The projections in the Bank of England’s November Inflation report showing inflation dropping to just 1% are fuelling speculation that either, or both, of the Monetary Policy Committee members who have been supporting a rate hike will back down. However, the arguments they have made in favour of tightening are not based on transitory price movements.
When the minutes of the November 5 and 6 MPC meeting are published Wednesday, the spotlight will be on whether Ian McCafferty and Martin Weale, who both voted for a 25 basis point from August through October, held that line.
While the latest Inflation Report central projection did show inflation holding well below the 2% target, and only getting there at the end of three years, this is a “best collective judgement” and individual MPC members’ views can diverge sharply.
The charts in the Inflation Report show an agreed central projection, where dissenting views are roughly equal on either side of it, and it is not until the minutes are published that the dissents emerge.
It was only a month ago that Weale set out some of the thinking behind his call for a rate hike in a speech and interview, and it is arguable the economic outlook has not deteriorated much since then, and even back then he was referring to euro area economic stagnation.
Similarly, fellow dissenter Ian McCafferty told LBC radio Tuesday that the downside risks in the eurozone could be overstressed and there were no signs of a sharp downturn on the continent.
On the evening of October 15 Weale delivered a densely argued speech at Hull University Business School, explaining why policymakers would be better off “setting policy with reference to the change in, rather than the level of, the margin of spare capacity.”
Weale argued that policy should place weight on what is much clearer – the rate at which spare is being eroded, using changes in unemployment an indicator.
He drew on work from Athanasios Orphanides, the MIT monetary economist and former Governor of the Bank of Cyprus, and used the BOE’s own models to support his case.
“My own sense is that the margin of spare capacity is now small and it is currently being used up rapidly,” Weale said.
MPC members best collective judgement in the November Inflation Report was that slack is currently around 1% of GDP but the report, said there was “a wide range of views” around this figure, and Weale and McCafferty may well believe it is already likely less than this.
Weale anticipated that, with slack being eaten up rapidly and wages for new jobs rising markedly, wage growth would pick-up from its anaemic levels. The subsequent labour market data have lent strong support to his views on earnings.
“We are seeing encouraging signs in the labour market, encouraging signs with respect to pay. We are seeing the start of real pay growth,” BOE Governor Mark Carney said at the Inflation Report press conference on November 12.
The BOE projected that four quarter average weekly earnings would rise from 1.25% in the fourth quarter of this year to 3.25% in 2015 and 3.75% in 2016.
So earnings growth is starting to accelerate, as Weale expected, and the Bank predicts that it will gather pace.
The most striking thing about the November Inflation Report, however, was not the upbeat earnings, or even growth, projections but the sharply lower inflation forecasts.
Here the best collective judgement was that headline CPI inflation would fall from an average 1.2% in the fourth quarter of this year to just 1.02% in the first quarter of next year and only rise gently to 1.95% by the fourth quarter of 2017.
That central view is drawn up from staff estimates with Carney, as chairman, helping thrash out an agreement with the range of views around it roughly equal on either side.
Weale and McCafferty could have individual estimates markedly higher than it, and the former did express disagreement with the central projection in the August Inflation Report.
The current convention is that MPC members do not publish dissenting forecasts in the report itself – you have to go back to the days of former MPC member Sushil Wadhwani, who was there from 1999 to 2002, to find that – so the fact that they both signed off on the report means little for their individual votes.
Both McCafferty and Weale are proponents of the view that policymakers should look through the impact of imported disinflation due to falling energy, and other commodity, prices and the pass through from the previous appreciation of sterling.
The Inflation Report estimates that “overall the prices of energy, food and other goods and services imported into the United Kingdom are projected, on average, to subtract just under 0.5 percentage point a quarter from annual CPI inflation in 2015.”
Add that back on and CPI would be at 1.93% by the fourth quarter of next year, just a sliver below the 2% target.
What the lower near term inflation outlook does raise, however, is the question of whether McCafferty and Weale feel the same need to get on and tighten to help ensure the path of rate hikes is gradual. Lower inflation outturns should ensure there is less risk of the MPC having to tighten more rapidly as it plays catch-up.
The Inflation Report’s central projection was based on implied market rates that showed CPI would be on track to hit the 2% target even with the first 25 basis point hike fully priced in by October 2015.
Do McCafferty and Weale “want to hike earlier than most rate setters, but then raise rates more gradually? Or do they believe interest rates just need to rise more than the consensus at the BoE ?” Rob Wood, UK economist at Berenberg says in a research note.
The minutes out at 0930 GMT Wednesday will shed light on their stance.