Inflation Report May 2008

Overview

In the United Kingdom, output growth moderated and surveys point to further easing. Indicators of household spending were mixed, while the investment climate worsened. International prospects deteriorated, especially in the United States. Stresses in global financial and credit markets intensified in March but latterly there have been signs of improvement. Sterling depreciated further and in April the MPC cut Bank Rate by 0.25 percentage points. Under the assumption that Bank Rate moves in line with market yields, the Committee's central projection is for output growth to slow further over the next year and then recover. But there is a risk that the slowdown may be more prolonged.

CPI inflation was 2.5% in March. Energy and import cost pressures increased. Pay growth remained muted but measures of household inflation expectations rose. In the central projection, higher energy and import prices push inflation up sharply in the near term. The emerging margin of spare capacity, together with a declining contribution from energy and import prices, then brings inflation back to around the 2% target in the medium term. The conflicting risks to inflation from a more prolonged slowdown in demand growth and from the impact of persistently elevated inflation on inflation expectations have both increased since the February Report. Overall, the balance of risks is presently judged to lie to the upside.
Financial markets

Financial markets remained under stress. The dislocation in global wholesale funding markets intensified in March but conditions improved a little thereafter, in part reflecting central bank initiatives, including the introduction by the Bank of England of a long-term facility to swap liquid assets for high-quality, but presently illiquid, collateral. Even so, funding costs for banks remained elevated. These stresses in funding markets, coupled with the need to reduce balance sheet exposures to risk, were reflected in a further tightening in credit supply by UK banks, with higher premia charged, particularly to riskier borrowers, and the withdrawal of some products. As a result, mortgage approvals fell sharply, while loan growth to non-financial companies also slowed.

The MPC cut Bank Rate to 5% at its April meeting. Forward market interest rates imply less further policy easing than at the time of the February Report. The effective exchange rate for sterling depreciated by 31/@%, leaving it some 12% lower than at its peak last July. Only a small part of that fall can be directly attributed to movements in expected interest rates here and overseas. The remainder may indicate a reassessment by investors of the sustainable value of sterling or an increase in the risk premium required for holding sterling assets.
Domestic demand

Domestic demand growth moderated in 2007 Q4 on the back of a sharp slowdown in consumers' expenditure growth. The official estimate of retail spending suggested a resilient first quarter, but surveys of retailers and reports by the Bank's regional Agents were more downbeat. Housing market activity weakened further and house prices fell. Looking forward, the recent and prospective pickup in inflation will weigh on real household income growth. Together with the tightening in the supply of credit and increased precautionary saving, that can be expected to dampen household spending growth.

Business investment growth eased a little in the fourth quarter. And against a backdrop of heightened demand uncertainty and reduced credit availability, investment intentions fell back, pointing to a further moderation this year. Investment in dwellings is expected to fall sharply.

Government spending made a moderate contribution to nominal domestic demand growth in 2007. According to the fiscal plans set out in Budget 2008, the public sector's contribution to nominal demand growth is set to decline over the forecast period, similar to the path assumed in the February Report.
Overseas trade

International economic prospects have continued to deteriorate since the February Report. In the United States, output barely grew, employment fell, the housing market slump deepened and credit conditions tightened. But there is a considerable policy stimulus in the pipeline, which should in due course promote recovery. In the euro area, GDP growth eased and business surveys pointed to growth continuing at a subdued rate. In Asia, though, the pace of expansion remained robust, maintaining the upwards pressure on global commodity prices.

Weaker growth in overseas markets will bear down on the growth of UK exports. But the gain in competitiveness associated with sterling's depreciation, together with weaker import growth as the result of sluggish domestic demand, should help to boost the contribution of net trade to GDP growth over the next few years.
The outlook for GDP growth

According to the ONS's preliminary estimate, GDP growth in Q1 eased to 0.4%, on the back of slower growth in the non-distribution services and energy sectors. Business surveys and reports from the Bank's regional Agents point to a further moderation in growth in the second quarter.

Chart 1 shows the Committee's best collective judgement for four-quarter GDP growth, assuming that Bank Rate follows a path implied by market yields. In the central projection, output growth slows markedly through 2008, opening up a margin of spare capacity. Sluggish real income growth and tighter credit supply dampen consumer spending, while the weaker demand outlook and lower property prices also weigh on business and residential investment. Growth then recovers, as credit conditions ease and the lower level of sterling continues to feed through to net exports. The outlook is somewhat weaker than in the February Report over the first part of the projection.

Costs and prices

CPI inflation was 2.5% in March, some 3/4 of a percentage point higher than six months earlier, reflecting higher energy and food price inflation in particular. Higher energy and import prices are expected to exert further upward pressure on inflation through the rest of this year. Oil prices have risen by a quarter since the February Report, reflecting both continued growth in the demand for oil and constraints on oil supply. There was an equivalent movement in wholesale gas prices and a further round of domestic energy price increases over the summer seems probable. Price inflation of imported goods rose to its highest since 1995, in part reflecting the substantial depreciation of sterling.

The scale and persistence of the projected rise in CPI inflation is uncertain, however. Businesses early in the supply chain appear to have passed some of the cost increases through into higher output prices, and survey measures of businesses' pricing intentions have remained elevated. But a survey by the Bank's regional Agents suggested that many consumer-facing businesses were not in a position to pass on cost increases to their customers, perhaps on account of the weaker outlook for consumer demand.

Those businesses not able to pass on cost increases may instead attempt to push down on other costs, especially pay. But the past and prospective pickup in consumer price inflation may also lead employees to press for higher wages to compensate. So far, pay growth has remained subdued, despite quite strong employment growth. Easing employment intentions point to a weaker labour market in the future, which is likely to add to the downward pressure on wages.

Both pay and prices are likely to be influenced by expectations of future inflation. Measures of short-term household inflation expectations rose again, broadly in line with the recent and prospective movements in consumer price inflation. But some longer-term indicators of inflation expectations have also edged up. If expectations were to remain elevated, then that would pose an upside risk to inflation in the medium term.
The outlook for inflation

Chart 2 shows the Committee's best collective judgement of the outlook for CPI inflation, assuming that Bank Rate follows market yields. In the central projection, higher energy and import prices push inflation further above the 2% target, to a level requiring a number of explanatory open letters to the Chancellor. The margin of spare capacity, together with waning contributions from energy and import prices, then brings inflation back to around the 2% target in the medium term. The profile is higher than in the February Report for most of the projection.

As usual, there are substantial uncertainties surrounding these projections. The key risks to inflation are: on the downside, the possibility that a more prolonged period of subdued demand opens up a larger margin of spare capacity; and, on the upside, the possibility that the persistent period of above-target inflation leads to a lasting increase in medium-term inflation expectations. Both risks are judged to have increased since the February Report. Overall, the risks around the central projection to growth lie to the downside in the medium term, while those to inflation are to the upside. There is a range of views among the Committee on both the central projection and the balance of risks.
The policy decision

At its May meeting, the Committee noted that the immediate prospect was for a sharp increase in inflation, which was already above the target, and sluggish output growth. The latter would open up a margin of spare capacity, but that was likely to be necessary in order to return inflation to the target in the medium term. There were particular uncertainties relating to the severity of the slowdown and the future path of inflation expectations. The key challenge for policy was to balance those conflicting risks. The Committee judged at its May meeting that it was appropriate to leave Bank Rate unchanged in order to meet the target for CPI inflation over the medium term.