ ulili";Ition in m'Uluraclurjng indu ~ IQ Capacity uti lisation in consumer goods industries is q)cr C l' nla~c ur rc",mudcnh OIl lc .. s Ihan rull slightly above the average of the previous twenty years. capadt~ ) The main outliers are food, drink and tobacco, where o..,,,I,,,,I'J011 " """>" ():lOOC,I<)9J only 37 % of finns report capacity being underutil ised, 197~ '1I 1'I72_J"I) ')1 ''''n"'"'" .... ~e 19n_Jul) 9 1W and motor vehicles and transport. where over 93 % of All "' . "".T.~· ""e,, WO -0,2 rirms report underutilisation of capacity. The more that C "p",1 ~".~ I, .... h.",,,-, "' b' ' .S,8 ('"",u"... ', .",.1, "'" S5.7 ·n capacity uti lisation varies across industries, the greater h~~1. .1" " • .",,1 ,•• ~ ,,,.< ,, · 1) .1) wi ll be the upward pressure on prices (for a given overall ("hc",,, ,, I, ", ,,"~~ .I · 2. 1 1",,,Ie, .., ~2 1 - ) ~ I Icvcl of utilisation) as more firms run into capacity \ Ie,h.",,, ., 1'- n ~ "k' ,., ",., ... ". """""" ,n",I,,,,_,,, """""" .. ",~ ... , n.... ",,"1nL .. .,.~ gap'-can be estimated in vurious ways fro m survey ,~, \'''.,,< .... -«1, .. d.. , ,,,.. I ..... ,,, I .... ' result s and statisticalmodcls (see last August's QI/ar/erly HI/lie/ill, pages 309-1 0). Most measures poin t to a gap at the moment, although the CSO's coincident indicator suggests the gap has closed. 3.3 Summary The recovery in output seen so far has been at a moderate pace. The company sector's own spending has as yct made [jllle contribution to the recovery. though it may do so once the recovery becomes better established and as companies' ba l.a nce sheets improve. However, low growth in demand abroad and the expiry of temporary investment incent ives at the end ofOclObcr arc likely to inhi bit rapid invcstment growth. Thc personal sector 's savings ratio has fallen quitc sharply from its peak last year, blll consumption growth is still lagging behind GDP growth. Consumers scem cautious about borrowing. Though confidence may improve with the recent turnaround in the housing market. it seems unlikely that there will be a rapid fa ll in the savings ratio fuclled by borrow ings. After several years of below· trend output growth, there is scope fo r above-trend growth for several quarters before the markets for goods and services start to produce strong upward pressure on prices. The labour market 4 4.1 Earnings and settlements In the year IQ August underlying earnings in the whole economy rose by 3'/;,%. the sa me as in July. wel l down on the rises in the first quarter of 1992 (Chart 4.1 ). From Char! 4.1 February to July 1993, the reduction in twel ve-month Underlying earnings p, n J\\ lh earnings growth came almost entirely from the servi ces " <"".'~' , h ,. "~' "•• )"" <.. 10" _ ' l sector. but in August underlying earn ings growth in manu fac tu ri ng fel l. The rece ntly publ ished New - '" Earnings Survey showed Ihal earnings in the public sector rose by 4.3 % in the year to ApriL compared with - . 4.0% in the pri vate sector. but these figures were affected by settlements concluded before the 1'11% l il11il - . on public sector pay increases was imposed. - , The percentage increases in wage settlements have - , stopped fa ll ing. According to the Industrial Relations Service ( IRS ) measure. the median whole economy I ... "",,'1. ,,' ",,' . I". ",,' .. 1 '" ,,_ 0 settlement declined from 3% in the first quarter to 2% in IW) 9, ~! ql the second. rose to 2!/.% in the thi rd . Earlier fa ll s were largely att ributable to a bunching of settlements in the public sector (Chart 4.2). Surveys by the CBI and Incomes Data Services (lDS) are consistent with linic recent change in settl ement s. The most recent IDS data have shown a marked fal l in September. but recorded very few .~ e tll e m e l1t s. The CBI reports that in the three Chart 4.2 months to July over onc in fo ur companies froze their "ri\'alc llllt! puhlic M't:lCJr s clltt' mcnl~ "J pay. though some h:1\'e introduced bonlls sc hemes or lump sum payments instead. -," 4.2 - . Employment and unemployment Employment has started rising soone r after the turning - . point in output than it did in earlier cycles. In the e'lrly stages of the previous two recoveries. employment was still fa ll ing a year after output had begun to rise. One explanation fo r the change may be that the labour market - , is now more flexible and hence more responsive 10 output changes. wit h companies wi lling to take on new _ltlPIP " plp"pp,pl""""","",,, ,, _ 0 staff earl ier in the recovery. !fthi s is indeed the case. ,. 91 ~ 9' there will be less cyclical movernent in producti vity than 50""", I~ S in the past. and whole economy productivity will grow at a rate close 10 il s trend of around 2%. An alternative explanation is Ihat the recenl rise in employment Illay represcnt a revcrsal of se ntil11cllt after the fall in Aut umn 25 1992, whic h was stimulated by business pessimi sm around the time of sterling's ex. it from the ERM. On this Tahll'~ . \ view. employment wi ll ri se fu rt her only if output growth LahOlIl' lllarkl'1 indklllors goes well above 2%. A third possibility is that activity Lm",d K'"Ed",,,. "-""",,,1/, .0.1",,,<'<1 may be stronger than shown by the official dala; in tUn,!» I..;o'e,' _,01l.lf)ca, " car at" particular. the trade sta ti stics may be underestimating "" Ch.".~... t4'''l' (-X)", I\I'}\Q~ !l6 t ~4 ~ R,," " ~I~')I 10 ..1 10.5 '"10.1 .: "".1"),,,",,, Recent data give mixed signals about labou r market I mplo).·,! I.,,,, .. ,, 1<'"." pressures (sec Table 4.A). Unemployment fe ll by 13,600 ,·h,ng< (4'''l1 01),', I'N1 02 22 -174 \ 1""ul ..."U""~ "" in September. after rising for two months. Clai mant """' ~. (n.",,) INK)", ,\,,~ ,/\ ·~4 N . ~ unemploy ment has now fa llen by 84,000 si nce January IM~ I ', ~q \l '1.1 117 I IH! 11 1.5 \ """'"';'" 11 011"'" m,',"nIC "'If Au~ '.I' ~ 29 'II~ 9 .\6 1993 (see Chart 4.3). In the second quarter. the 11""" 1,,,,,hM'gh ,I"",·",,,,, \""~"' ~ OIl" ,\u~ ')1 1119 ()16 OA} work fo rce in employ men t increased for the first ti me \I'.~.', since 1990, with a substantial rise in se lf-em ploy ment. l.Kk,I~·,"~ a,,""~" " ,\"~ ~\ 5.75 Short-time work in g has fal len below its level in August E_""'n~' I1 ~ "~~l1h " " 'h.n~'·l 1989. Bu t manufacturing employment was down by ,Gill \1 .. "",.",,,,,,\~ (I ~·"'''''Ih d ..,,~") " "uS 91 5.00 '.00 24,000 in August. and overtime working in (Gill """",C' '" I I ~·,"'."h ,""n~"J , \us. '11 ! 75 4 ~5 5.75 manufaclUring fe ll after a sharp increase the mon th ~· 'II " " K· nl . before. The number of un fi lled vacancies at job centres IRS " 'kpl 9' 2 !.~ was vi rtually unchanged in September. !Os '. '>cpl '11 ()-19'.1 , "1.91" +-4.\11.," CUI \bn"r"",u,,"~ '. 1",,'Q' CRI "",,,,c, H~I\."'·I '. ''''''Q' " " " ,,, \1 •.,.","", " " Earl ier in the year, the abrupt end to the rise in clai mant unemployment. despi te the large recorded fall s in employment lhroughou t 1992, made it hard to gauge C ha rt -l.3 pressures in the labour market. But data from the U nl'lIlplo) lIll'nl and ,hl)rl·ll'nn urll' lIlplo~ lIIl'nll') Labour Force Survey (LFS) for March to May 1993 show that unem ployment- measured on the basis of those seeking work, rat her than those clai ming benefits- peaked duri ng the winter. when empl oyment began to increase. The LFS reports a fi rmer trend th an - . do the data derived from the unemploy ment register and employers' records. The LFS fo llows the Intern ational - , Labour Office (l LO) in counting as unemployed all those who do not have a job but who have sought work in the fo ur weeks be fore being surveyed. It shows th at unemployment fel l by 90,000 between the win ter 1992/93 and spring 1993. Over the same period, the I" Id,," "1,,,1 I,," "I "d,,", " _ 0 claiman t coun t. which covers just those claiming '''''' ". R~ !It. 17 !Ill 8'1 90 ~I ~~ q, unemployment-related benefits. fell by 40,000. A" ,,""'" ,0< 1•• (~ .., Kill... . ,_, ,..-., ...... ~ ~« .. "",... " ...... ,....wb) "'" H...... "..01""",,_ "' ...... ,''''' Although the unemployment rate is commonl y used as a measure of labour market slack. some analysts argue that it ignores potentia l workers who instead retire, stay on in education, or simply stay at home. An alternative is to look at the employment rate for the population of work in g age; if this is be low trend, then there is labour market slack. The LFS shows a rise in the empl oy ment rate between the winter and spring surveys, although it is still three percentage poin ts below its peak; most of the growth in employment since the wi nter has been in Table 4.U part-time work (sec Table 4.B). Lllbour force J, ul"\ ey: dlan ~b in emplo) menl Tbau",,,.h.GD. "'...... lIy od,.'led As in the 19805 recession. the rise in unemployment Spr.n, 1\190_ I'.',~ .. 1992193- si nce 1990 has been associated with a fall in the 'f'I'1n~ 1991 "",n, 1\1'9 .1 'participat ion' rale-the proporlion of the population of Emplt,l},,,,,,,,, AII(.) , 1.47) working age who are either in work or looki ng fo r it. In Mc.. · 1..102 '" 11'""",,, ·171 '" part the ra il may represent 'discouraged workers'. with Pull·"",." · 1.691 '" 1' ..1·1",,,,,, ,.. '"" people ceasi ng to look for work as ullemployment ri ses. ,.) T«,I ''''I..... ''.. ''''' .. I'M'''''..,'''·'''.. ~or«JJ< .. ".'"'''£ "'''''" .. ,''' ...... But the rigures probably overstate the fall in the 1.... 1) ",<1«">, ....,..., ... , .... ~ '" ,om"...,,,, participati on rate during a recession. for two main reasons. First. some of those with two jobs (about 4% of those in employment ) may lose one of them . causi ng the job count to fall wi thout add in g to the unemployment count. Second . some of the rise ill unemployment during a recess ion wi ll in volve people who. for a variety of reasons. do nOI cla im un employmell t re lated benefits. Fi gures from the Labour Force Survey point to a rise in non-claiman t unempl oy ment of 90.000. equiva lenlto 0.2% of Ihe population over 16. between spring 1990 and spring [993. These factors suggest that the ·true· participat ion rate fe ll by onl y 1.6 percentage poi nts. rather than 2 1>c rcentage poi nt !'>. In the mid-1980s.the participation rate rose once unemployment began to flallen out. and continucd to ri se un til 1989. when unemployment was close to it s trough. As the economy recovers from the recent reccssion. the participation rate may ri se again. as the Ilumber of peopl e wit h two jobs ri ses. and 'discouraged' workers decide to rc-enter the job market. Th is suggests that the measured unemployment rate may understate the degree of slack in labour market. and therefore understate th e scope for Clm!' t 4.4 \\' hole economy produ<'ti " ity in 1110 I·cl·cssions oLltpul to ex pund before wage pressures begin to mou nt. 4.3 Labour productivity and unit wage costs - )0 PrOducti vity growth has been much stronger during the - " recent recession than in previous downturns (Chart 4.-l ). In the early stages manufa cturing output fell around half as quickly as in the I 980s recession: but employment -+ " fell at much the same rate. so productivity be haved quite -c~L----+~------•• differently. In the f01ll1h quartcr of 1980. manufacturing - "' productivity was abollt 8% lower than a ycar earl ier: by - ,. contrast in the year to 1990 Q4 productivity fe ll scarcely - ' I'" I , , , I, ,_ 1I at all. because cmploye rs reactcd sooner and more fu lly QI 2 4' b 1 , 9 ID 11 12 IJ " 1I No_,,,( ...... ,,,,," """ d...,.".", to the fall in out put. [n both rccessions. productivity grew strongly when output began to recove r. However. it was closer to trend in the I 990s recession than in the I 980s onc. leaving less ground to make up. For exampl e. short -time working is lower now than at the comparable stage in the [980s cycle. and overtime per " worker is hi gher. This means that the pace of Table -I.C productivity growth may not be sustained for as long as CO lltrih\ltiun~ uf carl1in).:~ llnd producti\ it~ 10 unit it was in the early 1980s. Indeed. the latest monthly \\:I).:C cu~t\ data for manufacturing show that the annual increase in productivity fe ll to 4.4%. and its level was below that of I'<""'n,a~< d,,,,,sc, "" ' .. " .... I... ,~>J ,n "'~, ~,"' ~c .. Apri l. OU'1"" I '''piu)''O Chal·t -15 \\ Iwlt tC(JIlUm~ produdilit) ~lI1d unit 4.4 Summary \\:I).:c cu.,t~ ,.. ,,', ..... r< ' ..... 1<' on • I'''' " 'h,: I~ Wages are moving Illorc or less in line wi th past behaviour. given the changes in taxcs and the exchan ge _ 'n rate which have taken place. Recent labour market indicators suggest an end to the slackenin g seen during '"" "' ~< """ - . the recession. but not the sort of ti ghtenin g that mi ght - , stimulate significantl y fas ter pay increases, given expectations of inflation. Thus developments in unit labour costs may not be as favourable as in the reccnt past. S Ui if settlements and earni ngs growth remain ''''''''''''.~ , close to recent levels. then even if prOductiv ity growth is =-~~~~------T-- ' no beller than trend-an an nual 2% since 1980--unit labour costs would increase by less than 2% a year. Price dynamics 5 5.1 Ex ternal influences Chart 5. 1 Prim(lry produc/ pricl!.1 Stl'r lin ~ oil and Ill/Il-nit l'nmlllUd it) r)l ' i l'c~ Primary products (inc luding fuel s) comprise about onc 1'''''':1- 100 - I'" six th of UK imports. with industrial materials - "''' (agricultural non-foods and metals) making up three quarters of UK non-oil cOlll l11 odity imports and food the - I"' (hi ',' res!. Commodity prices may have a short-run effect on I K" ~"~..·. ,,1,0.1<,"''' ' _ I!I> UK inflation. though in the long run it is determined by domesti c monetary po licy. Commodity prices have dropped back in Ihe last eight months. having risen sharply in :>.Icrling term~ from September 1992. Sterling's depreciation last year. especiall y against the doll ar. together with :- trongcr ti mber prices. contributed to .. ri!'>e of nearl y -W% in the UK- weighted non-oi l commodities index between 1992 Q3 and 1993 Qt. Since then. !'>terl ing ha!'> ri.<.en. and timber prices have fa llen. a!'> worries about the co:-t implications of US environment al pol icy have ea~ed. This has offset slightly stronger food price!'> (reflecting in part the introduction of a coffee producers' withholding scheme). Sterling UK-weight ed no n-oil commodity Chart 5.2 prices fell by 7.1 % in Q2 ,HId a further 4.2% in Q3 (see Li\ 1I ~'" stm:ks a .~ a Il C I ' cc /ll a~c uf mine Chart 5.1). In the near term, the re is o nl y a ~ rnall ri sk of P'"Odlll'tioll 'O' signi fi cant inc reases in non-oil commod it y prices. Despite the introduction of the coffee scheme. similar agreeme nts between suppliers of indust rial mate rials I~"". -" (which have a large wcight in the UK index) remain -. unlikely. Other factors. such as large stockpiles -, (Chan 5.2) and the weakness of world demand. are likely -. to matter more. Sterli ng oil prices were ~Iab l e in the first half of 1993. then fe ll in the th ird quarter. Dollar oi l prices were lower as a result of conti nued production above quota by OPEC members. poorer prospects for demand and a favourable response to peace moves in the Middle East. which may help to safeguard long-term oil supplies. Prices increased up to 5% a ft er the 25 Septe mber OPEC I.j " ..... '" ."u1. I .ch• .,;' ,b, H,"l ... "",,,,, meeting. which decided upon a 24.5 million barrels a day quota. Although thi s is I million barrels a day above the official ceiling in 1993 QJ. (here is less chance th at the quota will be cxceeded : both Kuwait and Iran have agreed to produce with in their (higher) quotas. which they did not in 1993 Q3. Further. the new quotas. wh ich are to last for six months rather than the usual three, are below the expected demand fo r OPEC production. as fore cast by the International Energy Agency. Even so. (" ha,', 5.-' the dollar price of oil has drifted down since \ Iajur ... i, l>o ulllric ~' IJrudul'Cf pfkc ~ 30 September, leaving it 2% lower than at the time of the last Rl'fwrl. - , O" er.H'lI.1 illf/fllioll alld illlpol"l prices - , [nflationary pressures abroad remain weak - , (see Chart 5.3); for in stance, the latest figures show producers' pri ces actua lly fal ling in Japan. Accordin g to the Bank 's latest World Economi c Forecast. producer prices in the major six economi es are [ikely to increase by a littl e over 1% in [993 and a link over 2% in 1994. ------\,,L------' , There is no automatic link between overseas and domestic inflation: the exchange rate will move to ' - offset the differential. unless domestic monetary policy .' accommodates in flat ionary shocks from overseas. Movements in the exchange rate brought about by changes in monetary policy at home or abroad often affect the sterling price of imports much more. Thu s 12 percenlilge poi nts of the [4 % rise in UK import prices between 1992 Q3 ,1I1 d 1993 Q2 can be accounted for by the effec ti ve depreci ation of sterling, leaving only 2 percen1l.lge points to inflation measured in foreign cmrencies (C hart 5.4). Import pri ces from the EC have risen by 14% compared Ch:H"t 5 .... with a depreciati on of around 8% against EC currencies Thl' C\dHtIlj,:l' rl,tc and UK illl tJOrl price!> (Chart 5.5). This increase is we ll above what would " ",,", ,~<, ..... ".., "•• )< ... " .. I", normall y be expected. Further. Chart 5.6 shows that in -" ",,',., - " 1993 recorded U K import prices from other EC -" countries have increased significantly more than the - I ~ - " prices of man ufactured goods in those countries. • Despite recent improvements made by the CSO in their - ., calculation of EC price de fl ators. it is possible that the - , stati stics on UK impol1 prices have been exaggerated. -\l- \f--\\+lI-lHII'!--Ii.-.IH,j-- -+ , which would help to ex plain the muted response of domestic prices in the Uni ted Kingdom to last year's - depreciation. - . _". _I , !I" "I " d!!, 1,,, I,, !!.!! 1,,,1 ' I '" ,01, .. 1" _ I ~ 5.2 Input prices ""'~ o. "' .< !Ill 07 ., I~ 90 vI ~1 "3 ,. , I ,, 11 •• 1"" ,n.k, So far. the prices of imported materials purchased by manufacturers ha ve increased much less than the official data on import prices suggest- by 5% in the year to the second quarter. agai nst a fi sc in import prices of 13 %. In the twelve months to September, manufac turers' '" !'flce (1.1'''''''''' I Chart 5.5 imported input pri ces rose by 5.2%. Prices or Tht! sterling (''(change rute and import pric('s manufacturers' purchases or home-produced Illaleria ls (1992 Q3-1993 Q2) increased by 5. 1% in the twelve months 10 September. whereas prices or their rue l pu rc hases reil slightly (0.4%). The twelve-month increase in manuract urers· ~- tOlal input costs was 3.5% in September 1993. compared - " wit h 6.3% in August. The steep rise in input prices seen last autum n is now start ing to drop out or the " twelve-mont h compari sons. Food pri ces in the United Kingdom covered by the '" Common Agricultural Pol icy arc innuenccd by the green pound- the rate at whi ch the EC agricultural support is converted in to sterling. Bul. it was only at the end of December 1993 that the green pound was brought into li ne with the £/ECU rate rol lowin g the depreciation of sterling. Consequently. changes in food in put prices " ,,, B.- - II~ Producers' returns on capital depend on how prices move ,:c - I,. relati ve 10 costs and 10 what ex tent capital is uti lised. -""'" 111 Chart 5.7 shows that the real return on capital or non - 110 North Sea industrial and commercial companies (lCCs). - '. which peaked berorc the recession began in 1990 Q2. reil ~ -I (It, - sharply to 6.2% in 1992 Ql. It has been rising since. ,. The trough in ICCs' profitability duri ng the recent recession was not nearly as deep as during the recession '" or the early I 980s. The relllrn on c Chart 5.8 shows a historically close relationship betwee n Ices' return on capital and the ir capac ity utilisa! ion. However. during the boom or the late 1980s. and particularly during the subsequent recession. thi s link weakened and profitability varied less. for two main reasons. First. firms have adjusted their labour inpu ts quicker in the recent reccss ion than in earli er periods. Second. and partl y rerlccting the first ractor. competiti veness deteriorated much less in the 1990s recession than in the earl y 1980s. so tha! there was much less downward pressurc 0 11 firm s' profit margins.(l) I , , I L I ! I ! , I I ' I I I I ' I I I I ' I _ 0 I~O 11 " 17 ~ " ~ I ~ V ~ " .' (I) Scc Ih e IJm,k of 1:."g/(lfPlI QIIIPn.'rl'· /I"II~I"'. Aug'''' 199.1. 'CU"'P;lIl) prolilabillly ""d lin:mcc· . p~c, .\/,1- 7 1 Chart 5.~ An increase in profitabili ty duri ng an upswing is not Rail' of I'l·t ur n on capital .Hld cap;ll'il ~ ulili~alion necessarily inconsistent wit h progress in reducing inflation. because higher profitability may arise from - '1 ( ...... ) ... ,),"', ... ,.. increased util isation of capital rat her than fro m any , ... ,,10-' ...... , increase in prices relative to cost. Chart 5.9 shows - " trends in the rate of retu rn on capital for non North Sea ICCs. and the ratio of profi ts to cost. The profi ts to cost - . ratio is more stable than the rate of return or the capacity • uti lisation measure and has varied less du ring the recent recession tha n in previous cycles. Si nce the mid-1980s UK import prices have increased much more slowly than consumer prices. T his has all owed real wages to "' - '"i''' 10,,,'" ""'" increase in line wit h domestic prod ucti vit y, as well as a ri se in the share of profi ts in GDP. " ", '~""".F ,,' .... "",... ,,,, ",. '"rn',,!,,"""! .."" Il) '"11) ",I,,,,J ,~ , Il,~, ,M ~,'''''' ,.. "r"" .,,,h .. "'r''''<.''"' ",,' ,~ .... " .,h < I" ,," ~ ",," ,,,'',,,,' ,,, '" , h"~ ~,.,h '''' ,"' .," ,.. " , ~ t , ",,,,"n ,,, « Hr l.. ) " ..... ",," """ ""1"" Alt hough some of the effects of l a~ t year's depreciati on Tahk 5 ..\ have still to work through to prices. the immediate Conlrihutiun,,'" tu nlllnufaclllrt:r ~' oUlput price effects will start to drop OLL t of twelve- month i nl b li,m ' ~' comparisons in the nex t few months. However, as noted in Section 4, producti vity increases are often largest in 1...... 2 '99' , ,·~t Q' Q' Q' Q' Jul )' the earl y mont hs of recovery. so that unit labour costs , 22 1.7 3,~ 2A "". 1..1><"" P""'''''''''> " " may soon become a less benign influence on cost " ,. 1 ..1 ~ _ o. U 1... 1>< ... , ",,', n n " pressures. The ex tent to which companies have l'nll '.'.11 ,""" managed to defend profitability duri ng the recession ,'_1,1, ., · 1 2 •• .,·0.6 '" means that margins may make a mi lder contribution to , Ihl"'l po,c' "' ., " " " " inflation than in previolls recoveries, though there are , ''''Ui'M 11I.,,,,,,,c,",,, " " -1) 2 ·0. 3 " " " " " important sectoml differences. , \I .ri , n,,~, U {"'7.(hJ'~'1 W ,.. " " " , p... , "21 1 ~ 2 J H, 0 .,1"" "c'", . " " (., (' . ~ul>"d ,.~ < ... ~ ''''''",",,"' .. 'h< , ... "" ....'h I",... ,h ,"" ",. 1«1 b) ~ «"'" "''''W ,,, .. I ~"' ,""",."",,,,,, ,...... , ... f.. lk ... , ",, "''''' .... '.n'' 0" "'>'" , 1""" ~ ') ._\'" , ""'''~" 01' 'h' , ,, "'. n ~ ,.. '" ~''' ' ~ ... *"",,, ..... 1'<"""""" '" , ~ .. ",dl» uo" " ",,", I""" '" ,'" ","M ,.. ,.. ,.I, , ,~"'" ",.y""' ..... , ...... " .... ,,'''' "( ~ '''''' ' " J '<' '''''''''">"< '·h."~" ,on • )<.. '."H" !'rrre ,~m""'''' 5.4 Summary World commodilY prices are like ly 10 be he ld in check by weak world dCl11iJnd and large s l oc kp i l e~. so it i!<. un li kely Ihat upward pressures o n fi rms' prices will e merge rrom this direclio n. Nor should the rebuJld ing of profit abi lity after the recessio n be a problem. ICCs' retu rn o n capita l has been rising since 1992 QI and is already above the average ro r the last 20 years. Spare capacity has not reduced pro fitabil ity to the ex lent it has done in Ihe past. Increases in the pri ces of im ported in puts have been offset by reducti o ns in uni t labo ur costs in manufacturin g . .~o it sho uld nOI be a cause for concern that the rati o o f Olllput prices 10 input prices has fal len. 6 Prospects for inflation During the twO years that sterling participated in the ERM. inflation expectations declined significantly. But they rose sharply after sterling left the ERM in CIHu't ('.1 September last year. The new framework for monetary Inl1'1lillll tUIlI ~ tr\ll' lure dl'rhed rrnm policy announced in October 1992 was designed to help :.:ilt-cdj!cd "rke.. restore credibility. This section first reviews I',·",... - , developme nt s in inflation expectations and then presents the Bank"s own view of the prospetts for inflation to mid-199S. ! .... ,,90' - I - :10..' ,,,,,, , 6. 1 Evidence from financial markets - . The previous two Reports have described how the term -, structure of expected inflation can be estimated fro m yields on conventional and index-linked giits. There was - . a marked rise in longer-term inflat ion expectations fo llowing sterl ing's departure from the ERM. By ". December 1992. annual inflation was expected to be some two percentage points higher in around ten years' ti me than had been expected in early September. Movements in gi lt yields suggest that expectations remained around these higher levels until the spring of 1993. and it was onl y in the early summer that there was any sustained decline. Expected inflation in around ten Charlll.2 years' time fell by over one percentage point between Co tllpari ~lIn of tU'tX inllatiun l"urccasL<; for early May and earl y August (sec Chart 6. I). The faU I 'J'J3 Q-l cont inued int o October, bringing expectations down I'" ,,"' close to where Ihey bad been before sterling's ex it from - . the ERM. Provided there is some risk premium on conventi onal gi lts. these figures suggest that longer-term inflation expectations now lie within the Government 's 1%-4% range. though they do not yet indicate full faith in price stabi lity. 6.2 Private sector forecasts - . Forecasts prod uced by private sector organisations such as C ity firms and academic insti tutions indicate how . I.. . . 0 (J,., "",I)n I ... I·." M ... "'1"" .\1 .) h_Iol) ""I .... '" O Lhart 6.3 lower quarti les (one qumter of the forecasts being above Comp:lri ~ oll of RPIX inn:llioll fore~: a s t s ror the upper q Uallile. one quarter below the lower quarti le). 199-' Q-' Last wi nter the median forecast remai ned near to 4%. I...... ' -, wit h the majority of forecasters concerned that the depreciati on of sterli ng and higher im port prices would put upward pressure on RPIX inflation. As these fears have abated. forecasts have been lowered : and their - , spread has nat urally narrowed. as data for more of 1993 have become avail able. -, Charl 6.3 shows the evolution of the median forecast for RPIX inflation for the year to 1994 Q4. Here too. expectations have been fal ling during thi s year. although not qu ite as much as for the 1993 forecasts. By r n f-'p« ... _ ... _<,"'"r<' .. ".'I! .....'h,"'I~I'l'1' • f •• p«...... '" pn«'...... , .. ,lit 11_'h,'"' ''''''' ...... , I ..... 6.3 Surveys of inflation expectations Perhaps not surprisingly. the Smit h New Court/Gal lup Survey of fu nd managers shows a si mi lar picture 10 that suggested by gi lt -edged prices: that inflation expectations rose in October of lasl year bu t have gradually fal len back (see Chart 6.4.) Most other surveys also recorded 11 jump in expectations aft er - , sterling le ft the ERM . A Gallup survey of employees continues to show a majority expect ing inflation to be -, 4% or below over the nex t twelve 1110nth s if 'don'\ knows' arc excluded (see Chart 6.5). The October C B I Industrial Trends Survey reveals that 72% of its ! IA SON I) II M "~ l j)"SO respondents arc expect ing their domestic output prices to lY9l q, Chart 6.5 remain the same over the next four months. and the Iblunce of cm plo) cc~ e.'I;pccting :1111111:11 price remainder are nearly equally split between price cut s and illnatiul1 1(1 be Ic ~s tlmn or C{IU:llto-,q Itlcreases. H.I.....,'I"" " .. ) -" _N A survey wit h :l different pallcrn is Dun and - " Bradstreet·s. which asks managing directors whether ~------~~-1-.' they think their selling prices will increase or decrease. -" As Chart 6.6 shows. the surveys undertaken late last year had substantial majorities expecti ng to cut prices. bu t by the summer of th is year a small majority expected their sell ing prices to ri se. And accordin g to an EC/Gallup Survey. consumers are more pessimistic about inflation prospects than at an y ti me since February 1991 (C hart 6.6). Lc~Lu~~~wu~~~~-_.- 9 1 91 9' 1.,gh,lr ""''«'"'" "' 1""'"" ,lit 1"" .... ~,." ~h"h ,"11 .." .. I ",~" "-" ""'" "1"" "'"$ H."" "" G. ",,~ '\ "" ·'Y Q' , mrl,,)«.· r<"" "P«'"""'" 6.4 Bank projections The short-I"III/ olltlook As in previous Reports the Bank's own projections are Chart (d, shown for two periods. The near-term prospect in nun aud II I'ad'll"c('I Sllnc~ on C'l: I}Cct:llions of Chart 6.7 is simply a statistical extrapolation of recent ,cllin j.! prkc, and EC/{;:lllup l'on~U lll cr inllation l·'PCl't:.liun, trends in some RPI components, incorporating known faclors such as changes in administered prices and pre-announced plans to change indirect taxes. Duties are assumed 10 be adjusted in line with Ihe RPI (as are benefits in the longer-term projections). In the latest Ihree months RP1X inflati on has ri sen a little more than projectcd last time: 3.3% compared with 3.1 %. This difference partly reflects smaller than expected falls in food prices ill Jul y, and partly the larger than expected recovery in the prices of household goods and clothing and footwear associated with the end of the summer sales. Looking further ahead, the large discounting by retailers ,_, "",,Iw 1'<",...... ,~. '" • )'" , .. ,"', inflation- the twelve-month change in the RPI-will - , rise rapidly. because c uts in mortgage rates in November -, and December last year will be dropping out of the compari son. - , Longer-Term projectiol/s - , To conduct monetary policy e ffectively, it is necessary to form a view about the likely course of inflation over the longer term. Chart 6.8 shows the Bank's projections fo r -, RPIX inflation to the middle of 1995. along with the actual figures so fa r and the projection published in the " , t , , , " last ReporT. The projection is based on the assumpt ion " " \I " of unchanged interest rates, with the exchange rate '"" '''"f' " """",d .. '"" ..._ .. , I""F''''' 1" "' '" ,,""", to", """ft ,m. ,...... ·h (",,,, ..,, '" ,.... ,..~ holding uncovered interest parity, that is, ensuring nominal rates of return in the United Kingdom and overseas, adjusted for movements in exchange rates, are equal. ", Chart 6.8 The projection for RPI X is liule changed from three IH)IX intllllion I ) roj l'c ti o n ~ mid oullurns months ago. The most likely path is for a small ri se --- - k""',V' .., unt il the first quarter of next year. peaking at an annual - - K'·' X'jIrn .... '''''''''''.. II',.''m rale above 3'/:%. Aft er that RP IX inftation is likcly to ''''''""' ...... ,.. ,... J'''' <.-1"" fa ll gradua ll y. Excludi ng changes in indirect and local -," authority taxes. it may fall to arou nd 3% by Ihe middle of 1995. This reftects the continuing high level of - . unemployment and the shortfall in output relative to i t ~ potential. combined with further fal l ~ in inflationary - . ex pectations. It is consistent with the current growth rates of the monetary aggregates. The revisions to the - , Bank forecast have been sma ll er thi s time than they were three months ago. because the economic news in the last quarter has been less surprisi ng than the news received in the previoll s quarter. However. Chart 6.8 , , , I ,_ " shows that RP[ X inftation is now expected to be a liute - I , " '" '" 'I' Q\ hig her until the end of 1994tl1an was ex pected in Aug ust. and a liul e lower thereafter. These changcs n.. ''''''' "",r, nooJ ... ,"" «"" .. ""'..... '_, f'io' '" "'.... " "'" """"_ "<'4< Of"" 'I" "'0_' pn« ...,,, . .. p"."", ... , ,,"'. 1'41 , "" reflect two main factors: ~ ' ''''' ,...... ,.. "',,.,[[) _~~" ."h '''''''''''OSCf:>O< '"''''' .."d ...... , ''' , .... ' ", .. 11 0,( ~k h ,., KI'IX .." .... '''I ' -Ar. ~.,,' ..,""'.) ..... -,,,,,,,, ..., ... , P",I ,,10.,... _, • recent fig ures for underl ying inflation have been a litt le higher than had been expected in the summer. when it was sti lt uncertain how fa r price cuts associated with the sales and seasonal foods would be reversed: • projections fo r the level of demand in the world economy have been rev ised downwards repeatedly by most forecasters, inct udin g the IMF and OECD. Subject to the exchan ge rate ass ulllption. this means that the demand for British ex ports will be lower towards the end of the forecast horizo n. and the output gap hi gher. With a floating exchange rate. it is not ctear that lower infl ation overseas wi lt affecl UK inftation at all. If exchange rates were to Illove 10 offset inflation different ial s between home and overseas. domestic developments alone would determi ne the domestiC' inflation rate, and the real exchange rate would not be affected by nominal shocks. In thi s fo recast. however. the exchange mte develops according to uncovered in terest parity. The news that real output abroad is lower than had been expected means Ihat real interest rates overseas are likely to be lower than UK real rates. and 10 remain so fo r the rest of the forecast period. There has been a deflationary shock in Europe. and the resulting chan ge in the exchange rate only partiall y offsets the effect of the change in the outl ook for overseas inflation. The result is that lower inflation in the rest of the world is expected to lead to smaller pri ce increases for imports from the middle of 1994. and sterli ng's real exchange rate is expected to risc a little. given the assumptions of the projection. The feed-through from world to U K inflation is not o nc for one. but it is large enough to generate the slight f,11 1 in inflation we see in 1994 H2 and 1995 H l. compared with the essentially flat profile presented in the Inst/l/j7(1 /iol/ Report. UI/certain/ies Our projections will soon start to cover prospects for achieving the lower half of the [%-4% target range for RPIX 1nflation by the e nd of the Parliament. But variolls uncertainties wil l have a considerable e ffect on the path of inl"1.l1iOI1 even be fo re that. The first conce rns the exchange rate. This will depend on interest rates abroad as well as in the United Kingdom . On the whole. other EC countries have been re luctant to see big depreciations of thei r currencies since the demise of the narrow band of the exchange rale mechanism. so interest rates are falling only as fa st as they arc cut in Germany. Overseas interest rates will also be influenced by the level of activi ty. which has been weaker than most observers expected. If atte mpts to sti mulate rccovery lead 10 bigger than expected Cllts in interest rates. this would be likely to push up the sterling exchange rate and reduce inflationary pressures in the sho rt run. A second source of uncertainty is the behaviour of wage bargainers. If firms and employees believe that inflation will remain low. then any target level of real wages will be associated with lower nominal wages and prices than otherwise. But it is possible that the increases in headline inflation likely in Ihe nex t few months may slow down the re visio n of inflationary expectations. In which case. there is a danger Ihat wage bargainers will seltle for excessively hi gh nominal wages. followed by increases in producer prices un warran ted by the stance of monetary policy. It needs to be properly understood that one-off boosts (0 the level of prices. for instance from higher indirect taxes. do not mean any slackening of anti-inflationary policy. and should not be regarded as permanent increases in the underlyi ng rme of inflmion. Conclusions 7 Since the August Rc'po/"{. most twcJve-morllh measures of inflation have ri sen. Headline inflation has gone up from 1.2 % to 1. 8%: RPI X inflation frolll 2.8% to 3.3%: and infl Gi ven curren t policies. the Ban k'~ view of the most likely outt urn is that inflation- both headline and RPIX - will rise until the mi ddle of 199-l and then start to decline again. The new information avai lable since the August Repol"/ has led to a small upward rev ision in the twelve-month inflation rates expected over the next few months. but it has nOl produced any sign ificant change to the expected rate of inflation two years from IlOW. The central projection remains wit hin the target range for RP[ X inflation. But there is a sli ght possibi lity that in the first half of next year inflati on wi ll briefly rise above the top of the target range. This is partly because of changes in indirect and local au thority taxes. Excluding these ta xes. inflation is expected to start falling in early 1994. and could rcach a level close 10 the middle of the target range in 1995. Headline inflation wi ll rise particu larl y sharply as past reductions in mor1gage interest payments fa llout of the twelve-month comparison. and mortgage irll eresl relief is restricted from next Apri l. Such projections are inevitably subject to a largc margin of error. What matters is the direction in which inflation is headed. There arc particular uncertainties associated with a profile of in fl ation that fin;t rises and then falls. because that may affect lon ger-term expectations of inflation. Expectations of inflation can have a significant effect on wage bargaining. If the ShOrt-fun .N Inilath'" Kq)ull N,"~",hc' I'N\ increase in inflation is simply extrapolated forward and earnings start to ri se more rapidl y. then more of the growth of nominal demand which is ex pected over the next year or two will take the fo rm of hi gher prices rather than higher output and employment. But if the rise in the pu bl ished infl.llion rates is perceived as temporary. then the monetary stance wi ll be consistent wi th lowe r inflation and stronger output. For thi s optimist ic outcomc 10 be achi eved. much wil l depend on sustaining the credibility of anti-inflationary policics. The continuing output gap. modera!e growth of nominal dem:lIld. and slow growth in broad money and credi t. al l point to the possibility of bringing inflation down further 4() Reprinfed from Ih e November Bank or England Quarlerly Bullelin Price £4.00 \\ \\ \