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Home > Publications > Overview of the Inflation Report February 2014
 

Overview of the Inflation Report February 2014

 
The UK recovery has gained momentum and inflation has returned to the 2% target. Reduced uncertainty, easier credit conditions and the stimulative stance of monetary policy should support continued solid economic growth, with the expansion in demand becoming more entrenched and more broadly based.
Robust growth has not so far been accompanied by a material pickup in productivity. Instead, employment gains have been exceptionally strong and unemployment has fallen much more rapidly than expected. The LFS headline unemployment rate is likely to reach the MPC’s 7% threshold by the spring of this year. Even so, the Committee judges that there remains spare capacity, concentrated in the labour market.
Inflation is likely to remain close to the target over the forecast period. Given this, and with spare capacity remaining, the MPC judges that there remains scope to absorb slack further before raising Bank Rate. Moreover, the continuation of significant headwinds — both at home and from abroad — mean that Bank Rate may need to remain at low levels for some time to come.

Economic outlook
Demand and supply
The UK economy grew by 1.9% in 2013, the strongest annual growth rate for six years. Much of that expansion was driven by consumer spending, as lifting uncertainty and easing credit conditions prompted households to reduce their rate of saving. That brightening in the economic environment also prompted a revival in the housing market, with housing transactions in 2013 Q4 up more than 25% on a year earlier, accompanied by a pickup in house price inflation. This revival helped support strong growth in housing investment. In contrast, business investment has remained subdued, although surveys of investment intentions suggest that it is likely to gather pace this year. Despite stronger activity in the United Kingdom’s main overseas markets, export performance continued to disappoint. The strength of domestic activity contributed to a slight firming in short-term market interest rates and a further appreciation in sterling.

The recovery in output has not yet been matched by a material pickup in productivity growth. Instead, gains in employment have been exceptionally strong: since the MPC announced its policy guidance last August, almost half a million more people have found work. As a result, the LFS headline unemployment rate has fallen much more rapidly than the Committee anticipated and is likely to reach the MPC’s 7% threshold by the spring of this year.

With unemployment nearing that threshold, the Committee has reviewed the current and prospective degree of spare capacity in the economy. Although such estimates are necessarily uncertain, the Committee judges that spare capacity remains, equivalent to around 1%–1½% of GDP and concentrated in the labour market. Around half of that slack reflects the difference between unemployment and an estimate of its medium-term equilibrium rate. Bank staff have revised down their estimate of the medium-term equilibrium rate reflecting the disproportionate falls in longer-term unemployment over recent months. The medium-term equilibrium rate is likely to continue to drift down over the forecast period as unemployment falls further. The remaining slack largely reflects an assessment that there is scope for companies to increase further the hours worked by their employees. In particular, despite an increase in average hours worked since last summer, the number of people indicating they would like to work longer hours has remained elevated.

The Committee continues to expect a gradual recovery in productivity growth. As demand picks up further, some businesses should be able to redeploy staff to more productive activities. Easier credit conditions and reduced uncertainty may allow capital and labour to be reallocated towards more productive companies. And a recovery in business investment should also provide support. The recent weakness in productivity growth has nevertheless caused the Committee to revise down its judgement of the likely strength of the response of productivity to higher demand. More generally, the timing and strength of the pickup in productivity remain highly uncertain.

Chart 1 shows the Committee’s best collective judgement for four-quarter GDP growth, assuming that Bank Rate follows a path implied by market interest rates and the stock of purchased assets stays at £375 billion. Growth eases a little in the near term as the initial fillip from the release of pent-up demand fades. Thereafter, the recovery is projected to move to a firmer footing: a gradual revival in productivity underpins a modest pickup in pay growth, while stronger demand and improved corporate sentiment drive a rebound in business investment.
 
Chart 1
GDP projection based on market interest rate expectations and £375 billion purchased assets
 
Current GDP projection based on constant nominal interest rates
 
Please click on the image above to view an enlarged version of the chart.

The fan chart depicts the probability of various outcomes for GDP growth. It has been conditioned on the assumption that the stock of purchased assets financed by the issuance of central bank reserves remains at £375 billion throughout the forecast period. To the left of the vertical dashed line, the distribution reflects the likelihood of revisions to the data over the past; to the right, it reflects uncertainty over the evolution of GDP growth in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of GDP growth would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter green areas on 30 occasions. In any particular quarter of the forecast period, GDP growth is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth can fall anywhere outside the green area of the fan chart. Over the forecast period, this has been depicted by the light grey background. See the box on page 39 of the November 2007 Inflation Report for a fuller description of the fan chart and what it represents.

The strengthening of activity in advanced economies means that the risks around the global outlook are judged to be more balanced than of late. However, tensions in some emerging economies have resurfaced, and the need for further adjustment within the euro area continues to pose a risk to UK growth. At home, the main risks to the durability of the recovery are that sustained weakness in productivity prevents a pickup in household incomes and that companies are slow to increase their capital expenditure in response to rising demand. But the possibility of a virtuous cycle in sentiment, spending and incomes means there could be even greater near-term momentum in growth.

A gradual revival in productivity growth, together with a slight easing in the pace of expansion, should lead to a marked slowing in the rate at which the degree of spare capacity is used up. As a consequence, based on the same assumptions as Chart 1, unemployment is expected to fall less rapidly than in the recent past (Chart 2), with some spare capacity likely to remain even at the forecast horizon.
 
Chart 2
Unemployment projection based on market interest rate expectations and £375 billion purchased assets

Cumulative probability of unemployment having fallen below the 7% threshold
 
Please click on the image above to view an enlarged version of the chart.
 
The fan chart depicts the probability of various outcomes for LFS unemployment. It has been conditioned on the assumption that the stock of purchased assets financed by the issuance of central bank reserves remains at £375 billion throughout the forecast period. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of unemployment would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter blue areas on 30 occasions. In any particular quarter of the forecast period, unemployment is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions unemployment can fall anywhere outside the blue area of the fan chart. Over the forecast period, this has been depicted by the light grey background. The calibration of this fan chart takes account of the likely path dependency of the economy, where, for example, it is judged that shocks to unemployment in one quarter will continue to have some effect on unemployment in successive quarters. The fan begins in 2013 Q4, a quarter earlier than the fan for CPI inflation. That is because Q4 is a staff projection for the unemployment rate, based in part on data for October and November. The unemployment rate was 7.1% in the three months to November, and is projected to remain at 7.1% in Q4 as a whole.

But the future path of unemployment is highly uncertain. In particular, for a given growth profile, slack will be eroded more quickly if the impediments to productivity growth are more deeply rooted and take longer to rectify. Alternatively, unemployment may fall more slowly if companies have greater capacity than the MPC judges to expand output without increasing employment or if there is a period of catch-up in productivity as companies adopt a backlog of innovations and technical advances.

Costs and prices
CPI inflation fell to 2% in December, a fall of almost 1 percentage point since June. The vast majority of that fall appears to reflect the impact of various one-off and idiosyncratic price movements, rather than a more generalised easing in underlying cost and price pressures, which were already subdued. Oil prices have fallen by around 6% over the past year and other commodity prices have fallen by more than 10%. The further appreciation of sterling should also act to dampen import price pressures. Domestically, unit labour costs have risen less than their average historical rate, in part reflecting the drag on pay from labour market slack. The news on inflation expectations since November has, on balance, been good and most measures of medium-term expectations remain close to past averages. Overall, the MPC continues to judge that medium-term inflation expectations remain sufficiently well anchored.

Chart 3 shows the Committee’s best collective judgement of the outlook for CPI inflation, on the same basis as Chart 1. The near-term outlook is lower than in November, reflecting unexpectedly weak inflation outturns, smaller rises in utility prices than the MPC had assumed, and the impact of sterling’s recent appreciation. Inflation is expected to remain at, or slightly below, the target over the forecast period, as the waning impetus from past increases in import prices and from administered and regulated prices is offset by a diminishing drag from spare capacity. The probability of CPI inflation being at or above the 2.5% knockout 18 to 24 months ahead remains around one third (Chart 4).
 
Chart 3
CPI inflation projection based on market interest rate expectations and £375 billion purchased assets

Current CPI inflation projection based on constant nominal interest rates
 
Please click on the image above to view an enlarged version of the chart.

The fan chart depicts the probability of various outcomes for CPI inflation in the future. It has been conditioned on the assumption that the stock of purchased assets financed by the issuance of central bank reserves remains at £375 billion throughout the forecast period. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns of inflation are also expected to lie within each pair of the lighter red areas on 30 occasions. In any particular quarter of the forecast period, inflation is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions inflation can fall anywhere outside the red area of the fan chart. Over the forecast period, this has been depicted by the light grey background. See the box on pages 48–49 of the May 2002 Inflation Report for a fuller description of the fan chart and what it represents.
  
Chart 4
Probability that CPI inflation will be at or above the 2.5% knockout

Probability that CPI inflation will be at or above the 2.5% knockout
 
Please click on the image above to view an enlarged version of the chart.
 
The bars in this chart are derived from the same distribution as Chart 3. The bars indicate the assessed probability of inflation being at or above 2.5% in each quarter of the forecast period. The dashed line shows the average of the probabilities in 2015 Q3 and 2015 Q4, consistent with the 18 to 24-month period in the MPC’s price stability knockout.

The inflation outlook is sensitive to several factors. The path of inflation will depend on the pace at which slack is absorbed and the impact that slack has on wages and prices. It is possible that the recent unexpectedly sharp falls in inflation reflect underlying cost and price pressures that are weaker than currently judged. Inflation will also be sensitive to developments in commodity prices and the exchange rate, both of which can move sharply.

The policy decision
The UK recovery has gained momentum. Unemployment has fallen more sharply than expected; nonetheless spare capacity remains. CPI inflation has fallen back to the 2% target more quickly than anticipated and, with domestic costs well contained, is expected to remain at, or a little below, the target for the next few years.

At its February meeting, the Committee noted that the existence of spare capacity is both wasteful and increases the risk that inflation will undershoot the inflation target in the medium term. Moreover, the outlook for inflation meant that the near-term trade-off between keeping inflation close to the target and supporting output and employment was more favourable than in recent years. The MPC therefore judged that there remained scope to absorb spare capacity further before raising Bank Rate.

It seemed likely that data released over the next few months would show that the 7% threshold has been reached. The Committee agreed on further guidance for when the threshold was reached. That guidance is explained in the box ‘Monetary policy as the economy recovers’ on pages 8–9. Essentially, the MPC will seek to close the spare capacity in the economy over the next two to three years while keeping inflation close to the target. To that end, it judges that there is scope for the economy to recover further before Bank Rate is raised and, even when Bank Rate does rise, it is expected to do so only gradually and to a level materially below its pre-crisis average of 5%.

In the light of both the economic outlook and its policy guidance, the Committee voted to maintain Bank Rate at 0.5% and the stock of purchased assets at £375 billion.
 
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