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Inflation Report Inflation Report February 1999 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 judgment about the most likely path for inflation and output, and the uncertainties surrounding those central projections. The 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: Eddie George, Governor Mervyn King, Deputy Governor responsible for monetary policy David Clementi, Deputy Governor responsible for financial stability Alan Budd Willem Buiter Charles Goodhart DeAnne Julius Ian Plenderleith John Vickers The Overview of this Inflation Report is available on the Bank’s web site: www.bankofengland.co.uk/infrep.htm. The entire Report is available in PDF format on www.bankofengland.co.uk/ir.htm. Printed by Park Communications Ltd © Bank of England 1999 ISBN 1 85730 191 9 ISSN 1353–6737 Overview 1 Inflation on the RPIX measure was close to the 2 /2% target level for most of last year. Since the summer, however, economic developments both internationally and in the UK have substantially shifted the balance of risks to future inflation. This sharp deterioration in prospects for the world economy has worsened the outlook for UK exports, and domestic consumption growth has weakened. Moreover, the available evidence from the labour market and international price developments suggest that, in relation to demand, inflationary pressures have eased, at least for the time being. The Monetary Policy Committee has therefore reduced interest rates in recent months with the aim of keeping inflation on track to meet the target. Growth in the world economy in 1998 is likely to have been broadly as expected at the time of the November Inflation Report, but prospects for the period ahead have worsened. The difficulties facing some emerging market economies were highlighted by the collapse in mid January of the exchange rate regime in Brazil. Net capital flows to emerging market economies are likely to fall further, which entails weaker net exports for industrialised countries as a whole. If world demand growth is not to decline, higher domestic demand growth in those countries will be needed to offset weaker net trade. The recession in Japan appears likely to be more protracted than previously anticipated. Prospects for growth this year have weakened in the euro area. And there are downside risks to the remarkable buoyancy of domestic demand and output growth in the United States, where large external imbalances have been accumulating for some time. The probable consequences of these international developments and risks for the UK are weaker export growth, and even lower imported inflation. Aggregate output growth in the UK has slowed broadly as expected at the time of the November Inflation i Inflation Report: February 1999 Report. Growth in the third quarter of last year was revised down slightly to 0.4%, and the preliminary estimate of fourth-quarter growth was 0.2%. Survey measures of business and consumer confidence have stabilised since the autumn, albeit at low levels, and there is now somewhat less of a contrast between indications from official and survey data. But the sharp contrast remains between output growth in the manufacturing and service sectors. Household expenditure has been weaker than expected in relation to income and wealth, and part of this weakness is expected to persist. Inventories have grown more than anticipated, perhaps in large part involuntarily, and a substantial unwinding of stocks remains likely in the period ahead. Public expenditure is set to grow significantly, particularly for investment. But business investment growth, which has so far remained robust in the service sector, will probably slow sharply despite falls in the cost of capital. Annual broad money growth has continued to ease, in line with slowing nominal demand growth. Total credit growth has also moderated. Within this, unsecured lending to the personal sector continues to grow fast, but there is evidence that this is partly displacing other forms of household borrowing. The financial positions of both the personal and company sectors appear reasonably sound overall. Unemployment has declined slightly over the past three months, and the claimant count is at its lowest level since 1980. Employment growth has been strong, despite the slowdown in output growth, though hours worked have grown more moderately. But recent evidence on vacancies, recruitment intentions and reported skill shortages indicates that the labour market is no longer tightening. The degree of inflationary pressure in the labour market is especially hard to gauge given the continued suspension of the official Average Earnings Index pending the independent review commissioned by the Chancellor. The available evidence, including information from the Bank’s regional Agents, suggests that private sector wage settlements have stabilised over the past nine months, despite the cumulative tightening of the labour market. Wage drift—the difference between earnings growth and settlements—is likely to be decreasing at the current stage of the cycle. Although recent public sector pay settlements were higher than a ii Overview Chart 1 year ago, and both the Working Time Directive and the Current GDP projection based on constant National Minimum Wage are likely to increase labour nominal interest rates at 5.5% costs to some degree, upward pressure on overall pay Percentage increase in output on a year earlier 6 growth appears to be easing. This has led the Committee to lower significantly its profile for nominal 5 earnings growth. 4 3 This is consistent with lower inflation expectations. Measures of expected inflation—whether based on 2 surveys or on the difference between nominal and 1 index-linked bond yields—have fallen steadily over the + 1 0 past year, in many cases to levels around the 2 /2% – inflation target. And headline RPI inflation is likely 1 soon to fall below RPIX inflation for a period as recent 2 199495 96 97 98 99 2000 01 cuts in interest rates reduce mortgage interest payments. The fan chart depicting the probability distribution for output growth is rather like a contour map. At any given point during the forecast period, the depth of shading represents the height of the probability density function over a range of outcomes for output. The darkest The current projection for the growth rate of GDP— band includes the central (single most likely) projection and covers 10% of the probability. Each successive pair of bands is drawn to based on the assumption that the interest rate remains cover a further 10% of the probability, until 90% of the probability distribution is covered. The bands widen as the time horizon is constant at 5.5%—is shown in Chart 1. The central extended, indicating increasing uncertainty about outcomes. projection is for the four-quarter rate of GDP growth to 1 slow to between /2% and 1% during this year before recovering to around trend by the middle of 2000 as Chart 2 Current RPIX inflation projection based on domestic demand picks up. Quarterly growth is constant nominal interest rates at 5.5% expected to be close to zero in the first half of this year. Percentage increase in prices on a year earlier 6 The corresponding projection for RPIX inflation is shown in Chart 2. The most likely path is for inflation to 5 stay close to target over the next two years. But there is considerable uncertainty surrounding this projection, not 4 only because of the current difficulty of assessing labour 3 cost pressure. Indeed, some Committee members took 2.5 the view that the inflation profile should be about 2 0.2 percentage points lower because of somewhat stronger productivity growth, or weaker world prices, 1 than assumed in the central projection. 0 1994 95 96 97 98 99 2000 01 The Monetary Policy Committee has acted in response The fan chart depicting the probability distribution for inflation is rather like a contour map. At any given point during the forecast period, the to deteriorating prospects for external and domestic depth of shading represents the height of the probability density function over a range of outcomes for inflation. The darkest band includes the demand, and the more benign prospect for both imported central (single most likely) projection and covers 10% of the probability. Each successive pair of bands is drawn to cover a further 10% of the probability, until 90% of the probability distribution is covered. The bands and labour cost inflation, by reducing interest rates from widen as the time horizon is extended, indicating increasing uncertainty about outcomes. 7.5% to 5.5% over the past several months. Output growth at home has fallen—although broadly as expected in the November Report. The prospect remains one of a temporary slowdown followed by a pick-up of growth to around trend next year. The inflation outlook is uncertain. Inflation outturns in the past six months, inflation expectations on most measures, as well as the Committee’s central
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