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Bank of England Economic Outlook
05/06/2008
THE BANK’S BALANCING ACT GETS EVEN MORE CHALLENGING Roger Beales, from the Bank of England’s Agency for Greater London, explains the latest thinking of the Monetary Policy Committee (MPC) about prospects for the UK economy. At its April meeting, the Bank’s MPC cut interest rates to 5%; and left them unchanged in May and June. The Bank’s latest Inflation Report, published on 14 May, is available on the Bank’s website atwww.bankofengland.co.uk/publications/inflationreport/index.htm
High inflation will squeeze real take-home pay
Since February, the near-term outlook for inflation has deteriorated. This will lead to a squeeze on households’ real take-home pay, which in turn will slow consumer spending and output growth, perhaps sharply. So the balancing act faced by the MPC is even more challenging than it was in February.Financial market conditions have stabilised but remain fragile
Financial market conditions have stabilised somewhat since the introduction of the Bank’s Special Liquidity Scheme launched on 21 April, but they remain fragile. Commercial banks continue to adjust their balance sheets by raising new capital and lowering the supply of credit to the rest of the economy. The impact of tighter credit conditions has been most apparent in property markets, with commercial property prices falling by about 16% since last summer and house prices also now beginning to fall. In these circumstances, households are likely to save more of their income and spend less. This is part of a necessary rebalancing of the UK economy away from spending and importing, towards saving and exporting — a change that will be supported by sterling’s 12% depreciation since last August. The latest economic developments and the outlook are described briefly below:-Recent economic newsThe latest official estimates show GDP growth slowing further, to 0.4% in 2008 Q1. The official estimates of retail spending suggested a resilient first quarter, but surveys of retailers and the reports of the Bank’s regional Agents were more downbeat. Housing market activity weakened further. Against a backdrop of heightened demand uncertainty and reduced credit availability, businesses’ investment intentions fell back and investment in dwellings could fall sharply. Overseas, output in the US barely grew in Q1 and in the euro area business surveys point to growth continuing at a subdued rate. In Asia, though, the pace of expansion remained robust, maintaining the upward pressure on global commodity prices. Output growth to slow sharply this year As usual, the Bank’s forecasts are conditioned on market views of the outlook for interest rates, which are for modest falls in Bank Rate during the rest of 2008. On the MPC’s central view, output growth slows sharply through 2008 reflecting the squeeze on real incomes, the tightening in credit conditions and weaker prospects for world growth. This is a weaker forecast than was reported in February due to the fact that a number of downside risks have since crystallised. Growth recovers gradually through 2009 as credit conditions begin to ease and the depreciation of sterling boosts exports and reduces imports. The risks around the near-term outlook are balanced (that is, growth is equally likely to be higher than lower) but lie on the side of weaker growth further out, consistent with the possibility of a prolonged period of tight credit conditions and weak demand. The inflation outlook
Annual consumer price (CPI) inflation increased from 2.2% in January to 3.0% in April and rising energy and import prices will almost certainly push inflation higher still, possibly significantly, in the coming months. If energy prices stabilize, inflation should start to decline around the end of this year and settle around the 2% target in the medium term. But there is considerable uncertainty over this profile: for example, the near-term outlook rests on assumptions about the magnitude and timing of further rises in domestic gas and electricity prices which are extremely difficult to anticipate. Nevertheless, it is likely that with inflation above 3% for several quarters, the Governor will be required to write a number of open letters to the Chancellor over the next year.
There are both upside and downside risks to the medium term forecast. On the downside a more prolonged period of subdued demand growth could open a larger margin of spare capacity, pulling down on inflation. On the upside, inflation could remain above 2% for longer if above-target inflation begins to affect the expectations of those setting wages and prices. Both sets of risks have increased since February. To try to bring CPI inflation back down to the target too quickly would result in an undesirable degree of volatility in output. It is important to stress however that this does not mean the Committee will ignore the near-term rise in inflation. The extent of that deviation from target this year is likely to affect the behaviour of those setting prices and wages. So the Committee judges that some slowing in demand growth is necessary this year, thereby reducing pressure on the limited amount of spare capacity in the economy, in order to keep inflation close to its target in the medium term.In conclusion, the Committee is facing its most difficult challenge yet. We are travelling along a bumpy road as the economy rebalances, not helped by a period of very high commodity prices. But interest rates must not be set with the intention of preventing that adjustment. As the Committee’s remit states, “the real stability upon which economic prosperity is founded requires that inflation remain low and stable for a long period of time.” Inflation will return to target and growth will eventually recover to a sustainable rate. But we will need to be patient.
The latest Bank of England regional Agents’ summary of business conditions is available on the Bank’s website at: www.bankofengland.co.uk/publications/agentssummary/index.htm