Quarterly Inflation Report Nov 2008

There has been a marked deterioration in the outlook for domestic and global economic activity. Instability in banking and financial markets intensified to levels not seen for almost a century. And, in the United Kingdom, official estimates of GDP growth, business surveys and reports from the Bank's regional Agents all weakened sharply. The economy probably entered recession in the second half of 2008 and output is likely to contract further. Consumer spending faltered in the second quarter under the weight of tighter credit and the squeeze on household budgets. Residential investment continued to fall rapidly and prospects for business investment weakened. Under the assumption that Bank Rate follows a path implied by market yields prevailing prior to the Committee's November decision, the MPC's central projection is for output to continue to fall in the early part of the forecast, followed by a gradual recovery.

CPI inflation rose to 5.2% in September. Sterling depreciated further, placing renewed upwards pressure on import prices. Even so, the near-term outlook for inflation improved significantly in the wake of sharp falls in commodity prices. Measures of household inflation expectations fell back and earnings growth remained contained. In the central projection, inflation slows sharply in the near term, as the contributions from energy and food prices decline. Further out, inflation falls well below the 2% target, reflecting a larger margin of spare capacity and the waning impact on import prices from the lower level of sterling. The prospects for economic growth and inflation are judged to be unusually uncertain.
Financial markets

The global banking system experienced its most severe instability since the outbreak of World War I. Against a backdrop of a weakening economic outlook and increased aversion to risk, the process of financial sector consolidation and balance sheet adjustment became increasingly disorderly. Concerns about banks' solvency and strains in global money markets reached unprecedented levels. On 8 October, the UK authorities announced a comprehensive package to address the weaknesses in UK banks' balance sheets. Similar initiatives were announced by a number of other countries. Early indications suggest that these actions have helped to dissipate some of the concerns about possible bank failures.

The turmoil was accompanied by exceptional volatility in financial markets. In the period since the August Report, share prices fell by around a quarter in the advanced economies and by even more in many emerging markets. Sterling depreciated sharply, by some 6% for the effective exchange rate and by rather more against the dollar. And financial market participants revised down materially their expected path of policy rates in the advanced economies. Several central banks reduced official interest rates substantially. In the United Kingdom, the Monetary Policy Committee (MPC) lowered Bank Rate by 0.5 percentage points in October, as part of a co-ordinated action with six other central banks, and by a further 1.5 percentage points in November.
Domestic demand

The outlook for domestic demand deteriorated markedly amid a substantial tightening in the supply of money and credit. Household spending fell slightly in Q2 and indicators pointed to further contraction in the third quarter. Part of that weakening reflected the continued squeeze on households' purchasing power from past increases in energy and import prices. Although recent falls in commodity prices should alleviate much of that pressure, the boost to households' real incomes will be more than offset by weak employment, as companies shed labour. The conjunction of subdued real income growth, tight credit conditions and lower asset prices constrains consumer spending over the first part of the forecast.

Prospects for investment worsened. Business investment fell in the second quarter, restrained by the weaker, more uncertain outlook for demand and, increasingly, by reduced availability of credit. Weakness in residential and commercial property markets also pushed down on capital formation. Investment intentions dropped sharply.

In line with its usual convention, the Committee's central projection is based on the Government's tax and spending plans in Budget 2008, and the subsequent announcements over the summer on tax allowances and fuel duties. But the Government's announced intention to bring forward some planned spending commitments, together with the likelihood that the changing composition of output will lead to a fall in effective tax rates, suggests that the degree of fiscal stimulus may be greater than that assumed in the central projection.
Overseas trade

The outlook for the world economy deteriorated substantially, as indicators of near-term growth weakened and strains in global financial and banking markets intensified. In the euro area, surveys were consistent with continued softness in economic activity in Q3, following a contraction in the previous quarter. US output declined, as weakness in housing and labour markets persisted. And activity in emerging market economies slowed, as growth in exports to the advanced economies eased back. The lower level of sterling should mitigate the impact of decelerating world demand on UK export volumes. Even so, prospects for exports have weakened significantly since the August Report and the possibility of a larger and more widespread downturn in global demand poses a significant downside risk.
The outlook for GDP growth

GDP was estimated to have fallen by 0.5% in Q3. Business surveys and reports from the Bank's regional Agents weakened markedly and pointed to a further contraction in output in the fourth quarter.

Chart 1 shows the Committee's best collective judgement for four-quarter GDP growth. This assumes that Bank Rate, following a path implied by market yields prevailing prior to the Committee's November decision, falls from an average of 4% in the fourth quarter of this year to around 23/$% in the second half of next year, before picking back up to around 4% by 2011. In the central projection, a pronounced contraction in domestic demand causes output to fall in the early part of the forecast. The key drivers are a sharp tightening in the supply of money and credit, subdued growth in incomes and past falls in asset prices. However, there are a number of factors acting to stimulate activity over the forecast period: the assumed reductions in Bank Rate; a gradual expansion in credit supply as the effects of the authorities' recapitalisation programme take hold; lower world energy and food prices; the lower level of sterling; and a continued expansion in government spending. As a result, GDP begins to recover in the second half of 2009, rising somewhat above its historical average rate by the end of the forecast horizon. The central projection over the next two years is substantially weaker than in the August Report.

Costs and prices

CPI inflation rose to 5.2% in September, much higher than at the beginning of the year. But the near-term outlook for inflation improved substantially in the wake of sharp falls in commodity prices. These falls, if sustained, will cause the contribution from energy and food prices to decline rapidly. However, the speed with which overall inflation moderates will depend, in part, on the extent to which the lower level of sterling is passed through into higher import prices.

The weaker demand environment should also act to moderate increases in prices and wages. Companies may be forced to absorb a greater proportion of their costs in temporarily lower margins, while the loosening in the labour market is likely to erode the bargaining position of employees. But the impact of the current slowdown on prices and wages will be dampened by weaker growth in the supply potential of the economy. The supply capacity of companies is likely to be hindered by reduced availability of bank finance and trade credit, as well as by the redeployment of capital and labour away from sectors most affected by the downturn. Moreover, as employment prospects deteriorate, some people may be temporarily discouraged from searching for work.

A key risk highlighted in recent Reports has been that the sharp increase in CPI inflation over the past year might cause companies and households to revise up their expectations of future inflation. Most measures of inflation expectations have fallen back in recent months. Given the lower near-term outlook for inflation, the MPC judges that the risk of inflation expectations remaining elevated has diminished.
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 yields prevailing prior to the Committee's November decision. In the central projection, inflation falls sharply in the near term, as the contributions from energy and food prices decline. Further out, inflation falls well below the 2% target, reflecting a larger margin of spare capacity and the waning impact on import prices from the lower level of sterling. The central projection is significantly lower than in the August Report.

The prospects for economic growth and inflation are judged to be unusually uncertain, reflecting the exceptional economic and financial factors affecting the outlook. The biggest risks to inflation stem from the uncertain depth and persistence of the slowdown in demand. There are also marked uncertainties over: the extent to which the slowdown in demand results in spare capacity despite slowing supply growth, and the degree to which it feeds through into easing price pressures; the prospects for world commodity prices; and the likely scale and pace of pass-through of a lower exchange rate. The risks around the central projections for both GDP growth and inflation shown in Charts 1 and 2 are broadly balanced. But the heightened level of uncertainty means that the Committee has more confidence in the broad shapes of the fan charts than in the precise calibrations. There is a range of views among the Committee on both the central projection and the balance of risks.
The policy decision

At its November meeting, the Committee noted that the outlook for inflation had shifted decisively to the downside. The tightening in the supply of money and credit was likely to cause output to contract further. And CPI inflation was set to fall sharply. The risk of inflation materially undershooting the inflation target in the medium term had increased substantially. In the light of that outlook, the Committee judged that a significant reduction in Bank Rate was necessary in order to meet the 2% target for CPI inflation in the medium term, and accordingly lowered Bank Rate by 1.5 percentage points to 3%.