EEF blog

Today’s inflation report brings a more positive tone to the future outlook than has been seen for a while, with both the output and inflation forecasts having been revised in a positive direction. The improvement was driven by signs of early momentum picking up in the wider economy. We look at some of the reasons behind each of the revisions in turn.

Output forecast revised up

The upside surprise of 0.3% growth in the first quarter of this year underpins a number of other indicators that give rise to the expectation of stronger GDP growth over the course of this year. Demand and supply are expected to pick up gradually with a number of factors contributing to this change in view. While employment has fallen back somewhat, it is expected to pick up more than previous estimates, household real incomes have led to some up-tick in consumption and the extension to the Funding for Lending Scheme is expected to ease credit conditions and boost demand.

Risks do remain, however, and the recovery, though slow, will depend on how households and businesses respond. The international environment will continue to weigh on sentiment, particularly those risks pertaining to the Eurozone.

Inflation forecast revised down

In the past couple of months inflation remained sustained but for the first time in a while the forecast has been revised down though it will still take the best part of two years to return to target. The slow return to target is expected as administered and registered prices are to remain elevated.

The improvement in the overall forecast was driven by expectations of external price pressure being lower and higher labour market participation dampening down domestic pay pressures.

All in all, the picture is somewhat more positive but the overall trends are not much changed. Inflation will continue to remain above target for some time and, while the economy will remain subdued, it will be growing. As we have mentioned in an earlier blog we want to see the government doing everything possible to support growth, by providing more certainty to business that they have a plan get the economy growing again and ensuring decisions, such as the upcoming spending review, do everything possible to support growth.

The Decision

Bank rate held at 0.5%

Stock of asset purchases held at £375 billion.

The Discussion  

Financial markets

• Relatively limited reaction from financial markets to Cyprus bailout
• Equity markets continued to be buoyant, some major international equity indices at all-time nominal highs
• Little reaction to UK being placed on negative watch by Fitch

International economy

• Global growth continues to show gradual recovery with world trade and investment  picking up in early 2013 but pattern of growth remains uneven
• Tentative signs of strengthening confidence in the Euro area have  not been maintained
• US indicators positive with robust consumer spending, a strong housing market and growing employment despite more restrictive fiscal policy.
• Asia still showing evidence of expansion with Chinese PMI rising in March and business confidence improving in Japan.

Money, Credit, Demand and Output

• Turning to the UK, there is mixed news of activity in the first quarter of 2013 from official indicators
• Credit conditions have eased with the supply of credit increasing and some feed through in loan rates. However small companies continue to report more difficulties accessing finance and there has been little sign that easing of credit access has fed through into higher net lending to businesses.
• There is some evidence of increased supply of credit feeding through into the housing market.
• The committee agreed that a well-capitalised banking system is important for the capacity of the economy over time and saw merit in boosting lending through an extension to the FLS.

Supply, Costs and Prices

• Inflation expected to remain high, rising to 3% in the middle of the year
• Pay growth has continued to be weak
• Productivity remains puzzling as employment continued to increase despite falling output. Relatively low company failure due to low nominal interests rates and forbearance by lenders was discussed as one of the factors contributing to low productivity.
  

The minutes of the MPC meeting on 6 and 7 February show MPC members voted to maintain the bank rate at 0.5 and hold the level of quantitative easing at £375 billion.

Key points:

Financial markets

• Improved sentiment that has been showing through in financial asset prices since the summer has been sustained. 
• Accommodative policies of major central banks and the view that major downside risks had lessened improved prospects for a recovery in the global economy.
• Most major equity indices were close to post-crisis highs with strong rises seen in the UK, US and Japan

International economy.

• Overall there are few signs that improved sentiment is translating through into improved economic data.
• The US experienced a small contraction in q4 GDP but other economic indicators provide a more positive picture of the health of the economy.
• The Euro area contracted at the end of last year but the pace of contraction may be starting to ease.
• A fiscal stimulus package has been confirmed in Japan along with further rounds of asset purchases.
• China shows signs of returning to robust growth.

Money, credit, demand and output

• GDP contracted in q4 2012 as global uncertainty depressed industrial production and UK exports.
• Bank lending remained weak. Some signs that the FLS is having an impact and improvement has been seen in the housing market.
• Lower spreads on bank loans and increased availability of credit have been seen for large corporations but this is not as evident for small businesses.
• GDP is expected to remain weak in the near term with a slow but sustained recovery expected over the next three years as domestic credit conditions and the wider global economy improve.
• GDP expected to remain below the pre-crisis level until 2015.

Supply, costs and prices

• CPI inflation is expected to rise in the near term due to higher oil prices – which had risen 4% since the MPC’s last meeting – and the Sterling’s recent depreciation. Inflation may remain above the 2% target for the next two years.
• Private sector pay growth is expected to be close to 2% in the coming year and surveys suggest employment growth may be moderating.
• February’s Inflation Report outlined the expectation that output would continue a gentle recovery and productivity would increase, lessening unit wage costs. There is a lot of uncertainty around this view relating to productivity and demand growth.

The decision

MPC members decided to hold both the bank rate and the stock of asset purchases at their previous rates. The decision regarding the bank rate was unanimous but three people did vote in favour of increasing the size of the asset purchase programme by a further £25 billion, including Governor Mervyn King. This was unexpected and has been seen as a bit of a turnaround given that he has previously questioned the value of further quantitative easing saying it will have little impact on growth.

Last week I had a look at what we are expecting to happen to manufacturing sectors in the UK in 2013. Today I look at some international and global indicators.

Overall 2013 is looking brighter than 2012 with global growth, world trade and stock market prices picking up. Inflation and real commodity prices are expected to fall. Yet challenges and risks remain including on-going issues in the Eurozone and the stability of the middle-east so we do not expect the year to be plain sailing. Our own Executive survey shows that UK manufacturers are expecting things to pick up in 2013 but they also recognise both the risks they will face and the opportunities that exist in the coming year.

The minutes for the MPC's October meeting were released this morning 

The decision:

The committee voted unanimously to maintain the bank rate at 0.5% and continue with the programme of asset purchases totalling £375bn

There were some differences of opinion on the committee as to whether the asset purchase programme should be scaled up, but there was agreement to continue with the current programme of purchases and wait until there was more information in the next Inflation Report in November.

The background:

Financial markets

• ECB announced a programme of Outright Monetary Transactions
• Federal Reserve announced it would continue to engage in monetary easing until there was a sustained improvement in labour market
• Bank of Japan also announce further stimulus
• Yields on short-term government bonds in Spain and Italy have fallen

International economy

• Output growth soft in many advanced and emerging economies
• In the US employment growth had been weaker than at the start of the year but there were positive signs in the ISM (a leading indicator index similar to the PMI)
• Oil prices fell a little on the month

Money, credit, demand and output

• ONS revised up its estimate for GDP change in the UK in Q2 to a 0.4% contraction
• Net trade was a drag on growth in Q2
• Household credit growth was slow
• FLS likely to have eased access to credit for some households and companies but it is likely to take longer for FLS to feed through to corporate lending

Supply, costs and prices

• CPI fell to 2.5% in August (and yesterday’s figures showed it fell again, to 2.2% in September)
• Higher oil and energy prices will put some upward pressure on inflation
• Employment had continued to grow strongly, but productivity continued to deteriorate
• Factors to explain weakness in productivity could be: problems with access to credit reducing access to capital equipment; uncertain demand meaning firms are hiring new employees rather than investing a large initial layout in capital; low rates of company failure

A bit more good news on the inflation front as CPI edged down again to 2.5% in August. But it's likely future path together with the underlying health of the UK economy and likely global developments are still far from certain. 

This morning's MPC minutes highlight the range of possibilities for all these economic variables through the remainder of this year and the continuing dilemma facing policy makers.

Where does the Committee see inflation heading?

In short the answer is down, but not as quickly as the Committee had been expecting at the time of its August Inflation Report. Some commodity prices had been on the increase due to supply constraints and this, together with expected increases in utilities and food prices would be passed through to consumers later this year.  However, there was still judged to be spare capacity in the economy which would continue to bear down on inflation in the medium term.

What about growth?

Here the picture is a lot less clear.  The Jubilee impacts on GDP should be unwound in the third quarter and a boost from the Olympics should also bring a return to growth in the thiid quarter of this year.  While some business surveys had picked up a little, measures of sentiment appear to be pretty weak.  In addition, firms opting to retain or recruit rather than invest in new plant and machinery would indicate that many are reluctant to commit to increases in capacity in case the demand outlook deteriorates. 

The big international questions remain firmly on the table - where does the eurozone go from here, how will the US navigate its budgetary tightening in 2013 and are emerging economies in for a more prolong period of sub-trend growth?  Since the Committee met we've had more action from the ECB to purchase bonds of struggling countries, which markets reacted positively too, but eurozone politicians still have a mountain to climb in bring stability to the bloc.

A word on FLS

There was a fair amount of emphasis on the role of FLS in boosting borrowing by households and the corporate sector to support investment.  The Committee noted some initial positive signs that it was feeding through to lower lending rates, but acknowledged that this was going to be a long game with banks using the full 18 month window to draw funding from FLS. 

What's new for October?

The decision to proceed with asset purchases announced in July and keep rates at 0.5% was a unanimous one. But for some members:

additional stimulus was more likely than not to be needed in due course

It would, therefore, seem to be a question of when.  The October meeting will see a bit more evidence on whether activity in the UK did indeed pick up in the third quarter as expected.  However, there is unlikely to be a great deal more clarity on prospects for the external environment coming through in the next few weeks. With views that the risks to inflation remain balanced in the medium term, so it would seem the decision on what next for QE will be similarly balanced when the MPC meets again in October. 

Annual CPI fell to 2.5% in August from 2.6% in July 

A combination of factors put pressure on inflation in August with downward pressure slightly outweighing the upward pressure.

Downward pressure

↓ furniture
↓ household equipment and maintenance
↓ housing and household services, particularly domestic gas
↓ clothing and footwear.

Upward pressure

↑ Transport, particularly motor fuels

The general consensus and indeed the Bank of England’s forecasts were for inflation to fall below the 2% target in the latter half of this year. 

However, price rises have been somewhat more sustained than thought likely placing a question mark over future movements - will inflation remain higher than the 2% target or fall as previously expected?

A couple of pertinent factors:

• Transport costs: Petrol prices have already risen since August and oil prices are expected to be higher than previously forecast in the latter half of 2012.
• Energy prices: SSE have announced they will be increasing domestic gas and electricity prices by 9% from October

If inflation does remain elevated, this would not be good news for consumption, investment and growth

Wages grew only 1.5% in the year to July 2012 so the latest CPI figures show real wages are still falling.  If inflation remains higher than the 2% mark for longer, the pick-up in consumer confidence and consumption that was expected later in 2012 is likely to be delayed. 

This will have flow-on implications for businesses and may further imminent recovery in investment – which was expected to be boosted by a pick-up in consumption. And of course growth would also be impacted and could be lower in 2012.

The Inflation report points to lower inflation and slower economic growth.  Mervyn King sums it up:
 
“The economy will continue to face headwinds over the forecast period…  The recession in the euro area is damaging demand for our exports; a black cloud of uncertainty is hanging over investment; and the weakening euro is a further obstacle to the adjustment we need to make in our net trade position. Our efforts to bring about a rebalancing of the UK economy will require patience.”

Key points

Inflation is now expected to fall from its current level to be around or a little below target for much of the forecast period as external price pressures ease and domestic cost pressures stay muted.

Growth forecasts have been lowered across the forecast period.  Growth in 2012 is now expected to be close to zero, down from 0.8% expected in May.  The medium term outlook for growth has also been revised down from the May report to just over 2% for the rest of the forecast period.

Output has been volatile over the last couple of months but much of that is due to factors such as the jubilee which do not give a good indication of the underlying picture of the economy.  Despite these though, output has been broadly flat over the past two years.

Household spending has been held back by weak real income growth but pressure should start to ease.  Consumption is now expected to recover gently over the next year to provide moderate support for growth.

Business investment may pick up on the back of a gentle recovery in consumer spending.  Further information on corporate cash balances shows that there is probably some scope for businesses to increase investment but, as we have previously suspected, whether this eventuates is difficult to anticipate and depends on how companies respond to the environment.  Some interesting points:

- Two measures show that cash holdings have been increasing steadily over the past decade but it is difficult to know how much of this is held by non-financial corporations and so is available for investment. 

- There are alternative uses for cash that companies may be more inclined to go with, particularly in an uncertain environment. These could include dividends, paying down debt and equity buy backs.

- A continuing of the uncertain environment may lead companies choosing to hold on to their cash to either shore up their balance sheet so they are in good position for further shocks, or to wait until the investment environment becomes more favourable.

Trade and external demand have been somewhat weak. Euro area developments are likely
to have a pervasive impact on the UKs economic prospects but a modest recovery in global demand will lead to a pickup in export growth.

Productivity growth has been surprisingly weak and is expected to recover gradually but may stay below the long-run average for much of the forecast period.

Rising bank funding costs which are feeding through to higher rates for domestic borrower on the back of the Eurozone crisis have been concerning.  However, the bank expects the funding for lending scheme to reduce funding costs which could then feed through into lower lending rates.  Assessment by the bank, although very uncertain, indicates that the reduction in funding costs relative to current market conditions for the major UK banks could range between around 100 to 200 basis points if these banks used the scheme to borrow and also maintained their stock of net lending.

All up, the picture suggests a lengthening of the recovery period.  Mervyn King said the process of rebalancing will require patience - but it also requires action.  The Government needs to have a clear plan for how it will seek to support growth and provide the right environment for businesses to grow.

MPC members voted to hold the bank rate steady at 0.5% and to finance a further £50 billion of asset purchases that will take place over the next four months.  This decision brings the total quantity of quantitative easing to £375 billion. 

All nine members of the MPC voted to maintain the bank rate at 0.5%.  Seven members voted in favour of increasing the stock of asset purchases, with Spencer Dale and Ben Broadbent preferring to maintain the stock of asset purchases at £325 billion.

The fall in inflation to 2.4% announced yesterday was not unexpected by the MPC given reductions in oil and energy prices and the impact of the delay to fuel duty changes.

The Committee noted higher risks from weakening in global demand, outlook for GDP growth and export prospects.  While the reaction to the European council meeting has been generally positive and has led to improved market sentiment in Europe, there are increasing signs that the threat of disorderly resolution to the financial tensions in the euro area is affecting UK growth. The majority view was that upside risks to inflation had declined and the potential cost of greater stimulus was lower than the cost of providing too little. 

Economic developments over the month:

Financial markets

• The prevailing sentiment in financial markets remains one of caution and risk aversion.
• Some improvement in bank funding markets in continental Europe towards the end of the month.

The international economy

• Recent indicators continue to suggest a weak near-term outlook for global activity. 
• Composite Euro area PMI rose fractionally in June but remained consistent with contraction in the second quarter.
• Forward looking service sector business expectations suggest weak third quarter. 
• US manufacturing ISM index for June fell sharply indicating flat or declining output in the sector and the new orders index also contracted suggesting weakness could persist.
• Overall picture for emerging economies one of gradual reduction in the pace of growth. 
• Oil prices continued to decline for most of the month before picking up a little towards the end of June and early July.

Money, credit, demand and output

• GDP estimate unchanged but contribution to growth from trade, business investment and consumer spending were revised down and offset by an increase in government spending.
• Business survey indicators of activity have been weak. 
• The announcement of the Funding for Lending Scheme and the Banks activation of its ECTR facility are expected to provide a potentially significant stimulus to economic activity.

Supply, costs and prices

• CPI had fallen to 2.8% in May (though has since fallen further to 2.4% in June)
• CPI likely to be lower than expected in the near-term given low oil and energy prices and postponement of the fuel duty changes. 
• Private sector productivity had continued to fall despite a three month on three month rise in employment of 166,000 in April.
  

Yesterday’s inflation figures presented some good news for the MPC. CPI came in at a lower-than-expected rate of 3% meaning – for the first time in this Parliament – that the Governor of the Bank of England did not have to write a letter to the Chancellor of the Exchequer.

CPI inflation is now at its lowest level since February 2010, but it remains well above target, and has been for over two years. 

Yet this morning’s MPC minutes hint that increased monetary easing is more likely than an increase in interest rates any time soon. As with last month, all committee members voted to maintain the stock of asset purchases at £325bn with the exception of David Miles, who voted in favour of a £25bn extension to the scheme.

So given the high level of inflation why is more monetary easing on the table?

The UK economy is still weak. As with last week’s Inflation Report, the MPC’s minutes noted the significant risks to growth associated with the economic turmoil in the Eurozone. Similar points were highlighted yesterday, when the IMF released its review of the UK policy mix. In fact, the IMF argued that weak growth and limited underlying inflationary pressure suggest further monetary easing is required. 

Our own forecasts suggest that growth is likely to be weak, and inflation should fall back to target early next year. However, we now expect inflation to return to target later than we previously forecast, due to the increased outlook for oil and commodity prices: upside risks to inflation remain.

As King pointed out during the press release for the Inflation Report, the amount of spare capacity in the economy is difficult to predict, and will be affected by tight credit conditions and economic uncertainty, yet it is precisely this spare capacity that is expected to keep domestic price pressures under control.

Other upside risks to inflation noted in today’s minutes:

-         developments in global prices, such as for commodities

-         growth in domestic costs

-         degree to which companies seek to restore margins

The minutes also noted some downwards risk to inflation:

-         weak economic activity might result in inflation falling materially below 2% in the medium term

-         demand growth might be weaker than expected