Inflation Report August 2000 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 paths for inflation and output, and the uncertainties surrounding those central projections. This Report has been prepared and published by the Bank of England in accordance with section 18 of the Bank of England Act 1998. The Monetary Policy Committee: Eddie George, Governor Mervyn King, Deputy Governor responsible for monetary policy David Clementi, Deputy Governor responsible for financial stability Christopher Allsopp DeAnne Julius Stephen Nickell Ian Plenderleith John Vickers Sushil Wadhwani The Overview of this Inflation Report is available on the Bank’s web site: www.bankofengland.co.uk/inflationreport/infrep.htm The entire Report is available in PDF format on www.bankofengland.co.uk/inflationreport/index.htm Printed by Park Communications Ltd © Bank of England 2000 ISBN 1 85730 167 6 ISSN 1353–6737 Overview Growth with low inflation has continued in the UK economy. Output in the second quarter of 2000 was 3.1% higher than a year before, and inflation on the RPIX measure was 2.2% in June, just below target. Final domestic demand growth, having been strong throughout 1999, eased in the first quarter of this year— consumers’ expenditure continued to increase, but investment and government expenditure fell back. Robust growth in world trade has boosted demand for UK exports despite the strength of sterling, and imports have also grown at a brisk pace. Service sector activity has continued to expand strongly, while industrial production has recovered from weakness at the start of the year. Employment has risen further, and the unemployment rate has declined to its lowest level for a generation. But earnings growth has fallen back from the millennium-related boost to pay around the turn of the year. Commodity price increases—especially for oil—have put some upward pressure on costs. Sterling fell sharply in May, but the exchange rate remains strong. Activity and trade in the world economy have picked up strongly over the past year or so, and further expansion is in prospect. The momentum of demand and output growth in the United States continued into the first half of this year, but there are tentative signs of some deceleration. Recovery in the euro area, however, has gathered pace. The outlook in Japan remains uncertain—business profitability has improved but consumer demand remains subdued. Emerging market economies, especially those in East Asia, have consolidated upon their strong recoveries from economic setback two years ago. The oil price, though volatile, has generally been stronger than anticipated. In contrast to several years of weak commodity prices, this has given an upward impulse to inflation in a number of countries. The Federal Reserve and the ECB have increased interest rates further since May. There remain clear risks of abrupt and disorderly adjustment in the world economy—for example involving sharp falls in financial asset prices—but there is a good prospect of steady and broadly-based growth. Output in the United Kingdom is estimated to have increased by 0.9% in the second quarter. That is more than expected, and significantly above the 0.5% growth i Inflation Report: August 2000 recorded in the first quarter. The pick-up in output growth in recent months partly reflects a recovery in industrial production, especially in energy-related sectors, from a decline earlier in the year. But it also reflects strong expansion in service sector activity. While there is no uniform picture within manufacturing or within services, the sharp contrast between these broad sectors remains a feature of business surveys and reports from the Bank’s network of regional Agents. The pattern of demand growth in the first quarter— almost flat final domestic demand but positive contributions from net trade and stockbuilding— contrasts with that recorded in 1999. Consumer expenditure increased in Q1, though at a lower rate than in previous quarters, but investment and government expenditure declined. The slowing of domestic demand early in the year may have resulted in part from temporary factors—for example, unwinding of unusual strength in the run-up to the millennium. Domestic demand growth appears likely to have picked up in the second quarter, but there are indications—including the apparent cooling of the housing market—that the underlying momentum of consumption growth may be easing. In July, the Chancellor made his statement on the Spending Review, the broad lines of which had been drawn in the March Budget. Relative to the Budget, the profile for total government expenditure going forward is marginally higher—reflecting past underspending— and there is some increase in government consumption financed by lower social security and debt interest payments. Depending on the extent of possible future underspending, these measures may make a small addition to overall demand growth. Both exports and imports have risen surprisingly rapidly over the past year. Export volumes have been boosted, notwithstanding the high exchange rate, by the robust recovery in the world economy. But the growth rate of imports—supported by the combined strength of domestic demand and rising import penetration—has generally outstripped that of exports, and over the past three years the current balance has moved from surplus to a deficit approaching 2% of GDP. Despite the fall in sterling since May, some further deterioration of the net trade position is in prospect. Narrow money growth has moderated and broad money growth has risen—both to annual rates around 7%, somewhat above the growth rate of nominal GDP. ii Overview Strong credit expansion has continued. Corporate borrowing—from banks as well as capital markets—has risen sharply since last autumn, and annual growth in lending to households remains robust at around 10%. Most indicators suggest that the housing market is softening, although secured lending and mortgage approvals have so far stayed firm. The MPC has maintained the official interest rate at 6% since February. Near-term money market rates—a guide to expected future official interest rates—have eased further since the May Report. Longer-term bond yields and equity prices have been fairly stable over that period. The exchange rate, however, fell substantially following its rapid rise earlier in the year. The average value of sterling’s effective exchange rate index in the 15 working days to 2 August was 106.1, about 4% lower than three months ago. (This is the starting point for the exchange rate profile in the Committee’s projections described below.) Labour market behaviour is a key determinant of domestic inflationary pressure. Official data since the last Report have shown a benign combination of rising employment growth and a sharp fall in pay growth. Employment on the LFS measure has increased steadily since 1993, and grew by 0.5% in the three months to May. Average hours worked decreased, however, so total hours have not risen correspondingly. Unemployment has fallen further—to 5.6% on the LFS measure and to 3.8% on the claimant count, the lowest rate since 1975. Employment intentions are positive, particularly in the Chart 1 service sector, but widespread skill shortages persist. Current GDP projection based on constant nominal interest rates at 6% The headline measure of average earnings growth per Percentage increase in output on a year earlier 6 head fell from 6.0% in February to 4.6% in May. The boost to pay growth around the turn of the year appears 5 to have been in large part a temporary phenomenon 4 driven by millennium-related payments and bonuses. Wage settlements have been near 3% on average, though 3 there are some reports of prospective upward pressures. 2 Measures of labour productivity growth have picked up over the past year, and growth of unit labour costs has 1 + moderated to around 3%. These recent indications of 0 rather weaker-than-expected earnings growth combined – with falling unemployment provide some evidence that 1 1996 97 98 99 2000 01 02 underlying labour market performance is better than The fan chart depicting the probability distribution for output growth is rather like a contour map. At any given point during the forecast previously judged. period, the depth of shading represents the height of the probability density function over a range of outcomes for output. The darkest band includes the 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 Chart 1 shows the Committee’s assessment of the distribution is covered. The bands widen as the time horizon is extended, indicating increasing uncertainty about outcomes. outlook for GDP growth, on the assumption that the iii Inflation Report: August 2000 Chart 2 official interest rate remains at 6%. In the central Current RPIX inflation projection based projection, annual growth eases from its present rate to on constant nominal interest rates at 6% 1 around 2 /2%—near trend—before rising slightly in the Percentage increase in prices on a year earlier 5 second year of the forecast. The profile is similar to that in the May Report, with softer consumer demand growth 4 balanced by somewhat firmer external and public sector demand.