Assessing economic conditions
demand and supply...again
assessing demand
assessing inflationary pressure
By now, you should be clear about your task - to assess economic conditions and judge whether future inflation is likely to be above, below or in line with the Government's inflation target, and then decide what interest rate might best achieve the target. There is no unique way to go about building up your team's assessment of the economic situation and outlook. You should decide what you want to cover and how. But you need to keep a close eye on the economic principles that underpin monetary policy and the inflation process.
demand and supply...again 
In the Inflation section,
we explained that the amount of demand in the economy relative
to overall supply is an important consideration for policymakers.
The level of spending, in money terms, relative to the economy's
ability to produce will determine the extent of infationary
pressure in the economy. Assessing the level of demand, whether
it is growing more or less quickly than the economy's ability
to supply goods and services, and whether this is likely to
continue into the future, are key issues for monetary policy.
Interest rates are set to try to ensure that the level of demand,
in money terms, is consistent with the inflation target.
teams need to assess whether the level of demand is
exceeding the supply of goods and services
We explained how rising demand might result in output growing at a rate that leads to upward pressure on costs and prices. Teams need to assess whether there are signs that the level of demand is beginning to exceed the economy's potential to supply goods and services.
The task can be divided into two related parts:
monitoring and assessing demand conditions across the economy;
monitoring and assessing the extent of inflationary pressure in the economy.
assessing demand
Teams will need to build an overall picture of the current and future level of demand in the economy.
components of demand
Looking at the different components of demand will help teams to interpret and understand changes in overall demand. The main components are:
Consumers' expenditure
- spending on goods and services by households in the UK;
Capital expenditure
- investment in buildings and new equipment;
Expenditure on stocks of goods
- spending by firms on increasing their inventories of goods and materials;
Government expenditure
- spending by central and local government on health, education and other public services;
Expenditure on exports
- spending by foreigners on UK goods and services;
Expenditure on imports
- spending by UK residents on foreign goods and services.
Each of the main components of aggregate demand is likely to be growing at a different rate at any point in time, not least because they are influenced by different factors. For example, consumers' expenditure might be rising strongly because of the growth in wages and other earnings or because people are confident about the future. But exports might be falling because demand in overseas economies is declining or the exchange rate is rising. And investment might be weak because company profitability is low.
the extent of inflationary pressure in the economy will
depend on the overall level of demand
There are also links between different components of demand - for example, strong growth in consumer spending is likely to increase import demand, or perhaps make it more attractive to increase investment in consumer goods industries.
A large amount of the economic data that teams will come across relate to one or another of these components of demand. Consumer spending is by far the largest component of total demand in the economy. So it is important to track this particularly closely. The Economy section explains more about the different components of demand.
Whether firms are producing output for one component of demand or another is unlikely to affect the way they use resources. The pressure on costs and prices will be similar if output is rising too fast. The extent of inflationary pressure in the economy will depend on the overall level of demand.
money
The amount of money in the economy is the key determinant of the level of prices. It also provides important indications about demand conditions. Monetary statistics, such as narrow and broad money, as well as consumer credit and mortgage lending data, can provide information about whether spending is likely to rise.
output
Teams can also look at information that reflects the growth of output in the economy. We explained in the Inflation section that the rate at which the economy can grow over the long term depends on factors that increase the supply potential of the economy, ie the capacity of the economy to produce goods and services. But, in the short term, output (and employment) can rise and fall in response to changes in demand. Higher demand might be met by an increase in imports or from firms' stocks. But, in the short run, changes in output are likely to reflect changes in demand.
In addition to total output, information is available covering the output of different sectors of the economy, such as manufacturing and services. This can help to build evidence on economic conditions and how they might be changing.
Similarly, data on activity in the labour market - such as the change in the number of people in employment and unemployment - will also tend to reflect how quickly the economy is growing. All these aspects of the economy are covered further in The Economy section.
assessing inflationary pressure
Teams can monitor the growth of money, demand and output using all the economic data and information at their disposal. But remember it is when the level of spending in money terms starts to exceed what can be produced normally or comfortably with existing resources that prices tend to start rising more quickly. Ultimately, excess demand will be reflected in higher prices, not higher output.
The problem is that it cannot be known with any certainty by how much the economy can grow before it starts to generate inflationary pressure. There is no simple rule to follow. The pressure on capacity depends ultimately on the level of demand rather than its growth: an economy with plenty of spare capacity can grow more quickly than an economy where resources are fully utilised. But it is not possible to estimate with much precision how close the current level of output might be to the point at which producers start to reach capacity limits. It is not something that can be observed directly. The box below discusses the long term trend in the growth of output and the concept of the output gap.
sustainable growth and the output gap
Over time, the UK economy has grown at an average rate of about 21/2% a year. This is a useful guide to how much of an increase in output can be sustained over time, ie without generating inflationary pressure.
You will see this referred to as the trend or sustainable rate of growth. This reflects the rate of growth in the labour force and in productivity. Such things as investment in new equipment and technology, improved methods of production and distribution, and the development of skills have enabled productivity to rise.
Productivity increases and the growth of the labour force determine the growth in what is referred to as the economy's potential output. As we explained in the Inflation section, potential output is the 'normal capacity' level of output at which there is no upward or downward inflationary pressure in the economy. We said that actual output might grow by more than its sustainable rate in some periods and by less in other periods as the growth in demand fluctuates. Strong growth, such as that experienced in the late 1980s, has often been followed by falls in output - negative growth.
When growth is above or below its sustainable rate, you need to ask whether inflation is likely to move above or below the inflation target in the period ahead.
the economic cycle
The answer will partly depend on the stage of the economic cycle. After a recession, output might grow quickly without any signs of inflation rising. That is because there is spare capacity in the economy - the actual level of output has been growing below its potential level. This is generally associated with a reduction in inflationary pressure. As spare capacity in the economy is used up, there is an increasing likelihood that continued growth will result in rising inflation. Long periods of rising demand can take the level of output above its potential or sustainable level and are generally associated with rising inflationary pressure.
Economists refer to the difference between the actual level of output and the potential level of output as the 'output gap'. It can be positive - here defined as actual output above potential output - or negative. The output gap cannot be measured with any precision. No two economic cycles are alike and the rate of growth that the economy might be able to achieve through productivity increases can vary over time.
So it is not possible to have hard and fast rules about the output gap and its implications for future inflationary pressure. But this is still a helpful concept for assessing the balance of demand and supply in the economy as a whole.
spotting signs of inflation
In order to monitor how close the economy might be to operating at or beyond its normal capacity, evidence has to be gathered that might indicate production bottlenecks and pressure on resources within the production process, particularly in the labour market. This includes data on wages and other costs and prices.
evidence of inflationary pressure in the supply chain
and labour market can indicate that the economy
is operating close to full capacity
Cost and price data can help to tell us how close the economy might be to operating at full capacity by providing signs that inflationary pressure is building. But it is always necessary to understand what factors are driving higher or lower prices before we draw conclusions.
Rising raw material prices might, for example, reflect strong world demand and be a sign of wider or pending worldwide inflationary pressure. But, alternatively, higher prices could be due to factors affecting supply in particular sectors - for example, poor crop harvests can raise food prices, or output restrictions by oil producers can increase oil prices. In these instances, rising material prices might temporarily lead to more inflation as higher costs work through the supply chain and into consumer prices. But they are less likely to be a signal of general inflationary pressure than if prices were rising because of excess demand.
Similarly, if manufacturers' product prices start rising more quickly, you need to assess whether or not this reflects strong demand and pressures on capacity, allowing firms to pass on cost increases. Higher prices might reflect temporary or one-off influences such as a change in taxes or duties. These factors might influence the inflation rate for a period. But, unless this results in higher inflation expectations more generally - which then feed into wage negotiations and other prices - these effects should not have a lasting influence on inflation. This was explained in the Inflation section.
the labour market
The labour market is an important area for monitoring inflationary pressure. Employment levels might reach a point where there is likely to be upward pressure on wages and other earnings. Wage costs are a major part of total costs and so can have a significant influence on consumer prices. Rising wage costs not matched by higher productivity, may reflect pressures in the labour market, perhaps due to a shortage of skills and recruitment difficulties.
costs, profits and prices
It is also necessary to judge whether any increase in prices within the supply chain is likely to be passed on to consumers. Cost increases might mean lower profit margins for firms rather than higher prices for consumers, at least in the short run. For example, faced with higher costs, retailers might either take a cut in their profits, make offsetting cost savings elsewhere, or pass the cost increases on to consumers by charging higher prices.
The extent to which firms are able to pass on cost increases is likely to be influenced by demand conditions - when demand conditions are buoyant, retailers are more likely to be able to pass on cost increases to the consumer, and perhaps also boost their profit margins. Competitive conditions will also be important. If some retailers try to increase their prices and profits, other retailers might enter the market and eventually force prices down. These are the kinds of issue that teams will have to consider.
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