Prospects for inflation

The MPC noted in the February Report that UK data could be more than usually volatile in the near term, due to shifting expectations about Brexit in financial markets and among businesses and households. Since then, UK activity appears to have been slightly weaker than expected in 2018 Q4, with the latest ONS estimate of quarterly growth at 0.2%. However, GDP growth is expected to have risen to 0.5% in 2019 Q1 — stronger than projected in February — in part reflecting a boost from companies building up stocks ahead of a potential no-deal Brexit. That boost is expected to be temporary, and quarterly GDP growth is expected to slow to 0.2% in 2019 Q2.

Smoothing through those developments, the underlying pace of UK GDP growth appears to have been slightly stronger than was anticipated in February, but nonetheless marginally below potential. That subdued pace reflects the impact of the slowdown in global growth and Brexit uncertainties. UK GDP growth is projected to remain slightly below trend rates in the second half of this year. The uncertainty around the near-term outlook is judged likely to continue to be higher than usual, however. Given the current elevated Brexit uncertainties, some data over the coming quarters could continue to be volatile, and might provide less of a signal about the underlying path of the economy over the medium term.

As in previous Reports, the MPC’s projections — which are summarised in Table 5.A — are conditioned on 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 gradually over the forecast period.

The MPC’s projections are also conditioned on a range of UK asset prices. Over the past few months, expectations of policy rates in the US and euro area have fallen significantly (Section 1). Market expectations for the path of Bank Rate have followed these downwards. That path currently implies that Bank Rate rises to around 1% by the end of the forecast period (Table 5.B), around 15 basis points lower than in the February 2019 Report. Lower expectations for the path of interest rates in a number of countries have supported risky asset prices: global equity prices have risen and global corporate bond spreads have narrowed. Those developments are projected to support world and UK GDP growth. In contrast, the recent slight appreciation of the sterling exchange rate — which has risen by 1½% over the past three months — will dampen UK growth and inflation a little relative to February. Sterling’s appreciation appears to reflect financial market participants reducing the probability they place on a no-deal Brexit.

Under those assumptions, four-quarter UK GDP growth is projected to decline in the near term (Chart 5.1). That slowing partly reflects the continued effect of uncertainties around the eventual nature of the UK’s withdrawal from the EU. Uncertainty has had a particularly pronounced impact on business investment, which fell in every quarter in 2018 and is projected to decline further over coming quarters. The slowdown in world GDP growth over the past year or so has also weighed on UK activity, and net trade is projected to continue to dampen four-quarter UK growth in the near term as a result. In contrast, household spending is expected to continue to support demand growth, sustained by further growth in employment and wages. In 2020, four-quarter GDP growth begins to pick up, and it rises to over 2% by the end of the forecast period. The pickup is driven in part by some recovery in investment growth (Key Judgement 2), and is supported by a projected stabilisation in global growth (Key Judgement 1), as well as continuing increases in household consumption and government spending. Growth on average is a little higher than in the February Report (Table 5.C), partly reflecting the boost to demand from the lower yield curve and higher risky asset prices.

Following its annual reassessment of supply-side conditions in February, the MPC judged that potential supply growth would remain subdued relative to pre-crisis norms over the forecast period. The MPC judges that there is currently a small margin of excess supply. As GDP growth picks up in 2020, it rises above the subdued pace of potential supply growth, such that excess demand begins to build (Key Judgement 3). Excess demand rises to slightly above 1% of potential GDP by the end of the forecast period, notably higher than in February, with the unemployment rate projected to decline to 3½% (Chart 5.2).

CPI inflation was slightly below the MPC’s 2% target in 2019 Q1. It is projected to fall further below the target over the first half of the forecast period, and to a greater extent than was expected in February, largely reflecting lower expected retail energy prices. Further ahead, building excess demand leads to firmer domestic inflationary pressures (Key Judgement 4). CPI inflation picks up to above the target (Chart 5.3), and is still rising at the end of the three-year forecast period. Inflation is a little higher than the February projection at that horizon (Chart 5.4).

At its meeting ending on 1 May 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.

• 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; 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 ‘Chart slides and data’.

  2. The Minutes are available here.

5.1 The MPC’s key judgements and risks

Key Judgement 1: global GDP growth settles at around its potential rate

Four-quarter global GDP growth has slowed since 2017, to below its potential rate. That slowing has been broad-based, with growth declining in advanced and emerging economies (Section 1).

The slowing in global growth partly reflects a drag from financial conditions. Financial conditions tightened over 2018, in part due to the withdrawal of some monetary stimulus by the US Federal Reserve, which led to falls in risky asset prices in many emerging economies. In addition, trade tensions between the US and China have weighed on global growth. Growth in China has also weakened in response to past domestic policy tightening.

Since the end of 2018, global financial conditions have eased as expectations for the paths of monetary policy in a number of major economies have fallen and risky asset prices have risen. In addition, trade tensions between the US and China appear to have lessened somewhat. Those developments should support world growth. Quarterly global GDP growth is projected to be relatively stable at rates close to potential over the forecast period, such that four-quarter growth picks up a little over the near term and settles around potential rates.

Taken together, global growth — based on PPP weights — is projected to slow from 3¾% in 2018 to 3¼% in 2019, before picking up a little to 3½% in 2020 and 2021 (Table 5.E). Weighted by UK export shares, growth is expected to slow from 2½% in 2018 to 2% in 2019, before recovering slightly to 2¼% in both 2020 and 2021 (Chart 5.5). Those projections are a little higher than three months ago, partly reflecting the easing in financial conditions since then. The MPC judges that the risks around the projections remain broadly balanced, partly reflecting two-sided risks from trade tensions.

The slowdown in global growth over the past has weighed on UK GDP growth through trade channels, but that effect is projected to fade as global growth stabilises. Net trade dragged on UK growth over 2018. It is projected to continue to do so in 2019 Q1, partly reflecting the boost to imports from Brexit-related stockbuilding. As that effect fades, and world GDP growth stabilises at around its potential rate, net trade is projected to pick up, although it continues to weigh on four-quarter growth in the near term. Further out, it makes a broadly neutral contribution to UK GDP growth, similar to the February Report.

The global easing in financial conditions has been reflected in UK asset prices. As in other advanced economies, the expected path for policy rates in the UK is lower than in the February Report. UK equity prices are higher than they were three months ago, and corporate bond spreads are narrower. Taken together, those developments boost UK domestic demand relative to the February forecast through their impact on the financial conditions facing companies and households.

Key Judgement 2: UK domestic demand growth is soft in the near term, partly reflecting the impact of elevated Brexit uncertainties, before recovering

While quarterly UK GDP growth is expected to have picked up to 0.5% in 2019 Q1, the MPC judges that underlying momentum is marginally below potential at present. Growth in Q1 appears to have been lifted by erratic monthly movements in output (Section 2) as well as a greater-than-expected contribution from stockbuilding. Companies — particularly manufacturers — appear to have built up their levels of stocks substantially in the first quarter as they implemented contingency plans ahead of a potential no-deal Brexit. Much of this activity will reflect businesses building up stocks of goods sourced from the EU, and so will be reflected in higher imports. However, monthly survey and official data suggest that inventories have been built up to a greater extent than expected, and that some reflects domestic output including for export to companies on the continent (Box 3). The boost to growth will be temporary, however, and is expected to unwind in Q2 as companies stop building up their inventory levels. Consequently, quarterly GDP growth is expected to slow to 0.2% in 2019 Q2. Looking through the volatility in growth, GDP appears to have been slightly stronger than anticipated in February. Nevertheless, underlying growth is expected to have been slightly below potential and it is projected to remain soft in the second half of the year.

The soft recent pace of underlying UK GDP growth reflects the impact of subdued global growth (Key Judgement 1), as well as the impact of Brexit uncertainties, which have weighed on investment spending in particular. Business investment has been unusually weak since the referendum, and that weakness has intensified over the past year. Surveys, including the Bank’s Decision Maker Panel, suggest that the importance of Brexit as a source of uncertainty has remained elevated in recent quarters, while its impact on investment appears to have increased (Section 2). That might be because the value of deferring investment spending rose in the immediate run-up to the expected end-March EU exit date.

The housing market has also softened in recent quarters. Brexit uncertainties may have played some role in that too, though other factors, including policy changes, increased housing supply and affordability constraints have probably also played a part (Box 4). The softer housing market may have dampened GDP growth to a degree. Housing investment growth has weakened in recent quarters, following a number of years of strong growth driven by robust rates of private house building. Nevertheless, household consumption spending and individuals’ confidence about their own personal financial situation appear to have been relatively unaffected.

In the near term, Brexit uncertainties are assumed to remain elevated. They subside gradually over the second half of the forecast period, consistent with the MPC’s conditioning assumption of a smooth transition to the new trading relationship between the UK and EU.

As Brexit uncertainties dissipate, business investment picks up (Chart 5.6). Growth is also buoyed by otherwise supportive conditions, such as the lower cost of finance, which boosts growth by a little more than in February. Housing market activity and price inflation are also expected to pick up, as is housing investment growth.

Consumption growth has been underpinned by real income growth over 2018, given solid employment and wage growth. Consumption growth continues to support GDP growth throughout the forecast, and to a greater extent than in February (Table 5.F). GDP growth is also supported by government spending.

Taken together, the path for UK demand growth is a little stronger than in February. Four-quarter UK GDP growth slows in the near term, before rising to over 2% by the end of the forecast period. The MPC judges that the risks around this projection are balanced. On the upside, the apparent strength of GDP growth in Q1 could reflect a greater degree of underlying momentum, which could persist in the near term. On the downside, Brexit uncertainties could weigh on spending to a greater extent over coming quarters.

In general, the outlook for demand will depend significantly on how households, companies and financial markets respond to developments in the process of the UK’s withdrawal from the EU (see Box 5 in the February 2019 Report). Changes in people’s expectations about Brexit are likely to continue to affect economic data in the coming months given current elevated uncertainties. That means that incoming data might continue to be volatile and provide less of a signal about the underlying path of the economy over the medium term. As a result, the near-term outlook remains more uncertain than usual.

Key Judgement 3: as GDP growth recovers to above the subdued rate of potential supply growth, excess demand builds

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 there is currently a small margin of excess supply.

In the run-up to the February Report, the MPC completed a reassessment of UK supply-side conditions, and judged that potential supply would grow at a similar rate to recent years, which is much lower than pre-crisis rates. Labour supply growth is judged likely to be modest over the forecast period, largely driven by population growth. Productivity growth is projected to pick up a little relative to the very weak rates of the past few years, supported by higher investment over the forecast period. The pickup is gradual, though, with four-quarter potential productivity growth projected to reach around 1% by the end of the forecast period.

In the near term, demand growth is slightly below potential, such that excess supply remains over 2019. Further out, however, demand is projected to grow faster than potential supply. As a result, excess demand emerges and builds to slightly over 1% of potential GDP by the end of the forecast period. The unemployment rate falls further over the second half of the forecast period, and labour market tightness increases.

There are risks in both directions around the projections for labour supply growth and productivity growth and they will remain sensitive to developments in the timing and nature of the UK’s withdrawal from the EU.

Key Judgement 4: CPI inflation dips further below 2% during the first half of the forecast period, largely reflecting lower energy prices, but domestic inflationary pressures push inflation above the target further out

In 2019 Q1, CPI inflation fell to 1.9%, a little above the rate expected in the February Report. Energy price inflation was somewhat higher than expected reflecting higher sterling oil prices, partly offset by slightly lower-than-expected contributions from other CPI components.

During the first half of the forecast period, CPI inflation is expected to fall slightly further below the target and is weaker than was projected in February. That largely reflects expected developments in retail energy prices. Wholesale gas and electricity prices have both fallen over the past three months; that is expected to lead to lower utilities prices from 2019 Q4 (Section 4). In addition, while the sterling oil price has risen since the February Report, the sterling oil futures curve on which the MPC’s forecasts are conditioned now slopes downward. Taken together, retail energy prices contribute substantially less to CPI inflation on average over the forecast period than they have historically.

Import prices also exert some modest downward pressure on CPI inflation throughout the forecast period relative to February, partly reflecting the appreciation of sterling over the past three months. Imported cost pressures remain elevated, however, reflecting the impact of the referendum-related fall in sterling. Those upward pressures wane over time.

Over the forecast period, the rise in CPI inflation to above the target is driven by increasing upward pressure from domestically generated inflation, supported by building excess demand. Four-quarter wage growth picked up during 2018, reflecting the tightness in the labour market, and is expected to have been 3½% in 2019 Q1. Moreover, given the recent weakness in productivity growth, unit labour cost growth has strengthened to rates which are above historical averages. Consumer prices have not increased as rapidly as might have been expected given the pickup in the growth rates of labour and other production costs, which suggests that companies’ margins in the consumer sector may have been squeezed. That might be due to increased competitive pressures. Alternatively, there could be other factors offsetting the increasing pressure on retail prices from labour costs. For example, if higher import prices from sterling’s past depreciation were passed through more quickly than usual into consumer prices, they could now be exerting less upward pressure on inflation.

Conditional on market interest rates, CPI inflation is projected to rise over the second and third years of the forecast period (Table 5.G), ending it above the target. Relative to February, inflation is slightly higher and continues to rise at the end of the forecast period, reflecting the greater degree of excess demand. The risks around this projection are judged to be balanced. If the recent increase in unit labour cost growth begins to feed through into retail prices rapidly, CPI inflation could be higher than projected. CPI inflation could be lower if persistent competitive pressures restrain price increases, however.

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 over 2019, before picking up to above 2%. The pickup in demand growth is mainly driven by business investment growth, as the impact of Brexit uncertainties is assumed to wane. The risks around the projection are balanced, as in February.

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. As growth picks up from 2020, excess demand builds and the unemployment rate begins to fall.

CPI inflation has declined, and is projected to be below the MPC’s 2% target over much of 2019, largely reflecting lower energy prices. CPI inflation is then judged likely to pick up to above the target supported by domestic inflationary pressures, and is still rising at the end of the three-year forecast period (Chart 5.7). 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 rising towards the market path over the subsequent three years. Under that path, GDP growth is slightly stronger. Unemployment falls below 3½%. Inflation ends the forecast period a little further above the target at 2.3%.

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