Minutes of Monetary Policy committee meeting (2006-06-07)
mpc:
MINUTES OF THE MONETARY POLICY COMMITTEE MEETING HELD ON 7-8 JUNE 2006
1
At the start of the meeting, the Committee noted that the Bank of England's system for
implementing monetary policy had been reformed from 18 May. Since that date, the interest rate set
by the MPC, the official Bank rate, was paid on reserves held by commercial banks with the Bank.
mpc: 2
Before turning to its immediate policy decision, the Committee discussed developments in
financial markets; the international economy; money, credit, demand and output; and costs and
prices.
mpc: 3
Over the month, there had been sizeable movements in the prices of a range of financial assets.
Equity price indices in most advanced countries, including the United Kingdom, had fallen by between
4% and 8%, while the indices for many emerging market economies had declined by 10% to 20%.
Non-oil commodity prices had been volatile and the price of Brent crude oil had declined by around
6%. Credit spreads for riskier assets and the implied volatilities derived from options contracts had
risen.
mpc: 4
A number of market commentators had highlighted US developments as the proximate trigger
for these financial market movements. In particular, unexpectedly high outturns for consumer price
inflation; signs of some slowing in the pace of growth; and greater uncertainty about the outlook for
monetary policy may have led investors to reappraise US and global risks. If that were the case, recent
developments could perhaps be interpreted as a re-pricing of the risk incorporated in asset prices.
mpc: 5
A key question was whether the recent asset price falls would prove to be a limited correction or
the beginning of a more marked and sustained change. Most market commentary had suggested it was
likely to be a temporary adjustment, following the rapid asset price increases over the previous three
years. This appeared consistent with anecdotal evidence of there having been some unwinding of
speculative positions during May. Nevertheless, it was possible that there would be further falls in
financial prices.
mpc: 6
Despite the declines in equity prices, there had been little change in UK, US and euro-area
government bond yields over the month. To the extent that the trigger for recent movements had been
heightened concern about US prospects, it was somewhat surprising that US yields, in particular, had
remained stable. It was possible that the declines in equity prices in May had been a delayed response
to the rise in long-term bond yields observed between January and April. It was not clear, however,
why the prices of the different asset classes had not moved in a more synchronized fashion.
mpc: 7
Short-term market interest rates had also been little changed on the month. At the time of the
Committee's meeting, sterling market instruments implied an expectation of a 25 basis point rise in the
Bank of England's official rate by the end of 2006, with a second 25 basis point increase priced in by
the end of 2007. While the majority of private sector economists surveyed in the Reuters poll, by
contrast, continued to expect the official rate to be unchanged during 2006, the proportion of
respondents expecting a reduction in interest rates before the end of the year had fallen in recent
months, and there had been a rise in the proportion expecting the next change to be a rate increase.
mpc: 8
The sterling effective exchange rate index (ERI) had appreciated over the month, leaving it
almost 2% above the 15-day average value used as the starting point for the May
Inflation Report
projections. However, the sterling ERI remained within the range it had occupied in recent years. The
dollar had depreciated further against a range of currencies, leaving the dollar ERI almost 7% below its
level at the beginning of 2006.
mpc:
The international economy
mpc: 9
Developments in the world economy appeared to have been broadly consistent with the
projections incorporated in the May
Inflation Report, with signs of some rebalancing of demand
growth away from the United States and towards the rest of the world.
mpc: 10 In the euro area, GDP growth had increased to 0.6% in Q1. The expenditure composition of Q1
growth had been encouraging; in particular, household spending had accelerated sharply. Investment
growth had been weak but this appeared to have largely reflected the effect of bad weather on
construction investment and might therefore prove to be temporary. The available survey-based
evidence of industrial and consumer confidence, together with the Purchasing Managers' Indices
(PMI) for the manufacturing and services sectors, suggested that GDP growth had picked up further in
Q2. The flash estimate of headline consumer price inflation had increased to 2.5% in May.
mpc: 11 Growth in the United States had been strong in Q1 but appeared to have moderated since then.
This development was most notable for consumption -- the monthly growth rates of real household
spending had slowed progressively since November. Contributing to this, the pace of job creation had
weakened in recent months, consumer confidence had fallen, and the housing market seemed to be
slowing. These developments had been a little weaker than expected. Nevertheless, the
manufacturing and non-manufacturing Institute of Supply Management (ISM) survey balances had so
far suggested only a modest slowdown in growth. Headline and core measures of consumer price
inflation had increased in April. In addition, the University of Michigan survey of the general public's
twelve-month ahead inflation expectations had picked up sharply to 4% in May. These developments
appeared to have primarily reflected movements in energy prices. However, capacity utilisation had
continued to increase and was now comfortably above its long-run average level.
mpc: 12 There had been a steady pickup in the pace of Asian growth since the beginning of 2005.
Although Japanese GDP growth had slowed in 2006 Q1 this had been expected following the very
strong growth in the preceding quarter.
mpc: 13 A trade-weighted average of the export price deflators of the United Kingdom's major trade
partners had increased by almost 3% in the year to Q1. Although this was broadly in line with
developments in recent quarters, it remained high relative to the average over the previous 20 years.
mpc:
Money, credit, demand and output
mpc: 14 The Office for National Statistics' (ONS) second estimate of UK GDP in 2006 Q1 had left
growth unrevised at 0.6%. There had been minor revisions to the sectoral composition of GDP, with
manufacturing growth revised up slightly and the growth rate of the energy sector revised down.
mpc: 15 The first release of the income and expenditure data for Q1 had shown an uneven pattern in the
composition of growth between Q4 and Q1. Consumption growth was estimated to have slowed from
mpc: 0.8% in Q4 to 0.3% in Q1. At the same time, there had also been large swings in the contributions to
growth made by business investment, net trade and inventories.
mpc: 16 Recent indicators appeared consistent with some rebalancing of growth away from consumption
towards investment and exports. Caution needed to be applied, however, in interpreting the latest
figures since there were often sizeable revisions to the first estimates of the GDP expenditure
breakdown. Over the period since 1993, the average absolute revision to the first estimate of quarterly
consumption growth had been around 0.3 percentage points. It was possible that the slowdown of
consumption growth between Q4 and Q1 might ultimately be revised to show slightly weaker spending
in Q4 and stronger consumption in Q1. However, evidence from surveys and from the Bank's regional
Agents had been broadly consistent with the ONS's reported profile of strong household spending
growth in Q4 followed by a slowdown in Q1. There had also been anecdotal evidence from retailers
of selective price discounting ahead of Christmas and relatively low stocks (and therefore less price
discounting than usual) in the post-Christmas period. If this change in the seasonal pattern of
discounting were the explanation, the slowdown in consumption growth in Q1 might prove to be
temporary; it would then be sensible to look through the quarterly volatility by averaging the
consumption growth rates in Q4 and Q1 to give a picture of underlying quarterly consumption growth
of around 0.5%.
mpc: 17 Historically, business investment figures had been subject to even larger revisions than the
consumption data, with a tendency for the first estimates to be revised upwards. Reflecting the
considerable uncertainty about the investment figures, it might also be sensible to average their growth
rates across Q4 and Q1; if that were done, the underlying pace of quarterly business investment
growth in Q1 would be relatively modest at 0.4%. However, the recent improvement in survey-based
evidence of investment intentions, as well as the strengthening of output indicators, suggested that a
pickup in investment growth through the remainder of 2006 seemed likely.
mpc: 18 The available indicators appeared to suggest that the pace of GDP growth in Q2 was at least as
strong as that observed in Q1. While the manufacturing and service sector balances from the
CIPS/RBS surveys had eased slightly in May, they nevertheless remained above their Q1 average and
were at levels seen in the first half of 2004 when GDP growth had been relatively strong.
mpc: 19 There was also evidence of a pickup in the pace of consumption growth in Q2. Retail sales had
increased by 0.6% in April and the retailers' sales balance in the CBI
Distributive Trades Survey had
risen further in May, to its highest level since the end of 2004. In addition, evidence gathered by the
Bank's regional Agents, together with other surveys and the most recent figures for private car
registrations pointed to a strengthening of consumer spending growth.
mpc: 20 Not all the indicators for consumption were positive, however. The recent falls in equity prices,
if sustained, were likely to have a modest dampening effect on consumption growth; recent housing
market data had been somewhat mixed; and the three-month growth rate of unsecured lending had
continued to slow quite sharply. It was difficult to know how much weight to attach to this latter
development. If the slowdown were related to a tightening in credit conditions by banks, it might have
contributed to the slowdown in consumption growth in Q1. At the same time, however, the growth
rate of households' secured lending had remained strong. It was possible that households were
choosing to incorporate some of their unsecured debts into their secured borrowing, thereby lowering
their cost of finance. Alternatively, household spending growth may have been supported by sales of
financial assets or by faster income growth.
mpc: 21 The annual growth rate of the broad money aggregate, M4, had increased steadily since mid-
2003, reaching around 13% in April, its fastest annual growth rate since 1990. The strength of broad
money growth, together with large increases in asset prices since 2003, posed an upside risk to the
medium-term outlook for inflation -- at some point these money balances might be used to finance
consumption and investment spending, thereby boosting growth and inflation. In this regard, it was
notable that the annual rate of nominal GDP growth had picked up in Q1, after having slowed in 2005.
mpc: 22 The latest signals from the labour market data had been somewhat mixed. The Labour Force
Survey measure of the employment count had increased by 0.4% in Q1, slightly stronger than had been
assumed in the May
Inflation Report. Moreover, employer-based surveys had suggested a pickup in
employment intentions in April and May. However, unemployment had also increased further in Q1.
The labour force (the sum of employment and the number of people actively looking for work) had
increased by 0.6% in Q1, its fastest quarterly growth rate in 20 years.
mpc: 23 Since the fourth quarter of 2004, there had been a significant rise in the labour force participation
rate together with a gradual increase in the unemployment rate. In contrast, during the two previous
large cyclical increases in unemployment, the participation rate had fallen, reflecting discouraged
worker effects. Labour force participation rates among women and older workers had been steadily
increasing, perhaps prompted by changes in the fiscal regime, social custom or a greater need to save
for retirement. The Committee noted that recently the proportion of the unemployed in the 18-24 age
group had risen.
mpc: 24 It remained unclear whether the rise in the unemployment rate primarily reflected cyclical factors
or structural considerations. Wage inflation remained subdued which would be consistent with the
former interpretation, but it was not conclusive since a moderation in the real consumption wage was
to be expected in the face of higher energy prices.
mpc: 25 There had continued to be little evidence of any pickup in wage pressures. While the annual
growth rate of the headline average earnings index had increased in February, this seemed to have
been largely related to a shift in the pattern of bonus payments. Consistent with this, whole-economy
earnings growth had fallen back to 4.5% in March. Preliminary indications from wage agreements
struck in the three months to April suggested that pay settlements had edged down relative to a year
earlier. Given that around a quarter of all private sector wage agreements typically occur in April, this
was further evidence that second round effects arising from higher energy prices had been limited. It
was possible that the credibility of the inflation target, together with the effects of strong competition
in product markets, had led firms to believe that they would not be able to pass higher energy prices
through to their output prices. Firms might, therefore, have been putting downward pressure on wages
to offset higher energy-related input costs.
mpc: 26 The squeeze on producers' margins appeared to be continuing. Sharp increases in energy prices
had contributed to producer input price inflation remaining above 10% since late-2005. Despite this
development, producer output price inflation (excluding petrol) had remained broadly stable at around
1½% to 2½% since late-2004. There had been some indications of a slight increase in price pressures
in the services sector, with the average balance for April and May from the CIPS/RBS survey of prices
charged increasing to its highest level since 2004 Q3.
mpc: 27 In line with pre-release arrangements, an advance estimate of CPI inflation for May had been
provided to the Governor ahead of publication. This had indicated that inflation was 2.2% in May, up
from 2.0% in April; the increase between April and May had primarily reflected higher gas and
electricity prices. Looking ahead, there were a number of considerations that were likely to impact on
the short-term evolution of inflation. First, the recent fall in oil prices would likely feed through to a
decline in petrol prices. Second, the introduction of student top-up fees in the autumn might contribute
positively to inflation. Third, natural gas futures prices had increased since mid-February, raising the
likelihood of another round of wholesale gas prices later in the year. The impact of these factors on
the headline inflation rate would depend on how the prices of other goods and services were affected
by the associated changes in demand.
mpc: 28 The Bank of England's survey of the general public suggested that twelve-month ahead inflation
expectations had eased slightly between February and May but remained around half a percentage
point above the expectations recorded in August and November of 2005. The rise in 2006 might have
been a temporary reaction to the recently announced large increases in domestic gas and electricity
prices. However, there also appeared to have been an increase in the medium-term inflation
expectations held by financial market participants -- five-year forward inflation rates derived from the
difference in yields on nominal and index-linked UK government bonds had increased by around 30
basis points since the beginning of the year.
mpc:
The immediate policy decision
mpc: 29 The most significant news since the May
Inflation Report had related to developments in
financial markets. If the recent appreciation of sterling and falls in equity prices were sustained, then
the consequent impact on import prices and personal sector financial wealth would tend to reduce
inflationary pressures. However, the recent equity and commodity price falls had not been that large
when set against the sharp price increases observed over the previous twelve months; and the sterling
ERI had remained within the range it had occupied in recent years. If households and firms had
already assumed that some of the asset price increases over the past year were unlikely to be sustained,
then they might not change their spending significantly in response to the recent price corrections. If
this were the case, the impact on inflation from the recent movements in financial markets might prove
to be modest.
mpc: 30 It was not clear whether recent asset price falls would prove to be a limited correction or the
beginning of a more marked and sustained change. Most market commentators had suggested it was
likely to be a temporary adjustment. There was a risk, however, of a more prolonged and pronounced
correction of financial asset prices that might have a significant impact on growth and inflation in the
United Kingdom and its major trade partners. This risk arose from the fact that long-term interest rates
were still historically low; credit spreads were narrow relative to past norms; and the US current
account deficit remained sizeable.
mpc: 31 Aside from the financial market volatility, developments in the world economy appeared to have
been broadly in line with the May
Inflation Report projection. There were signs of some rebalancing
in the composition of world demand, with a pickup in the pace of euro-area and Asian growth and a
possible slowdown in the United States. It remained to be seen, however, if the US slowdown would
be sharper than envisaged in the May
Inflation Report and whether the recovery in the euro area would
be robust enough to withstand any such slowdown in US demand growth.
mpc: 32 In the United Kingdom, the second release of Q1 GDP had been slightly weaker than assumed at
the time of the May
Inflation Report. Also, consumption growth had been lower than expected. It was
difficult to know what weight to attach to the first estimates of the expenditure components of GDP
since the figures were prone to revision. The indicators for Q2 suggested that the pace of growth was
likely to have increased to a level that was at, or slightly above, its long-run historical average. The
rise in employment and the improvement in employment intentions looked consistent with this. There
were also some suggestions that investment and export growth might strengthen in the second half of
the year. Overall, therefore, the news about demand and output appeared to have been broadly
consistent with the May
Inflation Report projection.
mpc: 33 Producer input price inflation and import price inflation were high by recent historical standards
and there had been a pickup in the general public's inflation expectations since the turn of the year.
Nevertheless, CPI inflation had remained close to the target. Wage pressures had shown no signs of
increasing; this might have reflected the impact of continued inflows of migrant workers and the
increase in labour force participation.
mpc: 34 There were a number of upside risks to the outlook for inflation. Growth in the euro area and
Asia might well turn out stronger than had been assumed in the May
Inflation Report. The amount of
spare capacity in the UK economy might be less than the Committee had assumed in its central
projection, particularly if some of the increase in unemployment were related to structural factors. If
the pricing power of firms increased as the degree of spare capacity was removed, there was a risk that
firms would seek to restore their profit margins by pushing up prices. There was also a risk of higher
inflation stemming from stronger import prices than assumed in the Committee's central projection
and from the recent increase in UK inflation expectations. Finally, the strength of broad money
growth and the sharp increases in property and financial asset prices over the past year suggested that
the present stance of UK monetary policy might be accommodative.
mpc: 35 There were also, however, a number of downside risks to the outlook for inflation. While the
recent correction of financial markets might prove temporary, there was a risk that it would persist or
that asset prices might fall further in the coming months. The slowdown in the United States might
prove more pronounced than had been assumed in the May
Inflation Report and could adversely
impact euro area growth. In the United Kingdom, Q1 growth had been slightly weaker than expected
and there remained a risk that the erosion of spare capacity in the economy would be slower than
envisaged in the May
Inflation Report. Domestically generated inflation pressures remained weak and
the recent increase in the labour force suggested that wage developments might remain benign. While
it was important to pay close attention to movements in inflation expectations, the recent increase
appeared to have been linked to the rise in domestic gas and electricity prices; there was a chance,
therefore, that it would prove to be temporary.
mpc: 36 Different Committee members attached differing weights to the above arguments. Given that
recent developments had been broadly in line with the May
Inflation Report, and that there were
significant risks to the outlook in both directions, most members felt that the rate should remain
unchanged this month. For one member, however, the balance of risks to inflation, relative to the 2%
target, were sufficiently to the upside to warrant an immediate increase in rates.
mpc: 37 The Governor invited the Committee to vote on the proposition that the official Bank rate should
be maintained at 4.5%. Seven members of the Committee (the Governor, Rachel Lomax, John Gieve,
Kate Barker, Charles Bean, David Blanchflower and Paul Tucker) voted in favour of the proposition.
David Walton voted against, preferring an increase of 25 basis points.
mpc: 38 The following members of the Committee were present:
Mervyn King, Governor Rachel Lomax, Deputy Governor responsible for monetary policy John Gieve, Deputy Governor responsible for financial stability Kate Barker Charles Bean David Blanchflower Paul Tucker David Walton Simon Brooks was present as the Treasury representative.