CPI inflation was 2.4% in September, in line with the MPC’s expectation at the time of the August Report. Inflation has been boosted by the effects of higher energy and import prices. The contributions from these factors are projected to fade over the forecast period. UK GDP growth in 2018 Q3 is expected to be somewhat stronger than projected in August, but the outlook for growth over the forecast period is little changed. The MPC judges that supply and demand in the economy are currently broadly in balance. Conditioned on a path for Bank Rate that rises gradually over the next three years, and the assumption of a smooth adjustment to new trading arrangements with the EU, the MPC judges that a margin of excess demand is likely to build. That raises domestic inflationary pressures, which partially offset diminishing contributions from energy and import prices. CPI inflation is projected to be above the target for most of the forecast period, before reaching 2% by the end. The economic outlook will depend significantly on the nature of EU withdrawal. The MPC judges that the monetary policy response to Brexit, whatever form it takes, will not be automatic, and could be in either direction (Box 4).
The MPC voted in August to raise Bank Rate to 0.75%. The MPC’s projections are conditioned on a market-implied path for Bank Rate that implies a gradual further rise to around 1.4% at the end of 2021 (Table 5.A).1 In the run-up to this Report, the sterling ERI was around 1% higher than it was in the August Report, though 16% below its pre-referendum peak. As the Autumn Budget was announced following the finalisation of the projections, they are conditioned on the plans detailed in the March Spring Statement. As in previous Reports, the MPC’s projections are conditioned on a smooth adjustment to the average of a range of possible outcomes for the United Kingdom’s eventual trading relationship with the European Union.
The MPC’s projections under those assumptions are summarised in Table 5.B. Four-quarter GDP growth is projected to average around 1¾% over the forecast period (Chart 5.1), similar to the August Report (Chart 5.2). Boosted by temporary factors, quarterly growth in Q3 appears to have been a little stronger than had been expected in August, at 0.6%. Growth is projected to fall back to 0.3% in Q4, before settling at 0.4% in subsequent quarters, similar to the August forecast.
Over the recent past, consumption growth has been a little stronger than expected, while business investment has been weaker than expected. Over the forecast period, consumption is projected to grow modestly relative to historical rates, broadly in line with real incomes. Growth in business investment is expected to be subdued in the near term and then to pick up as Brexit-related uncertainty — which is dampening investment growth — wanes (Key Judgement 2). Net trade is also expected to contribute positively to growth, supported by relatively robust global demand and weaker sterling. Global GDP growth has slowed slightly and is likely to decline somewhat further. In particular, activity in emerging economies is projected to be weaker than in August, driven by tighter financial conditions. Nevertheless, global growth is likely to be above potential on average over the forecast period (Key Judgement 1).
In the UK, potential supply growth is projected to remain subdued relative to pre-crisis norms, reflecting lower productivity growth and slower population growth. So while the pace of UK demand growth is modest, it still exceeds potential supply growth. The MPC judges that demand and supply are currently broadly in balance, and that excess demand will build over the forecast period (Key Judgement 3). That leads to a continuing firming of wage growth and domestic inflationary pressures.
CPI inflation was 2.4% in September 2018, and 2.5% in 2018 Q3, in line with the MPC’s August forecast. Above-target inflation has been due to higher energy prices and the rise in import prices associated with sterling’s past depreciation. While domestic inflationary pressures build over the forecast period, the impact of energy and import prices is projected to fade (Key Judgement 4). The balance of these effects means that inflation is projected to be above the target for most of the forecast period, reaching 2% by the end (Chart 5.3), a broadly similar profile to August (Chart 5.4).
At its meeting ending on 31 October 2018, the MPC voted to maintain Bank Rate at 0.75%, 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 page i 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.
Conditioning path for Bank Rate implied by forward market interest ratesa
GDP projection based on market interest rate expectations, other policy measures as announced
Projected probabilities of GDP growth in 2020 Q4 (central 90% of the distribution)a
CPI inflation projection based on market interest rate expectations, other policy measures as announced
CPI inflation projection in August based on market interest rate expectations, other policy measures as announced
In aggregate, global demand has continued to grow at above-potential rates. World GDP growth has slowed slightly, however, and is expected to slow somewhat further over the forecast period, consistent with weakening indicators of global activity and trade. That moderation in growth partly reflects tightening financial conditions, particularly in some emerging economies. The continued rise in tariffs on trade between the US and China is also likely to weigh on activity. Nonetheless, global growth is projected to remain above potential on average over the forecast period.
In the US, activity has remained strong during 2018. Quarterly growth was 0.9% in Q3, higher than expected at the time of the August Report. GDP growth is expected to continue to be relatively robust in coming quarters, supported in part by a substantial fiscal easing (Section 1). As the boost from fiscal policy wanes in 2019, growth is expected to ease. The tariffs on trade that have been implemented and proposed between the US and some of its trading partners are also likely to weigh on growth (Box 1). The strengthening in the US dollar — reflecting strong growth in domestic demand and a related tightening in monetary policy — could also dampen activity. The recent strength of activity has resulted in excess demand in the US. That is judged likely to persist throughout the forecast period, with inflation projected to be above 2%.
Growth in China and other emerging economies is expected to have slowed somewhat in Q3, and some forward-looking indicators of activity have softened over 2018. Higher interest rates in the US, and a stronger dollar, have led to tighter financial conditions in many emerging economies as US dollar-denominated debts become costlier to service and the relative return on EME assets falls (Section 1). Those tighter financial conditions are weighing on growth relative to the recent past, as are trade tensions, and both factors are expected to do so to a greater extent than was expected at the time of the August Report. As a result, four-quarter emerging economy GDP growth is expected to weaken in the near term, and to be lower than expected in August throughout the forecast period. Growth prospects have deteriorated particularly markedly in Turkey and Argentina, where the tightening in external financing conditions has been significantly amplified by domestic factors.
Euro-area growth has also slowed in 2018. Q3 quarterly GDP growth, at 0.2%, was weaker than expected in August. Growth is expected to pick up somewhat in coming quarters (Table 5.C). But the projected path for activity is a little lower than previously expected on average over the forecast period (Table 5.D), in part reflecting the impact of lower demand from emerging economies.
Overall, global growth — based on PPP weights — is projected to be 3¾% in 2018, before slowing to 3½% in 2021 (Table 5.D). Weighted by UK export shares, growth is expected to slow from 2¾% to 2% over the same period (Chart 5.5). Those projections are a little lower than three months ago, and the risks are now judged to be tilted to the downside. Risks to emerging economies are judged to lie to the downside, reflecting the potential for a further tightening in financial conditions as US monetary policy continues to normalise. In addition, there is a risk that trade tensions intensify further.
The outlook for UK demand is similar to that in the August Report, with four-quarter GDP growth expected to average around 1¾%. As in August, growth is supported by net trade, partly reflecting above-trend global GDP growth. Business investment has fallen recently and growth is expected to remain sluggish in the near term (Table 5.C). In line with the conditioning assumption of a smooth Brexit, it then picks up materially as the drag from uncertainty fades, although the level of investment is lower than expected in August throughout the forecast. Over the same period, consumption growth remains relatively subdued, in line with growth in real incomes.
Net trade has contributed to growth over the past two years to a greater extent than it has historically. It has been supported by lower sterling, and export demand has benefited from robust growth in the global economy. Net trade is projected to make a positive contribution to GDP growth over much of the forecast period. The outlook will depend in part on how supply chains, both here and abroad, evolve in response to Brexit and any associated movements in sterling.
Business investment has been weak over the recent past, and is expected to have fallen by 0.5% in the year to 2018 Q3. That is materially weaker than had been expected in the August Report, largely reflecting increased uncertainty around Brexit, as indicated by companies’ responses to the Bank’s Decision Maker Panel Survey, and Agents’ reports. In the MPC’s central projection, which is conditioned on the expectation of a smooth adjustment to the UK’s eventual trading relationship with the EU, greater clarity emerges, boosting investment. Investment growth over the forecast is also supported by above-trend external demand growth, the low cost of finance and the relatively high rate of return on capital. In the latest projection, the level of investment is below that from August throughout the forecast period, with greater near-term weakness in growth and a somewhat faster rebound further ahead (Table 5.E).
Over the past couple of years, consumption has grown at rates below its pre-crisis average, largely reflecting weak growth in households’ real incomes. Consumption growth has been stronger than real income growth, however, and the household saving rate has declined (Section 2). Over the forecast period, the saving ratio is projected to remain broadly unchanged, as consumption grows in line with real incomes. Real income growth is expected to pick up, as nominal wage growth rises and the drag from energy and import price inflation fades (Key Judgement 4).
There is uncertainty about the extent to which households will adjust their spending and saving over the forecast period. According to current estimates, the saving rate has fallen to a historically low level over the past couple of years, and households might choose to build savings at a somewhat faster rate as real income growth rises, depressing spending. Households could, however, choose to lower their saving rate further, boosting consumption growth, particularly if Brexit uncertainty falls. Unemployment remains low and households’ expectations of their personal financial situations appear to have improved since 2017.
The speed at which demand can grow before it puts upward pressure on inflation depends on the degree of slack in the economy and on the growth rate of potential supply. The MPC judges that demand and supply are currently broadly in balance. Most indicators suggest that the labour market is currently tight and survey measures of capacity utilisation within companies suggest little scope to increase output with existing resources (Section 3). It is therefore likely that demand can only grow sustainably at rates in line with the expansion of potential supply.
Potential supply growth has been relatively low since the crisis. Over the forecast period, the MPC judges that growth in potential supply will remain subdued by historical standards at around 1½% per year on average, as set out in its assessment of supply-side conditions in February.
Labour supply growth is likely to be modest over the forecast period, with all of the increase expected to come from population growth. The population is projected to grow a little more slowly than recent rates, partly reflecting an expected decline in net inward migration in line with the ONS projections on which the MPC’s forecasts are conditioned (Section 3).
Offsetting that, productivity growth is projected to improve a little — picking up to about 1% — although remaining around 1 percentage point lower than pre-crisis norms. The improvement in productivity growth over the forecast partly reflects a gentle rise in the stock of capital, resulting from higher investment.
There are significant risks to the outlook for productivity. On the downside, productivity growth has been lower than expected since the financial crisis, and it could fail to pick up again. It might continue to be restrained by the factors dampening growth since the crisis (Section 3). On the upside, productivity growth could increase to closer to historical rates if UK companies invest more in ideas and processes that move them closer to how the most efficient businesses both domestically and internationally operate.
Conditional on market interest rate expectations of a gradual rise in Bank Rate over the forecast period, and on a smooth adjustment to new trading arrangements with the EU, demand is projected to grow a little faster than potential supply, such that a margin of excess demand builds over the forecast period.
In 2018 Q3, CPI inflation was 2.5%, in line with the MPC’s expectation at the time of the August Report. Within that, the contribution from fuel prices was higher than expected, offset by lower-than-expected clothing and footwear prices. Rising fuel prices reflect increases in the sterling price of oil, which is around 10% higher than in the run-up to the August Report. Higher fuel prices will continue to boost inflation in the near term. Further ahead, however, the contribution from fuel prices to inflation turns negative, as the oil futures curve on which the MPC’s forecast is conditioned is downward sloping.
Retail gas and electricity prices are also currently contributing positively to CPI inflation. They are likely to have risen further in October as some utility companies increased their prices (Section 4). Thereafter, utility prices will be affected by the Government’s proposed price cap on retail energy tariffs. That is expected to reduce their contribution to CPI inflation by around 0.2 percentage points in January. Under current plans, the cap will then be updated twice a year, in April and October. The MPC’s forecast reflects an assumption that the level of the cap will vary with underlying costs, including wholesale energy prices. While the wholesale gas futures curve has risen by around 15% since the August Report, it is downward sloping. Taken together with the projected fall in fuel price inflation, energy price inflation is expected to decline over the forecast period, although it is somewhat volatile (Chart 5.6).
In addition, the estimated contribution from import prices to CPI inflation remains elevated, reflecting the impact of sterling’s depreciation around the time of the EU referendum. That contribution has declined over 2018, however, and is expected to fade further over the forecast period.
The waning influence of these external factors on CPI inflation is projected to be partially offset by firming domestic inflationary pressures. Domestic cost pressures have been subdued over the past few years, but have risen as slack has been eroded, and are expected to strengthen further as excess demand builds. Since the August Report, underlying wage growth has risen as the labour market has remained tight and unemployment has fallen further. Survey indicators of companies’ hiring difficulties and pay are consistent with wage growth increasing further, which pushes up growth in unit labour costs. Over the forecast period, private sector and whole-economy unit labour cost growth are projected to rise (Table 5.D), leading to a gradual building in domestic inflationary pressures. 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, CPI inflation is projected to decline towards the target. In the central projection, inflation is judged likely to be above 2% over much of the forecast period, before returning to the target towards the end of the third year. The MPC’s forecast for CPI inflation is broadly similar to that in August (Table 5.F).
MPC key judgementsab
World GDP (UK-weighted)a
Indicative projections consistent with the MPC’s modal projectionsa
Retail energy price inflationa
Q4 CPI inflation
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 remain around 1¾%. That projection is similar to the August forecast (Table 5.G). Within demand, consumption growth is projected to be modest relative to historical rates, but net trade and business investment support growth, conditioned on the assumption of a smooth withdrawal from the EU and an accompanying decline in uncertainty. The risks around the projection are balanced, as in August.
The economy’s supply capacity is judged likely to grow at a subdued pace — of around 1½% per year on average — over the forecast period, so excess demand builds. The unemployment rate is broadly stable (Chart 5.7).
CPI inflation has fallen back since the beginning of 2018, but remains above the MPC’s 2% target. The inflation overshoot reflects the impact of cost pressures from energy and import prices. Inflation is projected to fall further towards the target as those effects continue to wane, more than offsetting building domestic inflationary pressures. Under the market path for Bank Rate, inflation is judged likely to be above the target for most of the forecast period before reaching 2% by the end (Chart 5.8). The inflation projection is broadly similar to August, and the risks remain balanced (Chart 5.9).
Charts 5.10, 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 is that Bank Rate remains at 0.75% throughout the three years of the forecast period, before rising towards the market path over the subsequent three years. Under that path, GDP growth is stronger, and a greater degree of excess demand emerges. Unemployment falls below 3½%. Inflation ends the forecast period above the target at 2.3%.
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. The main assumptions are set out in a table at www.bankofengland.co.uk/inflation-report/2018/november-2018.
2 The Minutes are available at www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2018/november-2018.
Annual average GDP growth rates of modal, median and mean pathsa
Unemployment projection based on market interest rate expectations, other policy measures as announced
Inflation probabilities relative to the target
Projected probabilities of CPI inflation in 2020 Q4 (central 90% of the distribution)a
GDP projection based on constant nominal interest rates at 0.75%, other policy measures as announced
Unemployment rate projection based on constant nominal interest rates at 0.75%, other policy measures as announced
CPI inflation projection based on constant nominal interest rates at 0.75%, other policy measures as announced
The outlook for growth, employment and inflation depends significantly on the nature of EU withdrawal, in particular: the form of new trading arrangements between the EU and UK; whether the transition to them is abrupt or smooth; and how households, businesses and financial markets respond.
As the MPC has communicated, the implications of these developments for the appropriate path of monetary policy will depend on the balance of their effects on demand, supply and the exchange rate. The MPC judges that the monetary policy response to Brexit, whatever form it takes, will not be automatic and could be in either direction.
Withdrawal from the EU will affect demand for goods and services produced in the UK. Any reduction in the ease with which UK companies can trade will lower UK exports. Business investment will respond to changes in uncertainty and financial conditions. UK households and companies are likely to adjust their spending in light of changes to their expected future earnings and income as well as the uncertainty around those expectations. Those effects on demand over the MPC’s policy horizon are likely to be more negative the greater the disruption to the economic relationship between the EU and UK.
The extent to which changes in demand affect inflationary pressures will depend on how the supply capacity of the economy evolves. Reductions in openness as the UK’s trading relationship with the EU changes are likely to reduce the economy’s productive capacity for a period of time. The supply capacity of the economy could be affected as mismatches in the labour market increase and as companies shift production away from the goods and services the UK has been exporting to the EU — for which demand from abroad will fall — and towards those that the country has tended to import or could export to new markets that have become more attractive in relative terms. Those shifts in production will neither be seamless nor costless, as resources in different sectors are often highly specialised. This will drag on supply as the adjustment process unfolds.
Usually, changes in supply are gradual, so have less bearing on monetary policy in the short term than changes in demand. If the future economic relationship between the EU and UK changes only gradually, supply losses too would emerge relatively slowly.
In some Brexit scenarios, however, it is possible that the UK’s supply capacity could fall sharply. For example, an abrupt and disorderly withdrawal could result in delays at borders, disruptions to supply chains, and more rapid and costly shifts in patterns of production, severely impairing the productive capacity of UK businesses.
The prospects for inflation will also depend on how the exchange rate reacts and on any tariffs that result from the new trading arrangements. Sterling fell sharply around the time of the referendum. This reflected the judgement by financial markets that leaving the EU would lower UK real incomes, for example through raising costs or reducing productivity in the tradable sector. In the case of a smooth transition to a relationship that is judged to have a relatively small long-term economic impact, financial market participants might expect a smaller hit to UK real incomes than currently, causing the exchange rate to appreciate. In contrast, a disruptive withdrawal from the EU could result in a more pessimistic view and some further depreciation. Tariffs, if imposed by the UK on imports of EU goods and services, would add to inflationary pressures in the short term.
The appropriate response of monetary policy to any particular Brexit scenario will depend on the balance of the effects on demand, supply and the exchange rate.
In the case of a smooth transition to a relatively close economic relationship, the extent to which domestic inflationary pressures increase would depend on the balance between an expected rebound in demand as uncertainty fades, any further impacts on supply over the MPC’s policy horizon, and the likely appreciation of sterling.
In contrast, a disruptive withdrawal from the EU would probably result in a further decline in the exchange rate and a large, immediate reduction in supply. Tariffs might also be extended. Each of these developments would tend to increase inflation. Set against that, it is likely that demand too would weaken, reflecting lost trade access, heightened uncertainty and tighter financial conditions. The overall extent of inflationary pressures would depend on the balance of these forces, as well as the evolution of inflation expectations.
Three other considerations will be important to the conduct of monetary policy.
First, current circumstances differ materially from those immediately following the referendum. At that time, the economy was operating with a material degree of excess capacity and inflation was below the target. As Article 50 had not yet been triggered, Brexit was at least two years away and its nature was highly uncertain. Therefore many of the supply-side effects were distant. At present, inflation is above the target and the MPC judges that demand and supply in the economy are broadly in balance. In some scenarios, the UK’s trading relationships with the EU could change abruptly with a material negative impact on the supply capacity of the economy over the monetary policy horizon.
Second, there is little that monetary policy can do to offset supply shocks. Large negative supply shocks occur relatively rarely in advanced economies. In such circumstances, the appropriate monetary response will depend on whether the hit to demand is more than that to supply, and the extent of any exchange rate effects on inflation.
Third, in exceptional circumstances, the MPC’s remit allows the Committee to extend the horizon over which it returns inflation to the target in support of its objectives for growth and employment. Given the starting position, this flexibility would only become relevant if the shock to demand were greater than that to supply. In that event, as it did following the referendum, the Committee would explain clearly its approach to managing any trade-off between inflation and output variability, including the horizon over which it is seeking to return inflation to the target.
Although the nature of EU withdrawal is not known at present, and its impact on the balance of demand, supply and the exchange rate cannot be determined in advance, under all circumstances, the MPC will respond to any material change in the outlook to bring inflation sustainably back to the 2% target while supporting jobs and activity.
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 Q4 to 2019 Q2 if judgements evolve as expected
|1: global GDP growth slows to around its potential rate, as financial conditions tighten||
|2: net trade and a rebound in business investment support UK activity, while consumption growth is modest||
|3: a margin of excess demand builds as demand growth exceeds subdued potential supply growth||
|4: domestic inflationary pressures continue to build, while the contributions from energy and import prices dissipate||
This box reports the results of the Bank’s most recent survey of external forecasters, carried out in October.1 On average, respondents expected four-quarter GDP growth to remain broadly stable over the next three years at around 1.5% (Table 1). That is slightly lower than the November Inflation Report forecast. While the average of external forecasters’ central projections for growth has been broadly stable over the past two years, the range of projections has narrowed (Chart A).
External forecasters’ expectations for sterling were slightly higher, on average, than three months ago. Respondents, on average, expected CPI inflation to fall slightly below the target from the second year (Table 1).
On average, external forecasters’ central projections for the unemployment rate were broadly similar to three months ago and remained higher than the equivalent Inflation Report forecast. But the average probability placed on the unemployment rate being less than 4% in both one and two years’ time rose (Chart B).
External forecasters’ central expectations for Bank Rate in one and two years’ time were similar, on average, to three months ago, while they fell at the three-year horizon (Chart C). Coupled with a rise in the market-implied path for Bank Rate since the August Report (Section 1) that has meant that the average central projection of external forecasters is now more in line with financial market expectations. As in recent surveys, almost all forecasters expected the current stock of gilt and corporate bond purchases to remain broadly stable over the next three years.
1For detailed distributions, see ‘Other forecasters’ expectations’.
Averages of other forecasters’ central projectionsa
The average of forecasters’ projections for GDP growth
has changed little in the past two years, but the range of expectations is narrower
Forecasters’ central projections for four-quarter GDP growth in two years’ time
The average probability attached to the unemployment rate being below 4% in coming years has been rising
Averages of forecasters’ probabilities attached to unemployment rate outturns in one and two years’ time
Expectations of Bank Rate are more in line with financial market prices than three months ago
Market interest rates and averages of forecasters’ central projections of Bank Rate