Prospects for inflation

Section 5 of the Inflation Report - May 2018

Inflation has fallen by more than expected since the start of the year, reaching 2.5% in March. It seems likely that pass-through of sterling's depreciation to import prices is somewhat smaller than previously expected. GDP growth was weaker than expected in Q1, in part due to a temporary drag from adverse weather. The MPC continues to judge, however, that a very limited degree of slack remains in the economy. As in February, based on a conditioning path for Bank Rate that embodies three 25 basis point rises over the next three years, a small margin of excess demand is likely to emerge by early 2020, raising domestic inflationary pressures such that inflation settles at the 2% inflation target.

GDP growth slowed to 0.1% in Q1, according to the preliminary estimate, from 0.4% in Q4 and below the projection three months ago. That partly reflected the temporary disruptive impact of adverse weather across the country (see Box 3). As in the February Report, the MPC continues to judge that very little spare capacity remains in the economy. Growth is likely to be revised up a little over time (Section 2) and to the extent that weakness in activity reflected disruptive weather, it is unlikely to have had any significant effect on the degree of spare capacity. Moreover, the labour market has remained robust, with unemployment falling further in the three months to February. In Q2, as the drag from weather effects unwinds, growth is expected to bounce back to 0.4%, broadly consistent with the latest survey indicators, although there will be considerable uncertainty about underlying momentum in the first half of the year until more data become available.

Growth also dipped in the euro area, United States and China at the start of the year. This appears to reflect erratic factors, including weather. Overall momentum in the global economy is still judged to be robust.

UK CPI inflation has fallen back more rapidly than expected three months ago. It now seems likely that pass-through of the past depreciation of sterling to import prices is somewhat smaller than previously thought. Regular pay growth has picked up, broadly as expected three months ago, and there are continuing signs that domestic inflationary pressures are building gradually.

Financial conditions are similar to those underlying the February Report. The MPC's projections are conditioned on a path for Bank Rate that reaches 1.2% by early 2021 (Table 5.A).1 In the 15 working days to 2 May, the sterling ERI was 1% higher than in the run-up to the February Report, but it remains 15% below its late-2015 peak. As in previous Reports, the MPC's projections are conditioned on the average of a range of possible outcomes for the United Kingdom's eventual trading relationship with the European Union. They also assume that households and companies base their decisions on the expectation of a smooth adjustment to those new trading arrangements. Since the February Report, a draft Withdrawal Agreement between the UK Government and the European Union, including an implementation period ending on 31 December 2020, has been published. This pushes back the date at which the UK would move to new trading arrangements.

The assumptions underlying the MPC's May projections and the medium-term outlook for growth and inflation, summarised in Table 5.B, are broadly similar to the projections set out in the February Report. Following a period of weakness at the start of this year, GDP is then projected to grow at around 1¾% a year (Chart 5.1). That modest growth is supported by robust global growth (Key Judgement 1), as the euro-area recovery continues and US growth picks up further. Robust world activity continues to support UK exports, with the past depreciation of the sterling exchange rate also providing a continued boost to net trade, which contributes positively to growth over the next three years (Key Judgement 2). That in turn supports UK business investment, helping to offset the drag from uncertainty around the United Kingdom's future trading arrangements. Household spending growth remains subdued over the forecast period, in line with the muted recovery in real income growth.

Although demand growth is projected to be modest by historical standards, it is faster than supply growth, which is restrained by continued weakness in productivity growth (Key Judgement 3). With very little slack at the start of the forecast period, the economy moves into excess demand by early 2020 and domestic inflationary pressures build further (Key Judgement 4). Inflation falls more rapidly than in February (Chart 5.3), reflecting a smaller assumed boost from the past depreciation of sterling, and settles at the 2% target by mid-2020 (Chart 5.2).

At its meeting ending on 9 May 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.2 The remainder of this section sets out the MPC's projections, and the risks around them, in more detail.

5.1 The MPC'S key judgements and risks

Key Judgement 1: global growth remains robust

Global growth has strengthened over the past two years, with many countries growing at above-trend rates. That has contributed to a rise in commodity prices, with dollar oil prices up a further 6% since February. It has also reduced spare capacity in many countries, which is projected to support global inflation over the forecast period.

In the euro area, where the recovery has been particularly marked, growth dipped to 0.4% in Q1 in contrast to the pickup suggested by surveys at the start of the year. Some of that news may well reflect a drag from weather effects that will probably unwind in Q2. Although surveys have also softened a little, they remain consistent with quarterly growth a little over ½%, above its estimated potential rate. Growth is projected to remain around that rate in the second half of the year. It slows towards potential thereafter as the support to growth from accommodative monetary policy and the past improvement in confidence and credit conditions wanes. Indicators of domestic inflationary pressures have remained subdued in the euro area, consistent with a degree of slack remaining in the economy. Inflation is projected to rise to around 1¾% over the forecast period, as that slack is absorbed.

The US has been growing at above-trend rates since 2016 and core inflation has picked up more recently. Growth is projected to fall back more slowly over the forecast period than had been assumed three months ago (Table 5.C) as a consequence of additional support from fiscal policy measures signed into law in February. With the economy already operating close to, if not a little above, full capacity, inflation is projected to be above 2% from around the middle of this year.

GDP growth in China slowed in Q1 but is expected to pick up in Q2. Expansionary fiscal policy, robust credit growth and the strength in global demand growth, is expected to support activity in coming quarters. In other emerging economies, commodity producers are benefiting from higher prices for their exports. Emerging economies, particularly those with large US dollar‑denominated debts and high external financing requirements, remain vulnerable, however, to a sharper‑than‑expected rise in US interest rates or a stronger US dollar exchange rate.

Taking advanced and emerging economies together, based on PPP weights, global growth is projected to be 4% in 2018 before slowing to 3½% (Table 5.C). Weighted by UK export shares, growth is around 3%, slowing in the second half of the forecast period as slack is absorbed. The projection is broadly similar to that of three months ago (Chart 5.4) but the slight softening in momentum, which was widespread across regions, means the risks around it are now judged to be balanced rather than weighted to the upside. There is still a risk of a larger upswing in productivity growth than projected, which would allow economies to grow more quickly before upside risks to inflation emerge. On the downside, trade tensions have increased (Section 1). While the tariffs announced by the United States and China to date are likely to have limited effects on activity and inflation, there is a risk of escalation.

Key Judgement 2: investment and net trade support UK demand, while consumption growth remains subdued

While the world economy has strengthened, UK growth has slowed to modest rates. On the expenditure side, UK growth has rotated towards net trade and business investment and away from consumption (Section 2). That pattern continues over the forecast period as households continue to face weak growth in real incomes.

Net trade contributed positively to growth in 2017 and is projected to continue to do so throughout the forecast period. That in part reflects the support to UK exports from strong overseas demand. Net trade has also been supported by the lower sterling exchange rate, which boosts exports and discourages imports. For some time, both exports and imports have been projected to grow relatively weakly as companies here and abroad begin to adjust trading relationships in light of the United Kingdom's vote to withdraw from the European Union. As set out in Box 5, gross trade flows have been stronger than projected over the past year, suggesting that little adjustment has happened so far. Moreover, the draft transition agreement to preserve UK access to the single market until end-2020 suggests that most of the adjustment still to come is likely to happen beyond the three-year forecast horizon. Gross trade flows are therefore projected to grow a little faster over coming years than previously assumed (Table 5.D), but these changes have no implications for net trade or, therefore, aggregate demand.

Business investment has been supported by external demand, limited spare capacity, the relatively high rate of return on capital and the low cost of finance, even as the rise in Bank Rate in November has fed through to borrowing costs (Section 1). Its pace of growth has, however, been more modest than would be expected at this stage of the economic cycle and relative to investment growth in other countries, probably a result of the anticipation of and uncertainty over Brexit, as suggested by a range of survey evidence and contacts of the Bank's Agents. Overall, business investment is projected to grow a little faster than current rates (Table 5.D), as global growth and capacity pressures encourage spending, and the drag on growth from uncertainty wanes.

Consumption growth has slowed to subdued rates. Households have faced a period of falling real income as the lower sterling exchange rate fed through to higher prices (Key Judgement 4). Aggregate household real incomes are no longer falling, but real income growth is still subdued and rises only a little over the forecast period. Spending has not slowed as much as total post-tax income, and the saving ratio has fallen to a relatively low level (Section 2).

There have been signs of weakness in consumer spending in Q1 including in data on retail sales and consumer credit (Section 2). In the central projection, that weakness is largely assumed to reflect erratic factors, including the impact of adverse weather, that unwind in the second quarter. Annual consumption growth recovers gradually to reach 1¼% by 2019, broadly in line with income (Table 5.D). That is well below its historical average rate of around 3%. The saving ratio is projected to remain around its current rate. There is greater-than-usual uncertainty about the near-term momentum in consumer spending and the extent to which households adjust their spending and saving to the past fall in their real incomes.

Weak real income growth has probably also weighed on the housing market. House price inflation has slowed and activity remains subdued (Table 5.E). That is despite average mortgage interest rates falling over recent years as credit spreads have narrowed (Section 1). Over the forecast period, a gradual widening in credit spreads, albeit a slightly smaller one than assumed three months ago, alongside the gently upward sloping yield curve, raises mortgage rates, but the recovery in income growth supports the housing market. House price inflation is projected to pick up a little and approvals to rise (Table 5.E), though they remain significantly below levels seen prior to the crisis.

Key Judgement 3: very little slack remains and the pace of potential supply growth is modest

There is a limit to how rapidly the economy can grow without putting upward pressure on inflation. In the aftermath of the financial crisis, the UK economy had scope to grow above its potential rate as spare capacity was used up. Now, with unemployment around its equilibrium rate and few signs of slack elsewhere, the speed at which demand can grow sustainably depends on how fast supply capacity is expanding. As set out in the MPC's February reassessment of the supply side of the economy, supply is expected to grow at a slower pace than was typical prior to the financial crisis.

The MPC continues to judge that very little spare capacity remains in the economy. Although growth is estimated to have slowed sharply in Q1, this estimate is likely to be revised up a little over time (Section 2). Moreover, to the extent that weakness in activity reflected the disruptive impact of adverse weather, it is unlikely to have had any significant effect on the degree of spare capacity. Other indicators of slack, such as unemployment, do not point to any reduction in capacity pressures.

Over the forecast period, supply growth remains modest by historical standards at around 1½% a year. Within that, labour supply growth, which boosted supply growth during the economic recovery, is projected to slow a little further. That slowing in part reflects lower net inward migration flows, in line with ONS projections. Offsetting that, structural productivity growth is projected to pick up a little.

Since the financial crisis, productivity growth has been subdued in the United Kingdom, as in many other economies. Weakness in investment has led to slow growth in the capital stock — a key driver of productivity growth. Moreover, the efficiency with which companies use their capital and labour to produce output also seems to have been rising only slowly. One influence on UK productivity is the anticipation of, and response to, post-Brexit trading relationships. That is likely to have weighed on investment. Over the forecast period, growth in productivity is projected to be a little faster than its average in recent years (Chart 5.5) as increases in investment begin to feed through, but is expected to remain around half the rate seen before the financial crisis.

The extent of the recovery in productivity growth remains very uncertain. On the downside, as set out in the MPC's latest evaluation of its forecast performance (see Box 5), productivity growth has continued to disappoint over the past year and may well do so again. On the upside, annual productivity growth has averaged 2% over many decades and it could pick up by more than expected. For example, the rise in job-to-job flows could lead to better diffusion of ideas and skills between companies, raising productivity growth.

Conditional on market interest rate expectations of three 25 basis point rises in Bank Rate over the forecast period, demand is projected to grow a little faster than potential supply over the forecast period. As in February, a small margin of excess demand emerges by early 2020 and builds thereafter, putting upward pressure on domestic inflation (Key Judgement 4).

Key Judgement 4: with demand outstripping potential supply, domestic inflationary pressures continue to build while the contribution from energy and import prices dissipates further

CPI inflation has fallen back from its recent peak, and by more than expected at the time of the February Report. That largely reflects lower-than-expected inflation rates across a range of import-intensive CPI components. In addition, import prices have risen by slightly less than had been expected following the depreciation of sterling. In previous Reports, all of that shortfall in import prices was projected to be made up over the forecast period. But, with more signs that may not be happening (Section 4), the MPC now judges that import prices will rise by less (Chart 5.6). As a result, the contribution of import prices to CPI inflation diminishes more quickly than in the February projection.

Partially offsetting the decline in the contribution from import prices in the near term, there is a modest rise in the contribution of energy to CPI inflation over the next six months. Higher oil prices are passed through to retail petrol prices and recently announced tariff rises by some domestic energy suppliers take effect with other providers assumed to follow suit. The downward-sloping oil futures curve, on which the forecast is conditioned, means, however, that the contribution from energy prices is below average in the second half of the forecast period. In the later years of the forecast period, those below-average contributions broadly offset the positive contribution from import prices.

Where inflation eventually settles depends mainly on domestic inflationary pressures. These have been weak in recent years, reflecting the degree of spare capacity in the economy. The drag from slack has been most apparent in the subdued pace of wage growth since the financial crisis. Over the past year, wage growth has started to pick up gradually as the labour market has tightened further: unemployment has fallen to around its equilibrium rate; recruitment difficulties have risen; and people are moving between jobs at a similar rate to that before the crisis (Section 3). Although total pay growth was a little weaker than assumed in the February Report, that reflected lower bonus payments. Regular pay growth rose to just under 3%, as expected in February (Section 4). Pay deals seem to be picking up, broadly consistent with the results of the Bank's Agents' annual pay survey reported in February. Wage growth is likely to rise gradually over the forecast period as excess demand builds. As in February, that pushes up growth in unit labour costs — the cost to companies of employing someone relative to productivity. With productivity growth remaining below rates typically seen before the crisis, pay growth needs to be commensurately lower than its pre-crisis average for unit labour cost growth to be consistent with meeting the inflation target.

Conditional on market interest rates, domestic inflationary pressures are projected to build over the forecast period while the contribution from energy and import prices dissipates. In the central projection, CPI inflation is judged likely to settle around the 2% target from mid-2020 (Chart 5.7).

5.2 The projections for demand, unemployment and inflation

Based on these judgements, 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 pick up to 1¾% over the next year and remain there throughout the forecast period (Table 5.F). That projection is weaker than in February in the near term, reflecting the weak Q1 outturn, but similar further out (Chart 5.8) once that weakness has dropped out of the four-quarter rate. Within demand, consumption growth is projected to remain well below past average rates. But strong global growth, together with the lower level of sterling, supports net trade and investment. There is particular uncertainty around the near-term outlook given the weakness in activity indicators in Q1 both in the United Kingdom and abroad. The risks around the projection are judged to be balanced, rather than skewed to the upside as in February, reflecting more balanced risks around the global outlook.

As set out in the February Report, the Committee judges that the economy's supply capacity is likely to grow at a relatively modest pace of 1½% over the forecast period. Unemployment is projected to fall a little further (Chart 5.9) and the economy moves into excess demand by early 2020.

Above-target inflation since early 2017 entirely reflects the impact of higher import prices following sterling's depreciation and rises in energy prices. Inflation has fallen back from 3% to 2½% since late 2017. Inflation is projected to fall further over this year, before settling at the 2% target around mid-2020. The contribution from import prices to inflation is lower throughout the projection, fully accounting for the modest downward revision to the inflation projection in the medium term (Table 5.G). As in February, domestic inflationary pressures build to rates consistent with the 2% target over the forecast period. The risks around the inflation projection remain balanced (Chart 5.10).

Charts 5.11 and 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 above the target.

  • 1. Unless otherwise stated, the projections shown in this section are conditioned on: Bank Rate following a path implied by market yields; 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 Spring Statement 2018; commodity prices following market paths; and the sterling exchange rate remaining broadly flat. For more details see the 'Data from the May 2018 Inflation Report'

    2. Monetary Policy Summary and Minutes - May 2018.

Table 5.A

Conditioning path for Bank Rate implied by forward market interest rates(a)

Table 5.A

  • (a) The data are 15 working day averages of one‑day forward rates to 2 May 2018 and 31 January 2018 respectively. The curve is based on overnight index swap rates.
    (b) May figure for 2018 Q2 is an average of realised overnight rates to 2 May 2018, and forward rates thereafter.

Table 5.B

Forecast summary(a)(b)

Table 5.B

  • (a) Modal projections for GDP, CPI inflation, LFS unemployment and excess supply/excess demand. Figures in parentheses show the corresponding projections in the February 2018 Inflation Report. Projections were only available to 2021 Q1 in February.
    (b) The May projections have been conditioned on the assumptions that the stock of purchased gilts remains at £435 billion and the stock of purchased corporate bonds remains at £10 billion throughout the forecast period, and on the Term Funding Scheme (TFS); all three of which are financed by the issuance of central bank reserves. The February projections were conditioned on the same asset purchase and TFS assumptions.
    (c) Four-quarter growth in real GDP. The growth rates reported in the table exclude the backcast for GDP. Including the backcast 2018 Q2 growth is 1.7%, 2019 Q2 growth is 1.7%, 2020 Q2 growth is 1.7% and 2021 Q2 growth is 1.7%. This compares to 1.8% in 2018 Q2, 1.7% in 2019 Q2 and 1.7% in 2020 Q2 in the February 2018 Inflation Report.
    (d) Four-quarter inflation rate.
    (e) Per cent of potential GDP. A negative figure implies output is below potential and a positive that it is above.
    (f) Per cent. The path for Bank Rate implied by forward market interest rates. The curves are based on overnight index swap rates.

Chart 5.1

GDP projection based on market interest rate expectations, other policy measures as announced

Chart 5.1

  • The fan chart depicts the probability of various outcomes for GDP growth. It has been conditioned on the assumptions in Table 5.B footnote (b). To the left of the vertical dashed line, the distribution reflects uncertainty around revisions to the data over the past. To aid comparability with the official data, it does not include the backcast for expected revisions, which is available at Data from the May 2018 Inflation Report. To the right of the vertical line, the distribution 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.

Chart 5.2

CPI inflation projection based on market interest rate expectations, other policy measures as announced

Chart 5.2

Chart 5.3

CPI inflation projection in February based on market interest rate expectations, other policy measures as announced

Chart 5.3

  • Charts 5.2 and 5.3 depict the probability of various outcomes for CPI inflation in the future. They have been conditioned on the assumptions in Table 5.B footnote (b). 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 charts are 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 fans 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.

Table 5.C

MPC key judgements(a)(b)

Table 5.C

  • Sources: Bank of England, BDRC Continental SME Finance Monitor, Bloomberg Finance L.P., British Household Panel Survey, Department for Business, Energy and Industrial Strategy, Eurostat, ICE/BoAML Global Research (used with permission), IMF World Economic Outlook (WEO), ONS, US Bureau of Economic Analysis and Bank calculations.

    (a) The MPC's projections for GDP growth, CPI inflation and unemployment (as presented in the fan charts) are underpinned by four key judgements. The mapping from the key judgements to individual variables is not precise, but the profiles in the table should be viewed as broadly consistent with the MPC's key judgements.
    (b) Figures show annual average growth rates unless otherwise stated. Figures in parentheses show the corresponding projections in the February 2018 Inflation Report.
    (c) Chained-volume measure. Constructed using real GDP growth rates of 180 countries weighted according to their shares in UK exports.
    (d) Chained-volume measure. Constructed using real GDP growth rates of 181 countries weighted according to their shares in world GDP using the IMF's purchasing power parity (PPP) weights.
    (e) Chained-volume measure.
    (f) Chained-volume measure.
    (g) Chained-volume measure. Includes non-profit institutions serving households.
    (h) Chained-volume measure.
    (i) Chained-volume measure. Exports less imports.
    (j) Annual average. Chained-volume business investment as a percentage of GDP.
    (k) Level in Q4. Percentage point spread over reference rates. Based on a weighted average of household and corporate loan and deposit spreads over appropriate risk-free rates. Indexed to equal zero in 2007 Q3.
    (l) Based on the weighted average of spreads for households and large companies over 2003 and 2004 relative to the level in 2007 Q3. Data used to construct the SME spread are not available for that period. The period is chosen as broadly representative of one where spreads were neither unusually tight nor unusually loose.
    (m) Annual average. Percentage of total available household resources.
    (n) GDP per hour worked.
    (o) Level in Q4. Percentage of the 16+ population.
    (p) Level in Q4. Average weekly hours worked, in main job and second job.
    (q) Four-quarter inflation rate in Q4.
    (r) Average level in Q4. Dollars per barrel. Projection based on monthly Brent futures prices.
    (s) Four-quarter growth in unit labour costs in Q4. Whole-economy total labour costs divided by GDP at market prices, based on the mode of the MPC's GDP backcast. Total labour costs comprise compensation of employees and the labour share multiplied by mixed income.
    (t) Four-quarter growth in unit wage costs in Q4. Whole-economy total wage costs divided by GDP at market prices, based on the mode of the MPC's GDP backcast. Total wage costs are wages and salaries and the labour share multiplied by mixed income.

Chart 5.4

World GDP (UK‑weighted)(a)

Chart 5.4

  • Sources: IMF WEO and Bank calculations.

    (a) Calendar-year growth rates. Chained‐volume measure. Constructed using real GDP growth rates of 180 countries weighted according to their shares in UK exports.

Table 5.D

Indicative projections consistent with the MPC's modal projections(a)

Table 5.D

  • (a) These projections are produced by Bank staff for the MPC to be consistent with the MPC's modal projections for GDP growth, CPI inflation and unemployment. Figures show annual average growth rates unless otherwise stated. Figures in parentheses show the corresponding projections in the February 2018 Inflation Report.
    (b) Chained-volume measure. Includes non-profit institutions serving households.
    (c) Chained-volume measure.
    (d) Chained-volume measure. Whole-economy measure. Includes new dwellings, improvements and spending on services associated with the sale and purchase of property.
    (e) Chained-volume measure. The historical data exclude the impact of missing trader intra-community (MTIC) fraud.
    (f) Total available household resources deflated by the consumer expenditure deflator.
    (g) Whole-economy total pay.

Chart 5.5

Productivity(a)

Chart 5.5

  • Sources: ONS and Bank calculations.

    (a) Calendar-year growth rates. GDP per hour worked. GDP is at market prices and projections are based on the mode of the MPC's backcast.

Chart 5.6

Import price inflation(a)

Chart 5.6

  • Sources: ONS and Bank calculations.

    (a) Projections are four-quarter inflation rate in Q4. Excludes the impact of MTIC fraud.

Chart 5.7

Inflation probabilities relative to the target

Chart 5.7

  • The May and February swathes in this chart are derived from the same distributions as Charts 5.2 and 5.3 respectively. They indicate the assessed probability of inflation relative to the target in each quarter of the forecast period. The 5 percentage points width of the swathes reflects the fact that there is uncertainty about the precise probability in any given quarter, but they should not be interpreted as confidence intervals.

Table 5.F

Annual average GDP growth rates of modal, median and mean paths(a)

Table 5.F

  • (a) The table shows the projections for annual average GDP growth rates of modal, median and mean projections for four‑quarter growth of real GDP implied by the fan chart. The figures in parentheses show the corresponding projections in the February 2018 Inflation Report excluding the backcast. The projections have been conditioned on the assumptions in Table 5.B footnote (b).

Chart 5.8

Projected probabilities of GDP growth in 2020 Q2 (central 90% of the distribution)(a)

Chart 5.8

  • (a) Chart 5.8 represents the cross‑section of the GDP growth fan chart in 2020 Q2 for the market interest rate projection. The grey outline represents the corresponding cross‑section of the February 2018 Inflation Report fan chart for the market interest rate projection excluding the backcast. The projections have been conditioned on the assumptions in Table 5.B footnote (b). The coloured bands in Chart 5.8 have a similar interpretation to those on the fan charts. Like the fan charts, they portray the central 90% of the probability distribution.
    (b) Average probability within each band; the figures on the y‑axis indicate the probability of growth being within ±0.05 percentage points of any given growth rate, specified to one decimal place.

Chart 5.9

Unemployment projection based on market interest rate expectations, other policy measures as announced

Chart 5.9

  • The fan chart depicts the probability of various outcomes for LFS unemployment. It has been conditioned on the assumptions in Table 5.B footnote (b). The coloured bands have the same interpretation as in Chart 5.1, and portray 90% of the probability distribution. 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 2018 Q1, a quarter earlier than the fan for CPI inflation. That is because Q1 is a staff projection for the unemployment rate, based in part on data for January and February. The unemployment rate was 4.2% in the three months to February, and is projected to be 4.2% in Q1 as a whole. A significant proportion of this distribution lies below Bank staff's current estimate of the long-term equilibrium unemployment rate. There is therefore uncertainty about the precise calibration of this fan chart.

Table 5.G

Q4 CPI inflation

Table 5.G

  • The table shows projections for Q4 four‑quarter CPI inflation. The figures in parentheses show the corresponding projections in the February 2018 Inflation Report. The projections have been conditioned on the assumptions in Table 5.B footnote (b).

Chart 5.10

Projected probabilities of CPI inflation in 2020 Q2 (central 90% of the distribution)(a)

Chart 5.10

  • (a) Chart 5.10 represents the cross‑section of the CPI inflation fan chart in 2020 Q2 for the market interest rate projection. The grey outline represents the corresponding cross‑section of the February 2018 Inflation Report fan chart for the market interest rate projection. The projections have been conditioned on the assumptions in Table 5.B footnote (b). The coloured bands in Chart 5.10 have a similar interpretation to those on the fan charts. Like the fan charts, they portray the central 90% of the probability distribution.
    (b) Average probability within each band; the figures on the y‑axis indicate the probability of inflation being within ±0.05 percentage points of any given inflation rate, specified to one decimal place.

Chart 5.11

GDP projection based on constant nominal interest rates at 0.5%, other policy measures as announced

Chart 5.11

  • See footnote to Chart 5.1.

Chart 5.12

CPI inflation projection based on constant nominal interest rates at 0.5%, other policy measures as announced

Chart 5.12

  • See footnote to Chart 5.2.

Table 5.E
Monitoring risks to the Committee's key judgements

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.

Key judgement

Likely developments in 2018 Q2 to 2018 Q4 if judgements evolve as expected

1: global growth remains robust

  • Quarterly euro-area GDP growth to average a little above ½%.
  • Quarterly US GDP growth to average around ¾%.
  • Indicators of activity consistent with four-quarter PPP-weighted emerging market economy growth of around 5%; within that, GDP growth in China to average around 6½%.

2: investment and net trade support UK demand, while consumption growth remains subdued

  • Quarterly growth in business investment to average ¾%.
  • Net trade to provide a significant boost to quarterly GDP growth.
  • Quarterly real post-tax household income growth to average ¼%.
  • Quarterly consumption growth to average ¼%.
  • Mortgage spreads to widen a little.Mortgage approvals for house purchase to average around 65,000 per month.
  • The average of the Halifax/Markit and Nationwide house price indices to increase by around ¾% per quarter, on average.
  • After recovering somewhat in 2018 Q2, housing investment to be broadly flat.

3: very little slack remains and the pace of potential supply growth is modest

  • Unemployment rate to fall to 4% by the end of the year.
  • Participation rate to remain just under 63¾%.
  • Average weekly hours worked to fall slightly, to a little under 32.
  • Quarterly hourly labour productivity growth to average just over ¼%.

4: with demand outstripping potential supply, domestic inflationary pressures continue to build while the contribution from energy and import prices dissipates further

  • Four-quarter growth in whole-economy AWE regular pay to average around 2¾%.
  • Four-quarter growth in whole-economy unit labour costs to average around 2¾%.
  • Four-quarter growth in whole-economy unit wage costs to average around 2½%.
  • Non-fuel import prices to be broadly flat in the year to 2018 Q4.
  • Electricity prices to rise by 5¼% and gas prices by 4½% by the end of 2018.
  • Commodity prices and sterling ERI to evolve in line with the conditioning assumptions set out in
    www.bankofengland.co.uk/inflation-report/2018/may-2018.
  • Indicators of medium-term inflation expectations to continue to be broadly consistent with the 2% target.

Box 5: How has the economy evolved relative to the February 2017 Report?

The MPC regularly assesses how the economy has evolved relative to its forecasts. This box looks at how recent developments in GDP growth, the labour market and inflation compare to the projections in the February 2017 Report (Chart A1) and what the MPC has learnt from the evolution of the economy over that period.

The MPC's forecasts use conditioning assumptions for a number of variables, such as Bank Rate, the sterling ERI and US dollar oil prices. As such, when evaluating forecast performance it is important to abstract from the news introduced by those conditioning assumptions.1 Relative to the February 2017 projections, dollar oil prices are 17% higher than assumed, and the yield curve and sterling ERI are also slightly higher than assumed (Table 1).

The February 2017 Report forecast

In the February 2017 Report, four-quarter GDP growth was projected to slow gradually over 2017 (Panel 1 of Chart A). That reflected slowing consumption growth as households adjusted their spending to lower real income growth, driven largely by the past fall in sterling and the resulting rise in consumer prices. Business investment was expected to be broadly flat as uncertainty around the impact of Brexit continued to weigh on companies' spending. Offsetting that to some degree, the fall in sterling, along with a recovery in global activity growth, was projected to support exports and, in turn, boost the contribution from net trade. Taken together, the composition of demand was expected to rotate away from consumption growth and towards net trade.

CPI inflation was projected to rise above the 2% target, reaching 2.7% at the end of 2017 (Panel 2 of Chart A), almost entirely due to the fall in sterling feeding through to consumer prices. Although past falls in unemployment were expected to feed through to higher wage growth, domestic inflationary pressures were expected to remain relatively subdued in 2017 as some degree of spare capacity in the economy remained. For instance, the unemployment rate was projected to be stable at around 5% (Panel 3 of Chart A), above its equilibrium rate, which had been revised down to 4½% at the time of the February 2017 Report.

GDP growth has slowed broadly as expected in 2017

GDP growth has slowed since 2016 Q4, and was estimated to have been 2.0% in the five quarters to 2018 Q1 once the expected upward revision to the ONS data captured in the backcast is taken into account. That slowing was broadly in line with the February 2017 projection, and within the central bands of the MPC's fan chart (Chart A).

Growth has, however, been stronger than expected immediately following the referendum. In August 2016, the MPC had projected that GDP growth would slow sharply (Table 2 ), based on a range of indicators available at the time. Although growth did slow, it did not do so by as much as projected, in part as uncertainty probably weighed on consumer spending by less than expected. In following quarters, the MPC adjusted its forecasts in response to these developments and at a faster pace than other forecasters on average (Chart B ).2 Relative to those more recent projections, the latest outturn for 2017 has been broadly in line. Nevertheless, growth remains weaker than had been projected before the referendum in the May 2016 Report, which was conditioned on remaining in the EU.

Demand has rotated to a greater degree than anticipated

Although demand growth has slowed broadly in line with the February 2017 Report forecast, its composition has rotated to a greater degree than had been anticipated. Net trade — already expected to contribute positively to growth over much of the forecast — boosted GDP growth by more (Table 1) . And business investment growth also picked up by more than expected, although it remained weak relative to past expansions (Section 2). By contrast, consumption growth slowed by more than expected.

A significant driver of the additional rotation in demand growth has been stronger-than-expected global activity. Global growth, weighted by countries' shares in UK exports, has been ¾ percentage point stronger than projected in February 2017, pushing up external demand for UK goods and services (Table 1). That has been reflected in stronger‑than‑expected gross trade flows, particularly exports. Business investment growth is also likely to have been supported by the stronger global environment, in part as a result of more supportive global financial conditions.

Weaker-than-expected household spending growth has largely reflected lower-than-expected real income growth, such that the change in the saving ratio has been broadly as expected (Table 1). That slowing in consumption growth is despite more supportive financial conditions — falls in bank funding spreads and greater competition between banks, for example, led to narrower-than-expected mortgage spreads over 2017 (Section 1), even as reference rates rose ahead of the increase in Bank Rate in November.

Supply growth has been weaker and the degree of spare capacity narrower than expected

While aggregate demand has evolved broadly as expected, potential supply growth is estimated to have slowed by more than expected. That has reflected weaker-than-expected potential productivity, with slower-than-expected growth in output per hour judged to have reflected slower underlying productivity growth.

Partly offsetting that, potential labour supply appears to have been greater than anticipated. As part of its annual assessment of aggregate supply-side conditions, set out in the February 2018 Report, the MPC revised down its estimate of the equilibrium unemployment rate to 4¼% from 4½%. That judgement, to a large degree, reflected downside news in wage growth, which remained subdued (Table 1), alongside a further fall in the unemployment rate (Chart A1).

With potential supply growth weaker than expected but demand growth more in line, slack has been eroded more quickly than expected. As a result, in 2018 Q1 there is judged to have been a little less spare capacity than anticipated at the time of the February 2017 Report, while unemployment was around its equilibrium rate, rather than a little above it.

Higher oil prices have pushed up inflation, but non‑fuel import price growth has been slightly less than expected

CPI inflation was 2.7% in 2018 Q1, in line with expectations at the time of the February 2017 Report, but peaked at a higher rate during 2017 (Chart A1). Much of that upside news can be attributed to higher-than-expected energy prices, reflecting rises in dollar oil prices (Table 1), in part as global demand strengthened.

The main driver of above-target inflation has been the effect of the rise in import prices following the substantial depreciation in sterling over 2016. Import price growth has, however, been somewhat less than anticipated (Table 1).

Domestic cost pressures have been broadly in line with the February 2017 projection. Although wage growth has been weaker than anticipated, that weakness has in part been accounted for by weaker productivity growth. As a result, unit labour cost growth has been closer to expectations than wage growth (Table 1).

Implications for the MPC's projections

Overall, growth and inflation have developed broadly as expected in the February 2017 Report, and the key judgements underpinning those forecasts have been borne out in the main developments in the UK economy over this period (Table 2). GDP growth has slowed and the composition of demand has rotated, albeit to a greater degree than anticipated, largely reflecting stronger global growth. Although slower supply growth has meant a more rapid narrowing in spare capacity, the slightly faster pickup in CPI inflation has largely reflected external factors, particularly a rise in global energy prices.

These developments are reflected in the key judgements underpinning the MPC's May 2018 forecasts (Section 5). Consumption growth is still projected to remain subdued relative to historical norms, with a positive contribution from net trade and a pickup in investment growth offsetting that to a degree. Gross trade flows have been stronger than projected over 2017 and are expected to grow a little faster over coming years than previously assumed. The economy's potential supply capacity — or 'speed limit' — is expected to remain modest relative to historical averages, in part as productivity growth picks up only modestly. Inflation is expected to continue to fall back as the upward pressure from external cost pressures diminishes, although a little more quickly than previously anticipated, reflecting the smaller-than-expected rise in import prices.

Outturns relative to the MPC's fan charts

One way of assessing the significance of economic news is by comparing outturns against the MPC's fan charts over time. The 2018 Q1 outturns for GDP growth and CPI inflation were well within the central band of the February 2017 fan charts (Charts A, C and D). If the fan charts accurately describe the uncertainty faced by the MPC then, absent any news in the conditioning paths, outturns would be expected to lie evenly across the fan chart distribution over time, with 10% of outcomes in each decile.

Chart A1

GDP growth and CPI inflation have evolved broadly as expected, while unemployment fell further than anticipated

GDP, CPI and unemployment outturns and projections in the February 2017 Report(a)

Chart A1



Chart A2

Chart A2



Chart A3

Chart A3

  • (a) The projections were conditioned on: market interest rate expectations; the assumption that the stock of purchased gilts financed by the issuance of central bank reserves remained at £435 billion throughout the forecast period; the stock of purchased corporate bonds reached £10 billion and remained there throughout the forecast period; and the announced Term Funding Scheme (TFS) financed by the issuance of central bank reserves.
    (b) See footnote to Chart 5.1 in the February 2017 Report for information on how to interpret the fan chart.
    (c) The latest backcast is a judgement about the path for GDP in the mature estimate of the data.
    (d) See footnote to Charts 5.2 and 5.3 in the February 2017 Report for information on how to interpret the fan chart.
    (e) See footnote to Chart 5.6 in the February 2017 Report for information on how to interpret the fan chart.
    (f) The diamond shows Bank staff's projection for 2018 Q1, based on data to February.

Table 1

Assessing the anticipated developments underpinning the key judgements in the February 2017 Report

Table 1

  • Sources: Bank of England, BDRC Continental SME Finance Monitor, Bloomberg Finance L.P., British Household Panel Survey, Department for Business, Energy and Industrial Strategy, Eurostat, ICE/BoAML (used with permission), IMF World Economic Outlook (WEO), ONS, Thomson Reuters Datastream, US Bureau of Economic Analysis and Bank calculations.

    (a) Where partial data are available for the quarter, Bank staff's projection for that quarter, based on that data, is used.
    (b) Level in 2018 Q1.
    (c) Chained-volume measures. Change in percentage points between 2016 Q4 and 2018 Q1.
    (d) Constructed using real GDP growth rates of 180 countries weighted according to their shares in UK exports.
    (e) Percentage point contributions between 2016 Q3 and 2017 Q4. GDP at market prices is based on the mode of the MPC's backcast.
    (f) Excludes the impact of missing trader intra-community fraud. Per cent change between 2016 Q3 and 2017 Q4.
    (g) Based on a weighted average of household and corporate loan and deposit spreads over appropriate risk-free rates. Change in percentage points between 2016 Q4 and 2018 Q1.
    (h) Percentage of total available household resources. Includes non-profit institutions serving households. Change in percentage points between 2016 Q3 and 2017 Q4.
    (i) GDP per hour worked. GDP at market prices is based on the mode of the MPC's backcast. Change in percentage points between 2016 Q4 and 2018 Q1.
    (j) Figure for 2018 Q1 is Bank staff's projection, based on labour market data to February.
    (k) Percentage of the 16+ population. Level in 2018 Q1.
    (l) Average weekly hours worked in main job and second job. Level in 2018 Q1.
    (m) Whole-economy total pay. Per cent change in level between 2016 Q4 and 2018 Q1.
    (n) Whole-economy total labour costs divided by GDP at market prices, based on the mode of the MPC's GDP backcast. Per cent change in level between 2016 Q3 and 2017 Q4.

Table 2

News relative to selected forecasts

Table 2

  • Sources: ONS and Bank calculations.

    (a) Chained-volume measure, based on the mode of the MPC's backcast.
    (b) Data for 2018 Q1 is Bank staff's projection, based on data to February.
    (c) Percentage points. May not equal the difference between forecast and outturn due to rounding.

Chart B

The MPC's projection for GDP growth was revised up in late 2016
Projections for 2017 GDP growth(a)

Chart B

  • Sources: HM Treasury and Bank calculations.

    (a) Projections for annual average GDP growth in 2017. Chained-volume measure.
    (b) Based on the mode of the MPC's backcast.
    (c) External forecasters' projections are from Forecasts for the UK economy: a comparison of independent forecasts. The projections chosen are those collected ahead of each Inflation Report publication and only projections produced within one month of the Report are included in the sample.

Chart C

Dispersion of GDP growth outturns across deciles of the fan chart probability distribution(a)

Chart C

  • (a) Four-quarter GDP growth. Calculated for the market rate fan charts published since February 2004.

Chart D

Dispersion of CPI inflation outturns across deciles of the fan chart probability distribution(a)

Chart D

  • (a) Calculated for the market rate fan charts published since February 2004.

Box 6: Other forecasters’ expectations

This box reports the results of the Bank's most recent survey of external forecasters, carried out in April.1 On average, respondents expected four-quarter GDP growth to pick up to 1.7% in three years' time (Table 1). While this was broadly unchanged relative to expectations in February, it is somewhat lower than in May 2016. After the EU referendum, the average probability that forecasters attached to growth below 1% three years ahead rose sharply and has remained elevated, while the probability of growth above 3% has declined steadily (Chart A). Despite the recent fall in the unemployment rate to 4.2%, external forecasters, on average, had continued to expect it to rise over the next three years.

External forecasters' central expectations for CPI inflation at all horizons were broadly unchanged relative to three months ago. The average central expectation at the one-year horizon has fallen sharply over the past year (Chart B), slightly faster than the equivalent Inflation Report forecasts. The average central expectation for inflation in three years' time was, at 1.9%, slightly below the MPC's 2% inflation target.

External forecasters, on average, expected somewhat less monetary stimulus than they did at the time of the February Report: the average expectation for Bank Rate was around 0.3 percentage points higher over the next three years. The average central expectation for Bank Rate in three years' time remained, however, below its level in early 2016 (Chart C). As in February, almost all forecasters expected the current stock of gilt and corporate bond purchases to remain unchanged over the next three years.

Table 1

Averages of other forecasters' central projections(a)

Table 1

  • Source: Projections of outside forecasters as of 27 April 2018.

    (a) For 2019 Q2, there were 24 forecasts for CPI inflation, 24 for GDP growth, 20 for the unemployment rate, 22 for Bank Rate, 16 for the stock of gilt purchases, 13 for the stock of corporate bond purchases and 12 for the sterling ERI. For 2020 Q2, there were 15 forecasts for CPI inflation, 15 for GDP growth, 13 for the unemployment rate, 18 for Bank Rate, 14 for the stock of gilt purchases, 9 for the stock of corporate bond purchases and 11 for the sterling ERI. For 2021 Q2, there were 14 forecasts for CPI inflation, 14 for GDP growth, 12 for the unemployment rate, 17 for Bank Rate, 12 for the stock of gilt purchases, 8 for the stock of corporate bond purchases and 10 for the sterling ERI.
    (b) Twelve-month rate.
    (c) Four-quarter percentage change.
    (d) Original purchase value. Purchased via the creation of central bank reserves.

Chart A

The average probability attached to growth above 3% in three years' time has declined
Average probability for growth outturns in three years' time

Chart A

  • Sources: Projections of outside forecasters provided for Inflation Reports between February 2007 and May 2018.

Chart B

Expectations of inflation are broadly unchanged since February
Average of forecasters' central projections for CPI inflation

Chart B

  • Sources: Projections of outside forecasters provided for Inflation Reports between February 2007 and May 2018.

Chart C

Expectations of Bank Rate have risen in recent quarters
Bank Rate and average of forecasters' central projections of Bank Rate

Chart C

  • Sources: Bank of England and projections of outside forecasters provided for Inflation Reports between February 2007 and May 2018.

    (a) Quarter-end value.
This page was last updated 17 January 2019
Was this page useful?
Add your details...