Inflation was 3.1% in November, triggering an exchange of letters between the Governor and the Chancellor. The current overshoot of inflation above the 2% target is almost entirely due to the effects of higher import prices following sterling's depreciation, the contribution from which will dissipate in coming years. UK GDP growth is projected to remain around its current pace, a slightly stronger near-term outlook than in November, supported by strengthening global growth. While modest by historical standards, that pace of UK growth is more than sufficient to use up the limited slack remaining in the economy. Under a conditioning path that embodies just under three further 25 basis point rises in Bank Rate over the next three years, a small margin of excess demand emerges by early 2020 and builds thereafter. Inflation remains above the target as domestic inflationary pressures continue to firm.
The MPC voted in November to raise Bank Rate to 0.5%. That is feeding through into higher interest rates for companies and households in line with past experience (see Box 2). The MPC's projections are conditioned on a market-implied path for Bank Rate that is around 15 basis points higher than in November. That path implies a gradual further rise in Bank Rate to just under 1.2% at the start of 2021 (Table 5.A).1
The broad-based pickup in global growth has strengthened further, with global growth at its fastest pace in seven years and above-trend growth in 90% of the world economy. Healthy business and consumer confidence, and supportive financial conditions, mean the current pace of global growth is likely to persist at least throughout 2018 (Key Judgement 1). That is stronger than projected in November and the risks around the outlook for global growth are to the upside.
UK GDP growth was stronger than expected in Q4, although still modest by historical standards (Section 2). The strength in global growth is supporting net trade and business investment. The anticipation of and uncertainty around Brexit, however, appear to be weighing on investment, and the associated fall in sterling's exchange rate is squeezing households' real incomes and dampening consumption growth (Key Judgement 2). In the run-up to this Report, the sterling ERI was 3% higher than at the time of the November Report, though 16% below the peak in late 2015. As in previous Reports, the MPC's projections are conditioned on the average of a range of possible outcomes for the UK's eventual trading relationship with the EU. The projections also assume that, in the interim, households and companies base their decisions on the expectation of a smooth adjustment to that new trading arrangement.
Under those assumptions, four-quarter GDP growth is projected to average around 1¾% (Table 5.B), supported by the strength in global growth, a lessening drag from the fiscal consolidation, accommodative financial conditions and a modest recovery in household real income growth. The risks to the central outlook are skewed to the upside (Chart 5.1), stemming from the possibility of a greater boost from global demand.
Following its annual reassessment of supply-side conditions, the MPC judges that spare capacity has been further absorbed and that very little remains, despite a small downward adjustment in the Committee's judgement of the equilibrium unemployment rate. Furthermore, and notwithstanding a projected rise in structural productivity growth, overall potential supply growth is likely to remain modest by historical standards (Key Judgement 3). As a result, the pace of demand growth consistent with balanced domestic inflationary pressures is judged to be around 1½%, much slower than pre-crisis norms.
In the MPC's projections, the stronger pace of demand growth is sufficient to absorb the limited degree of spare capacity sooner than in the November projections, with the economy moving into excess demand by early 2020. That leads to a steady firming of domestic inflationary pressures (Key Judgement 4), albeit from rates below those consistent with the 2% target. There are signs of tightening in the labour market as unemployment has fallen, surveys suggest increasing recruitment difficulties and pay growth is beginning to rise in response (Section 4). In the central projection, unemployment falls a little further (Chart 5.2) and rising growth in pay outstrips that of productivity. That supports somewhat firmer growth of unit labour costs and rising domestic cost pressures more broadly.
Inflation is currently a percentage point above the MPC's 2% target, almost entirely due to the effects of higher import prices following sterling's depreciation. Those effects will diminish gradually in coming years. More recently, the rise in global oil prices has added somewhat to external cost pressures. Under the market path for interest rates prevailing at the time the forecast was finalised,1 domestic inflationary pressures firm while the contribution from energy and import prices dissipates. The balance of these effects means that inflation falls gradually but remains above the target in the second and third years of the forecast period (Chart 5.3).
At its meeting ending on 7 February 2018, the MPC voted to maintain Bank Rate at 0.5%, to maintain the stock of sterling non-financial investment-grade corporate bond purchases, financed by the issuance of central bank reserves, at £10 billion and to maintain the stock of UK government bond purchases, financed by the issuance of central bank reserves, at £435 billion. The factors behind that decision are set out in the Monetary Policy Summary on pages i–ii of this Report, and in more detail in the Minutes of the meeting. The remainder of this section sets out the MPC's projections, and the risks around them, in more detail.
Growth has picked up significantly across many economies over the past two years. The outlook for global growth appears to have strengthened somewhat further over the past three months. The current pace of quarterly growth is judged likely to persist at least over 2018, a stronger projection than in November (Chart 5.5).
In the euro area, above-trend growth has been supported by the accommodative stance of monetary policy, an easing in credit conditions, and reduced fiscal drag, alongside a steady rise in business and consumer confidence. Unemployment has fallen further, to its lowest level since 2009, though a significant degree of slack still appears to remain. These factors are projected to support continued above-trend annual average growth in 2018 at around 2¾%, compared with a projection of 2¼% in November.
In the United States, growth has also been robust in recent quarters. The tax cuts announced at the end of 2017 are likely to provide a greater and more immediate stimulus to spending than anticipated in November. That, combined with supportive financial conditions (Section 1), suggests a continuation of the current strong pace of quarterly growth in 2018 at around ¾%. Annual average growth is projected to accelerate to 3% in 2018, compared with a central forecast of 2¼% in the November projections.
Strengthening advanced-economy growth, alongside stable growth in China and improving outlooks in other emerging market economies, has led to a rise in some commodity prices. Oil and industrial metals prices have risen to their highest levels in several years. That will feed through into higher headline inflation rates in many countries in coming months and contribute to higher global export prices.
Based on PPP weights, global activity is projected to expand at an annual average rate of just over 4% in 2018 before slowing to 3½% by 2020 (Table 5.C) as remaining slack is absorbed and global inflationary pressures build. Weighted by UK export shares, growth is around 3% in 2018, slowing to 2¼% by 2020. It is possible that the current momentum in global growth could persist for longer than embodied in the central projection. To the extent that it is matched by stronger global productivity growth, and hence a faster pace of supply growth, it would be unlikely to lead to additional global inflationary pressure.
In contrast to the strengthening in global growth, UK growth has remained modest by historical standards. It picked up in Q4 and was stronger than expected (Section 2). Four-quarter GDP growth is projected to average around 1¾% over the forecast period (Chart 5.1), supported by strong global growth (Key Judgement 1) and a lessening drag from the fiscal consolidation following the measures announced in the November Budget. That is a slightly stronger near-term outlook than in November (Table 5.B).
Brexit is affecting both the level and composition of UK demand. The fall in sterling's exchange rate since late 2015 reflects financial market participants' judgements about the likely impact of Brexit on the United Kingdom's prospects. That fall has boosted consumer prices (Key Judgement 4) and depressed households' real incomes and spending. Households typically adjust their spending only gradually to changes in real income. While real income has fallen over the past year, four-quarter consumption growth has remained positive, slowing to around 1%, and the saving ratio has fallen.
Consumption growth is projected to remain subdued but stable over the next three years (Table 5.D), broadly in line with aggregate income growth such that the saving ratio remains broadly unchanged (Chart 5.6). Although the past fall in real income will continue to weigh on consumption, there are a number of factors supporting the current pace of growth. The contribution of import prices to inflation has probably peaked (Key Judgement 4). That, combined with a rise in nominal pay growth, will support some recovery in household real income growth (Table 5.E). Consumer confidence is only a little below past averages. Housing market activity slowed slightly in Q4, which combined with the recent fall in new housing starts is likely to drag on growth in housing investment in 2018 (Section 2).
In contrast to the weakness in consumption growth, net trade is expected to have made a significant positive contribution to GDP growth in 2017, supported by the strength in world demand and the past depreciation of sterling. Strong world demand, a low cost of capital, the high rates of return on capital and diminishing spare capacity have all supported business investment. Nevertheless, the drag from uncertainty around Brexit (see Box 3) has meant that investment growth has been notably weaker than in previous expansions.
In the central projection, the more persistent strength in global demand (Key Judgement 1) supports net trade, which continues to provide a significant boost to GDP growth (Table 5.C). That, in turn, leads to a gradual narrowing in the current account deficit to around 3¾% of GDP by the end of the forecast period. Alongside that, business investment growth picks up, also supported by global demand and intensifying capacity pressures. The outlook for business investment will remain sensitive to developments in and companies' perceptions of the United Kingdom's future trading arrangements.
The risks around the projection for GDP growth are skewed to the upside, stemming from the upside risks to global growth. The recent momentum in global growth may persist for longer than in the central projection (Key Judgement 1), and the boost to demand for UK goods and services from global demand could prove greater than anticipated.
The speed at which demand can grow before it puts upward pressure on inflation depends on the degree of spare capacity in the economy and on the rate of growth of potential supply. In recent years, elevated unemployment meant there was a significant degree of slack in the economy and demand could grow more quickly than potential supply without generating inflationary pressures. As unemployment has fallen and slack has been absorbed, the pace at which demand can grow has become increasingly dependent on the pace of potential supply growth.
In the run-up to this Report, the MPC completed its annual reassessment of supply-side conditions. The MPC judges that very little spare capacity remains. A range of evidence suggests that unemployment is close to its long-term equilibrium rate, which is now estimated to be 4¼%, slightly lower than estimated a year ago (see Box 4). Within companies, there appears to be some scope to increase output by raising the average number of hours worked by employees, but indicators suggest there is little capacity for companies to work their other resources more intensively (Section 3).
The MPC continues to judge that growth in potential supply will remain modest, relative to pre-crisis norms, at around 1½%. An important contributor to potential supply growth in recent decades has been population growth, which has been driven by strong net inward migration flows. Net inward migration has slowed over the past 18 months and, under the ONS's population projections on which the MPC's forecasts are conditioned, net migration slows slightly further in coming years. There is a risk that net migration will slow more sharply, however, reducing potential supply growth more materially (see Box 5).
Prior to the financial crisis, productivity growth was the largest driver of potential supply growth. In common with many other advanced economies, productivity growth in the UK has been persistently weak in recent years. Part of that global weakness is likely to reflect weak investment, which fell during the crisis and has only recovered gradually since then. As such, growth in the capital stock — the resources and equipment available for workers to produce output and a key driver of productivity — has been subdued. The weakness in productivity growth also appears to reflect weak growth in total factor productivity (TFP) — the efficiency with which companies use their labour and capital to produce output. The expansion in global trade and broadening of supply chains in the decade prior to the crisis is likely to have been one factor contributing to robust TFP growth during that period. Since then, growth in global trade and TFP have both been subdued.
Structural productivity growth is projected to pick up to just over 1% in 2019–20, broadly unchanged from the November projections. While that represents a pickup from the pace of productivity growth since the financial crisis, it is still around half the pre-crisis rate. Companies' anticipation of and response to post-Brexit trading relationships are likely to weigh on UK productivity growth. Uncertainty around Brexit appears to be holding back some investment (see Box 3) and any reduction in openness is also likely to weigh on TFP growth (Section 3). As explained in Box 6, although there has been little change to the MPC's judgement about the outlook for structural productivity growth, the profile for actual output per hour worked is lower than in the November projections (Table 5.C). Limited scope for companies to work their capital more intensively (Section 3) means output per hour worked now grows broadly in line with structural productivity.
There are significant risks in both directions to the outlook for productivity. Productivity growth has serially disappointed over the past decade and, in common with other forecasters, the MPC has marked down its forecasts numerous times. As such, it could fail to pick up by even the modest amounts assumed. Set against that, productivity, although volatile, has tended to grow by around 2% on average for many decades. Productivity could ultimately pick up by more than expected, particularly if there is a global upswing in trade and investment that benefits the United Kingdom.
At 3% in December, inflation remains above the MPC's 2% target, and the 3.1% outturn in November necessitated an exchange of letters between the Governor and the Chancellor, published alongside this Report. That overshoot was almost entirely due to the effects of higher import prices as a result of the past depreciation in sterling, though the recent rise in oil prices has also contributed. And it is possible that inflation could rise back above 3% temporarily.
Increases in global oil prices (Key Judgement 1) tend to be passed on to higher fuel prices quite quickly. The MPC's projections are conditioned on spot oil prices following the market futures curve, which is currently downward sloping (Table 5.C). The implied easing back in oil prices means that energy prices are weighing on inflation from the end of 2018.
The rise in non-energy import prices due to the depreciation in sterling will take several years to be passed on to consumer prices. Import prices have so far risen by slightly less than anticipated, given past experience (Section 4). Over the forecast period, import prices are assumed to make up that shortfall (Chart 5.7). Although the contribution from import prices to CPI inflation is likely to have peaked, import prices are projected to continue to push up inflation by around ½ percentage point over 2019 before that contribution diminishes further. Import prices are still pushing up inflation at the end of the three-year forecast period, but the recent appreciation of sterling means they contribute slightly less than projected in November, at just under ¼ percentage point.
There is a risk, however, that the contribution from import prices to inflation diminishes more rapidly than in the central projection. The more time that passes since the depreciation, the less likely it is that the shortfall in import prices relative to the size of the depreciation will be made up, and the greater the risk that import prices contribute slightly less to inflation over the forecast period.
As the effects from import and energy prices dissipate, inflation is supported by rising domestic inflationary pressures. The largest domestic component of companies' costs is labour. Although annual pay growth has been relatively subdued in recent years, it picked up by more than expected towards the end of 2017 and shorter-term measures suggest a further marked rise in annual pay growth in 2018 Q1 (Section 4). Indicators, including the recent Agents' annual pay survey, suggest pay growth is rising in response to the past tightening in the labour market and greater recruitment difficulties. The outlook for pay growth is stronger than in November (Table 5.D).
What matters for companies' costs is how fast pay grows relative to productivity — in other words, growth in their unit labour costs (ULCs). As productivity growth has been weak, unit labour cost growth has been much less subdued than pay growth. In the central projection, with unemployment falling slightly further (Chart 5.2), pay growth picks up, continuing to outstrip rising productivity growth (Key Judgement 3), and supporting somewhat firmer ULC growth (Table 5.C). There is a risk, however, that building pressure in the labour market leads to a more marked rise in pay and ULC growth over the forecast period.
The stronger outlook for demand growth (Key Judgement 2) coupled with modest potential supply growth (Key Judgement 3), means that the limited remaining degree of spare capacity in the economy is absorbed more quickly than in the November projections. In the central projection, under a conditioning path that embodies just under three further 25 basis point rises in Bank Rate over the next three years, a small margin of excess demand emerges by early 2020 and builds thereafter. Domestic inflationary pressures firm while the contribution from energy and import prices dissipates, and inflation remains above the target in the second and third years of the forecast period (Table 5.F).
Based on the judgements above and the risks around them, under the market path for Bank Rate and the assumption of an unchanged stock of purchased assets, the MPC projects four-quarter GDP growth to average around 1¾% over the next three years (Table 5.B). That projection is slightly stronger in the near term than in November (Chart 5.8). Consumption growth is projected to remain subdued relative to historical norms, partially offset by a positive contribution from net trade and a pickup in investment growth. The risks around the central projection are judged to lie to the upside (Table 5.G), stemming from the possibility of a greater boost from global demand.
The economy's potential supply capacity is projected to grow at a modest pace over the forecast period, lower than historical norms. There is judged to be only a very small degree of slack at the start of the forecast period. With demand growing faster than potential supply, that slack is fully absorbed and the economy moves into excess demand by early 2020. Unemployment is projected to fall slightly further (Chart 5.2), below its equilibrium rate.
Inflation is currently above the MPC's 2% target due to the effect of higher import prices following sterling's depreciation. While the contribution from energy weighs on inflation from the end of 2018, higher import prices are judged likely to push up inflation throughout the forecast period albeit to a diminishing degree. As those external price pressures wane, domestic inflationary pressures continue to build and, under the market path for Bank Rate, inflation is judged likely to remain above the 2% target in the second and third years of the forecast period (Chart 5.9). The risks around that projection are judged to be balanced (Chart 5.10).
Chart 5.11 and Chart 5.12 show the MPC's projections under the alternative constant rate assumption and an unchanged stock of purchased assets. That assumption holds Bank Rate at 0.5% throughout the three years of the forecast period, before it rises towards the market path over the subsequent three years. Under that path, GDP growth is stronger and inflation ends the forecast period further above the target.
1. Unless otherwise stated, the projections shown in this section are conditioned on: Bank Rate following the path implied by market yields on average in the 15 working days to 31 January; the stock of purchased gilts remaining at £435 billion and the stock of purchased corporate bonds remaining at £10 billion throughout the forecast period and the Term Funding Scheme (TFS), all three of which are financed by the issuance of central bank reserves; the Recommendations of the Financial Policy Committee and the current regulatory plans of the Prudential Regulation Authority; the Government's tax and spending plans as set out in the 2017 November Budget; commodity prices following market paths; and the sterling exchange rate remaining broadly flat. For more details see the 'Data from the February 2018 Inflation Report'.
Conditioning path for Bank Rate implied by forward market interest rates (a)
Forecast summary (a)(b)
GDP projection based on market interest rate expectations, other policy measures as announced
Unemployment projection based on market interest rate expectations, other policy measures as announced
CPI inflation projection based on market interest rate expectations, other policy measures as announced
CPI inflation projection in November based on market interest rate expectations, other policy measures as announced
World GDP (PPP-weighted)(a)
MPC key judgements(a)(b)
Indicative projections consistent with the MPC's modal projections (a)
Household saving rate (a)
Import price inflation (a)
Q4 CPI inflation
Projected probabilities of GDP growth in 2019 Q1 (central 90% of the distribution) (a)
Annual average GDP growth rates of modal, median and mean paths (a)
Inflation probabilities relative to the target
Projected probabilities of CPI inflation in 2020 Q1 (central 90% of the distribution) (a)
GDP projection based on constant nominal interest rates at 0.5%, other policy measures as announced
CPI inflation projection based on constant nominal interest rates at 0.5%, other policy measures as announced
The Committee's projections are underpinned by four key judgements. Risks surround all of these, and the MPC will monitor a broad range of variables to assess the degree to which the risks are crystallising. The table below shows Bank staff's indicative near-term projections that are consistent with the judgements in the MPC's central view evolving as expected.
Likely developments in 2018 Q1 to 2018 Q3 if judgements evolve as expected
1: the broad-based strength in global growth continues
2: the rotation in UK GDP growth away from domestic consumption and towards external demand and investment continues
3: very little slack remains and the pace of potential supply growth is modest
4: with demand outstripping potential supply, domestic inflationary pressures continue to build while the contribution from energy and import prices dissipates
Following the MPC's annual reassessment of supply-side conditions, potential supply growth over the forecast period is judged to be around 1½%, the same as in the November projections. Within that, the outlook for structural productivity growth is also broadly unchanged. But changes in the composition of spare capacity in the economy mean the MPC's projections for measured productivity — output per hour worked — have been revised down relative to November (Table 5.C). As explained in this box, that revision does not affect the outlook for trend growth over the forecast.
Structural labour productivity growth is a fundamental driver of potential supply growth in the economy and, hence, the pace of demand growth consistent with balanced inflationary pressures. It is determined by factors such as the availability of physical capital like buildings and IT equipment, and human capital like experience and education. Measured productivity — actual output per hour worked — can, however, temporarily deviate from its structural level for cyclical reasons. For example, if firms are underutilising their capital due to previous weakness in demand then there is scope for output to grow without an increase in the number of hours employees work. As demand recovers and firms use up that spare capacity, output per hour will grow even if structural productivity is unchanged. Output per hour worked could also rise above structural productivity if firms experience a temporary boost in demand for the goods and services they produce that leads them to operate above normal capacity levels, which would tend to lead to inflationary pressure.
In the November Report, growth in measured productivity — output per hour worked — was projected to rise to just over 1¼% over the forecast period (Table 5.C). Companies were judged to have some scope to increase their capital utilisation and around ¼ percentage point of the projected rise in productivity growth reflected companies using up that spare capacity. The rest of the pickup in productivity growth reflected a rise in structural productivity.
In this Report, the MPC has reassessed its view of the composition of slack remaining in the economy. With almost no spare capacity judged to be remaining in companies' capital utilisation, output per hour worked is projected to grow broadly in line with structural productivity. As explained in Key Judgement 3, the outlook for structural productivity growth is broadly unchanged from the November projections and embodies a rise to just over 1% over the forecast period (Table 5.C).
This box reports the results of the Bank's most recent survey of external forecasters, carried out in January.1 On average, respondents expected four-quarter GDP growth to slow a little further over the coming year, before picking up to 1¾% in three years' time (Table 1). Relative to expectations three months ago, that average GDP growth forecast was broadly unchanged at the one and two-year horizons but weaker further ahead (Chart A). External forecasters, on average, continued to expect a small rise in unemployment, but to a lower level than three months ago.
External forecasters' central expectations for CPI inflation at the one and two-year horizons were, on average, lower than three months ago. On average, external forecasters placed around a 50% probability on inflation being at or above the 2% target in two years' time, lower than the 60% average probability placed on that outcome three months ago (Chart B).
External forecasters, on average, expected somewhat less monetary stimulus over the next three years than they did at the time of the November Report, broadly consistent with the steepening of the market-implied path for Bank Rate (Chart C). As in November, almost all forecasters expected the current stock of gilt and corporate bond purchases to remain unchanged over the next three years.
1. For detailed distributions, see 'Other forecasters' expectations'.
Averages of other forecasters' central projections(a)
Expectations of GDP growth three years ahead have declined
Average of forecasters' central projections for four-quarter GDP growth
Risks to inflation are now judged to be broadly balanced around 2%
Average of forecasters' probability distributions for CPI inflation in two years' time (a)
Expectations of Bank Rate are slightly higher than in November
Market interest rates and average of forecasters' central projections for Bank Rate