Inflation analysis: the Bank could do even better
Monday 11 March 1996
Rorschach tests may have fallen out of favour in some psychiatric circles but clearly not at the Bank of England. In its latest Inflation Report you will find several examples disguised as graphs depicting the Bank's latest inflation projections and the range of uncertainty surrounding them. The charts fan out as time passes and the uncertainty deepens. By 1998, they encompass inflation forecasts as high as 4.5 per cent and as low as 0.5 per cent, all in shades of vermilion and violet. What does this image remind you of, old boy? Beware the response "a hand-waving economist". It guarantees 10 years incarceration in the UK forecasting industry. It is therefore preferable to reply that the chart represents a probability distribution of projected inflation outcomes - an attempt by the Bank to convey a sense of forecasters' uncertainty. But this does not get us very far. We know that forecasts are inherently uncertain and that the crystal ball gets ever-cloudier the further we peer into it. The problem is that the Bank's approach blends together various sources of uncertainty and is insufficiently precise about the circumstances in which inflation could head north or drop south. This is a pity because in all other respects the Inflation Report is a paragon of analysis, the best thing to emerge from the Bank in years.
Presenting uncertainty is not easy but the Bank could do better by regarding its report as a navigational chart to point out the rocks on which the economy might founder. It could present several forecasts, clearly conditional on different states of the world and on different assumptions about the way the economy behaves. This would clarify the nature of the uncertainty and quantify those aspects which pose the greatest threat to the Chancellor's inflation goals. Had this been done, the Chancellor might have had a better idea of the risks he was running by cutting interest rates in the face of strong monetary growth. To be sure, the Bank agonises over the growth of broad money supply in the UK, now running at an underlying 10 per cent. But nowhere does the report quantify possible linkages between money supply and activity which would be the precursor to rising inflation.
Had it entertained (as one possibility) a more monetarist view of the economy, the Bank might have identified linkages along these lines. The first concerns the build-up of bank deposits held by financial institutions. The growth of wholesale bank deposits accounts for nearly 3 percentage points of the 5.5 percentage point jump in broad monetary growth over the last year. The key question is whether the extra deposits are a genuine increase in the demand for money or an excess of supply. The chances are it is an excess. Institutions have acquired cash as a result of Britain's merger and acquisitions boom. Companies have bought equity with cash; institutions, in turn, have deposited it with banks who were keen to raise deposits in order to lend to acquisitive companies. The Bank describes this merry-go-round in detail but does not consider how the excess cash could be expunged - for example through capital outflow being placed in assets abroad which could be less vulnerable to inflation. The first risk posed by high monetary growth is therefore to sterling.
The second consequence concerns the stock cycle, which may prove to be a less painful affair than many suppose. Everyone knows that manufacturers have excessive inventories, the result of an unexpected shortfall in export demand. The surveys suggest that industry should already have de-stocked, but so far, this does not appear to have happened. Gross domestic product is still rising, as are stocks. If the figures are to be believed, it may well be that companies' buoyant liquidity is enabling them to take a more relaxed view about the speed with which to adjust their stock overhang.
The third consequence concerns the housing market and its wider role in the economy. The build-up of personal bank and building society deposits is the other main component of the acceleration of broad money supply. If this is also in excess of requirements, it may well be switched into other assets which offer a higher return. In the housing market, expectations of rising prices against a background of falling home loan rates could trigger a sharp jump in transactions and then in prices. The process would be partly self-feeding - higher prices inducing higher demand - the mirror image of last year's depression in the housing market. There are already signs of recovery. According to the Halifax figures, house prices rose at an annualised 3.5 per cent in the three months to February.
Consumer spending would undoubtedly respond. But the stimulus of rising property values should not end there. The scale and growth of small business is highly dependent on the value of collateral tied up in housing, a consequence of banks' lending policies. Research by economists at Exeter University suggests that a 10 per cent increase in the value of housing equity would result in a 5-6 per cent rise in small business starts.
There is a real risk that private-sector spending will take off rapidly in the next 12 months, consumers' spending growth of 4 per cent being well within the bounds of possibility. Come to think of it, this may be the hidden message in the Bank's Rorschach charts. The blot on the landscape is simply another dose of inflation.
Bill Martin is chief economist at UBS
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