UK MPC Decision-Making
By Sheryl Dong, Birce Akay, Daniel Carey and Dillon Oppon-Ferguson
The previous article introduced who the members are in the MPC and the timeline for them making decisions. This article looks at the detailed perspectives of consideration during their decision-making process from the Bank of England’s November 2020 Monetary Policy Report.
I. The Monetary Policy Committee focused on the following aspects and made preliminary judgments before they made final decisions.
- The international economy
- Financial markets
- Credit conditions and monetary developments
- Demand and output
- Supply, costs and prices
1. The international economy
Why the MPC cares:
The Bank concerns itself with the global economy because of the interconnectedness of the UK economy with other economies. This comes in the form of global trade whereby global demand has an effect on demand for UK exports, for if global growth was to increase then trade amongst other countries in Europe and America would increase, leading to greater demand for the UK to supply output to the global economy and thus contributing to inflation. The base rate differentials between the UK and the rest of the world also affect the inflows and outflow of currency, which indirectly affects inflation as well. It is also good for the BoE to note the performance of the international economy to see examples of possible effects of policy in different economies i.e. observing the effects of negative rates in the euro-zone, and using that to aid the decision of implementing a negative rate system in the UK economy.
Overall, the international economy at present is doing better than expected. Economies are beginning to rebound in growth since Q2 2020 from the previous 9% fall in global GDP growth in Q1. The bank estimates that the euro-zone grew at 12.7% and the US at 7.4% in Q3 2020, all of which were higher than expected. What was initially thought by advanced economies was that economic growth, in all sectors, would rebound once lockdown restrictions eased. However, what has been observed instead has been a K-shaped recovery whereby different sectors are recovering from the crisis at different rates. For example, in the US and the Euro-zone sectors that are led by consumer spending, such as retail, have grown at a much quicker pace than other sectors that require physical contact like manufacturing. Since high growth in one sector compensates for slow-growth in another sector, the BoE has observed much higher growth rates in advanced economies.
How the MPC sees:
Since the international economy has performed better than expected, the UK economy will also likely follow this path due to interdependence of economies with one another. Therefore, it has led the BoE to maintain the majority of their current policies. Already knowing that the international economy provides a point of reference for the bank, potential indications of a rise back to global output levels using the same expansionary fiscal and monetary policies may suggest that the BoE consider maintaining its base rate level and asset-purchasing programme.
2. Financial markets
Why the MPC cares:
The financial markets are important to the BoE because they have a major effect on the real economy in the sense that financial markets help to finance businesses and investors which filters to the real economy. This is done through changing short-term interest rates via changing the deposit interest rate on reserves, implementing QE and influencing the term-structure of interest rates by forward guidance, which in turn affects market interest rates and influences consumption and investment decisions. So, the BoE needs to watch how the financial markets react to their policy implementation to see if their policies are influencing the real economy in the desired way.
Overall, the financial markets have been somewhat weaker in performance than the bank has anticipated. Corporate bond spreads (the difference between government bond yields and corporate bond yields) have fallen a little further than anticipated in Q2&3 of 2020, measures of volatility in the exchange rate have indicated greater fluctuations in the future for the sterling and the FTSE 100 has rebounded less stronger than other indices (mainly explained by the composition of the index, with various sectors being affected by COVID in different ways). This has suggested to the Bank that financial markets are acting weaker than expected.
How the MPC sees:
The belief is that by leaving the right conditions in financial markets, the activity seen will start to pick up again once COVID restrictions have been eased and the economy slowly recovers itself back to pre-COVID levels. This movement has been seen in other major areas like the US and the Euro-zone, whereby their indices have all begun to rise, in value, to levels seen before COVID-19 (see chart 2.8) whilst employing similar policies of maintaining policy at the effective lower bound and their asset purchasing programmes. So the BoE has decided to maintain short-term base-rates, the level of quantitative easing and increase the target stock of government bonds by £150 billion.
3. Credit conditions and monetary developments
Why the MPC cares:
Credit conditions are closely monitored by the MPC because they are directly related to corporate interest rates and the aggregate demand (e.g. household spending, investment housing demand) and also because monetary policies such as QE influence the cost of borrowing.
Corporates have raised almost £80 billion of net finance since the beginning of the year, which is approximately three times higher than what has been raised on average over the past four years. Many businesses access credit through government-backed loan schemes; Over £60 billion has been approved in total under the Bounce Back Loan Scheme (BBLS), the Coronavirus Business Interruption Loan Scheme (CBILS) and the Coronavirus Large Business Interruption Loan Scheme. This has contributed to a decline in corporate interest rates, particularly for SMEs. In the absence of these schemes, the cost of credit may have increased, and credit availability would have experienced a fall since banks factored in increased credit risk. The recently announced extension of government-backed lending schemes and the Bank’s Term Funding Scheme with additional incentives for SMEs (TFSME) will continue to support credit access. Credits have been available for many firms that needed to borrow, however, some corporates, especially the ones in the sectors most exposed to the impact of the pandemic, have reported tighter credit conditions.
Interest rates on new mortgages have increased. Interest rates are now almost 50 basis points higher than in April for mortgages with a 75% loan to value (LTV) ratio and 165 basis points higher for those with a 90% LTV. Rates for 90% LTV mortgages are at their highest level since 2015. Mortgage spreads have widened as mortgage rates have increased and risk-free rates have fallen. Despite the rise, spreads remain lower than in the years after the Great Recession. Demand for mortgages has been very strong, reflecting the strength in housing demand since May. The high volume of applications has led to operational difficulties.This might be the reason why spreads have increased and the number of mortgage products, especially at higher LTVs, remains constrained. Higher spreads and reduced availability may also reflect concerns over the economic outlook and reduced risk appetite from lenders. Tighter mortgage availability is anticipated over the forecast period.
Conditions for consumer (unsecured) credit such as personal loans and credit cards are observed to be tighter. And these conditions could have contributed to lower lending volumes. Another explanation for the reduction could be a sharp decrease in demand for unsecured credit since household spending has been contracted.
4. Demand and output
Why the MPC cares:
The BoE aims to ensure inflation at a target rate of 2% but also help the government to stabilise economic growth, which could be represented by a steady GDP growth rate. By estimating the rate of output growth and the size of output gap, the BoE is able to have a more profound understanding of the position the economy lies in the business cycle, which facilitates the setting of monetary policies so that aggregate demand in the economy can be guided to grow in line with productive potential. It also helps the BoE to know which component specifically in the aggregate demand function that could impose a threat to the state of the economy, so that it can adjust policies more precisely and, if necessary, in advance.
The UK and the BoE do not have a specific target for GDP growth rate. However, it is regarded to be acceptable at a level which is at least as the same as the same time period last year, which ensures a steady output growth over time.
In August, output has recovered a little (from April 2020 levels), though it remained 9% below its 2019 Q4 level and is expected to be 9% lower across Q3 as a whole, as is shown as the Q3(b) dashed line in the graph. The output gap in Q2 2020 is around 50% larger than the peak-to-trough fall in GDP during the financial crisis.
Much of the recovery in GDP in Q3 is expected to be driven by the increase in consumption since April which is expected to have risen by around 30% in Q3 but still 5% below its level in 2019 Q4. The chart below shows the changes in consumer spending by sector. The pickup in consumption reflects increased spending on household furnishings, clothing and other big-ticket items. Card spending data also suggest that spending on household goods in August was around 20% higher than the same time last year.Having fallen sharply in April, Visa data suggest that spending in hotels and restaurants was around 5% higher in August than the same time last year. The Government’s Eat Out to Help Out (EOTHO) scheme will have accounted for some of this strength. It is also possible that the pickup reflected perceptions of reduced health risks at that time.
In contrast, the recovery in business investment is expected to have been much weaker as businesses are discouraged from making new investments by uncertainty about the future level and pattern of demand and government’s counter-measures to the Covid-19. Brexit-related uncertainty also adds up in the sluggish recovery in business investment.
Both imports and exports recovered since their troughs earlier in the year but still remained below their 2019 Q4 levels. Net trade provided a boost to GDP growth in Q2 as imports fell by more than exports, however it is expected to drag on GDP growth in Q3 as UK spending recovered and imports will rise faster than exports.
How the MPC sees:
Overall, the near-term growth outlook is unusually uncertain as it will largely depend on the progression of the virus and how consumers and businesses respond. However, in general, GDP is expected to fall by around 2% in 2020 Q4, which is a 6 pp smaller decrease than expected in the August Report (-8%). This suggests that the economy is still under recovery and the BoE should endeavour to fasten the process while maintaining inflation stability.
5. Supply, costs and prices
Why the MPC cares:
The labour market, as the vehicle through which economic factors directly determine unemployment and with strong 2nd order effects on inflation and output, is a natural focus of the MPC. The size and complexity of these concepts however, mean various measures are sometimes employed by the MPC to capture dynamics missed by conventional metrics (given below).
Unemployment (the proportion of the labour force who are not currently in work but looking for employment) and employment (the proportion of the labour force in work) are measured through the Office of National Statistic’s quarterly Labour Force Survey (LFS). While there is no explicit target for unemployment on the bank’s mandate, through its effect on growth, low unemployment is assumed to be an implicit part of the remit.
Inflation is measured through the Consumer price index (CPI), the weighted price average of a representative basket of consumer goods based on the average British household’s consumption. The Bank’s primary target is 2% inflation over the medium-term. To this end, the bank tries to anchor inflation expectations, which are observed through agent-type specific surveys.
The current outlook
Despite a 19.8% contraction in GDP from March to August, unemployment rose to only a modest 4.5%. The MPC suggests two possible reasons. First, government support was quickly forthcoming during the lockdowns. An estimated 9 millon people were on furlough under the CJRS in May (this number sat at 1.75 millon by the first half of October) and 2.7 millon self-employed had their incomes supported through the SEISS. This directly lessened redundancies and the need of the self-employed to search for new work. Second, restrictions have made job searching more difficult. The ‘Marginal attachment ratio’ (a measure of those who want a job but are not actively searching for one), peaked in August. As individuals not searching for work are not technically unemployed, they would have been omitted from the summer’s statistics.
Notably, the MPC referenced an Office of National Statistics (ONS) warning regarding the reliability of their survey data currently, and further observed HMRC tax records show a larger (and likely more accurate) fall in employment since March. As the ONS revise previously released numbers going forward, they may come to show a more accurate (and worse) picture of unemployment statistics.
The (LFS) unemployment rate is expected to rise to 6.3% in Q4 2020 and peak in Q1 2021 at 7.75%. This slack in labour markets will further plateau the price level. With the CPI at 0.6% in Q3 2020, and an expected modest rise to 0.9% by March 2021, expected inflation still falls well below the BOE’s 2% target. Throughout the year, low energy prices and a VAT tax cut for the hospitality sector, on top of the usual recession-caused slack, have kept prices stable. However, survey data suggests inflation expectations of households and firms are starting to pick up, although this trend has not yet emerged in financial markets.
II. The Monetary Policy Committee took all the information above into consideration and made the following key judgements.
- In the near term, activity is dampened by Covid developments and temporarily lower trade as businesses adjust to new arrangements with the EU.
- Over time, uncertainty dissipates gradually and spending recovers.
- There is some long-lasting scarring of the economy’s supply capacity.
- Spare capacity in the economy is currently weighing on inflation, but it is eroded over time and inflation returns to the target.
Key judgement 1: Dampened activity in the near term
In the near term, activity is judged to be dampened by Covid developments and temporarily lower trade as businesses adjust to new trading arrangements with the EU.
The MPC thinks that there are risks around the extent to which Covid restrictions weigh on spending in the near term, particularly until the end of 2021 Q1. The uncertainty around the evolution of the pandemic and changes in government support schemes is considered to be substantial and this is very important for the MPC as different developments might have significant effects on activity. However, according to the MPC’s central forecast, the restrictions weigh on consumer spending, although the response is likely to be smaller than occurred in early 2020. The fact that consumers have changed how they spend might be one of the reasons for a weaker response; consumers may be more willing to continue to, for instance, buy goods online, especially given government measures supporting incomes. As opposed to this, some of the recent substitution into other goods and services might be less likely to happen in the future if past purchases reflected pent-up demand.
Moreover, there is uncertainty around the extent to which the initial adjustment to new trading arrangements with the EU will affect activity.The MPC’s projections are conditioned on the assumption that while firms adjust to the new trading arrangements with the EU, the cross-border trade decreases temporarily in the first two quarters of 2021 and this will decrease the activity temporarily. The Decision Marker Panel (DMP) Survey and a recent survey by the Bank’s Agents provide evidence for the fact that while a number of firms have undertaken some preparation for new arrangements, some businesses do not feel fully ready. Specifically, around a third of respondents were partially prepared for new UK-EU trading arrangements in the October DMP Survey. Furthermore, other surveys and evidence suggest that the degree of preparedness is lower among those who trade most frequently with the EU and that it will be difficult for all firms, in particular SMEs, to be fully prepared by the end of the transition period. The MPC believes that there is also uncertainty over how controls on the EU side of the border will be applied in practice. Hence, there are two-sided risks around the impact that the initial adjustment to the new trading arrangements will have on trade and activity, and its duration.
Overall, while highly uncertain, the risks to the near-term outlook for activity are judged to be skewed to the downside. The skew is smaller than was judged to be the case in the previous monetary policy report.
Key judgement 2: Uncertainty and consumer spending
The MPC came to the judgement that uncertainty will gradually fall in the future, and that consumer spending will start to rise again. This is because the savings rate has increased during COVID, but is anticipated to be run down after the crisis hence spending will increase. Since the savings rate, the rate at which consumers decide to hold their money rather than spend it, has increased, this suggests that in the short-term, consumers will probably hold onto their money since their spending is being halted by the pandemic and the government is supporting households’ incomes. So, there is no need for consumers to spend. This behaviour can be observed from data on the household savings ratio (figure 1) whereby the ratio has increased from 7.7%, 2019 Q4, to 29.1% in 2020 Q2. This means that whereas before households were saving less than a tenth of their income, now they are saving almost a third of their income, which illustrates the current typical behaviour of UK households. To save more rather than spend.
Explanations for short-term increases in the savings rate are mainly due to lockdown restrictions. If households remain at home, they can’t go out to retail shops, outdoor markets, and spend. This causes consumers to hold their money since not everything can be brought online. The BoE suggests that the accumulation of savings from being forced to save, could be run down maybe in the medium-term posing upside risk to activity. In other words, potentially alluding to increases in economic activity.
However, not all households are participating in the act of accumulating savings.
What we observe from figure 2 is that a smaller proportion of low- and middle-income earners have reduced spending (proportion of those who spend slightly variates between the segment of middle income earners), and that a growing proportion of higher income households have reduced their spending. This can be explained by ‘social consumption’, a term coined by the BoE to describe expenditures that result in social interactions such as going out to eat, watching a movie etc, to which is a greater component of spending in higher-income households relative to lower income households. This can be shown in figure 3, whereby the top decile spends 13.5% of their income on recreation & culture whereas the lowest income decile only spends 9.8% of their income on social consumption. Staples, on the other hand, take up 42% of the bottom deciles’ income whereas the top decile only uses 26% of their income on food and housing which explains why there is a relatively smaller change in reduction of spending by lower income households, because demand for staples stays relatively constant over time . Therefore, this survey evidence suggests that the act of running down accumulated savings will be done mainly by higher-income households, because middle- and lower-income households are not accumulating as much savings, as a proportion to their incomes.
One of the determinants for the bank’s outlook on consumer spending is health concerns. This is primarily because if consumers are concerned about their potential health, then they would adjust their spending accordingly to cover potential health costs i.e. hiring a private doctor, receiving private medical care. In the medium-term, lower rates of COVID cases are being projected so the risk to health should fall, allowing consumers a greater chance to spend their income. Additionally, perceptions about what will happen to the economy has affected the bank’s outlook for consumer spending because if consumers predict the economy will be negatively affected in the future, then the rational thing to do is to save for those rainy days. Those periods in which the economy is doing badly, consumers will end up saving to make ends meet. If, however, perceptions of the economy are somewhat good, we can expect consumer spending to slowly rise in the medium term as confidence starts to pick up in the economy. This pick-up in confidence derives from certainty about the UK’s relationship with the EU and prospects of other trade agreements. The BoE also places weight on unemployment to influence consumer saving since employment provides for people’s incomes, so hopefully decreases in unemployment in the medium-term will give households greater opportunities to spend with their realised greater income. Overall, these measures have influenced the bank’s judgement about consumer spending and uncertainty with the idea that in the short-term, these measures will be hugely hit by the pandemic, however in the medium-to-long term consumer spending will begin to rise and uncertainty will fall as economic prospects for the UK become clearer, and COVID cases fall.
Key judgement 3: Long-lasting low supply capacity
The supply capacity of the economy is the maximum potential output and is determined by the quantity of labour available and the amount of output that workers can produce. Its growth is driven by growth in labour, capital and TFP.The degree of spare capacity is the gap between the actual output and the maximum potential output and is an important determinant of inflationary pressures.
Covid has affected sectors of the economy differently as consumer spending patterns have changed, which also requires some changes in the pattern of production in the economy, hence a reallocation of labour and capital between sectors. New trading arrangements with the EU may also prompt some reallocation.
The MPC’s central forecast embodies a judgement that the rate of reallocation of labour between sectors is reduced by a degree of skills mismatch, which is accompanied by more significant structural changes than before. Some of the sectors hardest hit by the pandemic employ lots of young and low-skilled workers who may find it difficult to move between sectors (Henehan (2020)). And it is hard for any worker to move between sectors if the jobs involve different tasks. This can be quantified and shown via the extent of ‘task reallocation’ required in various scenarios. In a relatively extreme scenario where the pattern of consumer spending is unchanged from 2020 Q3, bank staff estimate that the extent of task reallocation over the forecast period would be somewhat higher than in recent years. This slows the pace of decline of unemployment and leads to some rise in the medium-term equilibrium rate of unemployment, which harms the supply capacity of the economy.
Similar to labour, capital such as plant and machinery can be specialised for specific tasks. The more specialised capital is, the harder it is to sell to a new owner to ‘redeploy’ it. Bank staff have estimated capital ‘redeployability’ scores for different types of assets using a similar approach to Kim and Kung (2017). Information and communications technology, machinery and buildings are highly redeployable as they are used across many industries. Other structures, for example infrastructure used in the mining and energy sectors, have lower redeployability scores. Some of the sectors hit hardest by the pandemic use very specialised assets. One example is the airline industry: there are very few alternative uses for aircraft and the associated infrastructure. If output in these sectors does not recover, some of these assets could be mothballed or scrapped before the end of their usual lifespan. This poses a downside risk to the MPC’s central projection for supply through lower investment and capital accumulation.
Previous information has shown that investment will remain low in the near term which will therefore also lower the growth rate of total factor productivity (TFP). There could be a positive compositional effect on aggregate productivity as sectors which tend to be more productive grow faster than others. Some of the sectors negatively affected by Covid, such as accommodation and food services, have lower productivity than average. Aggregate productivity was boosted in Q2 as a result, although it is unclear to what extent this will persist. The pandemic has also forced many firms to innovate, but the positive economic effects in the long run are highly uncertain.
Working from home is expected to be more widespread after the pandemic. More widespread remote working could increase the average number of hours employees spend working and could also increase participation in the workforce, further increasing the total number of hours worked in the economy. The effect on productivity, however, still remains uncertain.
Overall, the MPC expects the combination of a period of lower investment and a process of reallocation to lower the economy’s supply capacity relative to what it would have been in the absence of Covid.
Key judgment 4: Spare capacity and inflation
While the MPC believes there is considerable spare capacity in the economy, they stress the present difficulties in measurement. As such, their judgment pulls in numerous indicators to paint a vague picture of existing spare capacity.
Regarding aggregate demand, total hours worked have fallen and wage pressures are weak. With unemployment expected to rise into the start of the new year, this slack is predicted to persist.
Meanwhile, business rates relief and lower rents have acted to keep costs down. With a forecast increase in vacancies carrying the latter through the next quarter as well. This has acted against cost-push inflationary pressures brought about by social distancing measures.
More generally, the impact of spare capacity on inflation has itself been muted during the crisis. Despite the drastic fall of GDP in Q2 of 2020, inflation has remained strictly positive. The MPC highlights 3 reasons the usual transmission could be absent. Falling demand has been most heavily concentrated in consumer-facing industries, who tend to exhibit higher levels of price stickiness. Meanwhile uncertainty persists to a large degree, discouraging agents from changing behaviours, and specifically discouraging firms from changing prices.
Finally, the nature of the UK’s withdrawal from the EU must be considered. If no agreement is reached, the MPC predicts falling supply and demand will leave spare capacity approximately unchanged. However, tariffs would certainly have an inflationary effect at first, as consumption bundles take time to adjust to higher import costs.
III. Based on the key judgments made, the Monetary Policy Committee made the following final decisions.
- Maintain bank rate at 0.1%
- Maintain ongoing £20bn of corporate bond purchases
- Maintain ongoing of £100bn gilt purchases and increase by a further £150bn
This article is written by: Sheryl Dong (Head of UK Monetary Policy Research), Birce Akay (Research Associate, UK Monetary Policy Research), Daniel Carey (Research Associate, UK Monetary Policy Research) and Dillon Oppon-Ferguson (Research Associate, UK Monetary Policy Research).This article is reviewed by Jason Jia (VP, Monetary Policy Research).