Quarterly Inflation Report

Overview

Much of the world economy remained in recession, with levels of activity in many countries significantly lower than a year ago. But there were more encouraging signs looking ahead. Financial market strains eased and bank funding conditions improved a little, although financial conditions remained fragile. Household and business confidence picked up somewhat from the very low levels observed in the financial crisis last autumn.

In the United Kingdom, the recession appeared deeper than previously estimated and GDP fell further in the second quarter of 2009. But the pace of contraction moderated and business surveys suggested that the trough in output was near. The prospects for domestic economic activity are underpinned by the considerable stimulus from the easing in monetary and fiscal policy and the past depreciation of sterling. Output will be boosted as the inventory adjustment runs its course. But there are also factors that are likely to hinder recovery, both in the United Kingdom and abroad. Credit conditions are likely to remain tight as banks continue to repair their balance sheets, and past falls in asset prices and high levels of public and private debt will weigh on spending. On balance, the stimulus should lead to a slow recovery in economic activity, but the timing and strength of that recovery remains highly uncertain.

CPI inflation fell back to a little below the 2% target. The margin of spare capacity in the economy increased further and pay growth remained weak. Under the assumptions that Bank Rate moves in line with market rates and the stock of assets purchased through the issuance of central bank reserves reaches £175 billion, the downward pressure from the margin of spare capacity means that inflation is more likely to be below target in the medium term than above. But there are significant risks to the inflation outlook in each direction.
Financial and credit markets

The MPC maintained Bank Rate at 0.5% and continued its programme of asset purchases. Gilt yields rose over the past three months, but were probably lower than they would have been in the absence of the asset purchase programme. The functioning of corporate credit markets improved and large companies increasingly turned to bond and equity markets for finance. Money growth remained weak despite the asset purchase programme. It was likely that some of the extra money had been used by investors to buy securities issued by banks and by businesses to repay bank debt.

Growth in the stock of loans to households remained subdued, and the stock of outstanding loans to businesses fell. Housing market activity recovered modestly providing some support to house prices. Strains within financial markets eased as the perceived risk of a more severe downturn receded. Equity prices rose internationally. The sterling effective exchange rate appreciated, but was still around 20% below its 2007 peak.
Global activity

World output contracted markedly in the first quarter of 2009, although indicators of near-term activity had picked up materially since then. The turnaround was most marked in some Asia-Pacific economies where growth appeared to have rebounded strongly in 2009 Q2. The pace of contraction in US domestic demand eased in Q2, and indicators of consumption and investment in the euro area improved. But global credit conditions remained tight and prospects for a sustained recovery in world output were uncertain. The substantial depreciation of sterling should continue to encourage both domestic and overseas spending to switch towards UK-produced goods and services.
Domestic demand

Households' consumption was estimated to have fallen by 3% in the year to 2009 Q1. A number of factors were likely to have depressed consumption over the past year. Asset prices had fallen, and the effects of the financial crisis and attendant recession may have led households to revise down their expectations of future earnings. Increased uncertainty about the economic outlook and the possibility that taxes may rise in the future may have encouraged households to save more.

More timely data suggested that the pace of contraction in consumption eased in the second quarter of 2009. Investment spending plummeted in 2009 Q1. Business investment was estimated to have fallen by nearly 8% and dwellings investment by more than 12%. Low levels of capacity utilisation, nervousness about the outlook for demand, and tight credit conditions all weighed on investment spending. Those factors also pushed down inventory levels, which fell sharply.

The Committee's projections are conditioned on the fiscal plans set out in the 2009 Budget. Those plans embodied a marked rise in the ratio of public sector debt to GDP. Stabilising that ratio will require some combination of lower government spending and higher taxes, as a share of GDP.
The outlook for GDP growth

GDP was estimated to have fallen by 0.8% in 2009 Q2. Downward revisions to growth around the turn of the year indicated that the recession was deeper than previously thought. Nominal spending was estimated to have fallen by 4% in the year to 2009 Q1. But business surveys suggested that the trough in output was near.

Chart 1 shows the Committee's best collective judgement for four-quarter GDP growth, assuming that Bank Rate follows a path implied by market rates and the stock of assets purchased through the issuance of central bank reserves reaches £175 billion and remains at that level throughout the forecast period. The considerable stimulus from the easing of monetary and fiscal policy and the past depreciation of sterling should lead to a recovery in economic activity. Output will receive a further substantial boost as the inventory adjustment runs its course. But there are also factors that are likely to hinder recovery, both in the United Kingdom and abroad. Credit conditions are likely to remain restrictive as banks continue to repair their balance sheets, and past falls in asset prices and high levels of public and private debt will weigh on spending.

The timing and strength of those factors are highly uncertain. There are some encouraging signs that the Bank's asset purchases have helped to reduce the price of credit and raise the value of some assets. And money growth picked up slightly in Q2. Nevertheless, it is difficult to predict with precision the impact of the asset purchase programme on nominal spending and inflation. The effectiveness of the measures so far undertaken internationally to hasten a return to normal lending conditions is unclear, but so too is the extent to which the tightening of credit supply will prevent a recovery from taking root. High levels of public and private debt and concerns about job security may lead households to save more, although the low level of Bank Rate should dampen this. And the ease with which the United Kingdom is able to move towards a sustainable balance between domestic and external demand will depend on the degree to which current account surplus countries boost their domestic spending. On balance, the Committee continued to judge that the interaction of these factors pointed to a slow recovery in economic activity. The projected distribution for GDP growth is somewhat stronger than in the May Report, reflecting the increased monetary stimulus. The probability of activity contracting for a further sustained period is judged to have fallen.

Costs and prices

CPI inflation fell back to 1.8% in June, a little below the 2% target. The labour market loosened further and pay growth remained weak. Measures of households' inflation expectations were stable.

Inflation is likely to be unusually volatile in coming months, reflecting past changes in energy prices dropping out of the twelve-month comparison and the reversal of the reduction in VAT. It is more likely than not that inflation will temporarily fall below 1% in the autumn, requiring an open letter from the Governor to the Chancellor, before rebounding to around the target. Thereafter, the growing margin of spare capacity is likely to depress wage and price increases. But the impact of the lower level of demand on inflation will be dampened by the diminished supply potential of the economy.

Despite the recent appreciation of sterling, the substantial fall in the value of the exchange rate since the middle of 2007 had pushed up businesses' costs significantly. The extent to which companies have not yet fully adjusted to these higher costs and to which any further adjustment will come through higher prices rather than lower wages are key uncertainties surrounding the near-term inflation outlook.
The outlook for inflation

Chart 2 shows the Committee's best collective judgement of the outlook for CPI inflation, assuming that Bank Rate follows a path implied by market rates and the stock of assets purchased through the issuance of central bank reserves reaches £175 billion and remains at that level throughout the forecast period. The persistent margin of spare capacity bears down on CPI inflation, but that downward pressure is partly offset by the impact of sterling's depreciation on consumer prices in the near term, and by the judgement that inflation expectations remain anchored around the inflation target.

The way in which these factors will affect inflation is highly uncertain, and there is a range of views on their relative strength among Committee members. The downward pressure from the weak demand environment will depend on the timing and strength of the recovery, the impact of the slowdown on the supply capacity of the economy, and on the sensitivity of inflation to the degree of economic slack. The upward pressure from sterling's depreciation depends on the extent to which companies need to adjust further to the higher import costs and on whether this adjustment comes through higher prices or lower wages. There may also be upwards pressure on inflation from rising global energy and commodity prices if world growth picks up by more than expected. There are risks in both directions that inflation expectations may become less firmly anchored, although the Committee's commitment to maintain inflation close to target should help to limit those risks. The balance of these factors suggests that, conditioned on the monetary policy assumptions described above, inflation is more likely to be below target in the medium term than above. The projected distribution for inflation in the medium term is broadly similar to May.

Chart 3 shows the projection for CPI inflation conditioned on the assumptions that Bank Rate is held constant at 0.5% and the stock of purchased assets reaches £175 billion. This suggests that, on those assumptions, the risks of inflation being above or below the 2% target at the two-year horizon are broadly balanced, albeit that the path of inflation is rising.

The policy decision

At its August meeting, the Committee noted that the immediate prospect was for CPI inflation to fall substantially below the 2% target. Output appeared to be stabilising and the substantial stimulus from the easing in monetary and fiscal policy and the past depreciation in sterling should support a slow recovery in economic activity. But the margin of spare capacity in the economy was likely to continue to grow for some while, bearing down on inflation. In the light of that outlook, the Committee judged that to keep CPI inflation on track to meet the 2% target in the medium term it should maintain Bank Rate at 0.5% and increase the size of the programme of asset purchases financed by the issuance of central bank reserves to a total of £175 billion.