Prospects for inflation

UK GDP growth has been more volatile than usual over the first half of 2019, largely due to developments relating to Brexit. For example, GDP growth of 0.5% in 2019 Q1 was boosted by companies building up stocks in order to mitigate the effects of a possible disruptive EU exit on 29 March. For the same reason, some firms in the car industry brought forward their usual summer shutdowns to April, and the resulting decline in production weighed on output in Q2. The unwind of the effect from stockbuilding will also have weighed on GDP growth in that quarter. UK GDP is expected to have been flat in Q2.

Abstracting from those temporary factors, the underlying pace of UK GDP growth appears to have slowed since 2018 to below its potential rate. Subdued underlying UK GDP growth reflects weaker global growth as well as the impact of Brexit related uncertainties. Those factors are expected to continue to weigh on growth in the near term, and to a greater extent than was expected at the time of the May Report. Globally, growth has slowed and is expected to remain at below-potential rates over coming quarters, partly reflecting the impact of an intensification of trade tensions. Domestically, firms’ perceived uncertainties related to the Brexit process have become more entrenched. Contacts of the Bank’s Agents report having become more uncertain about the economic outlook than they had been prior to the extension of the EU withdrawal deadline (Box 2). The proportion of respondents to the DMP Survey that expect uncertainty to be resolved in the near term has fallen significantly over the past few months (Section 2). Those uncertainties about the nature of the transition and the UK’s eventual trading relationship with the EU, and therefore the economy’s future path, will weigh on spending.

Underlying UK GDP growth is projected to remain relatively soft over the next few quarters, and is somewhat weaker than in May. As a result, the small margin of excess supply that is judged to have emerged persists over the next year or so. Headline output growth may continue to be volatile around that underlying path while Brexit-related uncertainties remain elevated.

CPI inflation has been close to the MPC’s target throughout 2019 so far and was 2.0% in June. Inflation is expected to fall in the near term, reflecting lower energy prices. Core inflation, which excludes the effects of energy, food, alcohol and tobacco, was 1.8% in June, and is expected to be close to that rate over much of 2019 H2.

As in previous Reports, and consistent with the general approach to condition forecasts on Government policy, the MPC’s projections (summarised in Table 5.A) assume a smooth transition to the average of a range of possible outcomes for the United Kingdom’s eventual trading relationship with the European Union.¹ Consistent with that conditioning assumption, Brexit uncertainties are assumed to wane over the second half of the forecast period. All else equal, this boosts GDP growth and inflation.

The projections are also conditioned on a range of UK asset prices. Over the past few months, monetary conditions have loosened. The market yield curve currently implies that Bank Rate is expected to fall in the near term, and ends the forecast period at 0.6% (Table 5.B), around 40 basis points lower than in the May 2019 Report. The sterling exchange rate is 4% lower than in May. The lower path for market interest rates partly reflects the influence of global factors; interest rate expectations have fallen in the US and euro area as well as the UK (Section 1). UK asset price developments have also been driven by the growing weight that market participants have placed on the possibility of a no-deal Brexit. In contrast to the MPC’s forecast, which assumes a smooth Brexit, asset prices encompass the full range of potential Brexit outcomes, and the rising perceived likelihood of no deal has contributed to the lower market path for interest rates and the depreciation of the exchange rate, as well as weighing on some risky asset prices. Taken together, financial and monetary conditions have become more supportive of GDP growth and CPI inflation.

Under these assumptions, GDP growth is projected to pick up during 2020 and to be robust throughout the rest of the forecast period (Chart 5.1). Global growth picks up gradually, supported by lower interest rates in advanced economies (Key Judgement 1). UK domestic demand growth also rises as the dampening effect from Brexit-related uncertainties dissipates (Key Judgement 2). UK GDP growth is higher than in May in the latter part of the forecast period (Table 5.C), reflecting the boost to demand from looser monetary conditions.

As in previous Reports, potential supply growth is expected to remain subdued relative to pre-crisis rates. Consequently, the pickup in GDP growth to robust rates results in rising excess demand, which reaches 1¾% of potential GDP by the end of the forecast period, materially higher than in May (Key Judgement 3). The unemployment rate is projected to fall to 3.3% (Chart 5.2), well below the MPC’s estimate of its equilibrium rate of 4¼%.

Building excess demand leads to rising domestic inflationary pressures. After falling in the near term, CPI inflation is projected to rise above the MPC’s 2% target (Chart 5.3). At the end of the forecast period, it is 2.4%, notably higher than in the May Report (Chart 5.4).

However, while these projections assume that there is a smooth Brexit, the asset prices on which they are conditioned have been affected by a higher perceived probability of a no-deal Brexit. In the event of a Brexit deal, sterling would be likely to appreciate and market interest rates and UK-focused equity prices to rise. To illustrate the impact of those effects, Box 6 shows stylised sensitivities of the MPC’s projections to changes in asset prices. Illustrations suggest that projections for excess demand and inflation would be lower based on asset price assumptions more consistent with a smooth Brexit.

At its meeting ending on 31 July 2019, 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 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: while global activity has weakened and sentiment has deteriorated, looser financial conditions support the return of world growth to its potential rate in the medium term

Since late 2017, there has been a material and broad-based slowdown in world growth. Four-quarter global GDP growth — based on PPP weights — has slowed from above-potential rates of close to 4% to around 3% at the beginning of 2019. Higher-frequency indicators suggest that global growth is likely to remain subdued in the near term. For example, the JPMorgan global manufacturing export orders PMI has remained at low levels over the past few months (Section 1). In the near term, four-quarter global growth is expected to be somewhat weaker than in May.

The softening in the growth outlook appears in part to have reflected the impact of trade tensions, which have intensified since the May Report. Trade tensions are likely to affect the global economy through both direct and indirect channels. The estimated direct trade effects of the tariffs announced to date are relatively small, lowering PPP-weighted world GDP by around 0.2% by the end of the forecast period. These effects may be magnified by indirect effects of trade policy uncertainty on business confidence, which has deteriorated over the past year or so, particularly in the manufacturing sector. The indirect effects are judged likely to have dampened growth recently and continue to weigh a little on activity over the forecast period.

The slowdown has also reflected the impact of the tightening in financial conditions that occurred during 2018. That tightening was driven in part by the withdrawal of monetary stimulus by the US Federal Reserve, which affected financial conditions in emerging economies too. Growth in China also weakened in response to past domestic policy tightening.

Over 2019 so far, global financial conditions have eased. In particular, forward interest rates have fallen substantially in advanced economies. Easier monetary conditions in the US are expected to continue to contribute to looser financial conditions in emerging markets. Policy measures are also expected to support growth in China. Market participants’ expectations of interest rates in advanced economies appear to have eased partly in response to the slowdown in global activity and subdued inflationary pressures. Inflation has remained weak in the euro area and is also a little below target in the US.

In the central forecast, the easing in global financial conditions supports a gradual pickup in world GDP growth to its potential rate by the end of the forecast period. PPP-weighted global growth is projected to rise from 3% in 2019 to 3¼% in 2020 and 3½% in 2021 (Chart 5.5). Weighted by UK export shares, growth is expected to pick up from 2% in 2019 to 2¼% by 2021 (Table 5.E). Those projections are a little lower than three months ago, partly reflecting a greater drag from trade tensions.

The MPC judges that the risks around those projections are broadly balanced. On the one hand, the indirect effects of uncertainty on confidence might be smaller than judged likely in the central projection. On the other, trade tensions could intensify further.

Lower global growth will weigh on UK exports growth relative to May. In addition, net trade has been weaker than expected over the past, and some of that weakness is judged likely to persist over the forecast period, partially offsetting the boost to net trade from sterling’s recent depreciation. The contribution of net trade to annual GDP growth is expected to be volatile over 2019 and 2020, reflecting the impact of Brexit-related stockbuilding of imported goods in the UK. In 2021, net trade makes a broadly neutral contribution to UK GDP growth (Table 5.E).

Global factors have weighed on market interest rate expectations in the UK, which have also been affected by the perceived increase in the probability of a no-deal Brexit. The lower expected path for interest rates boosts UK domestic demand relative to the May forecast.

Key Judgement 2: on the conditioning assumption that there is a smooth Brexit, UK demand growth recovers after softening in the near term

As expected, recent UK output data have been volatile, in large part owing to Brexit-related effects on businesses. After growing by 0.5% in 2019 Q1, GDP is expected to have been flat in Q2 (Section 2).

Looking through recent volatility, underlying UK GDP growth appears to have softened in the first half of 2019 to below potential rates. Subdued growth partly reflects the impact of weaker global demand (Key Judgement 1), as well as the impact of Brexit uncertainties.

Over the past few months, firms’ reported uncertainties about Brexit — and therefore about the economy’s future path — have picked up. Contacts of the Bank’s Agents report being more uncertain about the economic outlook and the proportion of respondents to the DMP Survey who expect uncertainty to be resolved by the end of 2019 is down from around 40% three months ago to less than 20%. The MPC judges that underlying UK GDP growth is likely to remain subdued over the coming year, with Brexit-related uncertainties weighing on spending to a greater extent than in May.

Elevated Brexit uncertainties have weighed heavily on investment spending. Although business investment is estimated to have grown a little in 2019 Q1, that figure may have been affected by the introduction of a new accounting standard, IFRS 16 (Section 2). More broadly, investment remains low relative to previous expansions and to other countries. Surveys of investment intentions suggest that business spending is likely to remain weak over coming quarters.

Compared with business investment, household consumption growth has remained relatively strong during 2019 H1, underpinned by continued solid growth in real incomes. Consumption growth is projected to be steady in the near term and to remain resilient relative to growth in business investment.

The MPC’s forecast is conditioned on an assumption that there is a smooth Brexit. Consistent with that assumption, Brexit related uncertainties continue to be elevated over the first year of the forecast before subsiding over the second and third years. GDP growth is subdued initially before picking up strongly in the latter part of the forecast period. In particular, as details of the UK’s future trading relationships gradually emerge, business investment recovers (Chart 5.6).

Accommodative monetary conditions also boost domestic demand, supporting business investment and contributing to a recovery in housing investment. Household consumption growth also picks up over the forecast period (Table 5.F), as does real income growth, reflecting further falls in unemployment and relatively strong wage growth (Key Judgement 3).

The easing in monetary conditions means that the MPC’s projection for GDP growth over the latter part of the forecast period is higher than in May. Four-quarter UK demand growth rises to 2.5% in 2022. The risks around the MPC’s forecast, which is conditioned on a smooth Brexit, are judged to be broadly balanced. The outlook for demand will depend significantly on the outcome of the UK’s withdrawal from the EU, and how households, companies and financial markets respond to developments in the Brexit process.

Key Judgement 3: as GDP growth recovers to above the subdued rate of potential supply growth, excess demand and domestic inflationary pressures build

In the run-up to the February Report, the MPC completed its regular assessment of UK supply conditions, and judged that potential supply would continue to grow at a subdued pace, much lower than before the financial crisis. Much of the weakness relative to pre-crisis norms reflects a judgement that potential productivity will grow more slowly. Potential productivity growth is also likely to be affected by the prolonged period of uncertainty and weaker investment associated with the Brexit process.

Over 2019, underlying GDP growth is judged likely to be below its potential rate, such that a small margin of excess supply in the economy emerges. Further out, however, as demand growth picks up to above potential supply growth, excess demand builds. Given the robust pace of GDP growth (Key Judgement 2), excess demand reaches 1¾% of potential GDP by the end of the forecast period. The unemployment rate falls to 3.3%.

As excess demand builds, domestic inflationary pressures rise. The further declines in unemployment put upward pressure on wage growth, which has risen over the past couple of years (Section 3). Growth in unit labour costs has been robust over the recent past, given relatively strong wage growth and weak productivity growth (Section 4). Given the projected rise in wage growth, unit labour costs grow robustly in the latter part of the forecast period even as productivity growth recovers somewhat. In contrast to labour cost growth, some price based measures of domestically generated inflation have remained relatively low by historical standards over the past couple of years. As a result, companies’ margins in the consumer sector may currently be squeezed. Over the forecast period, consumer-facing companies’ margins are assumed to recover and build further as excess demand grows, adding to inflationary pressures.

Domestically generated inflation is projected to exert upward pressure on CPI inflation over the next three years, such that CPI inflation ends the forecast materially above the MPC’s 2% target. In the near term, however, inflation is projected to fall, largely due to lower energy prices, which are expected to decline in 2019 H2. Given the MPC’s conditioning assumptions about the wholesale costs of oil, gas and electricity, energy prices are projected to make a broadly neutral contribution to inflation over the second half of the forecast period (Box 5). That is a little higher than in May, at which point the forecast was conditioned on a downward-sloping oil futures curve, rather than an assumption that oil prices would remain flat. The 4% depreciation of sterling over the past three months also puts some upward pressure on CPI inflation relative to the May Report.

Conditional on market interest rates and other asset prices, as well as a smooth Brexit, CPI inflation is projected to be 2.4% in 2022 Q3 and is still rising at the end of the forecast period (Chart 5.7). The projection is notably higher than in May, largely reflecting the greater degree of excess demand. Relative to the MPC’s central case, the risks to inflation are judged to be broadly balanced.

As with GDP growth, the MPC’s projection for inflation will depend significantly on Brexit developments.

5.2 The projections for demand, unemployment and inflation

Based on the judgements above and conditioned on the market path for Bank Rate, as well as an assumption of a smooth withdrawal from the EU, the MPC projects four quarter GDP growth to be below potential in the near term, before picking up to around 2½%. The pickup in demand growth is mainly driven by business investment growth, as Brexit uncertainties are assumed to subside. The risks around the projection, which is conditioned on a smooth Brexit, are broadly balanced.

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. In the near term, there is a small margin of excess supply, but as growth recovers, excess demand builds and the unemployment rate falls.

CPI inflation is projected to fall temporarily below the MPC’s 2% target in the second half of 2019, largely reflecting a decline in energy prices. CPI inflation is then judged likely to rise above the target supported by domestic inflationary pressures (Table 5.G). The risks around the inflation projection remain balanced.

Charts 5.8, 5.9 and 5.10 show the MPC’s projections under the alternative constant rate assumption. That assumption is that Bank Rate remains at 0.75% throughout the three years of the forecast period, before moving towards the market path over the subsequent three years. Under that path, GDP growth is a little weaker for most of the forecast period and unemployment is a little higher. Inflation is slightly lower, although it still ends the forecast 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 Term Funding Scheme; 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 2019; commodity prices following market paths for two quarters, then held flat; the sterling exchange rate remaining broadly flat; and the prevailing prices of a broad range of other assets. The asset prices that the forecast is conditioned on embody market expectations of the future stocks of purchased gilts and corporate bonds. The main assumptions are set out in the ‘Download the chart slides and data’ link of the August 2019 Inflation Report.

  2. The Minutes are available here.