Prospects for inflation

The MPC voted in August to raise Bank Rate to 0.75%. The MPC’s projections are conditioned on a market-implied path for Bank Rate that implies a gradual further rise to around 1.4% at the end of 2021 (Table 5.A).¹ In the run-up to this Report, the sterling ERI was around 1% higher than it was in the August Report, though 16% below its pre-referendum peak. As the Autumn Budget was announced following the finalisation of the projections, they are conditioned on the plans detailed in the March Spring Statement. As in previous Reports, the MPC’s projections are conditioned on a smooth adjustment to the average of a range of possible outcomes for the United Kingdom’s eventual trading relationship with the European Union.

The MPC’s projections under those assumptions are summarised in Table 5.B. Four-quarter GDP growth is projected to average around 1¾% over the forecast period (Chart 5.1), similar to the August Report (Chart 5.2). Boosted by temporary factors, quarterly growth in Q3 appears to have been a little stronger than had been expected in August, at 0.6%. Growth is projected to fall back to 0.3% in Q4, before settling at 0.4% in subsequent quarters, similar to the August forecast.

Over the recent past, consumption growth has been a little stronger than expected, while business investment has been weaker than expected. Over the forecast period, consumption is projected to grow modestly relative to historical rates, broadly in line with real incomes. Growth in business investment is expected to be subdued in the near term and then to pick up as Brexit-related uncertainty — which is dampening investment growth — wanes (Key Judgement 2). Net trade is also expected to contribute positively to growth, supported by relatively robust global demand and weaker sterling. Global GDP growth has slowed slightly and is likely to decline somewhat further. In particular, activity in emerging economies is projected to be weaker than in August, driven by tighter financial conditions. Nevertheless, global growth is likely to be above potential on average over the forecast period (Key Judgement 1).

In the UK, potential supply growth is projected to remain subdued relative to pre-crisis norms, reflecting lower productivity growth and slower population growth. So while the pace of UK demand growth is modest, it still exceeds potential supply growth. The MPC judges that demand and supply are currently broadly in balance, and that excess demand will build over the forecast period (Key Judgement 3). That leads to a continuing firming of wage growth and domestic inflationary pressures.

CPI inflation was 2.4% in September 2018, and 2.5% in 2018 Q3, in line with the MPC’s August forecast. Above-target inflation has been due to higher energy prices and the rise in import prices associated with sterling’s past depreciation. While domestic inflationary pressures build over the forecast period, the impact of energy and import prices is projected to fade (Key Judgement 4). The balance of these effects means that inflation is projected to be above the target for most of the forecast period, reaching 2% by the end (Chart 5.3), a broadly similar profile to August (Chart 5.4).

At its meeting ending on 31 October 2018, 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 page i 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 GDP growth slows to around its potential rate, as financial conditions tighten

In aggregate, global demand has continued to grow at above-potential rates. World GDP growth has slowed slightly, however, and is expected to slow somewhat further over the forecast period, consistent with weakening indicators of global activity and trade. That moderation in growth partly reflects tightening financial conditions, particularly in some emerging economies. The continued rise in tariffs on trade between the US and China is also likely to weigh on activity. Nonetheless, global growth is projected to remain above potential on average over the forecast period.

In the US, activity has remained strong during 2018. Quarterly growth was 0.9% in Q3, higher than expected at the time of the August Report. GDP growth is expected to continue to be relatively robust in coming quarters, supported in part by a substantial fiscal easing (Section 1). As the boost from fiscal policy wanes in 2019, growth is expected to ease. The tariffs on trade that have been implemented and proposed between the US and some of its trading partners are also likely to weigh on growth (Box 1). The strengthening in the US dollar — reflecting strong growth in domestic demand and a related tightening in monetary policy — could also dampen activity. The recent strength of activity has resulted in excess demand in the US. That is judged likely to persist throughout the forecast period, with inflation projected to be above 2%.

Growth in China and other emerging economies is expected to have slowed somewhat in Q3, and some forward-looking indicators of activity have softened over 2018. Higher interest rates in the US, and a stronger dollar, have led to tighter financial conditions in many emerging economies as US dollar-denominated debts become costlier to service and the relative return on EME assets falls (Section 1). Those tighter financial conditions are weighing on growth relative to the recent past, as are trade tensions, and both factors are expected to do so to a greater extent than was expected at the time of the August Report. As a result, four-quarter emerging economy GDP growth is expected to weaken in the near term, and to be lower than expected in August throughout the forecast period. Growth prospects have deteriorated particularly markedly in Turkey and Argentina, where the tightening in external financing conditions has been significantly amplified by domestic factors.

Euro-area growth has also slowed in 2018. Q3 quarterly GDP growth, at 0.2%, was weaker than expected in August. Growth is expected to pick up somewhat in coming quarters (Table 5.C). But the projected path for activity is a little lower than previously expected on average over the forecast period (Table 5.D), in part reflecting the impact of lower demand from emerging economies.

Overall, global growth — based on PPP weights — is projected to be 3¾% in 2018, before slowing to 3½% in 2021 (Table 5.D). Weighted by UK export shares, growth is expected to slow from 2¾% to 2% over the same period (Chart 5.5). Those projections are a little lower than three months ago, and the risks are now judged to be tilted to the downside. Risks to emerging economies are judged to lie to the downside, reflecting the potential for a further tightening in financial conditions as US monetary policy continues to normalise. In addition, there is a risk that trade tensions intensify further.

Key Judgement 2: net trade and a rebound in business investment support UK activity, while consumption growth is modest

The outlook for UK demand is similar to that in the August Report, with four-quarter GDP growth expected to average around 1¾%. As in August, growth is supported by net trade, partly reflecting above-trend global GDP growth. Business investment has fallen recently and growth is expected to remain sluggish in the near term (Table 5.C). In line with the conditioning assumption of a smooth Brexit, it then picks up materially as the drag from uncertainty fades, although the level of investment is lower than expected in August throughout the forecast. Over the same period, consumption growth remains relatively subdued, in line with growth in real incomes.

Net trade has contributed to growth over the past two years to a greater extent than it has historically. It has been supported by lower sterling, and export demand has benefited from robust growth in the global economy. Net trade is projected to make a positive contribution to GDP growth over much of the forecast period. The outlook will depend in part on how supply chains, both here and abroad, evolve in response to Brexit and any associated movements in sterling.

Business investment has been weak over the recent past, and is expected to have fallen by 0.5% in the year to 2018 Q3. That is materially weaker than had been expected in the August Report, largely reflecting increased uncertainty around Brexit, as indicated by companies’ responses to the Bank’s Decision Maker Panel Survey, and Agents’ reports. In the MPC’s central projection, which is conditioned on the expectation of a smooth adjustment to the UK’s eventual trading relationship with the EU, greater clarity emerges, boosting investment. Investment growth over the forecast is also supported by above-trend external demand growth, the low cost of finance and the relatively high rate of return on capital. In the latest projection, the level of investment is below that from August throughout the forecast period, with greater near-term weakness in growth and a somewhat faster rebound further ahead (Table 5.E).

Over the past couple of years, consumption has grown at rates below its pre-crisis average, largely reflecting weak growth in households’ real incomes. Consumption growth has been stronger than real income growth, however, and the household saving rate has declined (Section 2). Over the forecast period, the saving ratio is projected to remain broadly unchanged, as consumption grows in line with real incomes. Real income growth is expected to pick up, as nominal wage growth rises and the drag from energy and import price inflation fades (Key Judgement 4).

There is uncertainty about the extent to which households will adjust their spending and saving over the forecast period. According to current estimates, the saving rate has fallen to a historically low level over the past couple of years, and households might choose to build savings at a somewhat faster rate as real income growth rises, depressing spending. Households could, however, choose to lower their saving rate further, boosting consumption growth, particularly if Brexit uncertainty falls. Unemployment remains low and households’ expectations of their personal financial situations appear to have improved since 2017.

Key Judgement 3: a margin of excess demand builds as demand growth exceeds subdued potential supply growth

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 demand and supply are currently broadly in balance. Most indicators suggest that the labour market is currently tight and survey measures of capacity utilisation within companies suggest little scope to increase output with existing resources (Section 3). It is therefore likely that demand can only grow sustainably at rates in line with the expansion of potential supply.

Potential supply growth has been relatively low since the crisis. Over the forecast period, the MPC judges that growth in potential supply will remain subdued by historical standards at around 1½% per year on average, as set out in its assessment of supply-side conditions in February.

Labour supply growth is likely to be modest over the forecast period, with all of the increase expected to come from population growth. The population is projected to grow a little more slowly than recent rates, partly reflecting an expected decline in net inward migration in line with the ONS projections on which the MPC’s forecasts are conditioned (Section 3).

Offsetting that, productivity growth is projected to improve a little — picking up to about 1% — although remaining around 1 percentage point lower than pre-crisis norms. The improvement in productivity growth over the forecast partly reflects a gentle rise in the stock of capital, resulting from higher investment.

There are significant risks to the outlook for productivity. On the downside, productivity growth has been lower than expected since the financial crisis, and it could fail to pick up again. It might continue to be restrained by the factors dampening growth since the crisis (Section 3). On the upside, productivity growth could increase to closer to historical rates if UK companies invest more in ideas and processes that move them closer to how the most efficient businesses both domestically and internationally operate.

Conditional on market interest rate expectations of a gradual rise in Bank Rate over the forecast period, and on a smooth adjustment to new trading arrangements with the EU, demand is projected to grow a little faster than potential supply, such that a margin of excess demand builds over the forecast period.

Key Judgement 4: domestic inflationary pressures continue to build, while the contributions from energy and import prices dissipate

In 2018 Q3, CPI inflation was 2.5%, in line with the MPC’s expectation at the time of the August Report. Within that, the contribution from fuel prices was higher than expected, offset by lower-than-expected clothing and footwear prices. Rising fuel prices reflect increases in the sterling price of oil, which is around 10% higher than in the run-up to the August Report. Higher fuel prices will continue to boost inflation in the near term. Further ahead, however, the contribution from fuel prices to inflation turns negative, as the oil futures curve on which the MPC’s forecast is conditioned is downward sloping.

Retail gas and electricity prices are also currently contributing positively to CPI inflation. They are likely to have risen further in October as some utility companies increased their prices (Section 4). Thereafter, utility prices will be affected by the Government’s proposed price cap on retail energy tariffs. That is expected to reduce their contribution to CPI inflation by around 0.2 percentage points in January. Under current plans, the cap will then be updated twice a year, in April and October. The MPC’s forecast reflects an assumption that the level of the cap will vary with underlying costs, including wholesale energy prices. While the wholesale gas futures curve has risen by around 15% since the August Report, it is downward sloping. Taken together with the projected fall in fuel price inflation, energy price inflation is expected to decline over the forecast period, although it is somewhat volatile (Chart 5.6).

In addition, the estimated contribution from import prices to CPI inflation remains elevated, reflecting the impact of sterling’s depreciation around the time of the EU referendum. That contribution has declined over 2018, however, and is expected to fade further over the forecast period.

The waning influence of these external factors on CPI inflation is projected to be partially offset by firming domestic inflationary pressures. Domestic cost pressures have been subdued over the past few years, but have risen as slack has been eroded, and are expected to strengthen further as excess demand builds. Since the August Report, underlying wage growth has risen as the labour market has remained tight and unemployment has fallen further. Survey indicators of companies’ hiring difficulties and pay are consistent with wage growth increasing further, which pushes up growth in unit labour costs. Over the forecast period, private sector and whole-economy unit labour cost growth are projected to rise (Table 5.D), leading to a gradual building in domestic inflationary pressures. 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, CPI inflation is projected to decline towards the target. In the central projection, inflation is judged likely to be above 2% over much of the forecast period, before returning to the target towards the end of the third year. The MPC’s forecast for CPI inflation is broadly similar to that in August (Table 5.F).

5.2 The projections for demand, unemployment and inflation

Based on the judgements above and the risks around them, 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 remain around 1¾%. That projection is similar to the August forecast (Table 5.G). Within demand, consumption growth is projected to be modest relative to historical rates, but net trade and business investment support growth, conditioned on the assumption of a smooth withdrawal from the EU and an accompanying decline in uncertainty. The risks around the projection are balanced, as in August.

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, so excess demand builds. The unemployment rate is broadly stable (Chart 5.7).

CPI inflation has fallen back since the beginning of 2018, but remains above the MPC’s 2% target. The inflation overshoot reflects the impact of cost pressures from energy and import prices. Inflation is projected to fall further towards the target as those effects continue to wane, more than offsetting building domestic inflationary pressures. Under the market path for Bank Rate, inflation is judged likely to be above the target for most of the forecast period before reaching 2% by the end (Chart 5.8). The inflation projection is broadly similar to August, and the risks remain balanced (Chart 5.9).

Charts 5.10, 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 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 stronger, and a greater degree of excess demand emerges. Unemployment falls below 3½%. Inflation ends the forecast period above the target at 2.3%.

• 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. The main assumptions are set out in a table at www.bankofengland.co.uk/inflation-report/2018/november-2018.

  ² The Minutes are available at www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2018/november-2018.