BOE slashes forecasts, hits the brakes on rate hike in November Inflation Report
Overview of the Inflation Report November 2014
The expansion in UK domestic demand has continued. But the outlook for global growth has weakened. Some asset and commodity prices have fallen, as have market interest rate expectations. Growth is projected to be a little weaker than in August. It slows slightly in the near term, settling back to around historical average rates, underpinned by a gradual pickup in demand abroad and a revival in productivity and real household income growth at home.
Inflation has fallen further below the MPC’s 2% target, reflecting the impact of lower food, energy and import prices and some continued drag from domestic slack. Inflation is expected to remain below the target in the near term, and is more likely than not to fall temporarily below 1% at some point over the next six months. It then rises gradually back to the target as external pressures fade and unit labour cost growth picks up. The MPC’s guidance on the expected path for Bank Rate continues to apply. When Bank Rate does begin to rise, the pace of rate increases is expected to be gradual, with rates probably remaining below average historical levels for some time.
Recent economic developments
Demand and supply
The global outlook has weakened since August. In the euro area, the United Kingdom’s largest trading partner, output grew only modestly in the first half of 2014. More timely survey indicators of activity and consumer and business confidence are consistent with continuing subdued growth. Growth has also slowed in some emerging economies, including China. Although US GDP grew solidly in Q3, household consumption growth remained subdued. Partly reflecting weaker external demand, UK exports fell in Q2 and surveys of export orders paint a less positive picture of the near-term outlook than three months ago.
Disappointing news on global activity was associated with some declines in risky asset prices, with financial markets exhibiting pronounced volatility during October. The FTSE All-Share is around 5% lower than in August and spreads on riskier corporate bonds have risen by 70 basis points on average. It is also possible that investors are now demanding greater compensation for holding some riskier assets. Market participants’ expectations for interest rates in three years’ time have also fallen notably since August in some advanced economies — for example, by around 60 basis points in the United Kingdom and around 40 basis points in the United States. In the United Kingdom, rates are now expected to remain below 2% over the next three years.
Against this backdrop of slower global activity, UK domestic demand growth has so far remained robust, supported by easier credit conditions and past rises in confidence. Consumer spending growth strengthened in 2014 H1, despite weak wage growth. Surveys suggest a continuation of strong business investment in the near term. Revisions in the Blue Book suggest that the UK recovery has been better balanced than previously estimated, with business investment playing a greater role.
Although housing investment rose markedly in Q2, housing market activity has moderated further. Mortgage approvals were broadly flat in Q3, weaker than expected in August, and house price inflation has also slowed. This may in part reflect some restriction in the availability of mortgage credit, but an easing in demand for housing finance may also have been a factor. The near-term outlook for housing market activity is softer than in August.
The unemployment rate continued to fall, reaching 6.0% in the three months to August. The most recent decline largely reflects fewer people participating in the labour market, with employment rising more slowly than earlier in the year. Private sector productivity growth has picked up a little, but still remains weak. The margin of spare capacity has probably narrowed a little over the past six months. But the central view of most MPC members is that slack remains broadly in the region of 1% of GDP. There is, however, considerable uncertainty around that central estimate, with a wide range of views on the Committee.
Costs and prices
CPI inflation was 1.2% in September, down from 1.9% three months ago, and much weaker than projected in August. Low CPI inflation partly reflects a decline in food and energy prices which, after pushing up CPI inflation for most of the past decade, are now weighing on the headline rate. These lower prices reflect falls in global commodity prices, which in turn reflect both the slowdown in global demand and positive news about supply. Prices of other imported goods and services are also lower. Although sterling has depreciated slightly since August, its rise over the previous year or so is pushing down import prices. Inflation in the euro area, a key source of UK imports, also remains low.
Cost pressures from the labour market remain subdued. Unit labour costs fell over the four quarters to Q2. While that fall was largely driven by the volatile non-wage component of labour costs, wage growth remains low relative to historical averages. That reflects both slack in the labour market and subdued productivity growth. The composition of employment gains has probably weighed on productivity and pay: much of the most recent rise in employment has been concentrated in lower-skilled occupations.
Most measures of medium-term inflation expectations have changed little since August and remain consistent with the 2% inflation target. However, some measures of short-term inflation expectations have fallen somewhat.
The outlook for GDP growth and inflation
Chart 1 shows the Committee’s best collective judgement for the outlook for four-quarter GDP growth, assuming Bank Rate rises gradually from late 2015, in line with the path implied by market interest rates, and the stock of purchased assets stays at £375 billion. Four-quarter growth is projected to fall back towards its historical average rate, somewhat above estimated potential supply growth. That central path is a little weaker than in August, reflecting the weaker global outlook and a softer profile for private sector domestic demand, the latter despite a lower implied path for Bank Rate. The risks around that central path are judged to be balanced, rather than skewed to the downside as in August.
