The Bank of England: Having it all

Cakes

Are you in favour of having your cake and eating it? If so, the Bank of England’s latest forecasts are for you. They show the Bank expecting a pick-up in the UK’s growth rate, with little change to the inflation outlook.

This is an unusual combination: normally, inflation rises when activity accelerates, as spare capacity is used up in the process. So instead of reacting to these growth forecasts by bringing forward the timing of an interest rate rise, financial markets responded by pushing expectations back a little. How has the Bank arrived at its conclusion and, given its poor track record in recent years, can we trust its forecasting judgements this time?

The Bank has more than doubled its 2017 GDP growth forecast compared with its immediate post-referendum view. Last August, the Bank’s monetary policy committee (MPC) expected growth to slow sharply to just 0.8% in 2017. In November, the committee raised its forecast to 1.4%, while arguing that the economy’s post-referendum resilience was merely pain deferred. But it now expects the economy to expand by 2.0% this year, in line with last year’s pace.

The latest upgrade reflects four factors: an easing of UK fiscal policy over the next few years, a firmer outlook for the world economy, supportive domestic credit conditions, and the fact that consumers are showing few signs of cutting back spending despite Brexit-related uncertainties.

The MPC is projecting a brighter future for the UK labour market

Back in November, the MPC was forecasting an increase in the unemployment rate from 4.8% to 5.6% by the start of 2019. It now expects unemployment to rise no higher than 5%, implying that a quarter of a million fewer people will be unemployed at the beginning of 2020 than it was forecasting three months ago. Normally, stronger job creation and lower unemployment would imply rising pay pressures, but not in this case – the Bank has revised down its outlook for wage growth. As Bank Governor Carney pointed out, “this is a good news story … more people can be in work without us having to adjust policy”.

So the Bank hasn’t raised its inflation forecasts in response to the stronger growth outlook, though it still expects inflation to breach the 2% target shortly.

After bottoming out at around zero in 2015, inflation could breach the MPC’s 2% target in the next month or so.

After bottoming out at around zero in 2015, inflation could breach the MPC’s 2% target in the next month or so. This reflects external factors – in particular, past falls in energy, food and other imported goods prices dropping out of the year-on-year comparison. Inflation is then expected to rise further in response to the fall in sterling, peaking around 2.8% at the start of 2018 and remaining above target throughout the next three years. However, because of the “exceptional circumstances” surrounding Brexit, the MPC’s remit requires it to take into account the impact of potential policy changes on GDP growth. As a result, the committee voted unanimously to keep interest rates at 0.25% this month – and, if economic conditions develop as it expects, rates could remain on hold through to the end of 2018.

But two big judgements underpin this story. First, it relies on the labour market having more spare capacity than previously thought, so the unemployment rate can fall as low as 4.5% without adding to pay pressures. For the Bank, the main trigger for this change of heart has been surprisingly subdued wage behaviour over the past four or five years. But what if that behaviour changes over the next few years, perhaps as a result of weaker inflows of migrant labour to the UK, or increasing skill shortages? In that case, pay pressures could rise faster than the MPC expects.

Second, the Bank’s forecasts for spending rely on consumers running down savings to the lowest level (on the household savings ratio measure) since records began in 1963. But will they really be willing to do this in the face of Brexit-related uncertainties? If not, the growth outlook could be weaker than the MPC expects. And if both judgements turn out to be wrong, the committee would face a dilemma: higher inflation indicating the need for higher interest rates, but weaker growth pointing in the opposite policy direction.

Do we trust the Bank?

Cynics might say that the revision to its labour market view is highly convenient for the Bank. After all, it allows the MPC to retreat from its pessimistic growth forecasts without being forced into a series of hasty rate rises or triggering a strong market reaction. To be fair to the MPC, however, its critics have tended to attribute more precision to its forecasts than the committee itself. Even last August, when it judged GDP growth of 0.8% the most likely outturn for 2017, the MPC attached a probability of at least 10% to growth coming in at 2% or more this year.

Governor Carney has not shied from the fact that there is a range of views within the committee on both wage pressures and savings behaviour, admitting “just because we agree today doesn’t mean that we would agree at the next meeting or subsequent meetings”. Nor are all members equally sanguine about the prospect of inflation breaching its 2% target for the next three years without respite. At its meeting earlier this month, “some members” were less tolerant of the inflation risks than in January, despite the revision to the Bank’s views on spare capacity. Whether these members would vote for a rate rise any time soon, and whether others could join their number, depends on how the data on pay and consumer behaviour develop in the months ahead.

In the meantime, before data reality intervenes, MPC members may wish to enjoy a brief moment of respite: stronger growth for no more inflation. What’s not to like?

 


The article above by Lucy O’Carroll, Chief Economist, previously appeared on the Aberdeen Assest Management ‘Thinking Aloud’ blog on 14th February 2017