Prospects for inflation

GDP growth slowed to 0.1% in Q1, according to the preliminary estimate, from 0.4% in Q4 and below the projection three months ago. That partly reflected the temporary disruptive impact of adverse weather across the country (see Box 3). As in the February Report, the MPC continues to judge that very little spare capacity remains in the economy. Growth is likely to be revised up a little over time (Section 2) and to the extent that weakness in activity reflected disruptive weather, it is unlikely to have had any significant effect on the degree of spare capacity. Moreover, the labour market has remained robust, with unemployment falling further in the three months to February. In Q2, as the drag from weather effects unwinds, growth is expected to bounce back to 0.4%, broadly consistent with the latest survey indicators, although there will be considerable uncertainty about underlying momentum in the first half of the year until more data become available.

Growth also dipped in the euro area, United States and China at the start of the year. This appears to reflect erratic factors, including weather. Overall momentum in the global economy is still judged to be robust.

UK CPI inflation has fallen back more rapidly than expected three months ago. It now seems likely that pass-through of the past depreciation of sterling to import prices is somewhat smaller than previously thought. Regular pay growth has picked up, broadly as expected three months ago, and there are continuing signs that domestic inflationary pressures are building gradually.

Financial conditions are similar to those underlying the February Report. The MPC's projections are conditioned on a path for Bank Rate that reaches 1.2% by early 2021 (Table 5.A).¹ In the 15 working days to 2 May, the sterling ERI was 1% higher than in the run-up to the February Report, but it remains 15% below its late-2015 peak. As in previous Reports, the MPC's projections are conditioned on the average of a range of possible outcomes for the United Kingdom's eventual trading relationship with the European Union. They also assume that households and companies base their decisions on the expectation of a smooth adjustment to those new trading arrangements. Since the February Report, a draft Withdrawal Agreement between the UK Government and the European Union, including an implementation period ending on 31 December 2020, has been published. This pushes back the date at which the UK would move to new trading arrangements.

The assumptions underlying the MPC's May projections and the medium-term outlook for growth and inflation, summarised in Table 5.B, are broadly similar to the projections set out in the February Report. Following a period of weakness at the start of this year, GDP is then projected to grow at around 1¾% a year (Chart 5.1). That modest growth is supported by robust global growth (Key Judgement 1), as the euro-area recovery continues and US growth picks up further. Robust world activity continues to support UK exports, with the past depreciation of the sterling exchange rate also providing a continued boost to net trade, which contributes positively to growth over the next three years (Key Judgement 2). That in turn supports UK business investment, helping to offset the drag from uncertainty around the United Kingdom's future trading arrangements. Household spending growth remains subdued over the forecast period, in line with the muted recovery in real income growth.

Although demand growth is projected to be modest by historical standards, it is faster than supply growth, which is restrained by continued weakness in productivity growth (Key Judgement 3). With very little slack at the start of the forecast period, the economy moves into excess demand by early 2020 and domestic inflationary pressures build further (Key Judgement 4). Inflation falls more rapidly than in February (Chart 5.3), reflecting a smaller assumed boost from the past depreciation of sterling, and settles at the 2% target by mid-2020 (Chart 5.2).

At its meeting ending on 9 May 2018, the MPC voted to maintain Bank Rate at 0.5%, 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.

5.1 The MPC'S key judgements and risks

Key Judgement 1: global growth remains robust

Global growth has strengthened over the past two years, with many countries growing at above-trend rates. That has contributed to a rise in commodity prices, with dollar oil prices up a further 6% since February. It has also reduced spare capacity in many countries, which is projected to support global inflation over the forecast period.

In the euro area, where the recovery has been particularly marked, growth dipped to 0.4% in Q1 in contrast to the pickup suggested by surveys at the start of the year. Some of that news may well reflect a drag from weather effects that will probably unwind in Q2. Although surveys have also softened a little, they remain consistent with quarterly growth a little over ½%, above its estimated potential rate. Growth is projected to remain around that rate in the second half of the year. It slows towards potential thereafter as the support to growth from accommodative monetary policy and the past improvement in confidence and credit conditions wanes. Indicators of domestic inflationary pressures have remained subdued in the euro area, consistent with a degree of slack remaining in the economy. Inflation is projected to rise to around 1¾% over the forecast period, as that slack is absorbed.

The US has been growing at above-trend rates since 2016 and core inflation has picked up more recently. Growth is projected to fall back more slowly over the forecast period than had been assumed three months ago (Table 5.C) as a consequence of additional support from fiscal policy measures signed into law in February. With the economy already operating close to, if not a little above, full capacity, inflation is projected to be above 2% from around the middle of this year.

GDP growth in China slowed in Q1 but is expected to pick up in Q2. Expansionary fiscal policy, robust credit growth and the strength in global demand growth, is expected to support activity in coming quarters. In other emerging economies, commodity producers are benefiting from higher prices for their exports. Emerging economies, particularly those with large US dollar‑denominated debts and high external financing requirements, remain vulnerable, however, to a sharper‑than‑expected rise in US interest rates or a stronger US dollar exchange rate.

Taking advanced and emerging economies together, based on PPP weights, global growth is projected to be 4% in 2018 before slowing to 3½% (Table 5.C). Weighted by UK export shares, growth is around 3%, slowing in the second half of the forecast period as slack is absorbed. The projection is broadly similar to that of three months ago (Chart 5.4) but the slight softening in momentum, which was widespread across regions, means the risks around it are now judged to be balanced rather than weighted to the upside. There is still a risk of a larger upswing in productivity growth than projected, which would allow economies to grow more quickly before upside risks to inflation emerge. On the downside, trade tensions have increased (Section 1). While the tariffs announced by the United States and China to date are likely to have limited effects on activity and inflation, there is a risk of escalation.

Key Judgement 2: investment and net trade support UK demand, while consumption growth remains subdued

While the world economy has strengthened, UK growth has slowed to modest rates. On the expenditure side, UK growth has rotated towards net trade and business investment and away from consumption (Section 2). That pattern continues over the forecast period as households continue to face weak growth in real incomes.

Net trade contributed positively to growth in 2017 and is projected to continue to do so throughout the forecast period. That in part reflects the support to UK exports from strong overseas demand. Net trade has also been supported by the lower sterling exchange rate, which boosts exports and discourages imports. For some time, both exports and imports have been projected to grow relatively weakly as companies here and abroad begin to adjust trading relationships in light of the United Kingdom's vote to withdraw from the European Union. As set out in Box 5, gross trade flows have been stronger than projected over the past year, suggesting that little adjustment has happened so far. Moreover, the draft transition agreement to preserve UK access to the single market until end-2020 suggests that most of the adjustment still to come is likely to happen beyond the three-year forecast horizon. Gross trade flows are therefore projected to grow a little faster over coming years than previously assumed (Table 5.D), but these changes have no implications for net trade or, therefore, aggregate demand.

Business investment has been supported by external demand, limited spare capacity, the relatively high rate of return on capital and the low cost of finance, even as the rise in Bank Rate in November has fed through to borrowing costs (Section 1). Its pace of growth has, however, been more modest than would be expected at this stage of the economic cycle and relative to investment growth in other countries, probably a result of the anticipation of and uncertainty over Brexit, as suggested by a range of survey evidence and contacts of the Bank's Agents. Overall, business investment is projected to grow a little faster than current rates (Table 5.D), as global growth and capacity pressures encourage spending, and the drag on growth from uncertainty wanes.

Consumption growth has slowed to subdued rates. Households have faced a period of falling real income as the lower sterling exchange rate fed through to higher prices (Key Judgement 4). Aggregate household real incomes are no longer falling, but real income growth is still subdued and rises only a little over the forecast period. Spending has not slowed as much as total post-tax income, and the saving ratio has fallen to a relatively low level (Section 2).

There have been signs of weakness in consumer spending in Q1 including in data on retail sales and consumer credit (Section 2). In the central projection, that weakness is largely assumed to reflect erratic factors, including the impact of adverse weather, that unwind in the second quarter. Annual consumption growth recovers gradually to reach 1¼% by 2019, broadly in line with income (Table 5.D). That is well below its historical average rate of around 3%. The saving ratio is projected to remain around its current rate. There is greater-than-usual uncertainty about the near-term momentum in consumer spending and the extent to which households adjust their spending and saving to the past fall in their real incomes.

Weak real income growth has probably also weighed on the housing market. House price inflation has slowed and activity remains subdued (Table 5.E). That is despite average mortgage interest rates falling over recent years as credit spreads have narrowed (Section 1). Over the forecast period, a gradual widening in credit spreads, albeit a slightly smaller one than assumed three months ago, alongside the gently upward sloping yield curve, raises mortgage rates, but the recovery in income growth supports the housing market. House price inflation is projected to pick up a little and approvals to rise (Table 5.E), though they remain significantly below levels seen prior to the crisis.

Key Judgement 3: very little slack remains and the pace of potential supply growth is modest

There is a limit to how rapidly the economy can grow without putting upward pressure on inflation. In the aftermath of the financial crisis, the UK economy had scope to grow above its potential rate as spare capacity was used up. Now, with unemployment around its equilibrium rate and few signs of slack elsewhere, the speed at which demand can grow sustainably depends on how fast supply capacity is expanding. As set out in the MPC's February reassessment of the supply side of the economy, supply is expected to grow at a slower pace than was typical prior to the financial crisis.

The MPC continues to judge that very little spare capacity remains in the economy. Although growth is estimated to have slowed sharply in Q1, this estimate is likely to be revised up a little over time (Section 2). Moreover, to the extent that weakness in activity reflected the disruptive impact of adverse weather, it is unlikely to have had any significant effect on the degree of spare capacity. Other indicators of slack, such as unemployment, do not point to any reduction in capacity pressures.

Over the forecast period, supply growth remains modest by historical standards at around 1½% a year. Within that, labour supply growth, which boosted supply growth during the economic recovery, is projected to slow a little further. That slowing in part reflects lower net inward migration flows, in line with ONS projections. Offsetting that, structural productivity growth is projected to pick up a little.

Since the financial crisis, productivity growth has been subdued in the United Kingdom, as in many other economies. Weakness in investment has led to slow growth in the capital stock — a key driver of productivity growth. Moreover, the efficiency with which companies use their capital and labour to produce output also seems to have been rising only slowly. One influence on UK productivity is the anticipation of, and response to, post-Brexit trading relationships. That is likely to have weighed on investment. Over the forecast period, growth in productivity is projected to be a little faster than its average in recent years (Chart 5.5) as increases in investment begin to feed through, but is expected to remain around half the rate seen before the financial crisis.

The extent of the recovery in productivity growth remains very uncertain. On the downside, as set out in the MPC's latest evaluation of its forecast performance (see Box 5), productivity growth has continued to disappoint over the past year and may well do so again. On the upside, annual productivity growth has averaged 2% over many decades and it could pick up by more than expected. For example, the rise in job-to-job flows could lead to better diffusion of ideas and skills between companies, raising productivity growth.

Conditional on market interest rate expectations of three 25 basis point rises in Bank Rate over the forecast period, demand is projected to grow a little faster than potential supply over the forecast period. As in February, a small margin of excess demand emerges by early 2020 and builds thereafter, putting upward pressure on domestic inflation (Key Judgement 4).

Key Judgement 4: with demand outstripping potential supply, domestic inflationary pressures continue to build while the contribution from energy and import prices dissipates further

CPI inflation has fallen back from its recent peak, and by more than expected at the time of the February Report. That largely reflects lower-than-expected inflation rates across a range of import-intensive CPI components. In addition, import prices have risen by slightly less than had been expected following the depreciation of sterling. In previous Reports, all of that shortfall in import prices was projected to be made up over the forecast period. But, with more signs that may not be happening (Section 4), the MPC now judges that import prices will rise by less (Chart 5.6). As a result, the contribution of import prices to CPI inflation diminishes more quickly than in the February projection.

Partially offsetting the decline in the contribution from import prices in the near term, there is a modest rise in the contribution of energy to CPI inflation over the next six months. Higher oil prices are passed through to retail petrol prices and recently announced tariff rises by some domestic energy suppliers take effect with other providers assumed to follow suit. The downward-sloping oil futures curve, on which the forecast is conditioned, means, however, that the contribution from energy prices is below average in the second half of the forecast period. In the later years of the forecast period, those below-average contributions broadly offset the positive contribution from import prices.

Where inflation eventually settles depends mainly on domestic inflationary pressures. These have been weak in recent years, reflecting the degree of spare capacity in the economy. The drag from slack has been most apparent in the subdued pace of wage growth since the financial crisis. Over the past year, wage growth has started to pick up gradually as the labour market has tightened further: unemployment has fallen to around its equilibrium rate; recruitment difficulties have risen; and people are moving between jobs at a similar rate to that before the crisis (Section 3). Although total pay growth was a little weaker than assumed in the February Report, that reflected lower bonus payments. Regular pay growth rose to just under 3%, as expected in February (Section 4). Pay deals seem to be picking up, broadly consistent with the results of the Bank's Agents' annual pay survey reported in February. Wage growth is likely to rise gradually over the forecast period as excess demand builds. As in February, that pushes up growth in unit labour costs — the cost to companies of employing someone relative to productivity. With productivity growth remaining below rates typically seen before the crisis, pay growth needs to be commensurately lower than its pre-crisis average for unit labour cost growth to be consistent with meeting the inflation target.

Conditional on market interest rates, domestic inflationary pressures are projected to build over the forecast period while the contribution from energy and import prices dissipates. In the central projection, CPI inflation is judged likely to settle around the 2% target from mid-2020 (Chart 5.7).

5.2 The projections for demand, unemployment and inflation

Based on these judgements, under the market path for Bank Rate and the assumption of an unchanged stock of purchased assets, the MPC projects four-quarter GDP growth to pick up to 1¾% over the next year and remain there throughout the forecast period (Table 5.F). That projection is weaker than in February in the near term, reflecting the weak Q1 outturn, but similar further out (Chart 5.8) once that weakness has dropped out of the four-quarter rate. Within demand, consumption growth is projected to remain well below past average rates. But strong global growth, together with the lower level of sterling, supports net trade and investment. There is particular uncertainty around the near-term outlook given the weakness in activity indicators in Q1 both in the United Kingdom and abroad. The risks around the projection are judged to be balanced, rather than skewed to the upside as in February, reflecting more balanced risks around the global outlook.

As set out in the February Report, the Committee judges that the economy's supply capacity is likely to grow at a relatively modest pace of 1½% over the forecast period. Unemployment is projected to fall a little further (Chart 5.9) and the economy moves into excess demand by early 2020.

Above-target inflation since early 2017 entirely reflects the impact of higher import prices following sterling's depreciation and rises in energy prices. Inflation has fallen back from 3% to 2½% since late 2017. Inflation is projected to fall further over this year, before settling at the 2% target around mid-2020. The contribution from import prices to inflation is lower throughout the projection, fully accounting for the modest downward revision to the inflation projection in the medium term (Table 5.G). As in February, domestic inflationary pressures build to rates consistent with the 2% target over the forecast period. The risks around the inflation projection remain balanced (Chart 5.10).

Charts 5.11 and 5.12 show the MPC's projections under the alternative constant rate assumption and an unchanged stock of purchased assets. That assumption holds Bank Rate at 0.5% throughout the three years of the forecast period, before it rises towards the market path over the subsequent three years. Under that path, GDP growth is stronger and inflation ends the forecast period above the target.

• Notes

  1. Unless otherwise stated, the projections shown in this section are conditioned on: Bank Rate following a path implied by market yields; the stock of purchased gilts remaining at £435 billion and the stock of purchased corporate bonds remaining at £10 billion throughout the forecast period and the Term Funding Scheme (TFS), all three of which are financed by the issuance of central bank reserves; the Recommendations of the Financial Policy Committee and the current regulatory plans of the Prudential Regulation Authority; the Government's tax and spending plans as set out in the Spring Statement 2018; commodity prices following market paths; and the sterling exchange rate remaining broadly flat. For more details see the 'Data from the May 2018 Inflation Report'

  2. Monetary Policy Summary and Minutes - May 2018.

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 2017 Report (Chart A1) 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 Bank Rate, the sterling ERI and US dollar oil prices. As such, when evaluating forecast performance it is important to abstract from the news introduced by those conditioning assumptions.¹ Relative to the February 2017 projections, dollar oil prices are 17% higher than assumed, and the yield curve and sterling ERI are also slightly higher than assumed (Table 1).

The February 2017 Report forecast

In the February 2017 Report, four-quarter GDP growth was projected to slow gradually over 2017 (Panel 1 of Chart A). That reflected slowing consumption growth as households adjusted their spending to lower real income growth, driven largely by the past fall in sterling and the resulting rise in consumer prices. Business investment was expected to be broadly flat as uncertainty around the impact of Brexit continued to weigh on companies' spending. Offsetting that to some degree, the fall in sterling, along with a recovery in global activity growth, was projected to support exports and, in turn, boost the contribution from net trade. Taken together, the composition of demand was expected to rotate away from consumption growth and towards net trade.

CPI inflation was projected to rise above the 2% target, reaching 2.7% at the end of 2017 (Panel 2 of Chart A), almost entirely due to the fall in sterling feeding through to consumer prices. Although past falls in unemployment were expected to feed through to higher wage growth, domestic inflationary pressures were expected to remain relatively subdued in 2017 as some degree of spare capacity in the economy remained. For instance, the unemployment rate was projected to be stable at around 5% (Panel 3 of Chart A), above its equilibrium rate, which had been revised down to 4½% at the time of the February 2017 Report.

GDP growth has slowed broadly as expected in 2017

GDP growth has slowed since 2016 Q4, and was estimated to have been 2.0% in the five quarters to 2018 Q1 once the expected upward revision to the ONS data captured in the backcast is taken into account. That slowing was broadly in line with the February 2017 projection, and within the central bands of the MPC's fan chart (Chart A).

Growth has, however, been stronger than expected immediately following the referendum. In August 2016, the MPC had projected that GDP growth would slow sharply (Table 2 ), based on a range of indicators available at the time. Although growth did slow, it did not do so by as much as projected, in part as uncertainty probably weighed on consumer spending by less than expected. In following quarters, the MPC adjusted its forecasts in response to these developments and at a faster pace than other forecasters on average (Chart B ).² Relative to those more recent projections, the latest outturn for 2017 has been broadly in line. Nevertheless, growth remains weaker than had been projected before the referendum in the May 2016 Report, which was conditioned on remaining in the EU.

Demand has rotated to a greater degree than anticipated

Although demand growth has slowed broadly in line with the February 2017 Report forecast, its composition has rotated to a greater degree than had been anticipated. Net trade — already expected to contribute positively to growth over much of the forecast — boosted GDP growth by more (Table 1) . And business investment growth also picked up by more than expected, although it remained weak relative to past expansions (Section 2). By contrast, consumption growth slowed by more than expected.

A significant driver of the additional rotation in demand growth has been stronger-than-expected global activity. Global growth, weighted by countries' shares in UK exports, has been ¾ percentage point stronger than projected in February 2017, pushing up external demand for UK goods and services (Table 1). That has been reflected in stronger‑than‑expected gross trade flows, particularly exports. Business investment growth is also likely to have been supported by the stronger global environment, in part as a result of more supportive global financial conditions.

Weaker-than-expected household spending growth has largely reflected lower-than-expected real income growth, such that the change in the saving ratio has been broadly as expected (Table 1). That slowing in consumption growth is despite more supportive financial conditions — falls in bank funding spreads and greater competition between banks, for example, led to narrower-than-expected mortgage spreads over 2017 (Section 1), even as reference rates rose ahead of the increase in Bank Rate in November.

Supply growth has been weaker and the degree of spare capacity narrower than expected

While aggregate demand has evolved broadly as expected, potential supply growth is estimated to have slowed by more than expected. That has reflected weaker-than-expected potential productivity, with slower-than-expected growth in output per hour judged to have reflected slower underlying productivity growth.

Partly offsetting that, potential labour supply appears to have been greater than anticipated. As part of its annual assessment of aggregate supply-side conditions, set out in the February 2018 Report, the MPC revised down its estimate of the equilibrium unemployment rate to 4¼% from 4½%. That judgement, to a large degree, reflected downside news in wage growth, which remained subdued (Table 1), alongside a further fall in the unemployment rate (Chart A1).

With potential supply growth weaker than expected but demand growth more in line, slack has been eroded more quickly than expected. As a result, in 2018 Q1 there is judged to have been a little less spare capacity than anticipated at the time of the February 2017 Report, while unemployment was around its equilibrium rate, rather than a little above it.

Higher oil prices have pushed up inflation, but non‑fuel import price growth has been slightly less than expected

CPI inflation was 2.7% in 2018 Q1, in line with expectations at the time of the February 2017 Report, but peaked at a higher rate during 2017 (Chart A1). Much of that upside news can be attributed to higher-than-expected energy prices, reflecting rises in dollar oil prices (Table 1), in part as global demand strengthened.

The main driver of above-target inflation has been the effect of the rise in import prices following the substantial depreciation in sterling over 2016. Import price growth has, however, been somewhat less than anticipated (Table 1).

Domestic cost pressures have been broadly in line with the February 2017 projection. Although wage growth has been weaker than anticipated, that weakness has in part been accounted for by weaker productivity growth. As a result, unit labour cost growth has been closer to expectations than wage growth (Table 1).

Implications for the MPC's projections

Overall, growth and inflation have developed broadly as expected in the February 2017 Report, and the key judgements underpinning those forecasts have been borne out in the main developments in the UK economy over this period (Table 2). GDP growth has slowed and the composition of demand has rotated, albeit to a greater degree than anticipated, largely reflecting stronger global growth. Although slower supply growth has meant a more rapid narrowing in spare capacity, the slightly faster pickup in CPI inflation has largely reflected external factors, particularly a rise in global energy prices.

These developments are reflected in the key judgements underpinning the MPC's May 2018 forecasts (Section 5). Consumption growth is still projected to remain subdued relative to historical norms, with a positive contribution from net trade and a pickup in investment growth offsetting that to a degree. Gross trade flows have been stronger than projected over 2017 and are expected to grow a little faster over coming years than previously assumed. The economy's potential supply capacity — or 'speed limit' — is expected to remain modest relative to historical averages, in part as productivity growth picks up only modestly. Inflation is expected to continue to fall back as the upward pressure from external cost pressures diminishes, although a little more quickly than previously anticipated, reflecting the smaller-than-expected rise in import prices.

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. The 2018 Q1 outturns for GDP growth and CPI inflation were well within the central band of the February 2017 fan charts (Charts A, C and D). 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.

• Notes
  1. For more on the role of conditioning assumptions, see Evaluating forecast performance', Independent Evaluation Office, November 2015.

  2. See box on pages 39–41 of the May 2017 Report.