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inflation for the following year, but then fell out of the
calculation a year later. Other examples would be a cut in excise duties or other taxes, or a one-off shift in the level of global commodity prices. The economy can also be hit by
more persistent shocks or forces. These continue to affect not only the level of prices but also the inflation rate for a prolonged period. One example would be the dislocation of the economy following the financial crisis, which has
of the UK economy should continue. GDP growth is expected to be at or just a little below historical average rates. Growth will be driven primarily by domestic demand. Consumers will see some improvement
in their real incomes, helped in the near term by lower energy and food prices and, further out, by improvements in labour productivity and wages. This should help drive healthy growth in consumer spending. On the investment side we should see a pickup in housing
The global financial shock, and the deep recession that ensued, necessitated a series of extraordinary policy measures
weighed on demand and inflation for a number of years. Another would be the entry of China into the global marketplace in the 1990s; the emergence of such a new large low- cost producer lowered the cost of manufactured goods globally, reducing the prices of imports into the UK over a prolonged period, and thus provided a persistent downdraft to the inflation rate. In terms of returning inflation to target,
temporary shocks are less amenable to changes in monetary policy. Monetary policy works with a lag; it probably has its maximum effect on the economy somewhere between 18 and 24 months after the policy change is implemented. So any deviations in inflation from a temporary shock will have faded away by the time monetary policy is having its largest effect. But how quickly is inflation likely to
return to target? That will depend on the underlying performance of the economy over the next couple of years. Last month, the MPC released its
latest quarterly Inflation Report setting out our forecast of how we expect the economy to perform. Our central forecast indicates that, over the next three years, the expansion
market activity and strong business investment growth. Offsetting that, fiscal consolidation will continue to act as a headwind. Growth in the global economy is
expected to pick up slightly, with somewhat stronger growth in the Euro area offset by some softness in emerging markets, particularly China, but we expect little net contribution to GDP growth from the external sector. The biggest risks that we identify to the UK growth outlook stem from international issues – most obviously from a disorderly conclusion to the debt negotiations in Greece, but also from potentially slower growth in China, and some economic instability in other emerging market economies too. The outlook for inflation is shaped by
the confluence of two factors – the speed with which the temporary shocks from oil, food and the exchange rate disappear, and how quickly the remaining spare capacity in the economy is absorbed, such that the current depressant effect on costs and wages fades. In the near term, it is likely that
inflation will remain around zero for a few months, until the temporary impact from oil, food and the exchange rate
fades as we move into next year. By this time next year, we expect inflation to have returned to around 1.5%, and by the end of 2016, to around 1.7%. As we look further into the future,
the level of spare capacity, and the implications of that for underlying wage pressure, become the more important driver. In our central forecast, we estimate that the remaining slack of 0.5% of GDP will be absorbed within the next year. As this occurs, and as productivity starts to show some recovery, wage growth is expected to pick up, to 4% by the end of 2016. This will return inflation to the target by the end of 2017.
Conclusion Since the recent crisis, monetary policy has become much more complicated. The global financial shock, and the deep recession that ensued, necessitated a series of extraordinary policy measures. But the economy is starting to return to more normal conditions, after arguably the biggest shock in over a hundred years, and we expect this healing process to continue over the forecast. As a result, the time of the extraordinary policy stance of recent years is gradually drawing to a close. There are economic conundrums that
remain. Should we expect the economy to return fully to the way it behaved pre-crisis? How will the economy respond to changes in the interest rate after such a long period at 0.5%? So, while for some of you the financial
crisis now already seems a good time ago, the issues and uncertainties of how the economy will perform in the post- crisis world will continue to challenge the MPC and macro-economists more widely for some time to come. CCR
Ian McCafferty is a Monetary Policy Committee member at the Bank of England Edited from the speech Negative inflation: the implications for monetary policy
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www.CCRMagazine.co.uk
July 2015
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