Prospects for inflation

Section 5 of the Inflation Report - May 2019

The MPC expects UK GDP growth to be a little below potential over 2019, reflecting subdued global growth as well as the impact of Brexit uncertainties. The impact of those uncertainties is assumed to subside gradually over the forecast period, consistent with the MPC’s conditioning assumption of a smooth withdrawal of the UK from the EU. Demand growth is therefore projected to recover and rises above the subdued rate of potential supply growth. As a result, excess demand builds and domestic inflationary pressures strengthen. CPI inflation is projected to remain somewhat below the MPC’s target over much of the first half of the forecast period, largely reflecting lower expected retail energy prices. It then picks up to above the target supported by those strengthening domestic inflationary pressures, and is still rising at the end of the three-year forecast period.

The MPC noted in the February Report that UK data could be more than usually volatile in the near term, due to shifting expectations about Brexit in financial markets and among businesses and households. Since then, UK activity appears to have been slightly weaker than expected in 2018 Q4, with the latest ONS estimate of quarterly growth at 0.2%. However, GDP growth is expected to have risen to 0.5% in 2019 Q1 — stronger than projected in February — in part reflecting a boost from companies building up stocks ahead of a potential no-deal Brexit. That boost is expected to be temporary, and quarterly GDP growth is expected to slow to 0.2% in 2019 Q2.

Smoothing through those developments, the underlying pace of UK GDP growth appears to have been slightly stronger than was anticipated in February, but nonetheless marginally below potential. That subdued pace reflects the impact of the slowdown in global growth and Brexit uncertainties. UK GDP growth is projected to remain slightly below trend rates in the second half of this year. The uncertainty around the near-term outlook is judged likely to continue to be higher than usual, however. Given the current elevated Brexit uncertainties, some data over the coming quarters could continue to be volatile, and might provide less of a signal about the underlying path of the economy over the medium term.

As in previous Reports, the MPC’s projections — which are summarised in Table 5.A — are conditioned on a smooth transition to the average of a range of possible outcomes for the United Kingdom’s eventual trading relationship with the European Union.1 Consistent with that conditioning assumption, Brexit uncertainties are assumed to wane gradually over the forecast period.

The MPC’s projections are also conditioned on a range of UK asset prices. Over the past few months, expectations of policy rates in the US and euro area have fallen significantly (Section 1). Market expectations for the path of Bank Rate have followed these downwards. That path currently implies that Bank Rate rises to around 1% by the end of the forecast period (Table 5.B), around 15 basis points lower than in the February 2019 Report. Lower expectations for the path of interest rates in a number of countries have supported risky asset prices: global equity prices have risen and global corporate bond spreads have narrowed. Those developments are projected to support world and UK GDP growth. In contrast, the recent slight appreciation of the sterling exchange rate — which has risen by 1½% over the past three months — will dampen UK growth and inflation a little relative to February. Sterling’s appreciation appears to reflect financial market participants reducing the probability they place on a no-deal Brexit.

Under those assumptions, four-quarter UK GDP growth is projected to decline in the near term (Chart 5.1). That slowing partly reflects the continued effect of uncertainties around the eventual nature of the UK’s withdrawal from the EU. Uncertainty has had a particularly pronounced impact on business investment, which fell in every quarter in 2018 and is projected to decline further over coming quarters. The slowdown in world GDP growth over the past year or so has also weighed on UK activity, and net trade is projected to continue to dampen four-quarter UK growth in the near term as a result. In contrast, household spending is expected to continue to support demand growth, sustained by further growth in employment and wages. In 2020, four-quarter GDP growth begins to pick up, and it rises to over 2% by the end of the forecast period. The pickup is driven in part by some recovery in investment growth (Key Judgement 2), and is supported by a projected stabilisation in global growth (Key Judgement 1), as well as continuing increases in household consumption and government spending. Growth on average is a little higher than in the February Report (Table 5.C), partly reflecting the boost to demand from the lower yield curve and higher risky asset prices.

Following its annual reassessment of supply-side conditions in February, the MPC judged that potential supply growth would remain subdued relative to pre-crisis norms over the forecast period. The MPC judges that there is currently a small margin of excess supply. As GDP growth picks up in 2020, it rises above the subdued pace of potential supply growth, such that excess demand begins to build (Key Judgement 3). Excess demand rises to slightly above 1% of potential GDP by the end of the forecast period, notably higher than in February, with the unemployment rate projected to decline to 3½% (Chart 5.2).

CPI inflation was slightly below the MPC’s 2% target in 2019 Q1. It is projected to fall further below the target over the first half of the forecast period, and to a greater extent than was expected in February, largely reflecting lower expected retail energy prices. Further ahead, building excess demand leads to firmer domestic inflationary pressures (Key Judgement 4). CPI inflation picks up to above the target (Chart 5.3), and is still rising at the end of the three-year forecast period. Inflation is a little higher than the February projection at that horizon (Chart 5.4).

At its meeting ending on 1 May 2019, 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 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.

  • 1. Unless otherwise stated, the projections shown in this section are conditioned on: Bank Rate following a path implied by market yields; the Term Funding Scheme; 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 2019; commodity prices following market paths; the sterling exchange rate remaining broadly flat; and the prevailing prices of a broad range of other assets. The asset prices that the forecast is conditioned on embody market expectations of the future stocks of purchased gilts and corporate bonds. The main assumptions are set out in the ‘Chart slides and data’.

    2. The Minutes are available here.

Table 5.A

Forecast summaryab

Table 5.A

  • a Modal projections for GDP, CPI inflation, LFS unemployment and excess supply/excess demand. Figures in parentheses show the corresponding projections in the February 2019 Inflation Report. Projections were only available to 2022 Q1 in February.
    b The projections have been conditioned on the Term Funding Scheme and the prevailing prices of a broad range of assets, which embody market expectations of the future stocks of purchased gilts and corporate bonds. The main assumptions are set out in the ‘Chart slides and data’.
    c Four-quarter growth in real GDP. The growth rates reported in the table exclude the backcast for GDP. Including the backcast 2019 Q2 growth is 1.6%, 2020 Q2 growth is 1.5%, 2021 Q2 growth is 2.1% and 2022 Q2 growth is 2.2%. This compares to 1.4% in 2019 Q2, 1.5% in 2020 Q2 and 1.8% in 2021 Q2 in the February 2019 Inflation Report.
    d Four-quarter inflation rate.
    e Per cent of potential GDP. A negative figure implies output is below potential and a positive figure 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.

Table 5.B

Conditioning path for Bank Rate implied by forward market interest ratesa

Table 5.B

  • a The data are 15 working day averages of one‑day forward rates to 24 April 2019 and 30 January 2019 respectively. The curve is based on overnight index swap rates.
    b May figure for 2019 Q2 is an average of realised overnight rates to 24 April 2019, and forward rates thereafter.

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.A 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 from the ‘Chart slides and data’. 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

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

Chart 5.2

  • The fan chart depicts the probability of various outcomes for LFS unemployment. It has been conditioned on the assumptions in Table 5.A 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 2019 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 3.9% in the three months to February, and is projected to be 3.9% 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.

Chart 5.3

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

Chart 5.3

Chart 5.4

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

Chart 5.4

  • Charts 5.3 and 5.4 depict the probability of various outcomes for CPI inflation in the future. They have been conditioned on the assumptions in Table 5.A 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

Annual average GDP growth rates of modal, median and mean pathsa

Table 5.C

  • 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 2019 Inflation Report excluding the backcast. The projections have been conditioned on the assumptions in Table 5.A footnote b.

5.1 The MPC’s key judgements and risks

Key Judgement 1: global GDP growth settles at around its potential rate

Four-quarter global GDP growth has slowed since 2017, to below its potential rate. That slowing has been broad-based, with growth declining in advanced and emerging economies (Section 1).

The slowing in global growth partly reflects a drag from financial conditions. Financial conditions tightened over 2018, in part due to the withdrawal of some monetary stimulus by the US Federal Reserve, which led to falls in risky asset prices in many emerging economies. In addition, trade tensions between the US and China have weighed on global growth. Growth in China has also weakened in response to past domestic policy tightening.

Since the end of 2018, global financial conditions have eased as expectations for the paths of monetary policy in a number of major economies have fallen and risky asset prices have risen. In addition, trade tensions between the US and China appear to have lessened somewhat. Those developments should support world growth. Quarterly global GDP growth is projected to be relatively stable at rates close to potential over the forecast period, such that four-quarter growth picks up a little over the near term and settles around potential rates.

Taken together, global growth — based on PPP weights — is projected to slow from 3¾% in 2018 to 3¼% in 2019, before picking up a little to 3½% in 2020 and 2021 (Table 5.E). Weighted by UK export shares, growth is expected to slow from 2½% in 2018 to 2% in 2019, before recovering slightly to 2¼% in both 2020 and 2021 (Chart 5.5). Those projections are a little higher than three months ago, partly reflecting the easing in financial conditions since then. The MPC judges that the risks around the projections remain broadly balanced, partly reflecting two-sided risks from trade tensions.

The slowdown in global growth over the past has weighed on UK GDP growth through trade channels, but that effect is projected to fade as global growth stabilises. Net trade dragged on UK growth over 2018. It is projected to continue to do so in 2019 Q1, partly reflecting the boost to imports from Brexit-related stockbuilding. As that effect fades, and world GDP growth stabilises at around its potential rate, net trade is projected to pick up, although it continues to weigh on four-quarter growth in the near term. Further out, it makes a broadly neutral contribution to UK GDP growth, similar to the February Report.

The global easing in financial conditions has been reflected in UK asset prices. As in other advanced economies, the expected path for policy rates in the UK is lower than in the February Report. UK equity prices are higher than they were three months ago, and corporate bond spreads are narrower. Taken together, those developments boost UK domestic demand relative to the February forecast through their impact on the financial conditions facing companies and households.

Key Judgement 2: UK domestic demand growth is soft in the near term, partly reflecting the impact of elevated Brexit uncertainties, before recovering

While quarterly UK GDP growth is expected to have picked up to 0.5% in 2019 Q1, the MPC judges that underlying momentum is marginally below potential at present. Growth in Q1 appears to have been lifted by erratic monthly movements in output (Section 2) as well as a greater-than-expected contribution from stockbuilding. Companies — particularly manufacturers — appear to have built up their levels of stocks substantially in the first quarter as they implemented contingency plans ahead of a potential no-deal Brexit. Much of this activity will reflect businesses building up stocks of goods sourced from the EU, and so will be reflected in higher imports. However, monthly survey and official data suggest that inventories have been built up to a greater extent than expected, and that some reflects domestic output including for export to companies on the continent (Box 3). The boost to growth will be temporary, however, and is expected to unwind in Q2 as companies stop building up their inventory levels. Consequently, quarterly GDP growth is expected to slow to 0.2% in 2019 Q2. Looking through the volatility in growth, GDP appears to have been slightly stronger than anticipated in February. Nevertheless, underlying growth is expected to have been slightly below potential and it is projected to remain soft in the second half of the year.

The soft recent pace of underlying UK GDP growth reflects the impact of subdued global growth (Key Judgement 1), as well as the impact of Brexit uncertainties, which have weighed on investment spending in particular. Business investment has been unusually weak since the referendum, and that weakness has intensified over the past year. Surveys, including the Bank’s Decision Maker Panel, suggest that the importance of Brexit as a source of uncertainty has remained elevated in recent quarters, while its impact on investment appears to have increased (Section 2). That might be because the value of deferring investment spending rose in the immediate run-up to the expected end-March EU exit date.

The housing market has also softened in recent quarters. Brexit uncertainties may have played some role in that too, though other factors, including policy changes, increased housing supply and affordability constraints have probably also played a part (Box 4). The softer housing market may have dampened GDP growth to a degree. Housing investment growth has weakened in recent quarters, following a number of years of strong growth driven by robust rates of private house building. Nevertheless, household consumption spending and individuals’ confidence about their own personal financial situation appear to have been relatively unaffected.

In the near term, Brexit uncertainties are assumed to remain elevated. They subside gradually over the second half of the forecast period, consistent with the MPC’s conditioning assumption of a smooth transition to the new trading relationship between the UK and EU.

As Brexit uncertainties dissipate, business investment picks up (Chart 5.6). Growth is also buoyed by otherwise supportive conditions, such as the lower cost of finance, which boosts growth by a little more than in February. Housing market activity and price inflation are also expected to pick up, as is housing investment growth.

Consumption growth has been underpinned by real income growth over 2018, given solid employment and wage growth. Consumption growth continues to support GDP growth throughout the forecast, and to a greater extent than in February (Table 5.F). GDP growth is also supported by government spending.

Taken together, the path for UK demand growth is a little stronger than in February. Four-quarter UK GDP growth slows in the near term, before rising to over 2% by the end of the forecast period. The MPC judges that the risks around this projection are balanced. On the upside, the apparent strength of GDP growth in Q1 could reflect a greater degree of underlying momentum, which could persist in the near term. On the downside, Brexit uncertainties could weigh on spending to a greater extent over coming quarters.

In general, the outlook for demand will depend significantly on how households, companies and financial markets respond to developments in the process of the UK’s withdrawal from the EU (see Box 5 in the February 2019 Report). Changes in people’s expectations about Brexit are likely to continue to affect economic data in the coming months given current elevated uncertainties. That means that incoming data might continue to be volatile and provide less of a signal about the underlying path of the economy over the medium term. As a result, the near-term outlook remains more uncertain than usual.

Key Judgement 3: as GDP growth recovers to above the subdued rate of potential supply growth, excess demand builds

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 there is currently a small margin of excess supply.

In the run-up to the February Report, the MPC completed a reassessment of UK supply-side conditions, and judged that potential supply would grow at a similar rate to recent years, which is much lower than pre-crisis rates. Labour supply growth is judged likely to be modest over the forecast period, largely driven by population growth. Productivity growth is projected to pick up a little relative to the very weak rates of the past few years, supported by higher investment over the forecast period. The pickup is gradual, though, with four-quarter potential productivity growth projected to reach around 1% by the end of the forecast period.

In the near term, demand growth is slightly below potential, such that excess supply remains over 2019. Further out, however, demand is projected to grow faster than potential supply. As a result, excess demand emerges and builds to slightly over 1% of potential GDP by the end of the forecast period. The unemployment rate falls further over the second half of the forecast period, and labour market tightness increases.

There are risks in both directions around the projections for labour supply growth and productivity growth and they will remain sensitive to developments in the timing and nature of the UK’s withdrawal from the EU.

Key Judgement 4: CPI inflation dips further below 2% during the first half of the forecast period, largely reflecting lower energy prices, but domestic inflationary pressures push inflation above the target further out

In 2019 Q1, CPI inflation fell to 1.9%, a little above the rate expected in the February Report. Energy price inflation was somewhat higher than expected reflecting higher sterling oil prices, partly offset by slightly lower-than-expected contributions from other CPI components.

During the first half of the forecast period, CPI inflation is expected to fall slightly further below the target and is weaker than was projected in February. That largely reflects expected developments in retail energy prices. Wholesale gas and electricity prices have both fallen over the past three months; that is expected to lead to lower utilities prices from 2019 Q4 (Section 4). In addition, while the sterling oil price has risen since the February Report, the sterling oil futures curve on which the MPC’s forecasts are conditioned now slopes downward. Taken together, retail energy prices contribute substantially less to CPI inflation on average over the forecast period than they have historically.

Import prices also exert some modest downward pressure on CPI inflation throughout the forecast period relative to February, partly reflecting the appreciation of sterling over the past three months. Imported cost pressures remain elevated, however, reflecting the impact of the referendum-related fall in sterling. Those upward pressures wane over time.

Over the forecast period, the rise in CPI inflation to above the target is driven by increasing upward pressure from domestically generated inflation, supported by building excess demand. Four-quarter wage growth picked up during 2018, reflecting the tightness in the labour market, and is expected to have been 3½% in 2019 Q1. Moreover, given the recent weakness in productivity growth, unit labour cost growth has strengthened to rates which are above historical averages. Consumer prices have not increased as rapidly as might have been expected given the pickup in the growth rates of labour and other production costs, which suggests that companies’ margins in the consumer sector may have been squeezed. That might be due to increased competitive pressures. Alternatively, there could be other factors offsetting the increasing pressure on retail prices from labour costs. For example, if higher import prices from sterling’s past depreciation were passed through more quickly than usual into consumer prices, they could now be exerting less upward pressure on inflation.

Conditional on market interest rates, CPI inflation is projected to rise over the second and third years of the forecast period (Table 5.G), ending it above the target. Relative to February, inflation is slightly higher and continues to rise at the end of the forecast period, reflecting the greater degree of excess demand. The risks around this projection are judged to be balanced. If the recent increase in unit labour cost growth begins to feed through into retail prices rapidly, CPI inflation could be higher than projected. CPI inflation could be lower if persistent competitive pressures restrain price increases, however.

Table 5.E

MPC key judgementsab

Table 5.E

  • 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 2019 Inflation Report. Calculations for back data based on ONS data are shown using ONS series identifiers.
    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. Forecast was finalised before the release of the preliminary flash estimate of euro-area GDP for Q1, so that has not been incorporated.
    f Chained-volume measure. Forecast was finalised before the release of the advance estimate of US GDP for Q1, so that has not been incorporated.
    g Chained-volume measure. Exports less imports.
    h Chained-volume measure.
    i Chained-volume business investment as a percentage of GDP.
    j Chained-volume measure. Includes non-profit institutions serving households.
    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 excluding fuel and the impact of MTIC fraud.
    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 constant 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 whole-economy unit wage costs in Q4. Whole-economy wage costs divided by GDP at constant prices, based on the mode of the MPC’s GDP backcast. Total wage costs are wages and salaries excluding non-wage costs and the labour share multiplied by mixed income.
    u Four-quarter growth in private sector regular pay based unit wage costs in Q4. Private sector wage costs divided by private sector output at constant prices, based on the mode of the MPC’s GDP backcast. Private sector wage costs are average weekly earnings (excluding bonuses) multiplied by private sector employment.

Chart 5.5

World GDP (UK‑weighted)a

Chart 5.5

  • Sources: IMF WEO and Bank calculations.

    a Annual average growth rates. Chained‐volume measure. Constructed using real GDP growth rates of 180 countries weighted according to their shares in UK exports.

Chart 5.6

Business investmenta

Chart 5.6

  • Sources: ONS and Bank calculations.

    a Annual average growth rates. Chained‐volume measure. Business investment data based on GAN8. Investment data take account of the transfer of nuclear reactors from the public corporation sector to central government in 2005 Q2.

Table 5.F

Indicative projections consistent with the MPC’s modal projectionsa

Table 5.F

  • 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 in parentheses show the corresponding projections in the February 2019 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.

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 2019 Inflation Report. The projections have been conditioned on the assumptions in Table 5.A footnote b.

5.2 The projections for demand, unemployment and inflation

Based on the judgements above and conditioned on the market path for Bank Rate, as well as an assumption of a smooth withdrawal from the EU, the MPC projects four-quarter GDP growth to fall over 2019, before picking up to above 2%. The pickup in demand growth is mainly driven by business investment growth, as the impact of Brexit uncertainties is assumed to wane. The risks around the projection are balanced, as in February.

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. As growth picks up from 2020, excess demand builds and the unemployment rate begins to fall.

CPI inflation has declined, and is projected to be below the MPC’s 2% target over much of 2019, largely reflecting lower energy prices. CPI inflation is then judged likely to pick up to above the target supported by domestic inflationary pressures, and is still rising at the end of the three-year forecast period (Chart 5.7). The risks around the inflation projection remain balanced.

Charts 5.8, 5.9 and 5.10 show the MPC’s projections under the alternative constant rate assumption. 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 slightly stronger. Unemployment falls below 3½%. Inflation ends the forecast period a little further above the target at 2.3%.

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 5.3 and 5.4 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.

Chart 5.8

GDP projection based on constant nominal interest rates at 0.75%, other policy measures as announced

Chart 5.8

  • See footnote to Chart 5.1.

Chart 5.9

CPI inflation projection based on constant nominal interest rates at 0.75%, other policy measures as announced

Chart 5.9

  • See footnote to Chart 5.3.

Chart 5.10

Unemployment rate projection based on constant nominal interest rates at 0.75%, other policy measures as announced

Chart 5.10

  • See footnote to Chart 5.2.

Box 6: How has the economy evolved relative to the February 2018 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 2018 Report (Chart A) 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 the sterling ERI, Bank Rate and US dollar oil prices. As such, when evaluating forecast performance it is important to separate the news introduced by those conditioning assumptions from the MPC’s forecast judgements.1 Over the past year, the news in these conditioning assumptions has been relatively small. The sterling exchange rate was little changed and Bank Rate has evolved broadly in line with developments implied by the yield curve at the time of the February 2018 Report. US dollar oil prices are slightly lower (Table 1).

The February 2018 forecast

In the February 2018 forecast, GDP was projected to grow by 1.8% in the four quarters to 2019 Q1 (Panel 1 of Chart A). GDP growth was expected to be supported by robust growth in the global economy, with net trade providing a positive contribution to GDP growth. Global growth was also expected to support business investment growth, despite ongoing Brexit-related uncertainty. Conversely, household consumption growth was expected to remain relatively subdued, reflecting modest real income growth as a result of the referendum-related sterling depreciation. The rotation of UK GDP growth away from domestic consumption towards investment and net trade that had been observed ahead of the Report was therefore expected to continue.

The MPC judged that the UK economy had only a very limited degree of slack at the time of the February 2018 Report. As part of its regular assessment of potential supply, the MPC lowered its estimate of the long-run equilibrium unemployment rate, from 4½% to 4¼%. Demand growth was expected to outpace the modest rate of supply growth, so that a small margin of excess demand was expected to emerge during the forecast period. Consistent with that, unemployment was expected to fall a little below its equilibrium rate, and then remain broadly flat over the forecast (Panel 2 of Chart A).

CPI inflation was above the 2% target at the time of the February 2018 Report (Panel 3 of Chart A). That was almost entirely due to the effects of higher import prices as a result of the referendum-related sterling depreciation, though higher oil prices also contributed to the overshoot. Those external forces were expected to slowly dissipate over the forecast, while domestic inflationary pressures were expected to rise. CPI inflation was projected to fall back towards the 2% target during 2018.

News in GDP growth, CPI inflation and the unemployment rate has been relatively small

Compared with the February 2018 forecast, GDP growth, unemployment and CPI inflation have all been within the central bands of the MPC’s fan charts (Chart A). These forecast errors are therefore small relative to the uncertainty implied by the fan charts. They are also small relative to past forecast errors.

There has been more news in the composition of demand

Although GDP growth has been in line with the February 2018 projection (Table 2), the expected rotation of GDP growth has not transpired. Business investment and net trade have been much weaker than anticipated, while consumption has been stronger.

Brexit-related uncertainty has weighed on business investment, which fell by just over 2% between 2017 Q3 and 2018 Q4 compared with the 4% growth projected in February 2018 (Table 1). The Bank’s latest DMP Survey suggested that investment was significantly lower than would have been the case in the absence of Brexit uncertainties (Section 2).

The slowdown in the global economy has driven weaker-than-expected net trade. UK-weighted world GDP growth was 1 percentage point lower than expected, with downside news in those economies with which the UK does more trade such as the euro area (Table 1). Exports rose by ¼%, having been expected to grow by 3¼%, and net trade has dragged on GDP growth rather than making a positive contribution. Weaker-than-expected global growth may also have contributed to lower business investment growth.

Offsetting the downside news in business investment and net trade, household consumption growth has been stronger than anticipated in the February 2018 Report. Both employment and real wage growth have surprised on the upside and that is likely to have supported consumption. Favourable credit conditions (Section 1) may also have played a role.

Supply growth has been slightly weaker than expected

Potential supply growth has been a little weaker than in the February 2018 projection. Within that, potential productivity growth is judged to have been lower than expected, largely offset by stronger-than-anticipated potential labour supply growth (Table 3).

In the February 2018 forecast, potential productivity was projected to increase by 1.5% between 2017 Q4 and 2019 Q1. This would have represented modest growth relative to the pre-crisis period — when it was estimated to have grown by more than 2% per year on average — but stronger growth than the post-crisis period. The latest estimates now suggest that potential productivity rose by 0.8%. This is estimated to have reflected both lower capital deepening than had been anticipated — which in turn is linked to the weakness of business investment growth — and slower growth in total factor productivity.

With potential supply growth and aggregate demand growth close to the February 2018 projections, the evolution of spare capacity has been broadly in line with expectations.

CPI inflation has been lower than expected, despite faster-than-expected pay growth

CPI inflation has surprised on the downside. It was 1.9% in 2019 Q1, 0.4 percentage points lower than anticipated (Table 2).

This downside news has occurred despite higher-than-expected labour cost growth. Labour is the largest domestic cost facing most businesses in the UK, and the combination of stronger-than-expected wage growth and weaker-than-expected productivity growth has meant that unit labour cost growth has been ¾ of a percentage point higher than anticipated (Table 1).

The downside news in CPI inflation has been concentrated in lower food price inflation. That could reflect the extent, or timing, of pass-through from the referendum-related sterling depreciation into food prices being different from what was expected. It may also have reflected margins in the food industry — as well as other businesses producing consumer goods and services — being squeezed. Margins are hard to measure, but some indicators do point to a squeeze over the past year (Section 4).

Over recent years, it is not clear that there has been a consistent pattern in CPI inflation forecast errors. CPI inflation was lower than projected in three of the five February Reports published since 2014, in one case it was higher, and in one case the data were in line with the forecast (Table 4).

Implications for the MPC’s projections

These developments have been reflected in the MPC’s latest projections and key judgements (Section 5).

In recent forecasts, the MPC has revised down its projection for global GDP growth, partly reflecting the unexpected weakness that materialised over 2018.

The news on the composition of domestic demand growth is also reflected in the latest forecast. Business investment is expected to remain weak while Brexit-related uncertainty persists, while household consumption growth is expected to continue at close to current rates.

The repeated undershoots in pay growth over previous years (Table 4), along with other evidence, led the MPC to revise down its estimate of the equilibrium unemployment rate from 5% to 4½% in early 2017 and to 4¼% in early 2018. Pay growth in 2018 picked up by more than expected, as the labour market tightened.

Over the past few years, productivity growth has repeatedly surprised to the downside with the unemployment rate falling more than expected (Table 4). This was one reason behind the MPC’s decision to revise down its productivity growth forecast in the February 2019 Report, following its regular reassessment of supply-side conditions. The MPC expects the unemployment rate to edge a little lower in the near term.

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. 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. Since 2004, GDP growth has tended to lie more often in the lower half of the fan chart distributions. The errors are more evenly distributed for CPI inflation apart from the top decile. The 2019 Q1 GDP growth outturn was in the lower half of the central band of the February 2018 fan chart (Charts A and B), as was inflation (Charts A and C).

Table 1

Assessing the anticipated developments underpinning the key judgements in the February 2018 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, Eikon from Refinitiv, Eurostat, ICE/BoAML Global Research (used with permission), IMF World Economic Outlook (WEO), ONS, 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 those data, is used.
    b Level in 2019 Q1.
    c Chained-volume measures. Per cent change between 2017 Q3 and 2018 Q4.
    d Constructed using real GDP growth rates of 180 countries weighted according to their shares in UK exports.
    e 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.
    f Excludes the impact of missing trader intra-community fraud. Per cent change between 2017 Q3 and 2018 Q4.
    g Percentage point contributions between 2017 Q3 and 2018 Q4. GDP at market prices is based on the mode of the MPC’s backcast.
    h Percentage of total available household resources. Includes non-profit institutions serving households. Change in percentage points between 2017 Q3 and 2018 Q4.
    i Based on the spreads over relevant risk-free rates in 2019 Q1.
    j Figure for 2019 Q1 is Bank staff’s projection, based on labour market data to February.
    k GDP per hour worked. GDP at market prices is based on the mode of the MPC’s backcast. Per cent change between 2017 Q4 and 2019 Q1.
    l Percentage of the 16+ population.
    m Average weekly hours worked in main job and second job.
    n Total pay excluding bonuses and arrears of pay. Per cent change between 2017 Q4 and 2019 Q1.
    o Whole-economy total labour costs divided by GDP at market prices, based on the mode of the MPC’s GDP backcast. Per cent change between 2017 Q4 and 2019 Q1.

Chart A

Forecast errors for GDP growth, unemployment
and CPI inflation have all been small relative to the MPC’s
February 2018 fan charts

GDP, unemployment and CPI inflation outturns and projections in the February 2018 Reporta

Chart A

Chart A

Chart A

  • a The projections were conditioned on: market interest rate expectations; the assumption that the stocks of purchased gilts and corporate bonds financed by the issuance of central bank reserves reached £435 billion and £10 billion respectively and remained there throughout the forecast period; and the announced Term Funding Scheme financed by the issuance of central bank reserves.
    b See footnote to Chart 5.1 in the February 2018 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 The diamond shows Bank staff’s projection for 2019 Q1, based on data to February.
    e See footnote to Chart 5.2 in the February 2018 Report for information on how to interpret the fan chart.
    f See footnote to Charts 5.3 and 5.4 in the February 2018 Report for information on how to interpret the fan chart.

Table 2

News since the February 2018 forecast

Table 2

  • Sources: ONS and Bank calculations.

    a Chained-volume measure, based on the mode of the MPC’s backcast.
    b Data for 2019 Q1 are Bank staff projections, based on data to February.
    c Percentage points. May not equal the difference between forecast and outturn due to rounding.

Table 3

Potential supply growth has been a little lower than in the February 2018 projection
Decomposition of estimated potential supply growtha

Table 3

  • Sources: ONS and Bank calculations.

    a Contributions to potential supply growth between 2017 Q4 and 2019 Q1, unless otherwise stated. Contributions may not sum to the total due to rounding.
    b Per cent change between 2017 Q4 and 2019 Q1.
    c Positive numbers would indicate that a fall in the equilibrium unemployment rate has increased potential labour supply.
    d The decomposition is based on a growth-accounting framework using a constant returns to scale Cobb-Douglas production function, with the elasticity of output with respect to capital set to 1/3. Total factor productivity is a residual.
    e Capital deepening refers to growth in capital services per person-hour. Capital includes structures, machinery, vehicles, computers, purchased software, own-account software, mineral exploration, artistic originals and R&D. Calculations are based on Oulton, N and Wallis, G (2016), ‘Capital stocks and capital services: integrated and consistent estimates for the United Kingdom, 1950–2013’, Economic Modelling.
    f Total factor productivity growth refers to improvements in the efficiency with which both capital and labour are used to produce output.

Table 4

Pattern of MPC forecast errors over time
Outturn data compared with past projections

Table 4

  • Sources: Eikon by Refinitiv, IMF WEO, OECD, ONS and Bank calculations.

    a Where partial data are available for the quarter, Bank staff’s projection for that quarter, based on those data, are used.
    b Differences between outturns and forecasts for the percentage point change in the unemployment rate. Negative values indicate that the unemployment rate was lower than expected.
    c Differences between outturns and forecasts for the annual CPI inflation rate in Q1 of the year after the forecast.
    d Constructed using data for real GDP growth rates for 180 countries weighted according to their shares in UK exports.

Chart B

Dispersion of GDP growth outturns across deciles of the fan chart probability distributiona

Chart B

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

Chart C

Dispersion of CPI inflation outturns across deciles of the fan chart probability distributiona

Chart C

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

Table 5.D 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 2019 Q2 to 2019 Q4 if judgements evolve as expected

1: global GDP growth settles at around its potential rate
  • Quarterly euro-area GDP growth to average a little above ¼%.
  • Quarterly US GDP growth to average ½%.
  • Indicators of activity consistent with four-quarter PPP-weighted emerging market economy growth of around 4¼%; within that, GDP growth in China to average around 6%.
  • Net trade to provide a small positive contribution to quarterly UK GDP growth.
2: UK domestic demand growth is soft in the near term, partly reflecting the impact of elevated Brexit uncertainties, before recovering
  • Business investment to fall by ¼% per quarter, on average.
  • Quarterly real post-tax household income growth to average just over ¼%.
  • Quarterly consumption growth to be between ¼% to ½%.
  • Mortgage spreads to widen a little.
  • Mortgage approvals for house purchase to average just over 60,000 per month.
  • The UK house price index to fall by just over 1¼% in the year to 2019 Q4.
  • Housing investment to fall by ½% per quarter, on average.
3: as GDP growth recovers to above the subdued rate of potential supply growth, excess demand builds
  • Unemployment rate to average 3¾%.
  • Participation rate to remain around 64%.
  • Average weekly hours worked to remain around 32.
  • Quarterly hourly labour productivity growth to average ¼%.
4: CPI inflation dips further below 2% during the first half of the forecast period, largely reflecting lower energy prices, but domestic inflationary pressures push inflation above the target further out
  • Non-fuel import prices to fall by just under ¾% in the year to 2019 Q4.
  • Electricity and gas prices to move in line with Ofgem’s energy price cap. The contribution of retail energy — gas, electricity and fuels — to CPI inflation to fall from around ¼ percentage point in 2019 Q2 to around -¼ percentage point in Q4.
  • Commodity prices and sterling ERI to evolve in line with the conditioning assumptions set out in this Report.
  • Four-quarter growth in whole-economy AWE regular pay to average around 3¼%.
  • Four-quarter growth in whole-economy unit labour costs to average around 2¾%.
  • Four-quarter growth in whole-economy unit wage costs to average just under 3%; growth in private sector regular pay based unit wage costs to average around 3¼%.
  • Indicators of medium-term inflation expectations to continue to be broadly consistent with the 2% target.

Box 7 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 slightly over the next three years (Table 1). That is a little stronger than the May Inflation Report forecast in the near term, but weaker further out. The average probability placed on GDP growth being less than 1% in three years’ time had fallen since the end of 2018, but remained elevated compared to before the referendum. The probability placed on growth being greater than 3% remained low (Chart A).

External forecasters, on average, expected CPI inflation to dip slightly below the 2% target over the second two years of the forecast (Table 1). Forecasters’ central projections for the unemployment rate implied a slight rise over the next three years — albeit by less than in February — and remained higher, on average, than the equivalent Inflation Report forecast (Section 5).

External forecasters’ central projections for Bank Rate, on average, had fallen relative to three months ago (Chart B), along with the market-implied path for Bank Rate (Section 1). Nonetheless, forecasters’ expectations for Bank Rate in three years’ time remained around ½ a percentage point above the market-implied path upon which the May Report is conditioned. On average, external forecasters expected three rises in Bank Rate over the next three years, to 1.5%. 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.

Table 1

Averages of other forecasters’ central projectionsa

Table 1

  • Source: Projections of outside forecasters as of 19 April 2019.

    a For 2020 Q2, there were 15 forecasts for CPI inflation, 15 for GDP growth, 13 for the unemployment rate, 15 for Bank Rate, 10 for the stock of gilt purchases, 10 for the stock of corporate bond purchases and 8 for sterling ERI. For 2021 Q2, there were 13 forecasts for CPI inflation, 13 for GDP growth, 12 for the unemployment rate, 14 for Bank Rate, 10 for the stock of gilt purchases, 9 for the stock of corporate bond purchases and 8 for sterling ERI. For 2022 Q2, there were 10 forecasts for CPI inflation, 11 for GDP growth, 10 for the unemployment rate, 12 for Bank Rate, 9 for the stock of gilt purchases, 7 for the stock of corporate bond purchases and 7 for 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 probability of GDP growth in three years’ time being less than 1% has fallen since the end of 2018, but remains elevated
Averages of forecasters’ probabilities attached to GDP growth outturns in three years’ time

Chart A

  • Sources: Projections of outside forecasters provided for Inflation Reports between February 2007 and May 2019.

Chart B

Chart B Forecasters’ projections of Bank Rate remain higher than market interest rates
Market interest rates and averages of forecasters’ central projections of Bank Rate

Chart B

  • Sources: Bloomberg Finance L.P., projections of outside forecasters provided for Inflation Reports in February 2019 and May 2019 and Bank calculations.

    a Estimated using instantaneous forward overnight index swap rates in the 15 working days to 30 January 2019 and 24 April 2019 respectively.
This page was last updated 02 May 2019
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