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Inflation Reports – The Bank of England May 2017

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The Inflation Report is a quarterly report issued by the Bank of England, which analyses many variables such as internal consumption, the growth of countries that are important in the international sphere, projections, among others. With the inflation report, first we have a panorama for the agents in the economy about the current situation of the economy and second, we can have some clues about the decision of monetary policy that the bank could take, since the priority by mandate of the Bank is inflation, although it also tries to influence the growth and the labour market.

In the May report, the bank had prospects that economic growth and inflation would continue to be influenced for the rest of the year by the response of households, businesses and financial markets to the expectations each had about the United Kingdom leaving the European Union. The behaviour of agents in the economy has been very volatile due to the behaviour of Brexit expectations, since at the beginning of 2017 consumers were pessimistic about the negotiations for an organised exit. But according to the Monetary Policy Committee (MPC) that pessimism was reduced throughout the year to May.

According to the committee, the expectations of the agents improved due to a moderate growth of the economy and a rebound in inflation. Sterling began to appreciate in the middle of 2017, possibly reflecting expectations of a more orderly Brexit process. The pound sterling appreciated 2.5% between February and May, but still below 16% of the highest level seen in November 2015. Due to the rise in inflation, real incomes of people fell so that the growth of consumption was reduced more than the bank predicted, but it was expected that in the last months of the year this variable would recover.

In the February projections of the MPC, it was expected that economic growth in the second quarter would stabilise in rates observed in previous periods and that at the end of 2017, the growth would be 1.9%, and in the following years would be close to 1.75%.

But at the meeting in May, we observed better global economic growth and better conditions in the financial markets, which led to better rates in the exchange between countries and orders of capital goods. There was also evidence of improvements in global demand which generated a rise in the prices of global assets, especially stocks.

The combination of stronger projections worldwide and the depreciation of the pound sterling led the MPC to improve its expectations on the net trade of the United Kingdom. This scenario, coupled with less uncertainty and better global growth rates, led the committee to expect better rates of capital investment so that exports would be able to respond to a more robust demand.

Regarding inflation, the Consumer Price Index (CPI) was above the Bank’s target of 2% due to the strong depreciation of the pound sterling, which was transferred to the basic goods consumed by households, in addition to a moderate increase in local goods. The negative aspect for people was a lower than expected increase in salaries which ended up affecting the real income of households.

The MPC expected inflation to continue to rise above the target in 2017, even reaching levels above 3% in the fourth quarter. As already mentioned, the expectations of a high inflation were great because since 2015, the pound sterling had depreciated sharply due to the negotiations for the UK exit from the European Union and the due restructuring of the economy after this happens.

The trend of wage growth softened in recent years despite high growth rates in job creation. Some factors that could generate this weak growth of wages were:

  • Weakness in worker productivity growth.
  • The uncertainty of the negotiations of the exit of the European Union by companies, for which they were not willing to increase salaries until they knew what the result of the negotiations would be, because this directly influences their cost function.

But the MPC expected these factors to dissipate over time, which would lead to better rates of wage growth over time since the unemployment rate was falling to rates close to those considered to be an equilibrium.

The committee was aware that monetary policy was not enough to influence the real adjustment of the British economy, as it was a necessary and inevitable adjustment that the economy had to go through. In addition, there was no certainty of what the conditions of trade were going to be after the negotiations were concluded so that low growth combined with high inflation rates was normal.

If the bank will try to fully compensate the effect of the depreciation of the pound sterling on inflation, higher unemployment rates and even very weak growth would be generated. That is why, despite the fact that the mandate of the bank is to have inflation close to its 2% objective, it is considered that in exceptional circumstances the committee must analyse and balance the macroeconomic variables so that imbalances are not generated in the economy.

That is why in the May meeting they decided to leave monetary policy unchanged to respond to the situation in which the British economy was. In a vote of 7 votes in favour and 1 against, it was decided to keep the rates at 0.25%. In addition, the committee voted unanimously to maintain the sterling stock of investment grade non-financial grade bonds, financed by the issuance of central bank reserves at £10 billion. The vote was also unanimous to maintain the stock of purchases of government bonds of the United Kingdom.

The committee made it clear that the monetary policy would respond in any direction depending on the economic perspectives so that in the long term it would be possible to locate inflation at acceptable rates. In general, the committee considered that, if the economy followed the estimated projections, the monetary policy could be hardened in the future. The bank’s projections depended mainly on three aspects:

  • That the low level of the pound sterling will continue to stimulate the price of consumers beyond the projected period.
  • That the wage increases that remained modest will accelerate in the projected period.
  • That the more moderate growth in household spending will be balanced by a rise in other components of demand.

In terms of the global panorama, as already mentioned, there was a better situation in several countries such as the United States, where, like the United Kingdom, unemployment rates were at levels similar to those observed before the 2008 crisis, but not in the Euro Area.

On the other hand, the committee expected global inflation to rebound especially due to the rise in fuel prices thanks to the OPEC agreement and a stronger demand for raw materials, but still there were special cases such as the United States where the behaviour of inflation was weak.

In conclusion, for the bank’s inflation expectations, it was presumed that for the rest of 2017, inflation would continue to rise due to the increase in food and energy costs, down to the fact that they are one of the most sensitive components of the CPI. In addition, the fact that the price of fuels has increased worldwide, the depreciation of the pound has meant that inflation also rises for this reason as it is more expensive for the British people, due to their reduction in purchasing power. The path of inflation in the following quarters of 2017 depended on how fast companies could pass the increase in external costs to the consumers.

Another problem that has generated high inflation is a slowdown in the economy because it has affected the purchasing power of households so that their consumption has been reduced and the devaluation was expected to cause inflation to be above that of the bank’s target range in the next three years.

Also, within the projections of the committee, a good dynamic of exports was expected for a better global demand for goods and services, and a devaluation already exposed that would serve as a boost to make their products more competitive. The following chart shows the main projections that the committee had at the May meeting.

 

Graph 53. Forecast summary. Retrieved on the 3rd of February 2018, From https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/may-2017.pdf?la=en&hash=92BA13788FBF71CBC9D800DDCD0EA3D217008867

Analysing what was stated in the inflation report by the Bank of England, it can be seen that the bank raised its rates in the meeting of November 2017. This was in line with what was stated in the report because it was not ruled out, tightening the monetary policy if the macroeconomic variables allowed it.

Throughout the year, the bank faced a trade-off between its main objective inflation and other important variables such as employment and economic growth. Inflation was above the target level of 2% imposed by the government due to the weakness of the pound sterling, which was a reflection of the uncertainty that the market had against the United Kingdom since 2015 when it was decided that it was going to start negotiating the exit from the European Union.

The uncertainty was generated due to the possible paths that the negotiations could take from stable commercial relations, without major sanctions such as tariffs on British exports or restrictions on capital flows, until the slow and clumsy negotiations that would generate an unwanted scenario on the part of the UK, and of the countries belonging to the economic union.

Since the fall of the pound sterling at the end of 2015, levels have not been achieved in its index with respect to other currencies seen before the Brexit results, which led to an increase in the cost of goods and services, which translated into a high inflation and a reduction in the consumption of the inhabitants of the UK.

During 2017, moderate economic growth was observed with low unemployment rates, but without a rise in wages. The following graph shows the behaviour of the unemployment rate during 2017. Based on the inflation report, it can be seen that the bank was correct in projecting lower unemployment rates at the end of the year.

 

Graph 54. UK Unemployment Rate. Retrieved on the 3rd of February 2018, From. https://tradingeconomics.com/united-kingdom/unemployment-rate

The following chart also shows how inflation continued to rise until the end of 2017, reaching levels close to 3%, which made it logical for the bank to raise interest rates due to the behaviour of inflation

 

Graph 55. CPI ANNUAL RATE. Retrieved on the 3rd of February 2018, From https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/l55o/mm23

The aspect that was not so positive was the economic growth due to the fact that it continued presenting moderate rates of growth.

 

Graph 56. Gross domestic product. Retrieved on the 3rd of February 2018, From https://www.ons.gov.uk/economy/grossdomesticproductgdp/timeseries/ihyq/pgdp

A few months after the May meeting, it was observed that the content of the inflation report was right for the British economy, and they decided to raise interest rates due to inflation that was increasingly growing and far from its objective. The behaviour of the market after the inflation report and meeting of the MPC in May can be seen in the following graph.

 

Graph 57 GPB:CUR. Retrieved on the 3rd of February 2018, From https://www.bloomberg.com/quote/GBP:CUR

You can see that sterling continued to appreciate since the May meeting so it is clear that investors have relaxed a bit more and are no longer so pessimistic about the UK situation. This appreciation has also helped households to recover a bit of the purchasing power lost since the Brexit elections, where a sharp drop in the pound sterling began and even after several years failed to reach levels seen before the crisis.

Following the foregoing in the inflation report, it can be concluded that the sterling trend continued since the beginning of the year and, as the committee mentioned, this is evidence of the change in expectations of the investors who expected smooth negotiations between the United Kingdom and the European Union, which would allow trade and capital regulations not to undergo drastic changes and the economy could grow at rates seen before the elections. In addition to the change in expectations, the November rate hike was also important because this shows signs that the committee sees a stronger economy.

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