Prospects for inflation

Section 5 of the Inflation Report - February 2019

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Published on 7 February 2019

UK GDP growth appears to have slowed, and is expected to remain subdued over much of 2019, reflecting both weakening global growth and the intensification of Brexit uncertainties. The impact of those uncertainties is projected to wane gradually, consistent with the MPC’s assumption of a smooth withdrawal of the UK from the EU. Conditioned on paths for interest and exchange rates that are somewhat more stimulative than in November, UK GDP growth begins to pick up later this year and is expected to be a little stronger in the medium term than was projected three months ago. Although it remains modest by historical standards, demand growth exceeds potential supply growth on average over the forecast. As a result, excess demand builds over the second half of the forecast period, raising domestic inflationary pressures. In the near term, inflation is expected to fall to slightly below the MPC’s 2% target, largely reflecting the sharp fall in oil prices which has occurred since November. As that effect unwinds, CPI inflation rises above 2%, and remains a little above the target for the rest of the forecast period.

UK growth appears to have softened in 2018 Q4. Quarterly GDP growth is expected to have slowed to 0.3%, from 0.6% in Q3. That slowing partly reflects the fading impact of temporary factors which boosted growth in Q3. Softer UK GDP growth also appears to reflect the impact of weaker global growth (Key Judgement 1). In addition, Brexit uncertainties have risen over the past three months and may be having a greater impact on the economy than was expected in November.

UK growth is projected to remain subdued in 2019, as those factors continue to dampen activity, with world growth remaining modest and Brexit uncertainties remaining elevated. The near-term outlook is more uncertain than usual at present, though. Shifting expectations about Brexit in financial markets and among businesses and households could lead to greater-than-usual short-term volatility in UK data, which may therefore provide less of a signal about the underlying path of the economy over the medium term.

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. Consistent with that conditioning assumption, the current heightened degree of uncertainty is assumed to subside over the forecast period, boosting growth (Key Judgement 2).

The MPC’s projections are also conditioned on a range of UK asset prices. Over the past few months, market expectations for the path of Bank Rate have fallen. That path currently implies a gradual rise in Bank Rate to around 1.1% by the end of the forecast period, around 25 basis points lower than at the time of the November 2018 Report (Table 5.A).1 At the same time, UK equity prices are a little lower and corporate bond spreads higher. There have been similar developments in financial conditions in other advanced economies, which have occurred alongside the weaker outlook for global growth. The sterling exchange rate has been volatile, largely reflecting Brexit news, but starts the projection a little lower than in November.

The MPC’s projections under those conditioning assumptions are summarised in Table 5.B. Four-quarter UK GDP growth is projected to decline in 2019, before rising to 2% by the end of the forecast period (Chart 5.1). That is lower than in the November Report in the near term, reflecting the impact of heightened uncertainty, weaker global GDP growth and tighter financial and credit conditions. Further out, UK GDP growth picks up as uncertainty wanes and as the stimulus from looser fiscal policy and lower paths for interest and exchange rates more than offsets the impact of lower global activity and tighter financial conditions. In the medium term, growth is higher than in the November Report. Over the forecast as a whole, growth remains modest by historical standards.

Following its regular reassessment of supply-side conditions, the MPC judges that demand and supply were broadly in balance in 2018 Q4. A small margin of spare capacity is projected to emerge during 2019, as demand growth remains weak. Further out, excess demand builds as demand growth recovers and exceeds potential supply growth (Key Judgement 3). Potential supply growth is projected to remain subdued relative to pre-crisis norms, and is a little weaker than forecast in November, due to slightly lower underlying productivity growth.

CPI inflation was close to the MPC’s 2% target at the end of 2018. It is projected to fall a little below the target temporarily over much of 2019, largely reflecting the impact of lower oil prices, then to rise back above 2% as that impact unwinds. Sterling’s past depreciation continues to put some upward pressure on inflation, although that effect wanes over the forecast period. In contrast, rising excess demand leads to a continued firming of domestic inflationary pressures (Key Judgement 4). The balance of these effects means that inflation is projected to remain a little above the target in the second and third years of the forecast period (Chart 5.2).

At its meeting ending on 6 February 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 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.

Table 5.A

Conditioning path for Bank Rate implied by forward market interest ratesa

Table 5.A

  • a The data are 15 working day averages of one‑day forward rates to 30 January 2019 and 24 October 2018 respectively. The curve is based on overnight index swap rates.
    b February figure for 2019 Q1 is an average of realised overnight rates to 30 January 2019, and forward rates thereafter.

Table 5.B

Forecast summaryab

Table 5.B

  • a Modal projections for GDP, CPI inflation, LFS unemployment and excess supply/excess demand. Figures in parentheses show the corresponding projections in the November 2018 Inflation Report. Projections were only available to 2021 Q4 in November.
    b The February projections have been conditioned on the Term Funding Scheme and the prices of a broad range of assets, which embody market expectations of the future stocks of purchased gilts and corporate bonds. See the conditioning assumptions document available from the ‘Download the chart slides and data’ link at www.bankofengland.co.uk/inflation-report/2019/february-2019 for more information about the changes made to the description of the conditioning assumptions since the November 2018 Report.
    c Four-quarter growth in real GDP. The growth rates reported in the table exclude the backcast for GDP. Including the backcast 2019 Q1 growth is 1.6%, 2020 Q1 growth is 1.3%, 2021 Q1 growth is 1.7% and
    2022 Q1 growth is 2.0%. This compares to 1.8% in 2019 Q1, 1.7% in 2020 Q1 and 1.7% in 2021 Q1 in the November 2018 Inflation Report.
    d Four-quarter inflation rate.
    e Per cent of potential GDP. A negative figure implies output is below potential and a positive figure that it is above.
    f Per cent. The path for Bank Rate implied by forward market interest rates. The curves are based on overnight index swap rates.

Chart 5.1

GDP projection based on market interest rate expectations, other policy measures as announced

Chart 5.1

  • The fan chart depicts the probability of various outcomes for GDP growth. It has been conditioned on the assumptions in Table 5.B footnote b. To the left of the vertical dashed line, the distribution reflects uncertainty around revisions to the data over the past. To aid comparability with the official data, it does not include the backcast for expected revisions, which is available from the ‘Download the chart slides and data’ link on the February 2019 Inflation Report page. To the right of the vertical line, the distribution reflects uncertainty over the evolution of GDP growth in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of GDP growth would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter green areas on 30 occasions. In any particular quarter of the forecast period, GDP growth is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth can fall anywhere outside the green area of the fan chart. Over the forecast period, this has been depicted by the light grey background. See the box on page 39 of the November 2007 Inflation Report for a fuller description of the fan chart and what it represents.

Chart 5.2

CPI inflation projection based on market interest rate expectations, other policy measures as announced

Chart 5.2


Chart 5.3

CPI inflation projection in November based on market interest rate expectations, other policy measures as announced

Chart 5.3

  • Charts 5.2 and 5.3 depict the probability of various outcomes for CPI inflation in the future. They have been conditioned on the assumptions in Table 5.B footnote b. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the darkest central band on only 30 of those occasions. The fan charts are constructed so that outturns of inflation are also expected to lie within each pair of the lighter red areas on 30 occasions. In any particular quarter of the forecast period, inflation is therefore expected to lie somewhere within the fans on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions inflation can fall anywhere outside the red area of the fan chart. Over the forecast period, this has been depicted by the light grey background. See the box on pages 48–49 of the May 2002 Inflation Report for a fuller description of the fan chart and what it represents.

5.1 The MPC’s key judgements and risks

Key Judgement 1: global GDP growth weakens further and settles at close to its potential rate

Four-quarter global GDP growth has slowed over the past year, to a greater extent than was expected in the November Report. Growth is expected to dip below trend in coming quarters, before rising to around potential rates.

The slowing in global growth has been associated with weaker world trade growth (Section 1). That has fallen since 2017, in part reflecting weaker demand growth in China, as well as the impact of higher tariffs on trade between the US and China more recently.

Slower global growth also reflects the impact of the past tightening in financial conditions. Global financial conditions tightened through 2018, from highly accommodative levels. That tightening partly reflected the withdrawal of monetary stimulus by the US Federal Reserve over the past few years, which also led to falls in risky asset prices in many emerging economies. In advanced economies, equity prices fell sharply at the end of 2018, and corporate bond spreads widened, before recovering in early 2019.

While those factors weigh on global GDP growth over the forecast, activity is projected to be supported by more accommodative monetary policy than was expected three months ago. Since November, financial market expectations for the future paths of policy rates have adjusted downwards, particularly in the US. Sharp falls in the oil price over the past few months will also boost GDP. As a result, quarterly global GDP growth is expected to pick up over 2019 and settle at similar rates to those projected in November.

In the euro area, quarterly GDP growth averaged 0.2% in 2018 H2, down from an average of 0.4% in 2018 H1 and substantially lower than the average of 0.7% over 2017. Only part of the recent slowdown is judged to reflect the impact of temporary factors, including bottlenecks in car production, and GDP growth is expected to recover somewhat during 2019. But the recovery is slow, and GDP is judged likely to remain lower than had been projected in November throughout the forecast period.

US GDP growth is expected to have slowed to 0.5% in 2018 Q4 from 0.8% in Q3, weaker than had been expected in November. GDP growth is expected to slow further in 2019 Q1, in part reflecting the recent partial federal government shutdown, although that effect is assumed to unwind in Q2. While four-quarter US growth is weaker in the near term than had been projected in November, it is broadly similar further out, as drags from lower equity prices, wider corporate bond spreads and trade tensions are broadly offset by a boost from the lower oil price and the substantial fall in the expected path for policy rates.

GDP growth in China slowed over 2018. Official estimates indicate that four-quarter real GDP growth declined to 6.4% in Q4 from 6.5% in Q3 and 6.8% in Q1. That is likely to reflect in part the impact of past policies to stabilise the financial system which are weighing on credit growth and investment. GDP growth is expected to decline a little further over the forecast period, reflecting the effect of tariffs on trade with the US and reduced business confidence, partially offset by recent stimulus measures taken by the Chinese authorities.

Activity in other emerging economies weakened over much of 2018 as financial conditions tightened. Conditions appear to have stabilised over the past few months, however, and quarterly GDP growth is expected to pick up slightly over the forecast period, broadly as projected at the time of the November Report.

Taking all these factors together, global growth — based on PPP weights — is projected to slow from 3½% in 2018 to 3¼% in 2019 and 2020, before recovering a little to 3½% in 2021 (Table 5.D). Weighted by UK export shares, growth is expected to slow from 2½% in 2018 to 2% a year through the forecast period (Chart 5.4). Those projections are a little lower in the near term than three months ago. The MPC judges that risks are balanced, as some previously identified downside risks have crystallised.

The deterioration in the global outlook will weigh on UK GDP growth through trade channels, as demand for UK exports weakens. Net trade is projected to provide less support to UK growth over the forecast than three months ago. It has been weaker than might have been expected over the past few years given the strength of world growth over much of that period and sterling’s depreciation, and the MPC judges that some weakness is likely to persist. Export growth is also lower reflecting the softer near-term outlook for global activity. Nonetheless, global GDP growth remains somewhat stronger than in the UK and that supports net trade. As a result, net trade makes a broadly neutral contribution to UK GDP growth over the second half of the forecast period.

Global developments will also affect UK activity through their impact on the financial conditions facing households and companies. As in other advanced economies, UK equity prices are slightly lower than they were at the time of the November Report, corporate bond spreads are wider, and bank funding costs are higher. Those developments may partly reflect the impact of changing expectations around the nature of the UK’s withdrawal from the EU, as well as global developments. The expected path for UK policy rates has declined alongside those in the US and euro area, and acts to offset the impact of lower equity prices, higher bond spreads and tighter credit conditions, however.

Key Judgement 2: UK domestic demand growth is soft over much of 2019, due in part to elevated Brexit uncertainties, before picking up

UK GDP growth appears to have slowed in 2018 Q4, and is expected to remain subdued over much of 2019, at lower rates than were projected in November. In part, weaker activity is judged to reflect the impact of softer global demand (Key Judgement 1). It is also likely to reflect the effect of heightened uncertainty around the UK’s withdrawal from the EU, which has intensified since November. Uncertainty appears to have weighed on business investment, which has been low recently compared with past expansions. Contacts of the Bank’s Agents report that uncertainty is the biggest headwind to investment spending. Moreover, recent business investment growth has been lower in the UK than in other advanced economies. Uncertainty may also be dampening housing activity. Having remained resilient for much of 2018, consumer spending may have weakened a little towards the end of the year (Section 2).

The impact of uncertainty about Brexit is assumed to wane gradually over the forecast period. The MPC expects bank funding costs to remain elevated for a period, in part reflecting continuing Brexit uncertainties. That will exert upward pressure on borrowing costs and weigh on spending relative to November. Continued competition between lenders in the mortgage market is, however, expected to dampen this pressure.

Four-quarter UK GDP growth is expected to rise to 2% by the end of the forecast period. That is higher than was projected in the November Report, in part reflecting the impact of fiscal policy. The MPC judges that the loosening of fiscal policy in Budget 2018 — in particular, through higher health spending — boosts activity, and raises GDP over the forecast period by around ⅓%, relative to November. The forecast is also conditioned on a lower expected path for Bank Rate and slightly lower sterling exchange rate, both of which will support GDP growth. Demand growth is also boosted as Brexit uncertainties dissipate, consistent with the MPC’s conditioning assumption of a smooth adjustment to the UK’s new trading relationship with the EU.

The projected pickup in demand is driven by a recovery in business investment. Business investment fell for the third consecutive quarter in 2018 Q3 and is expected to have declined further over the turn of the year. The outlook for business investment over the first half of the forecast has been revised down in response to the intensification of Brexit uncertainties (Chart 5.5). Investment growth recovers further out, buoyed by otherwise supportive conditions, including a relatively high rate of return on capital and the low cost of finance.

Consumption is projected to grow modestly by historical standards over the forecast period. Consumption growth over 2018 appears to have been broadly in line with household real income growth, albeit at below pre-crisis average rates. Consumption growth slows in the near term (Table 5.E), partly reflecting the impact of elevated uncertainty, before increasing gradually over the rest of the forecast period.

The outlook for demand will depend significantly on how households, companies and financial markets respond to developments in Brexit negotiations. In particular, changes in the exchange rate, uncertainty and financial conditions could have a substantial effect on the forecast (Box 5). In the near term, the forecast is more uncertain than usual, as it is likely that the impact of Brexit uncertainties could cause UK economic data to be more volatile than normal. For example, some households and companies may defer spending on major items. Alternatively, some companies have reported building up a higher level of stocks of supplies or finished goods to help minimise the potential effects of any disruption in cross-border supply chains in response to Brexit (see Box 4). That could affect quarterly GDP estimates, but is unlikely to have a persistent impact on the dynamics of the economy.

Key Judgement 3: potential supply continues to grow at subdued rates and excess demand emerges over the forecast

In the run-up to this Report, the MPC completed its regular reassessment of UK supply-side conditions (Section 3).

The MPC judges that demand and supply were broadly in balance in 2018 Q4. Most indicators suggest that the labour market is currently tight and survey measures of capacity utilisation within companies suggest that there is limited scope to increase output with existing resources. The expected slowing in demand means that a small degree of spare capacity is projected to emerge in early 2019. Towards the end of the year, however, demand growth is projected to pick up to exceed potential supply growth and excess demand emerges over the forecast period.

The MPC judges that potential supply growth will remain much lower than its pre-crisis pace at a little below 1½%, on average. On average over the forecast period, potential supply growth is slightly lower than was projected in the November Report, as the MPC judges that some of the factors that have weighed on productivity recently will be more persistent than previously anticipated.

Labour supply growth is likely to be modest over the forecast period, driven by population growth. Population growth is projected to slow from 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.

Potential productivity continues to grow at subdued rates. Four-quarter potential productivity growth is projected to rise gradually towards 1%. The improvement in productivity growth over the forecast largely reflects an assumed increase in the efficiency with which capital and labour are used to produce output — total factor productivity growth — which could be boosted by higher research and development (R&D) expenditure over recent years.

There are risks to the outlook for productivity. On the upside, productivity growth is assumed to remain substantially below pre-crisis average rates. It could pick up closer to historical rates, perhaps as the recent pickup in R&D spending raises productivity by more than expected. On the downside, productivity growth has been lower than expected since the financial crisis and may again fail to pick up. Changes in trading arrangements as a result of Brexit are also likely to affect the outlook for productivity.

Key Judgement 4: CPI inflation is supported by strengthening domestic inflation, although it falls slightly below the target temporarily due to lower energy prices

CPI inflation was 2.3% in 2018 Q4, 0.2 percentage points lower both than in Q3 and the rate expected in the November Report. The lower-than-expected outturn for inflation was partly accounted for by fuel prices, reflecting the substantial fall in oil prices that has occurred over the past few months: the sterling oil price is down by 25% since the November Report. Based on the oil futures curve on which the MPC’s forecast is conditioned (Chart 5.6), petrol prices will continue to exert downward pressure on CPI inflation over the coming year, and CPI inflation is expected to fall slightly below the 2% target over much of 2019.

CPI inflation is projected subsequently to rise above 2% as the impact of lower oil prices dissipates. In part, above-target inflation reflects an elevated, but waning, contribution from import prices. Higher imported costs resulting from the past depreciation of sterling are still being passed through to consumer prices.

While the contribution of import prices wanes, it is offset by domestic inflationary pressures, which have risen over the past few years as slack has been eroded and are expected to strengthen further as excess demand builds. Since the November Report, wage growth has continued to increase, reflecting the tight labour market. In conjunction with weak productivity growth, higher wage growth has pushed up growth in unit labour costs, which has been stronger than was expected in November. Over the forecast period, higher unit labour costs are passed through into CPI inflation. That is projected to be accompanied by some rebuild in companies’ margins, which appear to have been squeezed over the past as production costs have risen by more than consumer prices. There is a risk that any desired rebuild in margins is constrained by competitive pressures.

Conditional on market interest rates, CPI inflation is projected to be slightly above the target in the second and third years of the forecast period (Table 5.F).

  • 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 Autumn Statement 2018; commodity prices following market paths; 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. See the conditioning assumptions document available from the ‘Download the chart slides and data’ link on the February 2019 Inflation Report page for more information about the changes made to the description of the conditioning assumptions since the November 2018 Report.

    2 The Minutes of February MPC meeting.

Table 5.D

MPC key judgementsab

Table 5.D

  • Sources: Bank of England, BDRC Continental SME Finance Monitor, Bloomberg Finance L.P., British Household Panel Survey, Department for Business, Energy and Industrial Strategy, Eurostat, ICE/BoAML Global Research (used with permission), IMF World Economic Outlook (WEO), ONS, US Bureau of Economic Analysis and Bank calculations.

    a The MPC’s projections for GDP growth, CPI inflation and unemployment (as presented in the fan charts) are underpinned by four key judgements. The mapping from the key judgements to individual variables is not precise, but the profiles in the table should be viewed as broadly consistent with the MPC’s key judgements.
    b Figures show annual average growth rates unless otherwise stated. Figures in parentheses show the corresponding projections in the November 2018 Inflation Report. Calculations for back data based on ONS data are shown using ONS series identifiers.
    c Chained-volume measure. Constructed using real GDP growth rates of 180 countries weighted according to their shares in UK exports.
    d Chained-volume measure. Constructed using real GDP growth rates of 181 countries weighted according to their shares in world GDP using the IMF’s purchasing power parity (PPP) weights.
    e Chained-volume measure. Figure for 2018 is the outturn.
    f Chained-volume measure.
    g Chained-volume measure. Exports less imports.
    h Chained-volume measure.
    i Annual average. Chained-volume business investment as a percentage of GDP.
    j Chained-volume measure. Includes non-profit institutions serving households.
    k Level in Q4. Percentage point spread over reference rates. Based on a weighted average of household and corporate loan and deposit spreads over appropriate risk-free rates. Indexed to equal zero in 2007 Q3. Figure for 2018 is the outturn.
    l Based on the weighted average of spreads for households and large companies over 2003 and 2004 relative to the level in 2007 Q3. Data used to construct the SME spread are not available for that period. The period is chosen as broadly representative of one where spreads were neither unusually tight nor unusually loose.
    m Annual average. Percentage of total available household resources.
    n GDP per hour worked.
    o Level in Q4. Percentage of the 16+ population.
    p Level in Q4. Average weekly hours worked, in main job and second job.
    q Four-quarter inflation rate in Q4 excluding fuel and the impact of MTIC fraud.
    r Average level in Q4. Dollars per barrel. Projection based on monthly Brent futures prices. Figure for 2018 is the outturn.
    s Four-quarter growth in unit labour costs in Q4. Whole-economy total labour costs divided by GDP at market prices, based on the mode of the MPC’s GDP backcast. Total labour costs comprise compensation of employees and the labour share multiplied by mixed income.
    t Four-quarter growth in whole-economy unit wage costs in Q4. Whole-economy wage costs divided by GDP at market prices, based on the mode of the MPC’s GDP backcast. Total wage costs are wages and salaries excluding non-wage costs and the labour share multiplied by mixed income.
    u Four-quarter growth in private sector regular pay based unit wage costs in Q4. Private sector wage costs divided by private sector output at market prices, based on the mode of the MPC’s backcast. Private sector wage costs are average weekly earnings (excluding bonuses) multiplied by private sector employment.

Chart 5.4

World GDP (UK‑weighted)a

Chart 5.4

  • Sources: IMF WEO and Bank calculations.

    a Calendar-year growth rates. Chained‐volume measure. Constructed using real GDP growth rates of 180 countries weighted according to their shares in UK exports.

Chart 5.5

Business investmenta

Chart 5.5

  • Sources: ONS and Bank calculations.

    a Calendar-year growth rates. Chained‐volume measure. Business investment data based on GAN8. Investment data take account of the transfer of nuclear reactors from the public corporation sector to central government in 2005 Q2.

Table 5.E

Indicative projections consistent with the MPC’s modal projectionsa

Table 5.E

  • a These projections are produced by Bank staff for the MPC to be consistent with the MPC’s modal projections for GDP growth, CPI inflation and unemployment. Figures in parentheses show the corresponding projections in the November 2018 Inflation Report.
    b Chained-volume measure. Includes non-profit institutions serving households.
    c Chained-volume measure.
    d Chained-volume measure. Whole-economy measure. Includes new dwellings, improvements and spending on services associated with the sale and purchase of property.
    e Chained-volume measure. The historical data exclude the impact of missing trader intra-community (MTIC) fraud.
    f Total available household resources deflated by the consumer expenditure deflator.
    g Whole-economy total pay.

Chart 5.6

Sterling oil pricea

Chart 5.6

  • Sources: Bank of England, Bloomberg Finance L.P., Eikon from Refinitiv and Bank calculations.

    a US dollar Brent forward prices for delivery in 10–25 days’ time converted into sterling.
    b Fifteen working day averages to 24 October 2018 and 30 January 2019 respectively.

Table 5.F

Q4 CPI inflation

Table 5.F

  • The table shows projections for Q4 four‑quarter CPI inflation. The figures in parentheses show the corresponding projections in the November 2018 Inflation Report. The projections have been conditioned on the assumptions in Table 5.B footnote b.

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 fall during 2019, before picking up to close to 2% in 2021 (Table 5.G). Demand growth is weaker than the November forecast in the near term (Chart 5.7), but the projection is somewhat higher further out. Demand and business investment growth are boosted as Brexit uncertainties are assumed to subside. Fiscal policy loosening supports demand relative to the November forecast. Consumption growth is projected to be modest relative to historical rates. The risks around the projection are balanced, as in November.

The economy’s supply capacity is judged likely to grow at a subdued pace — of just under 1½% per year on average — over the forecast period. That is slightly slower than projected in November, and excess demand builds to a somewhat greater extent.

The unemployment rate rises a little in 2019, as demand growth weakens, before falling back as growth recovers (Chart 5.8).

CPI inflation has declined, and is projected to fall below the MPC’s 2% target over much of 2019, partly reflecting a decrease in petrol prices. CPI inflation is then judged likely to rise above the target as domestic inflationary pressures build (Chart 5.9). It is projected to be a little higher than in November over much of the third year of the forecast period, reflecting the greater degree of excess demand. The risks around the inflation projection remain balanced.

Charts 5.10, 5.11 and 5.12 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 rising towards the market path over the subsequent three years. Under that path, GDP growth is slightly stronger. Unemployment falls to 3½%. Inflation ends the forecast period a little further above the target at 2.3%.

Table 5.G

Annual average GDP growth rates of modal, median and mean pathsa

Table 5.G

  • a The table shows the projections for annual average GDP growth rates of modal, median and mean projections for four‑quarter growth of real GDP implied by the fan chart. The figures in parentheses show the corresponding projections in the November 2018 Inflation Report excluding the backcast. The projections have been conditioned on the assumptions in Table 5.B footnote b.

Chart 5.7

Projected probabilities of GDP growth in 2020 Q1 (central 90% of the distribution)a

Chart 5.7

  • a Chart 5.7 represents the cross‑section of the GDP growth fan chart in 2020 Q1 for the market interest rate projection. The grey outline represents the corresponding cross‑section of the November 2018 Inflation Report fan chart for the market interest rate projection. The projections have been conditioned on the assumptions in Table 5.B footnote b. The coloured bands in Chart 5.7 have a similar interpretation to those on the fan charts. Like the fan charts, they portray the central 90% of the probability distribution.
    b Average probability within each band; the figures on the y‑axis indicate the probability of growth being within ±0.05 percentage points of any given growth rate, specified to one decimal place.

Chart 5.8

Unemployment projection based on market interest rate expectations, other policy measures as announced

Chart 5.8

  • The fan chart depicts the probability of various outcomes for LFS unemployment. It has been conditioned on the assumptions in Table 5.B footnote b. The coloured bands have the same interpretation as in Chart 5.1, and portray 90% of the probability distribution. The calibration of this fan chart takes account of the likely path dependency of the economy, where, for example, it is judged that shocks to unemployment in one quarter will continue to have some effect on unemployment in successive quarters. The fan begins in 2018 Q4, a quarter earlier than the fan for CPI inflation. That is because Q4 is a staff projection for the unemployment rate, based in part on data for October and November. The unemployment rate was 4.0% in the three months to November, and is projected to be 4.0% in Q4 as a whole. A significant proportion of this distribution lies below Bank staff’s current estimate of the long-term equilibrium unemployment rate. There is therefore uncertainty about the precise calibration of this fan chart.

Chart 5.9

Inflation probabilities relative to the target

Chart 5.9

  • The February and November swathes in this chart are derived from the same distributions as Charts 5.2 and 5.3 respectively. They indicate the assessed probability of inflation relative to the target in each quarter of the forecast period. The 5 percentage points width of the swathes reflects the fact that there is uncertainty about the precise probability in any given quarter, but they should not be interpreted as confidence intervals.

Chart 5.10

GDP projection based on constant nominal interest rates at 0.75%, other policy measures as announced

Chart 5.10

  • See footnote to Chart 5.1.

Chart 5.11

CPI inflation projection based on constant nominal interest rates at 0.75%, other policy measures as announced

Chart 5.11

  • See footnote to Chart 5.2.

Chart 5.12

Unemployment rate projection based on constant nominal interest rates at 0.75%, other policy measures as announced

Chart 5.12

  • See footnote to Chart 5.8.

Box 5 Some sensitivities of the economy to uncertainties around the nature of the UK’s withdrawal from the EU

As set out in the November 2018 Report, the outlook for growth, employment and inflation depends significantly on the nature of EU withdrawal.1 Changes in expectations about the eventual Brexit outcome, and the uncertainties around those expectations, will affect the economy. This box explores the sensitivity of GDP and inflation to some of those channels.

The outcome of the Brexit negotiations is unknown at present, and that uncertainty is affecting the economic outlook. This effect comes through two main channels. First, changes in people’s expectations about the likelihood of different potential eventual outcomes — both for the form of new trading arrangements and the transition to them — can affect asset prices and the spending decisions of households and companies. Second, changes in the amount of uncertainty itself can affect demand in the economy. When uncertainty is elevated, companies have an incentive to postpone some investment projects until the outlook becomes clearer, for example. Households too might defer some spending, particularly on major purchases. Greater uncertainty also tends to push up risk premia on sterling assets, as investors are likely to require additional compensation to cover the associated greater range of possible outcomes. That weighs on the prices of financial assets such as corporate bonds, equities and bank funding instruments, leading to a tightening in financial conditions.

The MPC’s projections are currently conditioned on the assumption of a smooth adjustment to the average of a range of possible outcomes for the United Kingdom’s eventual trading relationship with the European Union. They are also conditioned on a range of asset prices.

Even under the assumption of a smooth adjustment, the economy can behave very differently depending on what households, firms and financial markets expect about the nature of the eventual trading relationship and the transition to it. When greater clarity emerges about the nature of EU withdrawal, the MPC expects uncertainty to diminish and asset prices — particularly the exchange rate — to adjust. Those developments will affect the MPC’s projections for GDP and inflation. This box sets out the sensitivity of the MPC’s projections to movements in first, the exchange rate and second, measures of uncertainty and financial conditions.

Exchange rate

The sterling exchange rate has depreciated by around 17% since its pre-referendum peak. Over that period, it has been sensitive to news about the UK’s likely future economic trading relationship with the EU.

As explained in Box 4 in the November 2018 Inflation Report, the exchange rate may adjust when greater clarity emerges about the nature of EU withdrawal. If it becomes clear that there will be a smooth transition to a relationship that is judged to have a relatively small long-term economic impact, the exchange rate is likely to appreciate. In contrast, if there is an expectation that the long-term economic impact of the new relationship would be large, sterling could depreciate.

There is considerable uncertainty about the likely magnitude of those changes. To illustrate the sensitivity of the MPC’s projections to changes in the exchange rate, Table 1 shows how the projections for growth and inflation would differ if sterling appreciated or depreciated by 5%, all else equal. These are mechanical projections where the only change to the forecast inputs is the exchange rate path. No allowance is made for movements in other aspects of the forecast that are also likely to be affected by the driver of the exchange rate move. For example, if sterling appreciated in response to a reduced perceived probability of a ‘no deal’ Brexit, other asset prices might be expected to rise and uncertainty to fall.

Uncertainty and financial conditions

A range of evidence suggests that uncertainty has been elevated since the EU referendum, and that it has intensified over the past three months. For example, responses to the Deloitte CFO Survey suggest that the proportion of companies rating the level of financial and economic uncertainty facing their business as high or very high picked up further in 2018 Q4. Results from the Bank’s Decision Maker Panel (DMP) Survey suggest that the proportion of firms for which Brexit was in their top three sources of uncertainty increased further in the three months to January 2019 (Chart A). Consumer confidence about the general economic situation has been subdued since 2016 and households’ expectations about their own financial situation have deteriorated over the past few months (Section 2). Moreover, risk premia on UK financial assets have been elevated since the referendum. For instance, estimates of equity risk premia for UK-focused companies remain materially above their pre-referendum averages.

Heightened uncertainty is projected to wane gradually in the MPC’s central projection. Depending on how Brexit negotiations evolve, however, uncertainty could be higher or lower. Table 2 illustrates how different paths for uncertainty and financial conditions could affect the MPC’s forecasts for GDP growth and CPI inflation. For the purposes of this exercise, a shock has been applied to uncertainty, bank funding spreads, corporate bond spreads and equity prices. Measures of those are each one standard deviation of their historical series higher or lower than in the February central projection over the entire forecast period.2 In the first row of the table, uncertainty is persistently lower and financial conditions are looser, with bank funding spreads lower, corporate bond spreads narrower and equity prices higher. In the final row, uncertainty is persistently higher and financial conditions are tighter. As above, no allowance is made for movements in other aspects of the forecast that might also be affected by the underlying shock.

Table 2 shows that substantial shocks to uncertainty and associated changes in financial conditions can have a significant effect on the MPC’s projections.

Conclusion

As the MPC has communicated, the implications of Brexit developments for the appropriate path of monetary policy will depend on the balance of their effects on demand, supply and the exchange rate. It is likely that the exchange rate, uncertainty and financial conditions will remain particularly sensitive to Brexit developments in the months ahead. For example, if a deal and transition period were to be agreed in the near future, sterling could appreciate, which would exert downward pressure on the MPC’s forecasts for GDP and CPI inflation. It is also likely that uncertainty would wane more quickly, however, which would serve to boost GDP and CPI inflation. If the probability attached to a smooth transition was perceived to have fallen, that could lead to a sterling depreciation as well as a further intensification of uncertainty. The direction of the combined impact of any changes in those variables on the MPC’s projections for output and inflation cannot be determined in advance.

The monetary policy response to changes in the uncertainties around the nature of the UK’s withdrawal from the EU is therefore not automatic and could be in either direction. Under all circumstances, the MPC will respond to any material change in the outlook to bring inflation sustainably back to the 2% target over time while — consistent with its remit — supporting jobs and activity.

  • 1 See Box 4 in the November 2018 Inflation Report.

    2 Based on past data for the principal component of uncertainty indicators shown in the box on pages 14–15 of the May 2016 Inflation Report; bank all-in wholesale funding spreads; sterling investment-grade and sub-investment grade non-financial corporate bond yields; changes in FTSE All-Share equity prices; and the equity risk premium.

Table 1

GDP growth and inflation sensitivities to different exchange rate paths, holding everything else, including monetary policy, constanta

Table 1

  • a Modal projections for annual average GDP growth, excluding the backcast, and four-quarter CPI inflation rate.

Chart A

Brexit uncertainties have risen in recent months
DMP Survey: percentage of firms reporting that Brexit is in their top three sources of uncertaintya

Chart A

  • Sources: DMP Survey and Bank calculations.

    a Question: ‘How much has the result of the EU referendum affected the level of uncertainty affecting your business?’. Results show the percentage of respondents that place the EU referendum in their top three sources during the survey period.

Table 2

GDP growth and inflation sensitivities to different assumptions about uncertainty and financial conditions, holding everything else, including monetary policy, constanta

Table 2

  • a Modal projections for annual average GDP growth, excluding the backcast, and four-quarter CPI inflation rate.

Table 5.C Monitoring risks to the Committee’s key judgements

The Committee’s projections are underpinned by four key judgements. Risks surround all of these, and the MPC will monitor a broad range of variables to assess the degree to which the risks are crystallising. The table below shows Bank staff’s indicative near-term projections that are consistent with the judgements in the MPC’s central view evolving as expected.

Key judgement

Likely developments in 2019 Q1 to 2019 Q3 if judgements evolve as expected
1: global GDP growth weakens further and settles at close to its potential rate
  • Quarterly euro-area GDP growth to average ¼%.
  • Quarterly US GDP growth to average ½%.
  • Indicators of activity consistent with four-quarter PPP-weighted emerging market economy growth of around 4¼%; within that, GDP growth in China to average around 6%.
  • The contribution of net trade to quarterly UK GDP growth to be close to zero, on average.
2: UK domestic demand growth is soft over much of 2019, due in part to elevated Brexit uncertainties, before picking up
  • Business investment to fall by ½% per quarter, on average.
  • Quarterly real post-tax household income growth to average ¼%.
  • Quarterly consumption growth to average ¼%.
  • Mortgage spreads to widen a little.
  • Mortgage approvals for house purchase to average around 65,000 per month.
  • The UK house price index to increase by around ¼% per quarter, on average.
  • Housing investment to fall by ½% per quarter, on average.
3: potential supply continues to grow at subdued rates and excess demand emerges over the forecast
  • Unemployment rate to average around 4%.
  • Participation rate to average around 63¾%.
  • Average weekly hours worked to remain around 32.
  • Cumulative growth in hourly labour productivity to be ¼% to ½%.
4: CPI inflation is supported by strengthening domestic inflation, although it falls slightly below the target temporarily due to lower energy prices
  • Non-fuel import prices to rise by just over ¾% in the year to 2019 Q3.
  • Electricity and gas prices to contribute around ¼ percentage point to CPI inflation in 2019 Q2, as Ofgem’s energy price cap is raised.
  • Commodity prices and sterling ERI to evolve in line with the conditioning assumptions set out in this Report.
  • Four-quarter growth in whole-economy AWE regular pay to average around 3¼%.
  • Four-quarter growth in whole-economy unit labour costs to average around 3¼%.
  • Four-quarter growth in whole-economy unit wage costs to average just over 3%; growth in private sector regular pay based unit wage costs to average around 3¼%.
  • Indicators of medium-term inflation expectations to continue to be broadly consistent with the 2% target.

Box 6 Other forecasters’ expectations

This box reports the results of the Bank’s most recent survey of external forecasters, carried out in January.1 On average, respondents expected four-quarter GDP growth to remain broadly stable over the next three years (Table 1). In 2022 Q1, that is somewhat lower than the February Inflation Report forecast. On average, external forecasters expected the unemployment rate to pick up over the next three years.

A higher expected path for Bank Rate could explain some of the weakness in external forecasters’ projections relative to the February Report forecast. External forecasters’ central expectations for Bank Rate were, on average, little changed compared with three months ago (Chart A). But the fall in the market-implied path for Bank Rate since the November Report (Section 1) has meant that forecasters’ expectations are now further above the market-implied path for Bank Rate upon which the February Report forecast is conditioned. As in recent surveys, almost all forecasters expected the current stock of gilt and corporate bond purchases to remain broadly stable over the next three years.

External forecasters’ expectations for inflation have ticked up slightly since November, on average, and inflation is now expected to be at the target across all three years of the forecast. In addition to their central case, forecasters also report the distribution of probabilities that they place upon different inflation outcomes. Relative to November, forecasters placed a greater probability on inflation being at or above the target in three years’ time (Chart B).

Table 1

Averages of other forecasters’ central projectionsa

Table 1

  • Source: Projections of outside forecasters as of 25 January 2019.

    a For 2020 Q1, there were 20 forecasts for CPI inflation, 19 for GDP growth and for Bank Rate, 16 for the unemployment rate, 12 for the stock of gilt purchases, 10 for the stock of corporate bond purchases and 11 for sterling ERI. For 2021 Q1, there were 16 forecasts for CPI inflation, 14 for GDP growth, 13 for the unemployment rate, 15 for Bank Rate, 9 for the stock of gilt purchases, 7 for the stock of corporate bond purchases and 10 for sterling ERI. For 2022 Q1, there were 15 forecasts for CPI inflation, 14 for GDP growth, 13 for the unemployment rate, 15 for Bank Rate, 9 for the stock of gilt purchases, 7 for the stock of corporate bond purchases and 10 for sterling ERI.
    b Twelve-month rate.
    c Four-quarter percentage change.
    d Original purchase value. Purchased via the creation of central bank reserves.

Chart A

Expectations of Bank Rate are little changed, unlike market interest rates which have fallen
Market interest rates and averages of forecasters’ central projections of Bank Rate

Chart A

  • Sources: Bloomberg Finance L.P., projections of outside forecasters provided for Inflation Reports in November 2018 and February 2019 and Bank calculations.

    a Estimated using instantaneous forward overnight index swap rates in the 15 working days to 24 October 2018 and 30 January 2019 respectively.

Chart B

Forecasters are placing a greater probability on inflation being at or above the target in three years’ time
Average of forecasters’ probability distributions for CPI inflation in three years’ timea

Chart B

  • Sources: Projections of outside forecasters provided for Inflation Reports in November 2018 and February 2019.

    a Projections on the boundary of these ranges are included in the upper range, for example a projection of inflation being 2.0% is in the 2.0% to 2.5% range.

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This page was last updated 31 January 2023