Economics Weekly - How real is the inflation threat? Weekly economic data preview - Fed and BoE to quash speculation of early rate hikes
Economics Weekly - 22
How real is the
Recent developments have
raised concerns that the UK could be facing an
upsurge in price inflation over the coming years. Since early March, oil prices
have doubled; the economy has found a firmer footing; and broad measures of
inflation expectations have shifted higher. The rise in some of the
forward-looking inflation indicators has occurred as the Bank of England has
embarked on an unprecedented loosening in UK monetary policy. Having
cut interest rates to a record low, the Bank has turned to the unorthodox
policy of quantitative easing (QE) in an effort to stimulate lending and demand
through expanding money supply.
have turned upwards
The concern about future
potential inflation has started to unsettle bond markets. Medium and long-dated
gilt yields have backed up sharply since early March (see chart a). Part of
this upward adjustment reflects rising concerns over the current and
prospective level of public sector debt issuance. Part of it reflects rising
real interest rates and a more general reassessment of risk premia as equity
markets have improved. But the rise also reflects a noticeable shift higher in
the marketâ€™s perception of inflation risk.
Since the Bank unveiled
its quantitative easing programme in early March, long-dated breakeven
inflation rates have risen by around 1 percentage point, to 3.7%. RPI inflation
swaps tell a similar story. Since last November, the annual RPI two years
forward has risen from less than 1% to 3% (see chart b). Adjusting for
differences in methodology and definition, the increase in inflation
expectations suggests financial markets doubt the ability of the Monetary
Policy Committee (MPC) to meet the governmentâ€™s 2% inflation target over the
medium term. But it is not just the markets that have started to exhibit some
scepticism. The latest Bank of England/NOP Inflation Attitudes Survey shows
that the publicâ€™s perception of the inflation outlook over the next twelve
months picked up slightly in May, to 2.4% from 2.1% in February, despite slower
actual inflation ( see chart c).
But medium-term inflation
concerns are overdone
While there may be
justifiable concerns about the inflation outlook over the longer term, the
creeping pessimism about the medium-term prospects looks misplaced. With the
economy still in recession and unemployment continuing to rise sharply, the
current economic environment is more consistent with deflationary,
rather than inflationary conditions. Although â€˜green shootsâ€™ have
started to emerge, the prevailing level of space capacity indicates that
businesses are operating well below potential â€“ hardly a recipe for a
significant demand or supply induced rise in prices. We estimate that the UK is currently operating
with a negative output gap of around 6% - i.e. the level of actual output
is about 6% below the level that could potentially be produced given the
current pool of available labour, labour productivity and capital stock (see
chart d). Not surprisingly, inflation and the output gap are reasonably closely
correlated. As demand weakens, unemployment tends to rise, putting downward
pressure on wage and, with a lag, consumer price inflation.
Indeed, this describes
what has occurred over the past year or so. Since February 2008, claimant count
unemployment has risen by
760,000 and underlying average earnings growth has slowed from 3.7% to 2.7% (see
chart e); since last September, consumer price inflation has dropped from 5.2%
to 2.2%. With
certain to continue rising over the remainder of this year and into 2010, we
expect CPI inflation to fall further â€“ to below 1% by the end of this year,
(see chart f). Over the coming months, the fall in inflation also is likely to
be accentuated by favourable base effects, as last summerâ€™s sharp rise in food
and energy prices drop out of the annual comparison. Although unemployment is
still expected to be increasing for much of next year, headline inflation is
expected to gravitate slightly higher, as the temporary cut in VAT expires in
January and demand conditions gradually improve.
Even if GDP bounces
strongly, the output gap will remain negative for some time..
Nonetheless, it is
difficult to make a strong case for a fundamental shift higher in inflation
until the output gap closes. Such an outcome requires a sustained period of
above-trend growth. While recent indicators suggest the inventory adjustment
may now be largely complete, this points to a stabilisation in output, not
necessarily a resumption of growth. Moreover, even if the economy were to
exhibit a sharp rebound, it would take time for the level of spare capacity to
erode to the point where inflation pressures started to build again. Broadly
speaking, for the current output gap to close, GDP would have to rise by 2%
above trend over the next three years. While low interest rates and
quantitative easing may pose longer term risks, the degree of spare capacity
poses a formidable obstacle to a pick-up in inflation in the short term.
...trend growth may have
fallen, but not by enough to induce price pressures
Admittedly, there is a
caveat to this. Estimates of the output gap are almost impossible to derive
with precision as the growth potential of the economy changes over time in
response to changes in the capital stock, productivity, and the available pool
of labour. Since the credit crisis erupted, the capital stock has clearly been
depleted as a result of the decline in business investment and rising corporate
bankruptcies. This represents a permanent loss of output. Moreover, reports
suggest that migrant workers are increasingly leaving the country. Proponents of
rising inflation argue that these developments leave the UK more exposed to
inflation pressures when demand picks up. While this may be true over the
longer term, we believe it is highly implausible that the UKâ€™s trend rate of growth
has fallen to such a degree that the UK is exposed to
supply-side price pressures. Although the capital stock has been depleted, the
proportion of the UK population that is
economically active has actually risen slightly, as the downturn has obliged
some individuals to re-enter the labour market.
conditions pose little threat to inflation
Moreover, from a demand
perspective, there appears little threat of inflation. Unemployment continues
to rise sharply, credit availability remains constrained and household
indebtedness is close to a record high. None of these seem consistent with an
imminent improvement in corporate pricing power. Inflation looks set to stay
low for a while longer. Consequently, fears of an early rise in interest rates
Weekly economic data
preview -22 June 2009
Fed and BoE to quash
speculation of early rate hikes
The improvement in
economic activity data in recent weeks has raised market speculation about the potential
â€˜exit strategiesâ€™ central banks may employ from the various initiatives
undertaken to tackle the financial crisis. However, with considerable
uncertainty still overshadowing prospects for future economic growth and
inflation, we believe such considerations may be premature at this time. We
expect both the Fed and the BoE to communicate messages along these lines this
week. The FOMC will be armed with updated economic forecasts which, though
likely to show an improvement in underlying economic conditions, may also
predict that economic growth could remain weak for some time, increasing spare
capacity and reducing the medium-term threat posed by inflation. We expect the
committee on Wednesday to maintain the target range for the federal funds rate
at 0-0.25% and to keep its total purchases of Treasury securities unchanged at
$300bn on Wednesday. Members of the BoE MPC testify to a Treasury select
committee on the May Inflation Report on Wednesday. We expect the main message
here to be that with recovery still not assured, Bank rate will remain at 0.5%
for some time, while additional quantitative easing also cannot be excluded. It
is another big week for government bond issuance, with the US Treasury auctioning a
record $104bn. Euro zone PMIs, the German IFO survey, final US Q1 GDP and US personal
income and spending for May provide the main data highlights this week.
ô€‚„ It is a very quiet week for data in the UK, with the CBI
distributive tradesâ€™ survey on Wednesday and BBA lending figures on Tuesday potentially
the only releases of market interest. We expect the CBI headline reported sales
index to show a further decline to -20 in June, from -17 last month, as rising
unemployment and tight credit conditions increasingly weigh on retail spending.
We forecast BBA mortgage approvals rose above 30,000 in May, from 27,685 in
April, equating to year-on-year growth for the first time since November 2006.
However, the number of loans approved for house purchase in November 2006 was
79,981, highlighting how subdued market activity actually remains. The
Nationwide house price survey may also be published this week. However, the
main focus in the UK this week will be on the
BoE MPC testimony on Wednesday on the May Inflation Report , where we expect to
hear more about the economic outlook, the progress of quantitative easing so
far and how the timing and mechanics of an eventual exit strategy will be
determined. Senior BoE members, including governor King, will also testify on
the banking crisis later on Wednesday.
ô€‚„ Although we expect to hear that the overall policy stance will
remain unchanged following the FOMC meeting on Wednesday, the press statement
will be closely scrutinised for any clues about future direction. We look for
the FOMC to dampen recent market speculation of an early interest rate rise,
primarily by highlighting the high degree of uncertainty and risk still
surrounding prospects for inflation and economic growth. The need potentially
for increased purchases of treasury securities may also feature in the press statement,
although the current $300bn remit is unlikely to be changed at this time. The
Fed is already more than half way through its current programme, which it
expects to complete by Autumn. US data this week are
likely to support the view that the economy will return to modest growth in
coming quarters. We look for a solid rebound in personal spending in May,
underpinned by the boost to incomes provided by the recent stimulus plan. There
is a chance that initial jobless claims dipped below the 600k level in the week
to June 20 for the first time since January, a further indication that labour
market trends are improving. We also forecast modest increases in new and
existing home sales for the second consecutive month in May, as lower prices
spur renewed activity. Confirmation that the economy contracted by an
annualised 5.7% in Q1 2009 is unlikely to elicit much market reaction on
ô€‚„ Data in the euro zone this week are also expected to show that the
worst of the downturn may have passed, although prospects for recovery there
may not be as strong as in the US or UK. We look for further rises
in both the manufacturing and services PMIs, to 42.5 and 46 respectively,
though crucially still deep in contractionary territory. The German IFO survey
is also forecast to show a third consecutive rise in its business climate
index, to 85.5 in June, but this is still consistent with weak output growth.
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