Inflation Report

November 2010
 BANK OF ENGLAND

Inflation Report
November 2010

In order to maintain price stability, the Government has set the Bank’s Monetary Policy
Committee (MPC) a target for the annual inflation rate of the Consumer Prices Index of 2%.
Subject to that, the MPC is also required to support the Government’s objective of maintaining
high and stable growth and employment.

The Inflation Report is produced quarterly by Bank staff under the guidance of the members of
the Monetary Policy Committee. It serves two purposes. First, its preparation provides a
comprehensive and forward-looking framework for discussion among MPC members as an aid to
our decision making. Second, its publication allows us to share our thinking and explain the
reasons for our decisions to those whom they affect.

Although not every member will agree with every assumption on which our projections are
based, the fan charts represent the MPC’s best collective judgement about the most likely paths
for inflation and output, and the uncertainties surrounding those central projections.

This Report has been prepared and published by the Bank of England in accordance with
section 18 of the Bank of England Act 1998.

The Monetary Policy Committee:

Mervyn King, Governor
Charles Bean, Deputy Governor responsible for monetary policy
Paul Tucker, Deputy Governor responsible for financial stability
Spencer Dale
Paul Fisher
David Miles
Adam Posen
Andrew Sentance
Martin Weale

The Overview of this Inflation Report is available on the Bank’s website at

www.bankofengland.co.uk/publications/inflationreport/infrep.htm.
The entire Report is available in PDF at
www.bankofengland.co.uk/publications/inflationreport/2010.htm.
PowerPoint™ versions of the charts in this Report and the data
underlying most of the charts are provided at
www.bankofengland.co.uk/publications/inflationreport/2010.htm.
Contents

Overview 5

1 Money and asset prices 9

1.1 Financial markets 9

1.2 The banking sector 13
1.3 Credit conditions 15
1.4 Money 17
Box Monetary policy since the August Report 10

2 Demand 18

2.1 Domestic demand 18

2.2 External demand 24
2.3 Imports 26
Box Nominal demand and income 19
Box Household balance sheets 22

3 Output and supply 27

3.1 Output 27
3.2 Capacity pressures and companies’ supply capacity 28
3.3 The labour market 30

4 Costs and prices 32

4.1 Consumer prices 32

4.2 Spare capacity and labour costs 35
4.3 Inflation expectations 37
Box New survey evidence on prices and wages 36

5 Prospects for inflation 38

5.1 The projections for demand and inflation 38

5.2 Key judgements and risks 41
5.3 Summary and the policy decision 46
Box Financial and energy market assumptions 43
Box Output in previous recoveries 48
Box Other forecasters’ expectations 49

Index of charts and tables 50

Press Notices 52
Glossary and other information 53
 Overview 5

Overview

The United Kingdom continued to recover from the recent deep recession. Global output and world
trade grew robustly, although fragilities remain. The UK recovery is expected to continue, supported
by expansionary monetary policy, further growth in global demand and the past depreciation of
sterling. GDP growth is judged to be a little more likely to be above its historical average than
below it for much of the forecast period. Even so, the large fall in output during the recession means
that some spare capacity is likely to persist over the forecast period.

CPI inflation remained well above the 2% target, elevated by the restoration of the standard rate of
VAT to 17.5% and the past depreciation of sterling. Inflation is likely to stay above the 2% target
throughout 2011, given the forthcoming rise in VAT and continuing increases in import prices. As
the impact of those factors on inflation diminishes, inflation is likely to fall back, reflecting
continuing downward pressure from the persistent margin of spare capacity. But the timing and
extent of that decline in inflation are highly uncertain. Under the assumptions that Bank Rate
moves in line with market rates and the stock of purchased assets financed by the issuance of
central bank reserves remains at £200 billion, the chances of inflation being either above or below
the target by the end of the forecast period are judged to be roughly equal.

Financial and credit markets

Since the August Report, the MPC has maintained Bank Rate at
0.5% and its stock of purchased assets at £200 billion. Market
participants revised down further their expectations of the
near-term path of Bank Rate and raised their expectations of
future asset purchases by the MPC. Long-term government
bond yields in the United Kingdom, United States and
euro area declined further. UK corporate bond yields also fell,
while equity prices rose. The sterling effective exchange rate
remained around 25% below its mid-2007 level, albeit a little
weaker than three months earlier.

Conditions in UK banks’ wholesale funding markets improved,

although banks continue to face significant challenges in
refinancing maturing funding. The cost and availability of
finance for large companies improved further, but credit
conditions for small companies and households were still tight.
Annual growth in both bank lending and broad money
remained weak. Housing market activity continued to be
subdued and house prices fell slightly.

Demand
The robust recovery in global demand and world trade
continued, albeit unevenly. Output in many emerging
economies, especially in Asia, grew rapidly. Stronger activity in
6 Inflation Report November 2010

the euro area was concentrated in Germany and its

neighbours. In contrast, some smaller European economies
continued to face significant challenges as they responded to
concerns about their sovereign debt positions. US GDP
expanded at a moderate pace.

UK exports of goods grew robustly over the past year,

supported by the rebound in world activity and the
depreciation of sterling since mid-2007. But services exports
continued to fall, perhaps in part reflecting a shift in global
demand away from services in which the United Kingdom
specialises, such as banking. The level of sterling should
support a gradual narrowing in the trade deficit.

During the financial crisis, households and businesses in

aggregate cut back sharply on spending relative to their
incomes as the economic outlook deteriorated, uncertainty
increased and credit became less available. But private
domestic demand has since recovered to some extent.
Consumer spending picked up over the past year despite weak
income growth, so the household saving ratio fell back. In
contrast, financial saving by the corporate sector remained
elevated despite stronger investment and a return to inventory
accumulation.

A significant fiscal consolidation is under way. The

Committee’s projections are conditioned on the plans set out
in the June Budget and the October Spending Review. The
Spending Review provided more detail on the Government’s
expenditure plans but contained little additional news for the
Chart 1 GDP projection based on market interest rate macroeconomic outlook.
expectations and £200 billion asset purchases
Percentage increases in output on a year earlier
8 The outlook for GDP growth
Bank estimates of past growth Projection
7 GDP growth was provisionally estimated to be 0.8% in
6
5
2010 Q3, similar to its average in the first half of the year.
4 Growth over recent quarters appeared to have been stronger
3 than the Committee had expected at the beginning of the year.
2
1
But a number of surveys of output growth and confidence
+
0
–
were below levels seen earlier in the year, suggesting that
1
growth may slow in the near term.
2
3
4 Chart 1 shows the Committee’s best collective judgement for
ONS data
5 four-quarter GDP growth, assuming that Bank Rate follows a
6
7
path implied by market interest rates and the stock of
2006 07 08 09 10 11 12 13
purchased assets financed by the issuance of central bank
The fan chart depicts the probability of various outcomes for GDP growth. It has been reserves remains at £200 billion. The considerable stimulus
conditioned on the assumption that the stock of purchased assets financed by the issuance of
central bank reserves remains at £200 billion throughout the forecast period. To the left of the from monetary policy, together with a further expansion in
first vertical dashed line, the distribution reflects the likelihood of revisions to the data over the
past; to the right, it reflects uncertainty over the evolution of GDP growth in the future. If world demand and the past depreciation of sterling, should
economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best
collective judgement is that the mature estimate of GDP growth would lie within the darkest support recovery. Those factors are likely to encourage private
central band on only 10 of those occasions. The fan chart is constructed so that outturns are
also expected to lie within each pair of the lighter green areas on 10 occasions. In any particular sector spending and some rebalancing of the economy
quarter of the forecast period, GDP is therefore expected to lie somewhere within the fan on 90
out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth can fall towards net trade. But the strength of the recovery is likely to
anywhere outside the green area of the fan chart. Over the forecast period, this has been
depicted by the light grey background. In any quarter of the forecast period, the probability be tempered by the fiscal consolidation and the reduced
mass in each pair of identically coloured bands sums to 10%. The distribution of that 10%
between the bands below and above the central projection varies according to the skew at each availability of credit.
quarter, with the distribution given by the ratio of the width of the bands below the central
projection to the bands above it. In Chart 1, the ratios of the probabilities in the lower bands to
those in the upper bands are approximately 6:4 at Years 2 and 3; the downward skew is
somewhat smaller at Year 1. See the box on page 39 of the November 2007 Inflation Report for The outlook for growth is highly uncertain. The contribution of
a fuller description of the fan chart and what it represents. The second dashed line is drawn at
the two-year point of the projection. net trade to growth has so far been weaker than the
 Overview 7

Committee had expected, and it is unclear how persistent that

weakness will prove to be. Private domestic demand could
grow rapidly if confidence recovers, and if businesses reinstate
investment projects previously put on hold. But there are also
significant downside risks to the path of private demand,
especially to household spending. Some households may not
yet have fully adjusted to the forthcoming fiscal consolidation.
Chart 2 Projection of the level of GDP based on market In addition, there may be a further drag on consumption from
interest rate expectations and £200 billion asset weak confidence, higher savings for retirement, and some
purchases households’ high levels of debt.
£ billions
400
Bank estimates of past level Projection
390 There is a wider than usual range of views among Committee
380 members over the likely effects on growth of these various
370
factors. The Committee continues to judge that relative to the
360
most likely path — shown by the darkest band in Chart 1 —
350
the risks to growth are skewed to the downside. Taking into
account that skew, the Committee’s best collective judgement
340
is that GDP growth is a little more likely to be above its
330
historical average than below it for much of the forecast
ONS data 320
period. Chart 2 shows that output is likely to remain
310
significantly below the level implied by a continuation of its
300
0 pre-recession trend.
2006 07 08 09 10 11 12 13

Chained-volume measure (reference year 2006). See the footnote to Chart 1 for details of the
assumptions underlying the projection for GDP growth. The width of this fan over the past has
been calibrated to be consistent with the four-quarter growth fan chart, under the assumption Costs and prices
that revisions to quarterly growth are independent of the revisions to previous quarters. Over
the forecast, the mean and modal paths for the level of GDP are consistent with Chart 1. So the CPI inflation was 3.1% in September. The elevated level of
skews for the level fan chart have been constructed from the skews in the four-quarter growth
fan chart at the one, two and three-year horizons. This calibration also takes account of the likely inflation continued to reflect the restoration of the standard
path dependency of the economy, where, for example, it is judged that shocks to GDP growth in
one quarter will continue to have some effect on GDP growth in successive quarters. This rate of VAT to 17.5% and the past depreciation of sterling. The
assumption of path dependency serves to widen the fan chart.
forthcoming increase in VAT to 20% will put upward pressure
on inflation throughout 2011. Prices of commodities and other
Chart 3 CPI inflation projection based on market traded goods and services have continued to increase, raising
interest rate expectations and £200 billion asset companies’ costs and inflationary pressure.
purchases
Percentage increase in prices on a year earlier
6 Labour productivity has recovered to around its pre-crisis level.
On the assumption that underlying productivity continued to
5
grow during the recession, many companies should be able to
4 increase output significantly using their existing workforce and
3 capital. But other signs, such as the modest margin of spare
capacity reported in business surveys and the pickup in
2
employment, suggested that their scope to do so may be
1 more limited. Unemployment was stable but continued to
+
0
point to a sizable degree of slack in the labour market. Despite
– above-target inflation, measures of inflation expectations
1
appeared broadly consistent with meeting the inflation target
2006 07 08 09 10 11 12 13
2 in the medium term and earnings growth remained subdued.
The fan chart depicts the probability of various outcomes for CPI inflation in the future. It has
been conditioned on the assumption that the stock of purchased assets financed by the
issuance of central bank reserves remains at £200 billion throughout the forecast period. If The outlook for inflation
economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best
collective judgement is that inflation in any particular quarter would lie within the darkest Chart 3 shows the Committee’s best collective judgement for
central band on only 10 of those occasions. The fan chart is constructed so that outturns of
inflation are also expected to lie within each pair of the lighter red areas on 10 occasions. In the outlook for CPI inflation, based on the same assumptions
any particular quarter of the forecast period, inflation is therefore expected to lie somewhere
within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions as Chart 1. Inflation is likely to pick up a little further in the
inflation can fall anywhere outside the red area of the fan chart. Over the forecast period, this
has been depicted by the light grey background. In any quarter of the forecast period, the near term, and to remain above the 2% target throughout
probability mass in each pair of identically coloured bands sums to 10%. The distribution of
that 10% between the bands below and above the central projection varies according to the 2011, boosted by a rebuilding of companies’ margins and the
skew at each quarter, with the distribution given by the ratio of the width of the bands below
the central projection to the bands above it. In Chart 3, the ratios of the probabilities in the forthcoming increase in VAT. The projection over the first half
lower bands to those in the upper bands are approximately 4:6 at Years 2 and 3. The upward
skew at Year 1 is smaller. See the box on pages 48–49 of the May 2002 Inflation Report for a of the forecast period is higher than in August, in part
fuller description of the fan chart and what it represents. The dashed line is drawn at the
two-year point. reflecting further increases in import costs. As the impact of
8 Inflation Report November 2010

those effects on inflation wanes, inflation is likely to fall back

reflecting the continuing downward pressure on wages and
prices from the persistent margin of spare capacity.

There are substantial risks to the inflation outlook. Inflation

will be affected by future developments in commodity and
other traded prices, the degree of spare capacity and its impact
on wages and prices, and the evolution of inflation
expectations. Continued strong growth in some emerging
economies may lead to further upward pressure on the prices
of commodities and other imported goods and services, so
Chart 4 Assessed probability inflation will be above pushing up companies’ costs. The degree of spare capacity and
target
its impact on inflation in the medium term will depend on: the
August Inflation Report
strength of demand; the persistence of the reduction in
November Inflation Report
Per cent
100 productivity; the performance of the labour market; and the
sensitivity of wages to any labour market slack. Inflation may
80
fall further than expected if the degree of spare capacity is
larger or if it has a greater impact. But inflation may remain
higher than otherwise if the current period of above-target
60
outturns cause medium-term expectations of inflation to rise.

40
There is a wider than usual range of views among Committee
members over the likely effects on inflation of these various
20 factors. Chart 4 shows the Committee’s best collective
judgement of the probability of inflation being above the 2%
0 target along with the corresponding probability implied by the
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2010 11 12 13 August Report projection. On balance, the Committee judges
The November and August swathes in this chart are derived from the same distributions as that, based on the monetary policy assumptions described
Chart 3 and Chart 5.7 on page 40 respectively. They indicate the assessed probability of
inflation being above target in each quarter of the forecast period. The width of the swathe at above, the chances of inflation being either above or below the
each point in time corresponds to the width of the band of the fan chart in which the target falls
in that quarter, or, if the target falls outside the coloured area of the fan chart, the width of the inflation target by the end of the forecast period are roughly
band closest to the target. The bands in the fan chart illustrate the MPC’s best collective
judgement that inflation will fall within a given range. The swathes in Chart 4 show the equal. The most likely outcome is that inflation falls below
probability within the entire band of the corresponding fan chart of inflation being close to
target; the swathes should not therefore be interpreted as a confidence interval. The dashed line target by 2013, but the risks around that most likely path are
is drawn at the two-year point of the November projection. The two-year point of the August
projection was one quarter earlier. judged to be skewed to the upside.

The policy decision

At its November meeting, the Committee judged that the
recovery was likely to continue. The outlook for inflation in the
near term was higher than previously expected, in part
reflecting higher import prices. But inflation was still likely to
fall back in the medium term, reflecting the continuing
downward pressure from the persistent margin of spare
capacity. In the light of that outlook, the Committee judged
that maintaining Bank Rate at 0.5% and maintaining the stock
of asset purchases financed by the issuance of central bank
reserves at £200 billion was appropriate to meet the 2% CPI
inflation target over the medium term. But the prospects for
inflation remained highly uncertain and the Committee stood
ready to respond in either direction as the balance of risks
evolved.
 Section 1 Money and asset prices 9

1 Money and asset prices

The MPC maintained Bank Rate at 0.5% and the stock of asset purchases financed by the issuance
of central bank reserves at £200 billion. Since the August Report, market participants have revised
down their near-term expectations for Bank Rate, and the likelihood they attached to further asset
purchases has increased. Long-term interest rates fell further in the United Kingdom, the
United States and the euro area. UK equity prices rose and corporate bond yields declined.
Conditions in UK banks’ wholesale funding markets improved. Credit conditions facing large
companies appear to have eased over the past year, but conditions facing small businesses and
households do not appear to have improved as much. Bank lending to businesses and households
remained weak in Q3, as did broad money growth.

Since the August Report, market participants have revised

down their near-term expectations for Bank Rate, and the
likelihood they attached to further asset purchases has
increased. In part reflecting those expectations of further
monetary stimulus, government and corporate bond yields
fell, and equity prices rose (Section 1.1).

One uncertainty surrounding the macroeconomic outlook is

the extent to which deleveraging in the banking sector will
continue to restrict the supply of credit. Wholesale funding
conditions facing major UK banks have improved in recent
months, and banks have made progress in strengthening their
balance sheets. The banking sector continues, however, to
face long-term challenges (Section 1.2). Credit conditions for
large companies appear to have improved over the past year,
but conditions for small businesses and households do not
seem to have improved as much (Section 1.3). Broad money
growth remained weak in 2010 Q3 (Section 1.4).
Chart 1.1 Bank Rate and forward market interest rates(a)
Per cent
6
1.1 Financial markets
Bank Rate
5
Monetary policy and short-term interest rates
Since the August Report, the MPC has maintained Bank Rate at
November 2009 Report 4 0.5% — the level it was cut to in March 2009 — and the stock
of asset purchases financed by the issuance of central bank
3 reserves at £200 billion. The reasons behind the MPC’s
August 2010 Report decisions in September and October are discussed in the box
2
on page 10.

1
November 2010 In the period running up to the MPC’s November decision,
Report
market participants’ interest rate expectations for the next
0
2008 09 10 11 12 13 three years, estimated from overnight index swap (OIS) rates,
Sources: Bank of England and Bloomberg. were on average 0.4 percentage points lower than in
(a) The November 2009, August 2010 and November 2010 curves are estimated using overnight August 2010, and 2.3 percentage points lower than a year
index swap (OIS) rates in the fifteen working days to 4 November 2009, 4 August 2010 and
3 November 2010 respectively. earlier (Chart 1.1).
10 Inflation Report November 2010

Monetary policy since the August Report Committee voted to maintain Bank Rate at 0.5% and keep the
stock of asset purchases at £200 billion. One member voted to
The MPC’s central projection in the August Report, under increase Bank Rate by 25 basis points.
the assumptions that Bank Rate followed a path implied by
market interest rates and that the stock of purchased assets The news during the month leading up to the MPC’s meeting on
financed by the issuance of central bank reserves remained at 6–7 October had done little to alter the near-term growth
£200 billion, was for the recovery in economic activity to be outlook. Global activity data had been broadly as expected,
sustained. Under the same assumptions, CPI inflation was likely and were consistent with a modest deceleration as the support
to remain above the 2% target throughout 2011, before falling from the inventory cycle faded. In the United Kingdom, activity
back below the target during the second half of the forecast had continued to recover from its depressed level. But that
period. recovery seemed likely to be weaker in the second half of the
year than it had been in the first.
Developments in the month leading up to the MPC’s
meeting on 8–9 September were on balance consistent CPI inflation had remained unchanged at 3.1% in September.
with a reduction in near-term growth prospects in the Recent increases in commodity and import prices and the
United Kingdom. A number of indicators suggested that service 3% sterling depreciation over the previous month meant that
sector growth might decline during the second half of the year, inflation in the near term could be higher than the Committee
probably associated with a slowing in the overall growth rate of had previously expected. The potential upside risk to inflation
the economy. expectations did not seem to have changed substantially since
the previous MPC meeting. Most measures of inflation
Overseas developments had been mixed. The latest indicators expectations had moved little recently. And earnings and
suggested slowing growth in the United States, but that money growth had remained weak. But the likelihood of higher
second-quarter euro-area GDP growth had been stronger than near-term inflation had the potential to exacerbate this risk.
expected. In a number of peripheral euro-area countries GDP
had grown only slowly or had fallen, but this had been more Most members felt that the balance of risks had not altered
than offset by above-average growth in several northern sufficiently to warrant a change in the policy stance at this
European countries, including a 2.2% expansion in German meeting. On the one hand, they continued to believe that the
output. International short and medium-term interest rates economy contained a considerable margin of spare capacity
had declined substantially over the month. The falls in interest and, therefore, that demand could expand significantly before
rates would be likely to stimulate activity at home and widespread capacity constraints put upward pressure on
overseas. inflation. On the other hand, there were concerns about the
risks to inflation expectations from the persistent and
CPI inflation had remained at 3.1% in August, and pay growth prospective above-target inflation outturns. Some of those
measures had stayed subdued. Most indicators of inflation members felt that the likelihood that further monetary stimulus
expectations were broadly unchanged. Overall, the Committee would become necessary in order to meet the inflation target in
judged that the upside risk to inflation expectations, noted in the medium term had increased in recent months. But, for
the August Report, remained but had not changed materially them, the evidence was not sufficiently compelling to imply
over the month. that such a course of action was necessary at present.

A number of Committee members thought there had been For one member, however, the current degree of spare capacity
either a slight reduction or little change to the risks to activity, in the economy was sufficiently large that monetary policy
with weaker news about the prospects for 2010 H2 and the could afford to encourage more rapid growth without risking an
boost from lower market interest rates acting in opposite undesirable increase in underlying inflationary pressures.
directions. Other members thought that recent developments Another member continued to take the view that it was
indicated that the headwinds to a recovery in private sector appropriate to begin to withdraw some of the exceptional
demand in the United Kingdom and overseas were somewhat monetary stimulus. Seven members of the Committee voted to
stronger than previously thought, and that the downside risks maintain the current stance of monetary policy. One member
to activity had increased. voted to increase the size of the asset purchase programme by
£50 billion to a total of £250 billion. Another member voted
On balance, most members thought that the level of for an increase in Bank Rate of 25 basis points.
Bank Rate and stock of asset purchases financed by the issuance
of central bank reserves remained appropriate to balance the At its meeting on 3–4 November, the Committee voted to
risks to the inflation outlook in the medium term. But one maintain Bank Rate at 0.5%. The Committee also voted to
member thought it was appropriate to start to withdraw some maintain the stock of asset purchases financed by the issuance
of the exceptional monetary stimulus. Eight members of the of central bank reserves at £200 billion.
 Section 1 Money and asset prices 11

Chart 1.2 International ten-year spot government bond Longer-term interest rates
yields(a) UK ten-year spot government bond yields have declined
Per cent substantially since early April (Chart 1.2). In part, those
6
1 April declines reflect the fall in short-term interest rates, but
United Kingdom
longer-term interest rates have also declined. For example,
5
the implied cost of government borrowing in five years’ time
4
for a period of five years has fallen markedly (Chart 1.3).
Euro area(b) Large falls in ten-year spot yields have also occurred in the
3 United States and the euro area (Chart 1.2).
United States

2 Nominal long-term interest rates can be decomposed into

movements in real interest rates and an implied inflation rate,
1 by comparing them with rates on index-linked government
bonds. In the United Kingdom, the fall in five-year, five-year
0
2007 08 09 10 forward rates since April in part reflects a fall in real interest
Sources: Bloomberg and Bank calculations. rates (Chart 1.3), but also a decline in implied inflation. A
(a) Zero-coupon yield. range of indicators of inflation expectations are discussed in
(b) Derived from government bonds issued in France and Germany.
Section 4.
Chart 1.3 UK five-year nominal and real interest rates,
and implied inflation, five years forward(a) Lower long-term interest rates will tend to support other asset
Per cent
prices and activity. But the extent of that support will depend
1 April
7 on the cause of the decline in long rates. The recent fall is
6
likely to reflect a combination of several factors, including:
Nominal interest rates market perceptions that the risks associated with the
5 UK government bond market are smaller than in some
peripheral euro-area countries; expectations of additional
4
Implied inflation asset purchases; and a reassessment of prospective global
3 saving and investment. All of these explanations may be
consistent with market participants revising down their view of
Real interest rates 2
economic growth in parts of the world economy.
1
Investors have become more concerned about the
0
2007 08 09 10 sustainability of fiscal positions in some peripheral euro-area
Sources: Bloomberg and Bank calculations. countries since early April. That has encouraged investors to
(a) Derived from the Bank’s government liability curves. move towards the government bonds of countries where such
sovereign risks are perceived to be smaller. As a consequence,
Chart 1.4 Selected European ten-year government bond government bond yields in Greece, Ireland and some other
spreads(a) euro-area countries have risen markedly relative to German
Greece Spain government bond yields since April (Chart 1.4). In contrast,
Ireland United Kingdom
Portugal
the spread between ten-year UK gilts and German bond yields
Basis points
1,000 has narrowed slightly (Chart 1.4). Market contacts reported
1 April
900 that the formation of a new UK government and the
800
announcement of its plans for fiscal consolidation had reduced
700
the perceived risks associated with holding UK gilts.
600
The fall in long-term interest rates is also likely to reflect
500
higher expectations among market participants of further
400
asset purchases by some central banks. Previous asset
300
purchases have pushed down long-term interest rates.(1)
200 Around 50% of economists responding to the October Reuters
100 survey thought asset purchases in the United Kingdom would
Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov.
0 be resumed at some point, compared with 8% in the survey
2010

Sources: Bloomberg and Bank calculations.

(1) The impact of the Bank of England’s programme of asset purchases on the gilt market
(a) Spread over ten-year German government bond yield. is discussed in the box on pages 12–13 of the May 2010 Report.
12 Inflation Report November 2010

Chart 1.5 International equity prices(a) conducted in late July. Both the US Federal Reserve and the
Bank of Japan have announced additional asset purchases
FTSE All-Share Euro Stoxx
S&P 500 Topix since the August Report.
Indices: 2 January 2007 = 100
120
1 April
110 The fall in long rates might also reflect a change in the
prospective balance between global savings and investment. A
100
rise in world savings, largely reflecting increased saving in
90
Asian economies, was associated with low long-term interest
80 rates and the emergence of global current account imbalances
in the period running up to the financial crisis.(1)
70

60
Equities and corporate bonds
50 The FTSE All-Share fell sharply in May, but has since recovered,
rising by around 8% since the August Report (Chart 1.5). That
40
2007 08 09 10 has left UK equity prices at around the same level as in early
Source: Thomson Reuters Datastream. April, when long-term interest rates began to fall.
(a) In local currency terms.

As discussed above, it is possible that falls in long-term rates in

Chart 1.6 Sterling investment-grade corporate bond part reflected weaker growth prospects. That could lead to a
spread and yield
weaker outlook for corporate earnings, and put downward
Basis points
1,200 pressure on equity prices, which would tend to offset the direct
1 April
support to equities from lower interest rates themselves.
Yield 1,000

The available evidence does not suggest that earnings

800
prospects have weakened, however. Analysts surveyed by the
Institutional Brokers’ Estimate System have not revised down
600
their estimates of medium-term corporate earnings growth in
Spread(a) 400
the United Kingdom since April. Dividend swap prices for the
FTSE 100, which give an indication of expected dividend
200 growth, are around the levels seen in early April. And
information from options prices suggests that the probability
2007 08 09 10
0 that market participants ascribe to a sharp fall in the FTSE has
fallen back to around its level at the start of April, having risen
Source: Bank of America/Merrill Lynch.
sharply during April and May.
(a) Option-adjusted spread over equivalent-maturity government bonds.

The fall in long-term interest rates has pushed up corporate

Chart 1.7 Sterling non-bank investment-grade corporate
bond spreads less CDS premia(a) bond prices and lowered yields (Chart 1.6). Corporate bond
Basis points
spreads have risen slightly since April (Chart 1.6), although
200
spreads remain well below their late-2008 and early-2009
180 levels.
160

140 Conditions in the sterling secondary corporate bond market

120 have continued to improve. For example, the difference
100 between corporate bond spreads and credit default swap
80 (CDS) premia — an indicator of illiquidity premia — has fallen
60 during 2010 (Chart 1.7). The Bank has continued to act as a
40
backstop buyer and seller of high-quality corporate bonds
20
since August, on behalf of the Treasury, with purchases
financed by the issuance of Treasury bills and the
0
July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Debt Management Office’s cash management operations.
2008 09 10

Sources: UBS Delta and Bank calculations.

(a) The data are based on individual corporate bond spreads (relative to asset swaps) less their
corresponding CDS premia. The maturity of the bonds used in this calculation may not
necessarily match the maturity of the corresponding CDS premia, as data are typically only (1) See the box ‘The economics of low long-term bond yields’ on pages 6–7 of the
available for five-year CDS. The chart shows a five-day moving average median measure. May 2005 Inflation Report.
 Section 1 Money and asset prices 13

Chart 1.8 International nominal effective exchange rates Exchange rates

Indices: 2 January 2007 = 100
In the run-up to the November Report, the sterling effective
150
exchange rate index (ERI) was 3% lower than at the time of
Japanese yen 140 the August Report. The US dollar effective exchange rate has
130 fallen by around 5% since August, while the Japanese yen has
120
appreciated further (Chart 1.8). The sterling ERI remains
around 25% lower than in mid-2007. Section 4 discusses the
110
Euro impact of the exchange rate on consumer prices.
100
US dollar
90
1.2 The banking sector
80

Sterling 70
The major UK banks continue to face significant challenges. In
60
2007 08 09 10 particular, they will need to refinance substantial amounts of
maturing funding over the coming years, including that
presently supported by the official sector.(1) The availability
and cost of that funding is likely to depend, in part, on
investors’ perceptions of the strength of banks’ capital
positions.

While these long-term challenges remain, banks’ capital and

funding positions have improved during 2010. Market
sentiment towards banks has also improved. Announcements
by the authorities may have contributed to that. For example,
revised proposals for the new international prudential bank
regulations — the so-called Basel III rules — were received
positively by market participants. Market contacts reported
that this was largely because the proposed rules were seen to
allow a longer implementation period for banks to make
necessary changes to their balance sheets than market
participants had anticipated. But there remains uncertainty
among market contacts about the extent to which banks will
need to raise capital to meet regulatory requirements.

Capital
The major UK banks have made progress in strengthening their
balance sheets during 2010. The release of interim results for
2010 H1 showed that, in aggregate, the major UK banks’ core
Tier 1 capital ratio picked up further. In part, that reflected a
rise in retained earnings as profits increased.

Banks’ profitability has been supported by declines in losses on

lending to UK companies and households. Write-offs on
lending to private non-financial corporations (PNFCs) and on
secured lending to households fell during 2010 H1, although
write-offs on unsecured lending picked up. Lenders responding
to the Q3 Credit Conditions Survey reported that default rates
had fallen by more than expected in the previous survey, and
that loss rates given default were also generally lower than
had been anticipated.

(1) For further details, see the discussion on pages 50–52 of the June 2010 Financial
Stability Report.
14 Inflation Report November 2010

The commercial real estate sector remains a key risk for the
Chart 1.9 Property prices
banking sector, accounting for around half of the stock of all
Indices: peaks = 100
110
loans by UK-resident lenders to UK PNFCs.(1) Although
100 commercial property values have increased over the past year,
90 they remain around 35% below their mid-2007 peak
(Chart 1.9). And market contacts report that the rise in
80
commercial property values has been driven by prime
Commercial property prices(a) 70
properties, with little increase in the value of non-prime
60 commercial property. Some major UK lenders continue to
50 report that they are generally accommodating breaches of
House prices(b) 40
loan to value covenants provided that rental incomes are
sufficient to service the debt. If rental incomes fell, lenders
30
might be less willing to accept those breaches, which could
20
1996 98 2000 02 04 06 08 10 lead to a rise in losses.
Sources: Halifax, Investment Property Databank, Nationwide, Thomson Reuters Datastream and
Bank calculations. Funding
(a) Non seasonally adjusted. The latest observation is September 2010.
(b) The average of the Halifax and Nationwide measures. The published Halifax index has been
Banks’ ability to obtain long-term funding has improved since
adjusted in 2002 by Bank staff to account for a change in the method of calculation. The
latest observation is October 2010.
the August Report. Debt issuance by the major UK lenders was
strong in Q3 (as indicated in Chart 1.10), although issuance fell
Chart 1.10 Debt issuance by the major UK lenders(a) back in October. Banks have issued a range of debt
£ billions instruments, including covered bonds and asset-backed
100
Subordinated debt
securities (shown in the ‘Other’ bars in Chart 1.10). In addition
90
Unguaranteed senior debt to the debt instruments shown in the chart, market contacts
Guaranteed senior debt(b) 80
Other debt issuance(c)
have reported increased usage of other funding instruments,
70
which has helped banks diversify across providers of funds and
60 increase the maturity of their funding.(2)
50

40
Indicators of banks’ wholesale funding costs have been
30
broadly stable since the August Report. Three-month sterling
Libor-OIS spreads have been little changed. Major UK banks’
20
five-year CDS premia — movements in which would typically
10
be associated with changes in banks’ longer-term funding
0
2006 07 08 09 10 costs — have fallen a little relative to three months ago
Sources: Dealogic and Bank calculations. (Chart 1.11).
(a) Issuance with a value greater than or equal to US$500 million equivalent and original
maturity greater than one year. Data are converted into sterling terms. Includes debt
issuance by Banco Santander, Barclays, HSBC, Lloyds Banking Group, Nationwide and
Major UK banks are likely to try to reduce their dependence on
Royal Bank of Scotland. Data are shown at a quarterly frequency, the latest observation is
2010 Q3.
wholesale funding by attracting more retail deposits. The
(b) Senior debt issued under HM Treasury’s Credit Guarantee Scheme.
(c) Includes covered bonds, medium-term notes and residential, commercial and other
major UK lenders report that competition for retail deposits
asset-backed securities.
has remained intense, which is likely to have put upward
pressure on deposit rates. Indeed, spreads on retail deposits —
Chart 1.11 Major UK banks’ CDS premia(a)
such as those over equivalent-maturity swap rates for three
Basis points
250 and five-year fixed-rate bonds — have picked up by around half
August Report
a percentage point during 2010.
200
Changes in banks’ funding costs are likely to have implications
for the interest rates charged on business and household loans
150
(Section 1.3). As discussed in a recent Quarterly Bulletin
article, interest rates charged on new secured household
100
lending have fallen by much less than Bank Rate in recent
years, in part reflecting the rise in lenders’ funding costs
50
relative to Bank Rate (Chart 1.12).(3)

0
(1) Recent trends in lending to the real estate sector are discussed in a box on page 7 of
2007 08 09 10 the September 2010 edition of Trends in Lending.
(2) See the box on ‘Innovations in money market instruments’, Bank of England Quarterly
Sources: Markit Group Limited, Thomson Reuters Datastream and Bank calculations.
Bulletin, Vol. 50, No. 3, pages 168–69.
(a) The data show a weighted average of the CDS premia (at five-year maturity) of the major (3) See ‘Understanding the price of new lending to households’, Bank of England Quarterly
UK lenders, weighted by each bank’s share in total assets. Bulletin, Vol. 50, No. 3, pages 172–82.
 Section 1 Money and asset prices 15

Chart 1.12 New mortgage rate, Bank Rate and estimate 1.3 Credit conditions
of marginal funding cost(a)
Per cent
8 The extent to which companies and households face credit
Marginal
funding cost(b) constraints will affect the speed and strength of the recovery.
7
The data suggest that credit conditions facing large companies
Mortgage rate(c)
6 have improved over the past year. But the cost and availability
5 of credit for small companies and households do not appear to
have eased as much, and conditions remain tight relative to
4
pre-financial crisis levels.
3

2
Corporate credit conditions
The stock of bank loans to companies fell by around 3% in the
Bank Rate 1
year to 2010 Q3 (Chart 1.13). A tighter supply of bank credit
2004 05 06 07 08 09 10
0 relative to before the financial crisis has played an important
Sources: Bank of England, Bloomberg, British Bankers’ Association, Markit Group Limited and role in that decline. As discussed in previous Reports, the
Bank calculations.
reduced availability of credit since the financial crisis began
(a) The latest observation is October 2010.
(b) This is an estimated marginal funding cost for extending variable-rate sterling-denominated reflects, in part, the withdrawal of foreign lenders from the
loans. It is the sum of three-month Libor plus an average of the five-year CDS premia of the
major UK lenders (Banco Santander, Barclays, HSBC, Lloyds Banking Group, Nationwide, UK market. UK-owned lenders also tightened credit conditions
Northern Rock and Royal Bank of Scotland). Marginal funding costs may vary across lenders.
Lenders with a greater proportion of retail funding may consider the cost of deposits when substantially through late 2007 and 2008. Lenders responding
setting their marginal funding cost.
(c) 75% loan to value Bank Rate tracker mortgage. Sterling-only end-month average quoted to the Credit Conditions Survey have, however, reported that
rate. The Bank’s quoted interest rate series is currently compiled using data from up to
23 UK monetary financial institutions. overall corporate credit availability has improved over the past
year (Chart 1.14).
Chart 1.13 Sterling loans to PNFCs(a)
Recessions(b)
Sterling loans to PNFCs That improvement in the availability of bank credit has been
Percentage change on a year earlier
45
particularly marked for larger companies, according to reports
40
from the Bank’s Agents. And the cost of bank credit for large
35
companies also appears to have fallen. The Credit Conditions
30
Survey suggests that spreads, fees and commissions for large
25
PNFCs, which increased very sharply in 2008 and early 2009,
20
have begun to fall back over the past year (Chart 1.14).
15

10
Larger companies can also raise funds by issuing debt or
5
+ equity. Following very strong corporate bond issuance in
0
– 2009, net issuance has fallen back sharply in 2010 (Table 1.A).
5
Despite the slowdown in net issuance, there is some evidence
10
1965 70 75 80 85 90 95 2000 05 10 that a wider range of companies are accessing these markets
(a) M4 lending excluding the effects of securitisations and loan transfers.
(b) Recessions are defined as at least two consecutive quarters of falling output (at constant instead of borrowing from the banks. An unusually high
market prices). Recessions are assumed to end once output began to rise, apart from the
1970s where two separate occasions of falling output are treated as a single recession. proportion — around 40% — of those companies that have
issued corporate bonds in 2010 did so for the first time. The
Chart 1.14 Credit Conditions Survey: overall corporate
fall in the cost of bond finance, as indicated by corporate bond
credit availability and terms on loans to large PNFCs
Net percentage balances(a)
yields (Chart 1.6), may have encouraged such issuance. Net
60
issuance of equities has also fallen back but, on average, net
Looser credit conditions Spreads
40
issuance in 2010 has been stronger than in the years running
up to the financial crisis, largely reflecting fewer share
Overall availability
20 buybacks (Table 1.A).
+
0
– Overall, the availability and cost of finance for large companies
20 appears to have improved. A majority of the respondents to
the 2010 Q3 Deloitte CFO Survey reported new credit was
40
Fees and ‘available’ rather than ‘hard to obtain’ for the first time since
commissions
60 the series began in 2007 Q3. But the demand for credit
Tighter
credit conditions remains subdued according to the major UK lenders.
80
Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2007 08 09 10
Smaller businesses, which are more dependent on bank credit,
(a) Weighted responses of lenders. A positive balance indicates that more credit is available, or
that spreads or fees and commissions are lower over the past three months. continue to have difficulty accessing affordable finance,
16 Inflation Report November 2010

Table 1.A PNFCs’ equity and debt issuance(a) according to contacts of the Bank’s Agents. The stock of loans
to small businesses fell by around 5% in the twelve months to
£ billions August 2010, according to data from the British Bankers’
Averages 2010
Association, although some of that decline is likely to reflect a
2003–08 2009 Q1 Q2 Q3
fall in the demand for credit. Estimates of median interest
Equities rates charged on new variable-rate facilities to small and
Net issuance -0.7 2.6 0.6 1.5 0.0
medium-sized enterprises, which account for the greater part
Gross issuance 0.8 2.7 0.8 1.8 0.3
of new facilities, have remained little changed over the past
Repayments 1.5 0.0 0.2 0.3 0.3
six months.(1)
Corporate bonds(b)
Net issuance 1.1 1.5 0.5 -1.2 0.1
Gross issuance 2.6 4.3 2.4 1.4 1.7 Household credit conditions and the housing market
Repayments 1.5 2.8 2.0 2.6 1.6 Growth in the total stock of loans to individuals has remained
Commercial paper very weak during 2010 (Chart 1.15). That reflects subdued
Net issuance 0.0 -0.6 0.5 0.1 -0.6 growth in the stock of both mortgage debt, which represents
Gross issuance 4.4 3.3 3.0 2.0 2.4 around 85% of household debt, and also in the stock of
Repayments 4.4 3.9 2.6 1.8 3.0 consumer credit (Chart 1.15).
(a) Averages of monthly flows of sterling and foreign currency funds. Due to rounding, net issuance may not
equal gross issuance minus repayments. Data are non seasonally adjusted.
(b) Includes stand alone and programme bonds. Lenders’ responses to the Credit Conditions Survey suggest that
secured credit availability to households has not changed
significantly during 2010. There has also been little significant
Chart 1.15 Loans to individuals change in the cost of new secured borrowing: quoted rates on
Percentage changes on three months earlier (annualised) both two-year fixed-rate mortgages and Bank Rate tracker
20
mortgages have edged down only a little since January
(Chart 1.16).
16

12 Indicators of housing market activity, such as mortgage

Secured on dwellings
Total approvals and property transactions, have remained at low
8 levels during 2010 (Table 1.B). In recent months, there have
been some signs of a weakening in demand in the housing
4 market. The Credit Conditions Survey suggested that demand
+ for secured lending for house purchase fell in Q3. And
0
Consumer credit
forward-looking indicators of activity — such as the Royal
–
Institution of Chartered Surveyors (RICS) new buyer enquiries
4
2003 04 05 06 07 08 09 10 balance — also declined (Table 1.B).

House prices have fallen in recent months: the average of the

Chart 1.16 Average quoted interest rates on new Halifax and Nationwide house price indices declined by 1.4%
household borrowing(a) in the three months to October compared with the previous
Per cent
12 three months. The level of house prices in October 2010 was
Personal loan(b) similar to that a year earlier, and around 14% below its
10 October 2007 peak (Chart 1.9).

90% loan to value fixed-rate

mortgage(c)(d)
8 Lenders’ responses to the Credit Conditions Survey suggest that
the availability of unsecured credit has been broadly flat in
6
2010, having tightened markedly during 2008 and 2009.
75% loan to value New unsecured lending rates, such as those on personal loans,
4
fixed-rate mortgage(c)
have also been little changed in 2010, having risen markedly
Bank Rate tracker mortgage(e) 2
since the financial crisis began (Chart 1.16). The tightness of
credit conditions for unsecured lending is likely to have
0 weighed on the spending of some households (see the box on
2006 07 08 09 10
pages 22–23).
(a) Sterling-only end-month average quoted rates. The Bank’s quoted interest rates series is
currently compiled using data from up to 23 UK monetary financial institutions. The data are
non seasonally adjusted.
(b) Quoted interest rate on a £10,000 personal loan.
(c) Two-year fixed-rate mortgage.
(d) Series is only available on a consistent basis back to May 2008, and is not published for
March-May 2009 as only two or fewer products were offered in that period. (1) Recent developments in lending to small and medium-sized enterprises are discussed
(e) On mortgages with a loan to value ratio of 75%. in more detail in a box on pages 7–8 of the October 2010 edition of Trends in Lending.
 Section 1 Money and asset prices 17

Table 1.B Indicators of housing market activity(a) 1.4 Money

Averages 2009 2010
The four-quarter growth rates of broad money and bank credit
since 2000 Q4 Q1 Q2 Q3
remained extremely weak in 2010 Q3 (Chart 1.17). Those
Property transactions (000s)(b) 102 87 71 74 77
trends reflect, in part, the severe monetary squeeze
Mortgage approvals (000s)(c) 92 58 48 49 48
precipitated by the financial crisis: as banks tightened the
RICS sales to stock ratio(d) 0.37 0.30 0.27 0.27 0.24
supply of credit, fewer loans have been advanced, reducing
RICS new buyer enquiries(e) -2 25 -3 4 -10
RICS new instructions to sell(e) 4 14 10 21 23
deposit growth.
HBF net reservations(f) -6 35 10 -5 -38
HBF site visits(f) -14 8 -4 -18 -37 Household broad money growth has remained much weaker
than its average in the years leading up to the financial crisis
Sources: Bank of England, Her Majesty’s Revenue and Customs, Home Builders Federation, Royal Institution of
Chartered Surveyors and Bank calculations. (Chart 1.18). In addition to subdued growth in bank lending,
(a) Averages of monthly data. All series are net percentage balances unless otherwise stated. the weakness of household money growth may also reflect
(b) Number of residential property transactions with value £40,000 or above. Average since April 2005.
(c) Number of mortgage approvals for house purchase. households buying financial assets rather than keeping their
(d) Ratio of sales recorded over the past three months relative to the level of stocks on estate agents’ books at
the end of the month. savings on deposit, given the low returns available. Consistent
(e) Compared with the previous month.
(f) Compared with a year earlier. Q3 data are an average of July and August. Seasonally adjusted by Bank staff. with that, data from the Investment Management Association
show that sales of unit trusts have been very strong since the
beginning of 2009.
Chart 1.17 Broad money and bank credit(a)
Recessions(b) PNFC broad money growth has picked up from very low levels
Broad money
Bank credit
in early 2009 (Chart 1.18). That pickup may have in part
Percentage changes on a year earlier
25 reflected very strong levels of capital market issuance during
2009 (Section 1.3), although some of the proceeds appear to
20
have been used to pay down bank debt. The pickup may also
15 have reflected companies’ desire to build up cash buffers in the
face of uncertainty about future demand and credit availability
10
(Section 2).
5
+ The deposits of non-bank financial institutions excluding
0 intermediaries have fallen sharply in recent quarters, pulling
–
5
down broad money growth (Chart 1.18). That may reflect in
part those institutions buying the debt and equity issued by
1985 90 95 2000 05 10
10 PNFCs and UK banks. Purchases of PNFCs’ debt and equity
(a) The series are constructed using headline M4 and M4 lending (excluding securitisations)
would not directly affect headline M4 growth. But purchases
growth prior to 1998 Q4, and M4 and M4 lending (excluding securitisations) growth
excluding intermediate OFCs thereafter. Intermediate OFCs are: mortgage and housing
of UK banks’ net long-term debt and equity (Section 1.2)
credit corporations; non-bank credit grantors; bank holding companies; and those carrying
out other activities auxiliary to financial intermediation. Banks’ business with their related
would push down total broad money growth.
‘other financial intermediaries’ is also excluded, based on anecdotal information provided to
the Bank of England by several banks.
(b) Recessions are defined as in Chart 1.13.

Chart 1.18 Sectoral broad money(a)

Percentage changes on a year earlier
25

20

Households 15

10

5
+
0

PNFCs
–
5
OFCs excluding
intermediate OFCs(b)
10

15
2000 02 04 06 08 10

(a) Monthly data, unless otherwise specified.

(b) Based on quarterly data. For the definition of intermediate OFCs see footnote (a) in
Chart 1.17.
18 Inflation Report November 2010

2 Demand

UK real GDP rose by 1.2% in 2010 Q2 and is provisionally estimated to have increased by 0.8% in
Q3. Growth in the second quarter was driven by final domestic demand and stockbuilding. Net
trade in goods supported growth, but that was more than offset by an adverse contribution from
services trade. The October Spending Review set out plans for government spending over the next
four years, consistent with the reduction in public sector net borrowing announced in the June
Budget. The world economy has grown strongly in recent quarters. But, as in the United Kingdom,
a continuation of the recovery in private final demand will need to supplant the waning boost from
stockbuilding if growth is to be sustained.

Table 2.A Expenditure components of demand(a) Nominal GDP rose by 1.3% in 2010 Q2, reflecting a 1.2%
increase in real activity and a 0.2% rise in the deflator.
Percentage changes on a quarter earlier
Developments in nominal spending are discussed in the box on
Averages 2009 2010
1997–2008 2009 H1 Q3 Q4 Q1 Q2 page 19. Real GDP was provisionally estimated to have
increased by 0.8% in 2010 Q3 (Section 3).
Household consumption(b) 0.7 -1.0 -0.1 0.8 0.0 0.7
Government consumption 0.6 -0.3 -0.5 0.7 0.7 1.0
Investment 0.9 -7.0 1.5 -2.0 2.9 1.4 Following a fall of around 6½% during the recession, real
of which, business investment 1.2 -9.6 -2.7 -3.5 7.9 0.7
GDP rose by 2% during the three quarters to 2010 Q2. That
of which, dwellings investment(c) 0.3 -9.3 3.3 -5.3 0.2 10.4
Final domestic demand 0.7 -1.8 0.0 0.4 0.5 0.9
was driven by domestic demand, notably by the boost
Change in inventories(d)(e) 0.0 -0.2 0.6 0.1 0.2 0.8 from the turnaround in the stock cycle and by household
Alignment adjustment(e) 0.0 0.3 -0.8 0.1 0.5 -0.5 spending (Table 2.A). Government spending and business
Domestic demand 0.7 -1.6 -0.2 0.7 1.2 1.2
investment also contributed to the recovery. Net trade
‘Economic’ exports(f) 0.9 -5.0 0.8 3.6 -0.7 2.3
‘Economic’ imports(f) 1.2 -5.0 1.1 4.5 2.0 2.4
reduced growth substantially, in part reflecting measured
Net trade(e)(f) -0.1 0.1 -0.1 -0.3 -0.7 -0.1 weakness in financial services exports. The box on page 48
of which, goods(e)(f) -0.1 0.3 -0.2 -0.4 -0.4 0.3 discusses how that pattern of expenditure differs from
of which, services(e) 0.0 -0.2 0.1 0.1 -0.3 -0.4
recoveries following past recessions.
Real GDP at market prices 0.6 -1.6 -0.3 0.4 0.4 1.2
(a) Chained-volume measures.
(b) Includes non-profit institutions serving households.
In order for activity to continue to strengthen, a further
(c) Whole-economy dwellings investment.
(d) Excludes the alignment adjustment. recovery in private final demand is likely to be necessary to
(e) Percentage point contributions to quarterly growth of real GDP.
(f) Excluding the estimated impact of missing trader intra-community (MTIC) fraud. offset a waning boost from the working out of the stock cycle
and slower growth in government spending. Section 2.1
Chart 2.1 Stockbuilding by sector(a) examines the prospects for domestic demand. Section 2.2
£ millions Percentage points
3,000 1.0 considers external demand, including the outlook for UK
Contribution to quarterly GDP growth
(right-hand scale)
exports. Section 2.3 summarises developments in imports.
1,500 0.5

+ + 2.1 Domestic demand

0 0.0
– –
Stockbuilding
1,500 0.5 Stockbuilding contributed 0.8 percentage points to GDP
growth in 2010 Q2, following positive, but smaller,
3,000 Production industries, Stockbuilding 1.0 contributions over the previous four quarters. The Q2 strength
wholesale and retail trades (left-hand scale)
Other industries(b)
was driven by an increase in inventories held by manufacturers
4,500 1.5
and retailers after extended de-stocking (Chart 2.1). Much of
2007 08 09 10
stockbuilding’s contribution prior to that was driven by other
(a) Chained-volume measures.
(b) Excluding the alignment adjustment. industries — including construction and motor trades.
 Section 2 Demand 19

Nominal demand and income Chart A Counterparts to growth in gross final

expenditure on a quarter earlier(a)
Nominal GDP fell sharply between mid-2008 and mid-2009, Percentage points
3
but has since grown strongly. Other indicators of nominal
spending have also grown robustly recently. For example, 2

gross final expenditure — the sum of domestic spending and 1

overseas spending on UK exports — has risen by over 2% +
0
during each of the three quarters to 2010 Q2. This box sets –
out some of the counterparts to that strong recovery in 1

nominal spending. Taxes on products and production 2

less subsidies(b)
Imports(c)
3
All spending in the economy generates income that accrues to Compensation of employees
Gross operating surplus and other income
either domestic households and companies in the form of 4
Gross final expenditure (per cent)
wages and profits, to the government in the form of taxes, or 5
2006 07 08 09 10
to overseas companies via spending on imports. Chart A
shows that, following a period of weakness, growth in (a) At market prices.
(b) Includes a statistical discrepancy.
household and corporate income has recovered a little over (c) Excluding the estimated impact of MTIC fraud.

the past year.

squeezed household and corporate incomes. And, in their
Much of the recovery in gross expenditure growth, however, absence, private sector income growth might have been
reflected stronger spending on imports and higher taxes, stronger.
including the restoration of the standard rate of VAT to 17.5%
in 2010 Q1 and the temporary bank payroll tax in 2010 Q2 Temporary effects on inflation — including the increase in the
(Chart A). That highlights the impact of significant standard rate of VAT to 20% at the start of 2011 (Section 4) —
movements in the price of energy and other imports, as well may continue to influence nominal demand. But strength in
as the VAT increase; in the absence of those price rises, nominal demand growth will also depend on the extent to
nominal spending might have grown less strongly. But it is which household and corporate income growth recover further
also likely that higher prices for some goods and services (Section 5).

Stockbuilding is unlikely to provide such a large contribution to

growth in coming quarters. But the ratio of stocks to GDP
remains well below its pre-recession level. So a further
temporary boost to growth is possible if companies wish to
return the stock-output ratio closer to that level.

Government spending and fiscal policy

A substantial fiscal consolidation is under way in the
Chart 2.2 Public sector net borrowing(a)
United Kingdom. The MPC’s forecast is conditioned on the
Per cent of nominal GDP
12 fiscal plans set out in the June Budget and the October
10 Spending Review. As discussed in the August Report, the
Budget projected a large decline in public sector net borrowing
8
(Chart 2.2). During the first half of 2010/11, cumulative
6 borrowing has been broadly in line with that projection.
4
The consolidation is to be achieved primarily through reduced
2 public sector expenditure as a share of GDP; higher receipts
+
0 play a smaller role. The Spending Review confirmed the
– current expenditure path announced in the June Budget and
2
set out departmental spending budgets from 2011/12 to
1985 90 95 2000 05 10 15
4 2014/15, and more detail on non-departmental spending
Sources: HM Treasury, Office for Budget Responsibility and ONS.
(Table 2.B).
(a) Excluding the temporary effects of financial interventions. Data are for financial years.
Observations to the right of the vertical line are projections. Projections come from the The deterioration in the public finances during the recession
Office for Budget Responsibility’s Budget Forecast. Data for 2009/10 and earlier are based on
ONS data. was associated with an increase in net saving by households
20 Inflation Report November 2010

Table 2.B Public spending(a) and, to a lesser degree, private non-financial corporations
(Chart 2.3). With a major fiscal consolidation now in train,
Percentage changes on financial year earlier
Memo:
lower government borrowing will need to be matched by
projected corresponding adjustments in the financial balances of the
Average Financial years share in
1997–2008 2009 2010 2011 2012 2013 2014 2010(b) private and external sectors. The nature of the adjustments
will have important implications for the strength of the
Current expenditure 5.5 6.4 6.1 2.2 2.1 2.1 2.1 91
of which, benefits(c) n.a. 10.0 3.5 2.8 1.1 -0.1 2.9 28 recovery. For example, during the previous large fiscal
of which, debt interest(d) n.a. 1.3 40.1 7.4 12.7 10.3 9.0 6 tightening in the 1990s, lower government borrowing was
of which, other spending(e) n.a. 5.1 4.6 1.3 1.3 2.2 0.7 58 counterbalanced by reduced private sector net saving. But
Gross investment 12.2 5.5 -13.4 -14.8 -4.3 -6.0 3.5 9 those adjustments could also occur by way of a larger fall in
Total managed expenditure 5.9 6.3 4.1 0.7 1.6 1.6 2.2 100
the current account deficit, associated with weaker imports
Sources: HM Treasury, Office for Budget Responsibility, ONS and Bank calculations. stemming from weak domestic spending. Section 5 discusses
(a) Current prices. The public spending projections are consistent with the 2010 Spending Review. All of these the uncertainties around the path of private saving given the
projections will be reviewed by the Office for Budget Responsibility in their autumn forecast, which is due to
be published on 29 November 2010. fiscal tightening.
(b) Per cent of total managed expenditure.
(c) Includes social security benefits and tax credits. Projections from the June 2010 Budget have been adjusted
by the welfare measures announced in the 2010 Spending Review.
(d) Central government debt interest. Projections from June 2010 Budget. Recent household spending and income data
(e) Calculated as a residual.
Household spending increased by 0.7% in 2010 Q2, having
Chart 2.3 Financial balances by sector been flat in Q1. But that comparison is likely to overstate the
Percentages of nominal GDP
underlying increase in growth, as the Q1 weakness in part
10
reflected the restoration of the standard rate of VAT to 17.5%
and the heavy snowfall in January. Retail sales volumes rose
5 by 1% in 2010 Q3 after growing by 1.6% in Q2. And, following
+ the expiry of the government scrappage scheme, private new
0 car registrations continued to decline in Q3. Overall,
– household spending growth may have weakened slightly in
5 2010 Q3 relative to Q2.
Recessions(a)
Private non-financial corporations Developments in income will influence the path of spending.
Households(b) 10
United Kingdom to rest of Real disposable income fell by 1.6% in Q2 and by 2.6% on a
the world(c)
Government(d) year earlier. Within that, a partial recovery in nominal pre-tax
15
1988 91 94 97 2000 03 06 09 income from employment was more than offset by higher
(a) Recessions are defined as at least two consecutive quarters of falling output (at constant inflation, while the boost to income from government
market prices) estimated using the latest data. The recessions are assumed to end once
output began to rise. transfers net of taxes also waned (Chart 2.4).
(b) Includes non-profit institutions serving households.
(c) Net lending by the United Kingdom to the rest of the world is equivalent to the sum of the
current and capital accounts of the balance of payments.
(d) Excludes public corporations. Influences on household saving
The household saving ratio is estimated to have risen by
Chart 2.4 Contributions to four-quarter growth in real 9 percentage points between the start of 2008 and mid-2009
household disposable income(a) (Chart 2.5). As discussed in previous Reports, that increase is
Non-labour income Prices(d) likely to have reflected a combination of influences: weaker
Net transfers and taxes(b) Total (per cent)
Pre-tax labour income(c)
income expectations, including possible concerns over future
Percentage points
8 pension provision; higher precautionary saving; tighter credit
conditions; and heightened debt concerns. The main financial
6
counterpart to increased saving was a sharp fall in household
4 borrowing. The box on pages 22–23 discusses developments in
household balance sheets in more detail, including the results
2
of the latest survey carried out for the Bank by NMG Financial
+
0 Services Consulting.
–
2
The saving ratio had reversed around half of its previous
4
increase by 2010 Q2, reflecting stronger consumer spending
and weaker income (Chart 2.5). Some of the sharp decline in
2008 09 10
6 saving in Q2 may have been due to erratically low income. But
(a) Chained-volume measure. Includes non-profit institutions serving households.
the lower level is also likely to reflect economic factors.
(b) Transfers, including general government benefits minus employees’ National Insurance
contributions, less taxes, including income tax and Council Tax.
(c) Wages and salaries plus mixed income.
(d) Calculated as a residual.
 Section 2 Demand 21

Chart 2.5 Household saving ratio(a) The low level of interest rates, both short-term and
longer-term (Section 1), is likely to have been one factor
Per cent
14 supporting spending, relative to income.
12
The decline in saving could also suggest that households had
10
completed much of the adjustment to spending warranted by
8 the perceived reduction in their future incomes following the
financial crisis, or that they had revised down the scale of
6
reduction in incomes that they felt was likely. And households
4
may have started to reduce the amount of saving undertaken
2 for precautionary reasons as financial and economic instability
+ eased.
0
–
2 Movements in consumer confidence may, to some degree,
1985 90 95 2000 05 10
reflect those changes in income expectations and the desire to
(a) Percentage of household post-tax income (not adjusted to account for the impact of FISIM).
save for precautionary reasons; confidence was increasing
during some of the period when the saving ratio fell back
(Chart 2.6). Confidence has, however, fallen since 2010 Q1.
Chart 2.6 Indicators of consumer confidence
Differences from averages since 2000 A greater awareness of the extent of fiscal consolidation in
(number of standard deviations)(a)
2 prospect may be affecting saving, and could in part explain the
European Commission(b) recent fall in consumer confidence. Fiscal tightening will
YouGov(c)
1 directly reduce some households’ income growth over the
+ coming years, in part due to the freeze in public sector pay,
0
–
prospective reductions in public sector employment and the
slower growth of benefit payments. Households who think
1
that they might be affected could increase their saving. But
2
there is considerable uncertainty about the strength of that
Nationwide(d) channel and the extent to which households have already
3 adjusted. A series of special questions in this year’s NMG
survey suggested that households who receive more than half
4 of their labour income from the public sector were more
2000 02 04 06 08 10
concerned than other households about losing their job or
Sources: Research carried out by GfK NOP on behalf of the European Commission, Nationwide
and YouGov. suffering lower wages. But, somewhat surprisingly, they were
(a) Unless otherwise stated. no more likely than other working households to say that they
(b) This aggregate confidence index is derived by averaging the answers to questions 1, 2, 3, 4
and 8 in the GfK NOP survey carried out on behalf of the European Commission. were saving more in response to the fiscal consolidation.
(c) Overall prosperity index derived from the answers to questions 1, 2d, 4 and 5 of the YouGov
survey. Differences from average since January 2003.
(d) Differences from average since May 2004.
Overall, the MPC judges that consumption is likely to
continue to recover gradually, although significant risks remain
(Section 5). In the near term, it is possible that the increase in
Chart 2.7 Business investment to GDP ratio(a) the standard rate of VAT to 20% in January 2011 will encourage
Percentage point changes relative to pre-recession level households to bring forward some spending into 2010.
2.5

2.0
Investment
1.5 Real business investment stood 17% below its pre-recession
1980s
1.0 level in Q2. Relative to GDP, the fall was somewhat larger than
0.5 in previous recessions (Chart 2.7). As investment is more
+
0.0 import-intensive than other forms of expenditure, one reason
–
0.5 for that weakness may have been a rise in the price of
1990s 1.0
investment goods, relative to the prices of other goods and
1.5
services, following the large depreciation of sterling that started
Latest in mid-2007. That stands in contrast to falling relative prices
2.0
during previous recessions.
2.5
0 4 8 12 16 20 24 28 32
Quarters from pre-recession peak in GDP
Tight credit conditions may have also been restraining
(a) Chained-volume measures. Recessions are defined as in footnote (a) of Chart 2.3. investment. But there has been a gradual improvement in
22 Inflation Report November 2010

Household balance sheets enter the market for the first time, may have been affected
differently to spending by those who suffer from falling
The outlook for household spending depends in part on the prices, such as those wishing to trade down or leave the
extent to which households choose to strengthen their balance owner-occupied market.
sheets in the wake of the financial crisis. This box summarises
recent developments in household balance sheets, and The path of household secured debt is closely related to
uses the latest annual survey carried out for the Bank by movements in house prices. As house prices rose prior to the
NMG Financial Services Consulting to look at the distribution financial crisis, households needed to take out bigger
of debt.(1) mortgages to purchase a house, raising household debt. That
period of rising debt was associated with an increase in
Aggregate balance sheets and household spending housing equity withdrawal.(3) But only some of those
The stock of household financial and housing assets is withdrawals were used to finance household spending directly.
considerably larger than the stock of debt: in aggregate the Instead, many occurred naturally as houses changed hands:
household sector holds significant net wealth (Chart A).(2) for example, those who had built up considerable housing
Developments in those household balance sheet positions are equity withdrew it as they left the housing market, at the same
driven by patterns of asset and liability accumulation, as well time as first-time buyers took out increasingly large loans. The
as by changes in asset values. equity extracted by last-time sellers, together with those
trading down in the market, appears to have been used mainly
to build up their financial assets including bank deposits
Chart A Household financial assets, residential buildings (Chart B), while first-time buyers, and those trading up,
assets and financial liabilities(a) accumulated higher debts. Since the start of the recession, the
Per cent of annualised post-tax income
500 weakness of housing transactions has therefore limited the
Financial assets 450 amount of equity withdrawal, and has been associated with
400
slower accumulation of financial assets.
350

300
Chart B Household equity withdrawal and net
Residential buildings assets(b) 250 acquisition of financial assets including deposits(a)
200 Per cent of post-tax income
20
150
Acquisition of financial assets
100
Financial liabilities 15
50

0
1987 91 95 99 2003 07 10

(a) Financial assets and liabilities data are non seasonally adjusted. Acquisition of
(b) Annual data. The last observation is for end-2009. deposits
5

Housing equity
Asset — largely equity — prices are a significant influence on withdrawal
+
gross financial wealth. For example, the falls in financial assets 0

as a share of income in 2007 and 2008, and the subsequent –

rebound in 2009, were driven by fluctuations in equity markets 5
1987 91 95 99 2003 07
(Chart A). Those sharp changes in asset values may have led (a) Four-quarter moving averages. Acquisition of financial assets and deposits data are
non seasonally adjusted.
some households to reassess their future wealth and adjust
their spending.
Unsecured debt holdings, although a much smaller proportion
Movements in house prices have similarly affected the value of of household debt, also increased prior to the financial crisis.
housing assets over that period: asset values fell for the first And taking secured and unsecured debt together, the gross
time in twelve years in 2008, but recovered a little in 2009 financial liability to income ratio has fallen back only slightly
(Chart A). Those changes may have influenced household since then (Chart A), despite the weakness of net lending to
spending in a number of ways, including by affecting the value individuals (Section 1). The impact of those debts on
of collateral against which households can borrow to fund household spending will partly depend on the cost of debt
consumption. And consumption could also have been affected servicing. Debt interest payments are, in aggregate, currently
if different types of people are more sensitive to house price quite low relative to household income, reflecting the
changes. For example, spending by households who benefit accommodative stance of monetary policy. But distributional
from falling house prices, such as those wishing to trade up or data on the ability of consumers to service that debt may shed
 Section 2 Demand 23

additional light on the degree to which some households wish paying bills and credit commitments to becoming
to strengthen their balance sheets. unemployed.

Results from the 2010 NMG survey Evidence from the NMG survey suggests that households with
Respondents to the 2010 NMG survey reported, on average, high loan to value (LTV) ratios on their mortgages were more
greater difficulties in keeping up with bills and credit likely to find unsecured debt to be a burden than other
commitments than in the 2008 and 2009 surveys. And a net mortgagors or renters. That may reflect the fact that
balance of respondents also reported that they had become mortgagors with high LTV ratios tend to hold higher amounts
more concerned about their level of debt over the past two of unsecured debt than the average household, perhaps
years. When asked about their response to those concerns, because it is difficult for them to access more secured credit.
around 40% of households mentioned cutting back on
spending and around 30% mentioned avoiding taking out According to the NMG survey, the proportion of respondents
further debt, while only one in ten were actively making reporting that the value of their house was less than the value
overpayments on their existing debts. Nevertheless, of their secured debt fell slightly in 2010 (Chart D). But the
respondents who reported that they planned to, or had started proportion reporting an LTV ratio over 75% remained higher
to, increase their saving tended to attribute that, in part, to the than in 2007 or 2008.
need to reduce debts.
Chart D Distribution of loan to value ratios on
Around half of households hold some form of unsecured debt. mortgagors’ outstanding secured debt(a)
And difficulties in servicing that debt appear to have increased 2007 2009
across a wide range of those households in the latest NMG 2008 2010
Percentages of mortgagors
40
survey. For example, the proportion of respondents reporting
that unsecured debt was somewhat of a burden rose to its
highest level since at least 1995 (Chart C).
30

Chart C Burden of unsecured debt(a)

20
BHPS — somewhat of a burden BHPS — heavy burden
NMG — somewhat of a burden NMG — heavy burden
Percentages of unsecured debtors
50
10
45

40

35 0
0–25 25–50 50–75 75–100 100+
30 Loan to value ratio (per cent)

25 Sources: NMG Financial Services Consulting survey and Bank calculations.

20 (a) Outstanding mortgages and property values used in this survey are self-reported.

15

10
Conclusion
The stock of financial and housing assets is considerably larger
5
than the stock of household debt. But that aggregate position
0
1995 98 2001 04 07 10 masks significant differences in net wealth among different
Sources: British Household Panel Survey (BHPS), NMG Financial Services Consulting survey and types of households. The 2010 NMG survey suggests that
Bank calculations.
there has been a fairly sharp rise in the burden of unsecured
(a) Question: ‘To what extent is the repayment of these loans and the interest a financial burden
on your household?’. debt for some households, as well as an increase in concerns
about the level of debt. The MPC judges that concerns about
The ability to service debt will depend not only on outstanding balance sheets pose a downside risk to household spending in
debt holdings but also on servicing costs and disposable the medium term (Section 5).
income. Some of the recent increase in payment difficulties
(1) The survey was conducted between 24 and 30 September 2010.
among unsecured debtors may reflect the rise in interest rates (2) The role of human capital in household wealth is discussed in Dale, S (2009),
charged on some credit cards. Respondents to the NMG ‘Separating fact from fiction: household balance sheets and the economic outlook’,
available at www.bankofengland.co.uk/publications/speeches/2009/index.htm.
survey who reported that unsecured debt was a heavy burden Detailed data on property, financial, physical and private pension wealth are
presented in Office for National Statistics (2009), ‘Wealth in Great Britain: main
also reported larger falls in available incomes over the past results from the Wealth and Assets Survey 2006/08’.
year than the average household. And a larger proportion of (3) For further details on housing equity withdrawal, see the box on page 146 of ‘House
prices and consumer spending’, Bank of England Quarterly Bulletin, Summer 2006,
respondents than in previous surveys attributed difficulties pages 142–54.
24 Inflation Report November 2010

Chart 2.8 Capital expenditure by company size(a) corporate credit conditions over the past year, at least for large
businesses (Section 1). And the number of businesses
Indices: 2008 = 100
130 reporting to the CBI that the availability of external finance
20–49 employees
(10%) 120
was constraining investment has fallen since 2009.

300+ employees 110 Indicative data on investment split by company size may shed
(66%)
additional light on the impact of credit. A somewhat greater
100
fall in investment by smaller companies during the recession
90 (Chart 2.8) could indicate that they were struggling to raise
external finance: large businesses are likely to have access to
80
more sources of external funding (Section 1).
70
50–299 employees
(24%) Businesses may also be able to finance spending internally.
2006 07 08 09 10
60 Private non-financial corporations have continued to run a
Sources: ONS and Bank calculations. substantial surplus of profits over investment since the end of
(a) These data are from the ONS Quarterly Capital Expenditure Inquiry, and account for around the recession (Chart 2.3). And evidence from a special survey
two thirds of total business investment. The data are for the private sector, at current prices,
and are non seasonally adjusted. Figures in parentheses are shares of capital expenditure by the Bank’s Agents suggests that businesses currently have
in 2009.
above-normal cash holdings. That survey also suggested that,
on balance, companies intend to reduce their cash holdings
over the next twelve months, in part by increasing investment.
Table 2.C Surveys of investment intentions (plant and
machinery)(a) Uncertainty about the outlook could continue to hold back
Net percentage balances investment, however. Indicators of business confidence have
Averages 2009 2010 fallen and reports from the Bank’s Agents suggest that may
1999–2007 2008 H1 H2 Q1 Q2 Q3 have reflected some businesses’ uncertainty ahead of the
Manufacturing Spending Review. The results of another special survey by the
BCC 11 -3 -34 -10 -6 7 11 Bank’s Agents carried out just before the Spending Review
CBI -15 -34 -40 0 1 2 10 suggested that, on balance, more businesses planned to
Services expand capital expenditure over the next twelve months than
BCC 16 -4 -20 -6 -5 2 -1
during the past twelve months, although one third intended to
CBI -6 -24 -46 -22 -15 -14 -5
review those plans following the Spending Review.
Sources: BCC, CBI, CBI/PwC and ONS.

(a) Net percentage balances of companies that say they have increased planned investment in plant and Overall, the outlook for business investment appears to have
machinery over the past three months (BCC), or revised up planned investment in plant and machinery over
the next twelve months (CBI). BCC data are non seasonally adjusted and cover the manufacturing and strengthened somewhat, consistent with recent news in some
services sectors. CBI data cover the manufacturing, financial, retail and consumer/business services sectors.
The CBI services surveys are weighted together using shares in real business investment. investment intention surveys (Table 2.C).

2.2 External demand

Chart 2.9 IMF world GDP growth projections(a)
The global economy has grown strongly in recent quarters.
April 2009 July 2010
October 2009 October 2010
And the IMF’s projections for world GDP growth in 2010 have
April 2010
Per cent
been revised up significantly over the past 18 months, to a rate
6
above the average of about 4% over the decade prior to the
financial crisis (Chart 2.9). Their projection for growth in 2011
5
has remained broadly unchanged.
4
The euro area
3 Euro-area GDP rose by 1.0% in 2010 Q2, the strongest growth
for four years. Within that, German GDP increased by 2.2%, in
2 part driven by a pickup in final domestic demand (Table 2.D).
Indicators of near-term activity are nevertheless consistent
1
with some slowing in GDP growth in Germany and across the
euro area as a whole in Q3.
0
2010 11

Source: IMF World Economic Outlooks. Demand prospects remain weaker in a number of euro-area
(a) At constant prices. economies that are undergoing substantial fiscal
 Section 2 Demand 25

Table 2.D Final domestic demand in the United Kingdom’s major consolidations. For example, in Ireland — a relatively
trading partners(a) important trading partner for the United Kingdom — the
Percentage changes on a quarter earlier
Government recently announced that the fiscal adjustment
Averages 2010 over the next four years would need to be much larger than set
2000–07 2008 2009 Q1 Q2 Q3 out previously. And Irish GDP fell by 1.2% in 2010 Q2,
Euro area (43%) 0.5 -0.3 -0.5 0.1 0.5 n.a.
although these data are extremely volatile.
of which, Germany (9%) 0.2 0.1 -0.4 0.6 1.4 n.a.
of which, France (7%) 0.6 -0.1 0.1 -0.2 0.4 n.a. The United States
of which, Netherlands (7%) 0.4 0.2 -1.0 0.1 0.9 n.a. US GDP increased by 0.5% in 2010 Q3, slightly faster than
of which, Ireland (6%) 1.3 -2.3 -2.8 -2.8 1.5 n.a. in Q2, but slower than around the turn of the year. Taking Q2
United States (17%) 0.7 -0.6 -0.4 0.3 1.1 0.6 and Q3 together, final domestic demand growth strengthened
Japan (2%) 0.3 -0.6 -0.4 0.5 0.1 n.a. somewhat (Table 2.D), while the stock-cycle boost began to
Source: Thomson Reuters Datastream. fade. Net trade reduced growth substantially.
(a) Chained-volume measures. Figures in parentheses are shares in UK goods and services exports in 2009.
The path of consumer spending will be a key determinant of
the strength of the recovery in final demand. The saving rate
of US households has risen markedly since the start of the
Chart 2.10 US household indicators
financial crisis (Chart 2.10). That period saw a doubling in the
Recessions(a)
Unemployment rate (right-hand scale)
unemployment rate and a large fall in house prices. It is
Personal saving rate (right-hand scale) difficult to know whether households wish to increase their
Home prices (left-hand scale, which has been inverted)
Index: January 2000 = 100 Per cent
rate of saving further in order to repair their balance sheets.
0 12
Conditions in the labour market may continue to weigh on
30
spending. But the Federal Open Market Committee’s recent
10
decision to provide additional monetary stimulus should
60
8
support demand.
90
6 Asia
120 Activity in Asia has recovered significantly over the past year.
4 Robust GDP growth was maintained in the most recent data,
150
although there was a moderation in the pace of expansion in
2 some economies, reflecting, in part, earlier policy tightening.
180

For example, four-quarter growth in China slowed from 10.3%

210 0
1985 90 95 2000 05 10 in 2010 Q2 to 9.6% in Q3. Business surveys have, however,
Sources: Bureau of Economic Analysis, NBER, Standard & Poor’s/Case-Shiller and Thomson suggested strengthening growth in some large Asian
Reuters Datastream.
economies in recent months.
(a) Recession bars use NBER dating methodology.

World trade and UK exports

The prospects for exports depend in large part on the
sustainability and strength of the recovery in international
trade. World trade has grown more quickly than world GDP
since the end of the global recession, following an unusual
period in which it fell more sharply.(1) Growth in world imports
of goods slowed to 2% in the three months to August
compared with the three months to May, weaker than the 6%
rates recorded around the turn of the year. That may reflect
the waning influence of the stock cycle on global trade flows.

The outlook for UK exports will also depend on the extent to

which improved competitiveness for some companies,
following the 25% depreciation of the sterling exchange rate
since mid-2007, boosts external demand. UK exports of goods
and services increased by 2.3% in 2010 Q2, following a

(1) See ‘Interpreting the world trade collapse’, Bank of England Quarterly Bulletin, Vol. 50,
No. 3, pages 183–89.
26 Inflation Report November 2010

Chart 2.11 Ratios of UK exports to UK-weighted weather-related fall of 0.7% in Q1. Given rapid growth of
M6 imports(a) world trade in 2010 H1, that suggests that exporters continued
Indices: 2000 Q1 = 100 to lose global market share.
150

140 But that aggregate picture masks differences between goods

130 and services exports. Indicative estimates of UK exports
Services relative to world imports suggest that the fall in sterling has
120
supported goods exports over the past two years relative to
110 previous trends (Chart 2.11). In contrast, services exports
100 appear to have underperformed relative to global demand.

Goods 90
That weakness has in large part been driven by falls in exports
80 of financial services — which the United Kingdom specialises in
70 (Chart 2.12). That may reflect the impact of the crisis on the
1991 94 97 2000 03 06 09
demand for these, relative to other, services. It could also
Sources: ONS, Thomson Reuters Datastream and Bank calculations.
reflect difficulties in measuring financial services exports —
(a) Chained-volume measures excluding the estimated impact of MTIC fraud. UK goods
(services) exports divided by imports of goods (services) in Canada, France, Germany, Italy, particularly during the past few quarters, when respondents to
Japan and the United States, weighted using UK 2009 goods (services) export shares from
the 2010 Pink Book. The vertical lines mark the beginning of the major nominal exchange the CBI’s Financial Services Survey have reported strong growth
rate movements that began in 1992 Q3 (a depreciation), 1996 Q2 (an appreciation) and
2007 Q3 (a depreciation). in overseas business, but when UK exports of financial services
are estimated to have fallen sharply.
Chart 2.12 Cumulative contributions of services trade to
GDP growth since 2007 Q2(a)
Percentage points Overall, the MPC judges that the past exchange rate
Total depreciation will continue to boost UK exports although the
Financial extent of that boost remains uncertain (Section 5).
Other business
Computer and information
Royalties and license fees 2.3 Imports
Personal, cultural and recreational
Communications Imports depend on the level and composition of demand in the
Construction
economy, as well as the price of foreign goods and services
Government
relative to domestically produced ones. Imports increased by
Insurance
Transportation
Exports over 10% in the year to 2010 Q2, while import-weighted
Imports(b)
Travel demand rose by only around 6% during that same period.
1.5 1.0 0.5 – 0.0 + 0.5 1.0
That strength stands in contrast to developments during the
Sources: ONS and Bank calculations. recession, when imports declined more quickly than
(a) Chained-volume measures. import-weighted demand (Chart 2.13).
(b) A positive (negative) contribution to GDP growth from imports represents a fall (rise) in
imports.
Such large swings in imports relative to demand make it harder
Chart 2.13 UK imports and import-weighted demand(a) to identify the extent of expenditure switching towards
Percentage changes on a year earlier
16 UK-produced goods and services following the increase in
Imports(b) 12 import prices resulting from the mid-2007 depreciation of
sterling. Disaggregated data suggest that imports of travel
8
services — spending overseas by UK residents — have fallen
4 sharply since that depreciation (Chart 2.12). But substitution
+
0 away from imports in other sectors may take time as UK
– companies build a presence in markets currently supplied by
Import-weighted demand(c) 4
overseas producers.
8

12

16
1987 91 95 99 2003 07
Sources: ONS and Bank calculations.

(a) Chained-volume measures.

(b) Excluding the estimated impact of MTIC fraud.
(c) Calculated by weighting household consumption (including non-profit institutions serving
households), whole-economy investment (excluding valuables), government spending,
stockbuilding (excluding the alignment adjustment) and exports (excluding the estimated
impact of MTIC fraud) by their respective import intensities. Import intensities are estimated
using the United Kingdom Input-Output Analytical Tables, 1995.
 Section 3 Output and supply 27

3 Output and supply

Output growth was estimated to be 0.8% in Q3, similar to its average in the first half of the year,
and slightly above its long-run average. Companies’ effective supply capacity is likely to have fallen
during the recession relative to a continuation of its pre-recession trend. But the extent to which
that is temporary or permanent is highly uncertain and will depend in part on the evolution of
output growth. There is mixed evidence regarding the extent of spare capacity within companies.
Employment appears to have begun to recover but considerable labour market slack remains.

Output growth in 2010 Q3 was in line with its average in the

first half of the year (Section 3.1). Different indicators offer
contrasting views of the margin of spare capacity within
companies. Surveys suggest limited spare capacity within
companies, but productivity data imply that there may be
Chart 3.1 GDP and sectoral output(a)
more spare capacity. The signal from these data depends
Indices: 2006 = 100
110 crucially on the extent to which the fall in the supply capacity
of the economy relative to a continuation of its pre-recession
105 trend is temporary or permanent (Section 3.2). There have
Services
Construction been signs of some recovery in employment, but there is
100
conflicting evidence on the pace of that recovery (Section 3.3).
GDP

95
3.1 Output

Quarterly GDP growth in 2010 Q3 was provisionally

Manufacturing 90
estimated to be 0.8%. That was lower than growth of 1.2% in
Q2, but in line with its average in the first half of the year.
85
2003 04 05 06 07 08 09 10 Despite a year of expansion, the level of output in Q3 was still
(a) Chained-volume measures. GDP is at market prices. Indices of sectoral output are at basic
around 4% below its pre-recession peak (Chart 3.1), and
prices.
further still below the level implied by a continuation of its
pre-recession trend. As discussed in the box on page 48,
Chart 3.2 Indicators of construction output growth growth in the first year of this recovery has been somewhat
Differences from averages since 2000 (number of standard deviations)
5
faster than during the first year of both the 1980s’ and 1990s’
recoveries.
4

3
Growth in both Q2 and Q3 was boosted by strong growth in
Range of survey indicators(a)
2 the construction sector. Construction output is estimated to
1 have increased by 9.5% in Q2, accounting for around half of
+
0
the growth in GDP. That increase was partly due to a recovery
– following bad weather in Q1. Moreover, the rise was larger
ONS construction output(b) 1
than implied by survey indicators of construction output
2
(Chart 3.2). Construction was provisionally estimated to have
3 grown by 4% in Q3 — again that was stronger than implied by
4 business surveys. But other indicators are more consistent
2003 04 05 06 07 08 09 10
with marked strength in construction: employment rose
Sources: Bank of England, CIPS/Markit, Experian and ONS.
robustly in Q2 (Section 3.3) and building materials
(a) Measures included are the Bank’s Agents’ end-quarter score for construction output relative
to a year ago, the quarterly average of the CIPS/Markit construction activity index and the manufacturers reported their strongest output growth since
quarterly average of the Experian construction activity index. Data are to 2010 Q3.
(b) Quarterly growth. 1995 in the October CBI Quarterly Industrial Trends Survey.
28 Inflation Report November 2010

Service sector output grew by 0.6% in Q3, the same rate as in

Q2 and close to its historical average growth rate. The Q3
data are provisional — for example, Index of Services data are
only available for the first two months of Q3 — so it is possible
that they may be revised in due course. But they suggest that
services output growth was broadly based; growth ranged
from 0.5% to 0.7% across the main subsectors.

Since the trough in GDP, manufacturing output has grown

Chart 3.3 Indicators of aggregate output growth(a) more strongly than services output (Chart 3.1). That pattern
Differences from averages since 2000 (number of standard deviations) continued in Q3. The larger fall in manufacturing output
2
CBI during the recession and the faster recovery is consistent with
1 manufacturing being more cyclical than services. The demand
+ for durable goods is highly cyclical. And inventories tend to be
0 more prevalent in manufacturing, so stocks will have made
– larger contributions to manufacturing growth as the stock
BCC
1 cycle has progressed (Section 2). Moreover, manufacturing
CIPS(b) tends to be more export-intensive than services, and goods
2
exports have been stronger than services exports (Section 2),
suggesting that manufacturers have received a greater boost
3
ONS GDP(c)
from the recovery in world trade and the lower exchange rate.
4
2000 02 04 06 08 10
CIPS/Markit business activity indices in October were similar
Sources: BCC, CBI, CBI/PwC, CIPS/Markit and ONS.
to their Q3 averages (Chart 3.3). But those, and some other
(a) These measures are produced by weighting together surveys from the BCC (manufacturing,
services), the CBI (manufacturing, financial services, business/consumer services, distributive survey indicators of output growth and confidence, are below
trades) and CIPS/Markit (manufacturing, services, construction) using nominal shares in value
added. The BCC data are non seasonally adjusted. levels seen earlier in the year, suggesting growth may slow in
(b) The diamond shows October data.
(c) Quarterly growth, chained-volume measure at market prices. the near term.

3.2 Capacity pressures and companies’

supply capacity

Inflation depends, in part, on the level of output relative to

potential supply. The resultant margin of spare capacity can
be located either within companies or in the labour market.

Chart 3.4 Survey measures of capacity utilisation by A significant margin of spare capacity opened up within
sector companies during the recession, but its exact size is difficult to
Differences from averages since 2000 (number of standard deviations) quantify. One approach is to use evidence from surveys. A
3
second is to consider movements in productivity relative to a
Range of service survey
indicators(a)
2 measure of trend productivity; this proxies how much output
was produced relative to what could have been produced.
1
Taken at face value, the two approaches give differing views
+
0 about the amount of spare capacity within companies.
–
1
Business surveys suggest that there is relatively limited spare
Range of manufacturing 2
capacity within companies at present. Spare capacity in
survey indicators(b)
services appears to have narrowed in recent quarters, although
3 some remains (Chart 3.4). But surveys suggest that capacity
4
utilisation within manufacturing companies has closed more
2000 02 04 06 08 10 quickly and is now close to pre-recession levels.
Sources: Bank of England, BCC, CBI, CBI/PwC and ONS.

(a) Includes measures of services capacity utilisation from the Bank’s Agents, BCC and CBI. The
CBI measure weights together financial services, business/consumer services and distributive Productivity data appear to imply a larger amount of spare
trades surveys using shares in nominal value added. The BCC data are non seasonally
adjusted. capacity within companies. The fall in hours worked during the
(b) Includes measures of manufacturing capacity utilisation from the Bank’s Agents, BCC and
CBI. The BCC data are non seasonally adjusted. recession was proportionally smaller than the fall in output,
 Section 3 Output and supply 29

Chart 3.5 Labour productivity by sector(a) and therefore hourly labour productivity fell (Chart 3.5).
Indices: 2008 Q1 = 100 Recent developments in output (Section 3.1) and employment
112
(Section 3.3) mean that manufacturing productivity has begun
Continuation of
pre-recession trends(b)
108
to recover, although services productivity has remained
subdued. But productivity in both sectors remains far below
104 what would be implied by a continuation of pre-recession
trends. If the recession had little or no impact on the rate of
Services
100 underlying productivity growth, that would suggest that
companies have substantial spare capacity. In that case, they
96
should be able to meet higher demand without expanding
Manufacturing
their workforce, by increasing productivity back towards its
92
trend level. But if potential productivity growth has been
88
weaker than its pre-recession trend, there will be somewhat
2005 06 07 08 09 10
less spare capacity.
(a) Output per hour.
(b) Pre-recession trends are calculated by projecting forward labour productivity from 2008 Q2
using the average quarterly growth rate between 1996 Q1 and 2008 Q1.
One way to reconcile the surveys and productivity data is a fall
in the effective supply capacity of the economy relative to its
Chart 3.6 Operational capacity and output in the previous trend. That includes factors that might have
UK automotive industry(a) temporarily restricted companies’ ability to produce output
Number of units, thousands
550 but that do not affect their longer-run supply capacity. And if
Operational capacity(b) companies do not take into account temporarily unavailable
500
capacity when responding to surveys, survey measures may
450
understate the extent of capacity available to businesses in the
400
longer run.
350
Output(c)
300
Examples of shorter-run factors that may have reduced
effective supply include restricted access to the working
250
capital required for day-to-day operations, and temporary
200 reductions in capacity, such as shutdowns of some production
150
lines that are costly or difficult to reverse quickly. The UK auto
0
2006 07 08 09 10 industry is one example of an industry in which productive
Sources: PwC Autofacts and Bank calculations. capacity was reduced during the recession by shutdowns of
(a) The data cover all light vehicle manufacturing plants and powertrain plants. The plant-level
data are aggregated to produce industry-level measures of operational capacity and output.
production lines and reductions in the number of shifts.
Data have been seasonally adjusted by Bank staff.
(b) Operational capacity is a measure of the number of units that a factory can produce each
Plant-level data show that a measure of capacity in this
quarter. It is defined as the product of the number of working days, the number of shifts per
day, the number of hours per shift and the number of units each shift can produce in one hour.
industry fell by around 20% during the recession (Chart 3.6).
(c) Units assembled each quarter. The airline sector is another industry in which capacity fell in
the recession as companies withdrew aircraft from service in
response to weak demand (Section 4).
Chart 3.7 Employment in previous recoveries(a)
Indices: trough in output = 100
104
But surveys and productivity data could also be reconciled by a
more permanent hit to supply capacity. Supply may be
102 permanently lower relative to its pre-crisis trend if the
LFS employment: current
economic restructuring associated with the recession has led
Workforce Jobs: current
100 to a shift away from high-productivity industries towards
industries with lower productivity. And if skills acquired while
LFS employment: 1990s
98 working and while producing output are an important source
of productivity gains, then the falls in hours worked and in
output during the recession may have reduced the growth of
96
LFS employment: 1980s underlying productivity. Moreover, weak investment and a rise
in corporate liquidations are likely to have had a permanent
94
8 6 4 2 – 0 + 2 4 6 8 10 12 effect on supply during the recession. But the impact through
Quarters from trough in output
these channels is likely to have been relatively modest;
Source: ONS (including the Labour Force Survey).
quarterly investment flows are small relative to the size of the
(a) Recessions are defined as at least two consecutive quarters of falling output (at constant
market prices) estimated using the latest data. And the recoveries are assumed to begin in capital stock, and corporate liquidations rose by less than in
the quarter that follows the trough in output. LFS data are rolling three-month measures.
Workforce Jobs data are quarterly. the early 1990s recession, despite a larger fall in output.
30 Inflation Report November 2010

Chart 3.8 Quarterly changes in the Workforce Jobs The MPC judges that, on balance, there is likely to be
measure of employment significant spare capacity within companies; some that is
Thousands
200
immediately available and some that could be brought back as
demand recovers. But, if demand remains weak, companies
150
may scrap that capacity, and potential supply will become
100
permanently lower. The implications of spare capacity for the
50
+ MPC’s forecast are discussed in Section 5.
0
–
50
3.3 The labour market
100

Construction Other(a)
150 Labour demand
Services Total 200 Temporarily low productivity and significant spare capacity
Manufacturing
250 within companies should allow companies to meet higher
300 demand without expanding their workforce.
2007 08 09 10
(a) Includes agriculture, forestry and fishing, mining and quarrying, electricity, gas, steam and
air conditioning supply, and water supply, sewerage, waste and remediation activities. The latest employment data paint a mixed picture on this,
however. According to the Labour Force Survey (LFS),
Chart 3.9 Surveys of employment intentions and employment increased by 178,000 between the three months
measures of employment
Differences from averages since 2000 (number of standard deviations)
to May and the three months to August. But the less timely
3
Workforce Jobs data suggest a more modest pace of recovery
Range of survey indicators(a)
Workforce Jobs(b) 2 in employment. Workforce Jobs increased by 70,000 between
March and June, less than half the increase in LFS employment
1
over the equivalent period. Using either the Workforce Jobs or
+
0
LFS measures, employment appears to have stabilised, or
– begun to recover, earlier than during the previous two
1 recoveries where employment continued falling for around
two years after output had started rising (Chart 3.7).
LFS employment(b) 2

3 Sectoral differences in employment are potentially

informative, although a reliable breakdown is only available for
4
2000 02 04 06 08 10 Workforce Jobs. 53,000 of the increase in Workforce Jobs
Sources: Bank of England, BCC, CBI, CBI/PwC, Manpower and ONS (including the Labour Force Survey). between March and June was in construction (Chart 3.8),
(a) Measures included are based on employment intentions balances from the Bank’s Agents
(manufacturing and services), the BCC (manufacturing and services) and the CBI (manufacturing,
consistent with the large increase in construction output in Q2
financial services, business/consumer services) and are weighted using employment shares from
Workforce Jobs. The BCC data are non seasonally adjusted. The Manpower data which are also
(Section 3.1). In manufacturing, Workforce Jobs data suggest
included cover the whole economy.
(b) Percentage changes on a quarter earlier. Data are to 2010 Q2.
that employment has continued to decline: increases in
output appear to have been met by a recovery in hours and
Chart 3.10 Annual changes in employment(a) through higher hourly productivity. In services, employment
Thousands
1,000 has shown signs of stabilisation in recent quarters following
Private sector
800
previous large declines. Increases in average hours within the
Public sector(b)
Total
service sector have only been modest, perhaps related to an
600
increase in part-time working.
400

200 Overall, recent employment data look a little stronger than

+ might have been expected given the likely substantial degree
0
– of spare capacity within companies. But that difference is less
200
marked for Workforce Jobs than the LFS data, and it is too early
400
to draw strong signals from such movements. Further,
600 evidence from surveys of employment intentions tend to point
800 to somewhat weaker near-term employment growth than
1984 89 94 99 2004 09
Source: ONS (including the Labour Force Survey).
shown by either measure of employment (Chart 3.9).
(a) Total employment change is Q2 to Q2. Public sector employment changes are June to June.
The private sector change is defined as the difference between the whole economy and the Developments in demand and the extent of spare capacity
public sector changes. The dates on the chart show the year that the change in employment is
from, for example, 1999 represents the change in employment between 1999 Q2 and 2000 Q2. within companies will be key determinants of the prospects
(b) Total general government employees (excludes public sector corporations). Prior to 1991
changes in general government employment are estimated using Workforce Jobs data. Changes for employment. But the outlook for employment will also
in public and private sector employment are affected by reclassifications of organisations
between the public and private sectors. In particular, the transfer of further education college be affected by the prospective fiscal consolidation. The
and sixth-form school employees from the public to the private sector in April 1993 accounts
for a significant part of the fall in public sector employment between June 1992 and June 1993. public sector supported employment during the recession
 Section 3 Output and supply 31

Chart 3.11 Contributions to changes in the participation (Chart 3.10). But, according to Office for Budget Responsibility
rate since the start of the recession(a) projections, public sector employment is expected to fall by
Percentage point changes from three months to March 2008
0.4
approximately 500,000 — just under 2% of aggregate
employment — by 2015.
0.2

+
Labour supply
0.0 Labour supply may have been impaired by the recession, but so
– far these effects appear to have been modest. The participation
0.2 rate — the number of people working or seeking work as a
percentage of the adult population — has risen recently and
0.4
Non-students was only a little below its pre-recession level in the three
Students
months to August (Chart 3.11).
Total 0.6

The fall in the participation rate during the recession was

0.8
Jan. July Jan. July Jan. July
2008 09 10
entirely accounted for by an increase in the number of students.
Source: Labour Force Survey. And the unwinding of that explains much of the recent pickup
(a) Percentages of the 16+ population. Rolling three-month measures. in the participation rate. The fall in participation in the latest
recession was smaller, and so far less persistent, than the falls
Chart 3.12 Flows from unemployment to employment(a)
Per cent
associated with past recessions. For example, in the early
40
1990s there was a large rise in inactivity associated with
long-term sickness and a fall in older-worker participation. In
Short-term unemployed(b)
contrast, participation by older workers increased during this
30
recession.

20
Migration continues to boost labour supply. The data are
subject to significant uncertainty, but provisional ONS
estimates suggest that net inward migration has recovered
10 somewhat, having fallen during the recession. Future migration
Long-term unemployed(c) may be constrained by the cap on non-EU migration that was
initially implemented as a temporary cap in July 2010.
0
1998 2000 02 04 06 08 10
Sources: Labour Force Survey and Bank calculations. Even though measured labour supply has begun to recover, it is
(a) Based on quarterly LFS microdata that have been seasonally adjusted by Bank staff.
(b) Flows into LFS employment by those who had been unemployed for fewer than
possible that there may still be downward pressure on effective
twelve months divided by the number of people who were unemployed for fewer than
twelve months in the previous quarter.
labour supply from increases in long-term unemployment. The
(c) Flows into LFS employment by those who had been unemployed for more than
twelve months divided by the number of people who were unemployed for more than
long-term unemployed have a lower probability of finding work
twelve months in the previous quarter. than those who have been unemployed for shorter periods
(Chart 3.12), possibly because long periods of unemployment
Table 3.A Selected indicators of labour market pressure
impair the skills of those affected.
Averages 2010
since 1998 Q1 Q2 Q3 Long-term unemployment has continued to increase during
LFS unemployment rate(a) 5.7 8.0 7.8 7.7 2010 even as overall unemployment has stabilised (Table 3.A).
LFS long-term unemployment rate(a)(b) 1.4 2.4 2.5 2.6 But it remains markedly lower than in the mid-1980s and early
Vacancies/unemployed ratio(a)(c) 0.36 0.19 0.20 0.19 1990s. Moreover, the share of the long-term unemployed
Recruitment difficulties finding work has risen since the end of the recession and is now
Agents’ scores(d) 0.8 -2.8 -1.9 -1.6 above its pre-recession average (Chart 3.12).
BCC(e) 60 43 53 50
CBI skilled staff(f) 24 11 13 11
Labour market tightness
CBI unskilled staff(f) 6 2 2 4
A large amount of slack opened up in the labour market during
Sources: Bank of England, BCC, CBI, CBI/PwC and ONS (including the Labour Force Survey). the recession: the LFS unemployment rate rose by around
(a) The figure for 2010 Q3 shows data for the three months to August. 2.5 percentage points. The unemployment rate is still elevated
(b) Defined as those who have been unemployed for more than twelve months divided by the economically
active population. at close to 8%, and the vacancy to unemployment ratio also
(c) Number of vacancies divided by LFS unemployment. Vacancies exclude agriculture, forestry and fishing.
Average since June 2001. continues to signal a significant degree of slack (Table 3.A).
(d) Agents’ scores for recruitment difficulties in the most recent three months compared with the situation a
year earlier. End-quarter observations. The scores are on a scale of -5 to +5, with positive scores indicating And although some survey measures suggest that there has
more recruitment difficulties.
(e) Percentage of respondents reporting recruitment difficulties over the past three months. Non seasonally been an increase in recruitment difficulties in recent quarters,
adjusted. Manufacturing and services balances are weighted by shares in employment.
(f) Balances of respondents expecting skilled and unskilled labour to limit output/business over the next three most continue to suggest that companies perceive that the
months (in the manufacturing sector) or over the next twelve months (in the financial, business and
consumer service sectors), weighted by shares in employment. Averages since 1998 Q4. labour market remains loose.
32 Inflation Report November 2010

4 Costs and prices

CPI inflation was 3.1% in 2010 Q3. In part, the current elevated rate of inflation reflects past
strength in import prices and the VAT rise in January 2010. While the impact of import prices has
probably begun to wane, the increase in VAT to 20% in January 2011 is likely to mean that CPI
inflation will remain above the target throughout 2011. Labour cost growth has picked up
somewhat but remains subdued. Spare capacity, both in the labour market and within companies,
is likely to be bearing down on costs and prices. Measures of inflation expectations still appear
broadly consistent with CPI inflation being around the target in the medium term.

CPI inflation remains above the 2% inflation target. The

current elevated rate of inflation reflects a number of
temporary influences (Section 4.1). For example, the
restoration of the standard rate of VAT to 17.5% in January
2010 continues to affect the twelve-month inflation rate. And
Chart 4.1 Measures of inflation(a) it is likely that companies have continued to pass through
Percentage changes on a year earlier increases in import costs resulting from the depreciation of
6
sterling between mid-2007 and the end of 2008 (Section 4.1).
RPI 5
CPIY
4 The increase in the standard rate of VAT in January 2011 means
that CPI inflation is likely to remain above target throughout
3
2011. And near-term inflationary pressures — including higher
2 commodity and other world export prices, and a lower sterling
CPI exchange rate — appear somewhat stronger than at the time
1
+ of the August Report (Section 4.1). But it is likely that spare
0
–
capacity will continue to exert downward pressure on pay
1 growth and price inflation (Section 4.2) and, as the impact of
2
temporary influences wanes, inflation is likely to fall. The
2006 07 08 09 10 medium-term outlook will also depend on inflation
(a) Data are non seasonally adjusted. expectations (Section 4.3).

4.1 Consumer prices

Chart 4.2 CPI goods and services(a)
Percentage changes on a year earlier
6 Developments in CPI inflation
CPI services CPI inflation was 3.1% in September, unchanged from August
4
and July (Chart 4.1). Much of the strength in CPI inflation
reflects elevated goods price inflation, which remains well
above its average since 2000 (Chart 4.2). In contrast, services
Averages since 2000 2
price inflation is currently around its average since 2000. With
+
July’s CPI outturn of 3.1% lying more than 1 percentage point
0
away from target, the Governor, on behalf of the Committee,
– wrote an open letter to the Chancellor.(1) There remains a high
CPI goods 2 probability that the Governor will need to write further open
letters to the Chancellor in the coming months.
4
2000 02 04 06 08 10
(1) The letter is available at
(a) Data are non seasonally adjusted. www.bankofengland.co.uk/monetarypolicy/pdf/cpiletter100817.pdf.
 Section 4 Costs and prices 33

Chart 4.3 Stylised illustration of the contribution of As this subsection discusses, much of the recent strength in
changes in VAT to twelve-month CPI inflation(a) inflation reflects developments in non-wage costs such as
import prices and VAT. But it is likely that weak demand is
Past VAT changes(b)
Forthcoming VAT rise(c) Percentage point contribution to pulling down inflation (Section 4.2). There is considerable
twelve-month CPI inflation
2.0 uncertainty, however, about the precise impact of those
1.5
opposing influences.

1.0
The restoration of the standard rate of VAT to 17.5% in
0.5 January 2010 is boosting both goods and services price
+ inflation. There is considerable uncertainty about the precise
0.0
– impact of VAT on CPI inflation, but evidence from the ONS
0.5
appears broadly consistent with around half of the cut and
Solid lines: full pass-through(d) 1.0 subsequent reversal in VAT having been passed through into
Dashed lines: 50% pass-through(e) consumer prices. The blue lines in Chart 4.3 show how
1.5
different assumptions about pass-through of the temporary
2008 09 10 11 12
2.0 cut, and its subsequent reversal, could be affecting the path of
Sources: ONS and Bank calculations.
inflation.
(a) Data are shown at a quarterly frequency.
(b) Past changes in VAT are as follows: cut from 17.5% to 15% in December 2008; and rise from
15% to 17.5% in January 2010. The share of prices subject to VAT is based on the 2009
In addition to VAT, it is likely that CPI inflation, and particularly
basket. The examples make the simplifying assumption that businesses only adjust their
prices in the months in which VAT was changed.
goods price inflation, is currently being boosted by import
(c) Forthcoming VAT rise is from 17.5% to 20% in January 2011. The share of prices subject to
VAT is based on the 2010 basket. The examples make the assumption that one third of
prices. Import prices rose sharply following the depreciation of
affected businesses raise their prices pre-emptively by the end of 2010.
(d) All prices subject to the standard rate of VAT vary in response to the changes in VAT.
sterling between mid-2007 and the end of 2008: by the end
(e) The prices of half of the CPI basket subject to the standard rate of VAT vary in response to the
changes in VAT.
of 2009, non-energy import prices were around 15% above
their mid-2007 level. But the precise impact of that rise on
CPI inflation is difficult to judge. It will depend, in part, on
companies’ ability to offset rising import costs by reducing
other costs. Moreover, to the extent that companies do pass
through rising import prices, the timing and speed at which
they do so is uncertain. For example, some companies may
pass through cost increases only gradually, if they are unsure
whether the lower level of the exchange rate will persist.

Chart 4.4 Stylised illustration of the contribution of Notwithstanding those uncertainties, it is likely that import
import prices excluding fuels to CPI inflation(a) price pass-through following the depreciation continues to
Percentage points
4
have a substantial effect on CPI inflation. Chart 4.4 provides a
stylised illustration of how rising import prices might have
affected CPI inflation. The swathe, based on a range of
3
assumptions about the timing, speed and extent of import
price pass-through into consumer prices, suggests that the
2
peak impact may have occurred around the end of 2009, but
that the effect remained substantial into 2010.
1

+ Previous Reports have discussed the impact of weak demand

0 on costs and prices, and suggested that weak services price
– inflation throughout 2009 was likely to be a consequence of
1 the substantial degree of spare capacity. But services price
2008 09 10
inflation has picked up since the end of 2009. That is partly
Sources: ONS and Bank calculations. accounted for by the rise in VAT. In addition, higher air fares,
(a) Goods and services import prices excluding fuels and the estimated impact of MTIC fraud are
assumed to account for 25% of the CPI basket. The illustration is based on changes in
despite having a weight of only 2% in the CPI services basket,
non-energy import prices between 2007 Q2 and 2009 Q4, relative to their level in 2007 Q2.
The swathe is produced by constructing a number of stylised profiles for import price
account for half of the pickup in services price inflation since
pass-through based on different assumptions about the point at which pass-through begins,
the time it takes for pass-through to complete and the extent of pass-through into consumer
the end of 2009. In part, higher air fares reflect higher oil
prices. The start point for pass-through is varied between two and four quarters after the
change in import prices, the time taken for pass-through to complete is varied between
prices (Chart 4.5), which take time to pass through into air
two and four quarters and the extent of pass-through is varied between 75% and 100%.
The illustration ends in 2010 Q2.
fares because some airlines are likely to buy fuel in advance at
a fixed price. But higher air fares may also reflect
above-normal capacity utilisation in the airline industry in late
34 Inflation Report November 2010

Chart 4.5 CPI passenger transport by air, oil prices and 2009, in contrast to that in the service sector as a whole
capacity utilisation in the airline sector(a) (Section 3). That may be because some airlines withdrew
Differences from averages since 2004 Percentage change
aircraft from service in response to weak demand, increasing
4
(number of standard deviations) on a year earlier
40
the pressure on capacity as demand recovered. Over time,
CPI passenger transport
by air (right-hand scale)
companies are likely to restore that capacity as it becomes
3 30
economical to do so.
Twelve-month percentage
2 change in sterling oil price(b) 20
(left-hand scale) The outlook for CPI inflation
1 10 The impact of some of the factors boosting CPI inflation, such
+ +
as the depreciation of sterling that occurred between the
0 0
– – middle of 2007 and the end of 2008, is likely to wane in
1 10 coming quarters. But recent increases in commodity and other
Capacity utilisation in the airline
world export prices could lead to renewed upward pressure on
2 20
sector(b)(c) (left-hand scale) inflation. That upward pressure could be heightened if some
3 30 companies need to rebuild their profit margins, which were
2004 05 06 07 08 09 10
compressed during the recession. And the increase in VAT to
Sources: Bloomberg, CAA UK Airline Statistics, ONS and Bank calculations.
20% in January 2011 is likely to mean that CPI inflation will
(a) Data for CPI passenger transport by air and the sterling oil price are to September 2010. Data
for capacity utilisation in the airline sector are to July 2010. remain elevated for some time.
(b) Six-month moving averages.
(c) CAA data on used and available seat kilometres have been seasonally adjusted by Bank staff.
Capacity utilisation is then constructed as the difference between used seat kilometres and
available seat kilometres as a proportion of available seat kilometres. Energy price movements have been a key influence on
CPI inflation in recent years. Since the beginning of 2010, oil
Chart 4.6 Energy prices prices have been relatively stable and futures prices are only
Pence per therm $ per barrel 4% higher than at the time of the August Report (Chart 4.6).
150 150
Spot wholesale gas prices have risen during 2010 (Chart 4.6),
Oil(a) (right-hand scale)
and one gas supplier has announced that their retail prices will
120 120
Oil futures curve(b) rise by just under 10% with effect from December. The MPC’s
(right-hand scale)
latest projections are conditioned on the assumption that
90 90 domestic gas prices rise by around 10% in coming months —
that would boost CPI inflation by around 0.2 percentage
60 60 points.

30 30
Recent rises in non-energy commodity prices are also likely to
Gas futures curve(b) increase pricing pressures for some companies in coming
Gas(c) (left-hand scale) (left-hand scale)
quarters. Agricultural commodity prices have risen by around
0 0
2007 08 09 10 11 35% since the middle of 2010 (Chart 4.7). In part, that is
Sources: Bloomberg, Thomson Reuters Datastream and Bank calculations. likely to reflect temporary supply weakness: for example, bad
(a) Brent forward prices for delivery in 10–21 days’ time.
(b) Futures prices are averages during the fifteen working days to 3 November.
weather has pushed up wheat prices. But other commodity
(c) One-day forward price of UK natural gas. prices have also risen. For example, metals prices have
increased by around 25% since mid-2010. Past strength in
Chart 4.7 Commodity prices(a) commodity prices was associated with robust global growth,
Indices: 2000 = 100
350
particularly in emerging economies, and it is likely that the
recent recovery in global activity has increased demand for a
300 range of commodities.
Industrial metals 250
Export prices in some advanced economies have increased in
200 recent quarters (Chart 4.8), having fallen sharply in 2009. In
part, that pickup is likely to reflect rising commodity prices.
150
But in addition, reports from the Bank’s Agents suggest that
Agriculture and livestock
100 capacity constraints may have led to heightened cost
pressures in some emerging economies.
50

0 The recent rise in world export prices has been associated

2000 02 04 06 08 10
with a renewed pickup in UK import prices (Chart 4.8). And
Sources: Standard & Poor’s and Thomson Reuters Datastream.
the 3% depreciation in the sterling exchange rate since the
(a) The agriculture and livestock, and industrial metals series are calculated using S&P (dollar)
commodity price indices. August Report could boost import prices further in
 Section 4 Costs and prices 35

Chart 4.8 UK import prices and foreign export prices coming quarters. To a modest degree that will act against the
waning impact on CPI inflation from the depreciation of
Percentage changes on a year earlier
15 sterling that occurred between the middle of 2007 and the end
of 2008.
UK import prices excluding fuels(a) 10

Output prices provide one indication of future developments

5 in consumer prices, although judging how quickly supply chain
+
developments will affect CPI is not straightforward.
Manufacturing output price inflation remains elevated
0
(Chart 4.9) and output price inflation in the service sector has
–
picked up in recent quarters.
5
M6 export prices(b)

In addition to those supply chain pressures, the rise in VAT to

2002 03 04 05 06 07 08 09 10
10 20% in January 2011 is likely to mean that CPI inflation will
Sources: ONS, Thomson Reuters Datastream and Bank calculations. remain elevated for some time. Reports from the Bank’s
(a) Goods and services deflator, excluding the impact of MTIC fraud. Agents suggest that pass-through is likely to be close to full,
(b) Domestic currency export prices of goods and services in Canada, France, Germany, Italy,
Japan and the United States, weighted according to their share in UK imports in 2009. and that some companies may increase prices a little ahead of
the rise in the tax rate. Full pass-through would boost the
level of consumer prices by around 1.5%. But the impact of
Chart 4.9 Indicators of output prices the VAT rise on CPI inflation will be offset somewhat as the
Percentage changes on a year earlier effect of the restoration of VAT to 17.5% in January 2010 drops
8
out of the twelve-month comparison. If, however, as evidence
from the ONS suggests, pass-through from the temporary cut
6
in VAT and subsequent reversal was partial, then the
contribution of VAT to CPI inflation would pick up around the
4 turn of the year. Chart 4.3 shows the impact of different
Services output prices(a)
pass-through assumptions on CPI inflation.
2

+ 4.2 Spare capacity and labour costs

0

Manufacturing output prices(b) – The degree of spare capacity in the economy will be a key
2 determinant of inflation in the medium term, affecting
2001 02 03 04 05 06 07 08 09 10
companies’ pricing decisions and also labour costs.
(a) Based on the Services Producer Price Index. Data are non seasonally adjusted. Data are to
2010 Q2.
(b) Excludes food, beverages, tobacco and petrol. Data are non seasonally adjusted. Data are to
2010 Q3. Data are consistent with the Producer Prices Statistical Bulletin, September 2010.
The impact of spare capacity on prices
The recession is likely to have left some margin of spare
capacity within companies, although its precise degree is
difficult to judge (Section 3). That spare capacity reduces the
cost of expanding output, and so puts downward pressure on
prices. But the downward pressure may be moderated to the
extent that some companies temporarily suspended some
capacity, for example by mothballing plant and equipment,
and that it is costly to reinstate that capacity.

More generally, it is difficult to judge the degree to which

spare capacity is currently pulling down inflation, and
therefore its likely future impact. It is possible that spare
capacity is pulling down very sharply on inflation, but that
effect is being masked by upward contributions from import
prices and VAT (Section 4.1). But it is also possible that the
contributions from import prices and VAT are somewhat
smaller, and that spare capacity is having a correspondingly
more moderate impact on inflation. A smaller effect from
slack may, for example, reflect concerns over cash flow:
reports from the Bank’s Agents suggest that some companies
36 Inflation Report November 2010

New survey evidence on prices and wages Table 1 Companies’ reported and expected changes to prices and
wage costs(a)
Companies’ inflation expectations are an important influence
Percentage changes on a year earlier
on their pricing decisions and so on inflation. Since 2008 Q2, 2008(a) 2009(a) 2010
the CBI has asked companies a series of questions aimed at Q1 Q2 Q3
improving the available information in this area.(1) This box
Own prices(b)
describes recent movements, although the short backrun Past twelve months 1.7 -0.3 -0.6 0.0 -0.3
makes it difficult to draw firm conclusions. Next twelve months 1.1 0.0 0.7 0.5 0.3
General level of prices(c)
Companies report that their own prices have fallen, on Past twelve months 1.6 -0.6 -0.7 -0.3 -0.3
average, during 2009 and 2010 (Table 1). In the coming Next twelve months 1.0 0.0 0.6 0.1 0.4
twelve months, companies expect prices to increase only a Wage costs(d)

little (Table 1). It is too early to judge how accurate such Past twelve months 3.1 0.9 0.5 0.9 1.0
Next twelve months 2.4 0.8 1.3 1.6 1.5
expectations are, but prices in 2009 and 2010 were generally
reported to have turned out somewhat weaker than Sources: CBI, ONS and Bank calculations.

companies had predicted twelve months previously. (a) Data for the manufacturing, business/consumer services and distribution sectors are weighted together by
Bank staff using their shares in value added. Annual figures are averages of four-quarter growth rates, apart
Companies’ responses on the general level of prices in the from the 2008 figure, which is the average of 2008 Q2–2008 Q4.
(b) Companies are asked: ‘What has been the percentage change over the past twelve months in your own
markets they compete in have been broadly consistent with average output price for goods sold into UK markets and what is expected to occur over the coming
twelve months?’.
the responses on their own prices. (c) Companies are asked: ‘What has been the percentage change over the past twelve months in the general
level of prices in the markets that you compete in and what is expected to occur over the coming
twelve months?’.
(d) Companies are asked: ‘What has been the percentage change over the past twelve months in your
Respondents report that wage cost growth was relatively wage/salary cost per person (including overtime and bonuses) and what is expected to occur over the
coming twelve months?’.
subdued in 2009 and the first three quarters of 2010. Wage
cost growth is expected to pick up a little in the coming
twelve months. (1) The questions, developed in consultation with the Bank of England, ask
companies about price and wage developments over the past and also the coming
twelve months.

have kept prices up in order to maintain cash flow in the face

of difficulties in obtaining bank finance.

Labour costs
Table 4.A Private sector earnings(a) Nominal pay growth has picked up since 2009, but it remains
weak relative to its historical average (Table 4.A). Within
Percentage changes on a year earlier
Averages since 2009 2010
overall pay growth, pay settlements have remained muted.
March 2001 Q1 Q2 Aug.(b) After strength in 2010 Q1, the contribution from bonuses has
fallen back markedly. Data for the first two months of Q3
(1) AWE regular pay 3.4 1.2 0.9 0.6 2.2
(2) Pay settlements(c) 3.2 2.5 1.7 1.7 1.8
suggest that regular pay drift has picked up. The recent
(1)–(2) Regular pay drift(d) 03 -1.4 -0.8 -1.1 0.4 subdued rate of overall wage growth is likely to reflect two key
(3) Total AWE 3.5 -1.0 4.1 0.2 1.8 influences: the substantial degree of slack in the labour market
(3)–(1) Bonus contribution(d) 0.1 -2.1 3.2 -0.4 -0.5 and low productivity growth.
Sources: Bank of England, Incomes Data Services, the Labour Research Department, ONS and XpertHR.

(a) Based on quarterly data, unless otherwise stated.

Labour market slack is likely to be putting downward pressure
(b)
(c)
Data in the two months to August.
Average over the past twelve months, based on monthly data.
on pay growth. The unemployment rate is currently around
(d) Percentage points. 2.5 percentage points higher than before the recession
(Chart 4.10). That is likely to have been associated with a
moderation in pay growth.

But wage growth is also likely to have moderated in response

to weak productivity. Employment fell by much less than
output during the recession (Section 3). One way in which
companies were able to maintain employment, relative to
output, was to reduce pay growth, so partially offsetting the
effect of falls in productivity on their costs. But productivity
growth has recovered somewhat since then, and that is likely
 Section 4 Costs and prices 37

Chart 4.10 Employees’ compensation, labour to have contributed to the modest pickup in pay growth
productivity and the unemployment rate (Chart 4.10).
Per cent Percentage changes on a year earlier
0 8
The recent elevated rate of inflation could put upward pressure
1
Employees’ compensation on pay if employees seek compensation for the higher cost of
per hour(a) (right-hand scale) 6
2 living. According to the 2010 XpertHR Pay Prospects Survey,
3 4
around 60% of businesses take account of some measure of
inflation during pay negotiations. But the survey also suggests
4
2 that affordability matters, making it less likely that companies
5 will award pay increases that are not linked to improvements
+
6 0 in productivity and profitability. Private sector respondents to
7 Unemployment rate – the survey expect the median pay settlement in 2010/11 to be
(left-hand scale,
which has been inverted)
Labour productivity per 2 2%, the same as their expectation in 2009/10.
8 hour (right-hand scale)

9 4
2001 02 03 04 05 06 07 08 09 10 Judging the relative importance of these factors is not
Sources: ONS (including the Labour Force Survey) and Bank calculations. straightforward. A continued recovery in productivity could
(a) Employees’ compensation at current prices divided by LFS total hours worked. lead to further increases in earnings growth, but it is likely that
slack in the labour market will continue to keep pay growth
Table 4.B Survey measures of households’ inflation relatively subdued (Section 5). Companies’ expectations of
expectations(a) wage costs are discussed further in the box on page 36.
Per cent
Averages 2008 2009 2010 4.3 Inflation expectations
since 2000 H1 H2 Q1 Q2 Q3 Oct.

Expectations (number of years ahead) Inflation in the medium term will be determined, in part, by
YouGov/Citigroup(b) (1) 2.5 3.3 1.6 1.9 2.3 2.7 2.8 3.0 households’ and companies’ expectations of inflation. And, if
Barclays Basix (1) 2.9 4.0 2.3 2.4 2.8 3.4 2.5 n.a. they place some weight on current and recent inflation when
Bank/NOP (1) 2.5 3.7 2.3 2.4 2.5 3.3 3.4 n.a. forming their expectations, then recent high outturns might
Barclays Basix (2) 3.2 3.7 2.9 3.0 3.2 3.8 2.8 n.a.
cause their inflation expectations to increase.
Barclays Basix(c) (5) 3.8 n.a. 3.8 3.8 3.8 4.1 3.1 n.a.
YouGov/Citigroup(b) (5–10) 3.4 3.5 3.0 3.1 3.2 3.1 3.3 3.4
Since the August Report, developments in measures of
Memo: households’ inflation expectations have been mixed. The
CPI inflation 2.0 3.6 2.6 1.8 3.3 3.5 3.1 n.a.
Barclays Basix measures fell by around 1 percentage point at
Sources: Bank of England, Barclays Capital, Citigroup, GfK NOP, ONS and YouGov. the one, two and five-year horizons (Table 4.B). These are
(a) The questions ask about expected changes in prices, but do not reference a specific price index. All measures unusually large changes, and contrast with small rises in other
are based on the median estimated price change. Averages are based on quarterly data unless otherwise
specified. measures of households’ inflation expectations. Measures of
(b) Averages since November 2005. Based on monthly data.
(c) Average since 2008 Q3. households’ inflation expectations beyond one year ahead are
at or below their historical averages.
Chart 4.11 Market-based indicators of inflation
expectations and selected forecasters’ inflation As the box on page 36 discusses, companies expect only
expectations
moderate price increases in the coming twelve months. Other
Per cent
4.5 indicators of inflation expectations include measures derived
Five-year, five-year forward from financial market instruments and professional
RPI inflation implied from gilts 4.0
forecasters’ expectations (Chart 4.11). Financial market
3.5
measures of inflation expectations have changed little since
the August Report, although they were weaker than at the
3.0 beginning of 2010. The HM Treasury and Bank surveys of
Five-year, five-year forward
RPI inflation implied from swaps external forecasters’ expectations were also little changed.
2.5
HM Treasury survey of forecasters
for CPI four years ahead(a)
Overall, inflation expectations remain at levels that appear
2.0
Bank survey of forecasters for
broadly consistent with inflation being around the target in the
CPI inflation three years ahead
1.5 medium term. But the MPC will continue to monitor
0.0
2006 07 08 09 10 developments in inflation expectations closely.
Sources: Bank of England, Bloomberg, HM Treasury and Bank calculations.

(a) Taken from Forecast for the UK economy: a comparison of independent forecasts. Based on the
average of medium-term projections published in February, May, August and November.
38 Inflation Report November 2010

5 Prospects for inflation

Output has continued to recover but remains below its pre-crisis peak. The strength of the recovery
will depend on the extent to which household and corporate sector savings fall as the fiscal
consolidation proceeds, and on the support to net trade from the recovery in global demand and the
past depreciation of sterling. CPI inflation is likely to remain above the target throughout 2011,
reflecting the forthcoming increase in VAT and elevated import price inflation. Further ahead,
inflation is likely to fall back. But the timing and extent of that decline in inflation are uncertain.
Under the assumptions that Bank Rate moves in line with market interest rates and the stock of
assets purchased through the issuance of central bank reserves remains at £200 billion, the chances
of inflation being either above or below the target by the end of the forecast period are judged to be
roughly equal.

Chart 5.1 GDP projection based on market interest rate 5.1 The projections for demand and inflation
expectations and £200 billion asset purchases
Percentage increases in output on a year earlier The outlook for inflation remains highly uncertain. CPI
8
Bank estimates of past growth Projection
7 inflation has been volatile over the past three years, in part
6 reflecting substantial movements in factors such as global
5
commodity prices and exchange rates: further such shocks
4
3 may well occur over the forecast period. But the forthcoming
2 rise in VAT will put upward pressure on inflation throughout
1
+
0
2011. To the extent that people extrapolate from past inflation
–
1 rates when setting wages and prices, a further period of
2 above-target inflation could put upward pressure on inflation
3
4
throughout the forecast period. In the opposite direction,
5 however, significant spare capacity resulting from the deep
ONS data
6
recession should continue to weigh on inflation, and may well
7
2006 07 08 09 10 11 12 13 cause it to stay below the target later in the period, once the
The fan chart depicts the probability of various outcomes for GDP growth. It has been effects of higher VAT and import prices have diminished. The
conditioned on the assumption that the stock of purchased assets financed by the issuance of
central bank reserves remains at £200 billion throughout the forecast period. To the left of the MPC needs to set policy to balance those opposing risks to
first vertical dashed line, the distribution reflects the likelihood of revisions to the data over the
past; to the right, it reflects uncertainty over the evolution of GDP growth in the future. If inflation in the medium term.
economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best
collective judgement is that the mature estimate of GDP growth would lie within the darkest
central band on only 10 of those occasions. The fan chart is constructed so that outturns are also
expected to lie within each pair of the lighter green areas on 10 occasions. In any particular Chart 5.1 shows the outlook for real GDP growth, on the
quarter of the forecast period, GDP is therefore expected to lie somewhere within the fan on 90
out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth can fall assumption that Bank Rate follows a path implied by market
anywhere outside the green area of the fan chart. Over the forecast period, this has been
depicted by the light grey background. In any quarter of the forecast period, the probability mass interest rates. That chart, along with all the others describing
in each pair of identically coloured bands sums to 10%. The distribution of that 10% between
the bands below and above the central projection varies according to the skew at each quarter, the MPC’s projections shown in this section, is conditioned on
with the distribution given by the ratio of the width of the bands below the central projection to
the bands above it. In Chart 5.1, the ratios of the probabilities in the lower bands to those in the the assumption that the stock of purchased assets financed by
upper bands are approximately 6:4 at Years 2 and 3; the downward skew is somewhat smaller at
Year 1. See the box on page 39 of the November 2007 Inflation Report for a fuller description of the issuance of central bank reserves remains at £200 billion
the fan chart and what it represents. The second dashed line is drawn at the two-year point of
the projection. throughout the forecast period.

Despite the substantial fiscal consolidation that is now under

way, the recovery in output is likely to be maintained. That
reflects both the stimulus to private demand from monetary
policy, and a rebalancing of the economy towards net trade,
driven by the strengthening in the global economy and the
lower level of sterling.
 Section 5 Prospects for inflation 39

Chart 5.2 Frequency distribution of GDP growth based But the strength of the recovery remains highly uncertain. The
on market interest rate expectations and £200 billion contribution of net trade to growth has so far been weaker
asset purchases(a) than the Committee had expected, and it is unclear how
2012 Q4 persistent that weakness will prove to be. Private domestic
2013 Q4
Probability, per cent demand could grow rapidly if confidence recovers, and if
100
businesses reinstate investment projects that were previously
put on hold. But there are also significant downside risks to
80 the path of private demand, especially associated with the
outlook for household spending. Some households may wish
60 to adjust further to reductions in their future incomes
associated with the fiscal consolidation. That, in addition to
40 weak confidence, the high levels of debt owed by some
households, and the possibility that households may take
20
steps to improve the adequacy of their retirement provision,
may exert a greater drag on consumption. There is a wider
than usual range of views among Committee members over
0
<1.5 1.5–2.5 2.5–3.5 >3.5 the likely effects on growth of these various factors. Relative
GDP growth (percentage increase in output on a year earlier)
to the most likely path for growth — shown by the darkest
(a) These figures are derived from the same distribution as Chart 5.1. They represent the
probabilities that the MPC assigns to GDP growth lying within a particular range at a central band in Chart 5.1 — the risks are judged to be skewed
specified time in the future.
to the downside. Taking into account that skew, the
Committee’s best collective judgement is that four-quarter
GDP growth is a little more likely to be above 2.5% — around
its historical average rate — than below it for much of the
forecast period (Chart 5.2). Overall, the outlook for growth is
broadly similar to that in the August Report (Charts 5.3 and
5.4).

Given the substantial falls in output during the recession, GDP

is likely to remain significantly below the level implied by a
continuation of its pre-recession trend (Chart 5.5). Although

Chart 5.3 Projected probabilities of GDP growth in Chart 5.4 Projected probabilities of GDP growth in
2011 Q4 (central 90% of the distribution)(a) 2012 Q4 (central 90% of the distribution)(a)
Probability density, per cent(b) Probability density, per cent(b)
4 4
November November
August August

3 3

2 2

1 1

0 0
1.0 – 0.0 + 1.0 2.0 3.0 4.0 5.0 6.0 1.0 – 0.0 + 1.0 2.0 3.0 4.0 5.0 6.0
(a) Charts 5.3 and 5.4 represent cross-sections of the GDP growth fan chart in 2011 Q4 and 2012 Q4 for the market interest rate projection. They have been conditioned on the assumption that the stock of purchased assets
financed by the issuance of central bank reserves remains at £200 billion throughout the forecast period. The coloured bands in Charts 5.3 and 5.4 have a similar interpretation to those on the fan charts. Like the fan charts,
they portray the central 90% of the probability distribution. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that GDP growth in 2011 Q4 and 2012 Q4
would lie somewhere within the range covered by the histogram on 90 occasions. GDP growth would lie outside the range covered by the histogram on 10 out of 100 occasions. The grey outlines in Charts 5.3 and 5.4
represent the corresponding cross-sections of the August 2010 Inflation Report fan chart, which was conditioned on the same assumption about the stock of purchased assets financed by the issuance of central bank reserves.
(b) Average probability within each band; the figures on the y-axis indicate the probability of growth being within ±0.05 percentage points of any given growth rate, specified to one decimal place. As the heights of identically
coloured bars on either side of the central projection are the same, the ratio of the probability contained in the bars below the central projection, to the probability in the bars above it, is given by the ratio of the width of
those bars.
40 Inflation Report November 2010

Chart 5.5 Projection of the level of GDP based on the Committee judges that the supply capacity of the
market interest rate expectations and £200 billion asset economy also lies below that same trend, there is nonetheless
purchases likely to be some margin of spare capacity throughout the
£ billions forecast period.
400
Bank estimates of past level Projection
390
Chart 5.6 shows the outlook for CPI inflation, on the
380
assumption that Bank Rate follows a path implied by market
370
interest rates. Inflation is likely to remain above the 2% target
360
throughout 2011, boosted by the increase in VAT effective in
350 January, elevated import price inflation, and by some
340 businesses continuing to rebuild profit margins, which were
330 compressed during the recession. The projection is higher in
ONS data 320 the first half of the forecast period than in August (Chart 5.7),
310 in part reflecting higher import price inflation stemming from
300 the recent depreciation of sterling and increases in a range of
0
2006 07 08 09 10 11 12 13 commodity prices, and also the likelihood of somewhat larger
Chained-volume measure (reference year 2006). See the footnote to Chart 5.1 for details of the increases in domestic gas prices than assumed in August (see
assumptions underlying the projection for GDP growth. The width of this fan over the past has
been calibrated to be consistent with the four-quarter growth fan chart, under the assumption the box on page 43). Further ahead, CPI inflation is likely to
that revisions to quarterly growth are independent of the revisions to previous quarters. Over
the forecast, the mean and modal paths for the level of GDP are consistent with Chart 5.1. So fall back to around the target, as the effects of higher import
the skews for the level fan chart have been constructed from the skews in the four-quarter
growth fan chart at the one, two and three-year horizons. This calibration also takes account of prices and VAT diminish, and persistent economic slack,
the likely path dependency of the economy, where, for example, it is judged that shocks to GDP
growth in one quarter will continue to have some effect on GDP growth in successive quarters. particularly in the labour market, continues to restrain the
This assumption of path dependency serves to widen the fan chart.
growth of wages and prices.

There are significant uncertainties around the outlook for

inflation. The near-term overshoot of the target may be more
pronounced, particularly if there is continued strength in
commodity price inflation, perhaps linked to robust growth in
emerging economies. And the recent sustained period of
above-target inflation might cause inflation expectations to
rise, putting further upward pressure on inflation itself: that
risk would be heightened if commodity prices continued to
increase. But a greater degree of downward pressure on
inflation from persistent spare capacity might cause inflation

Chart 5.6 CPI inflation projection based on market Chart 5.7 CPI inflation projection in August based on
interest rate expectations and £200 billion asset market interest rate expectations and £200 billion asset
purchases purchases
Percentage increase in prices on a year earlier Percentage increase in prices on a year earlier
6 6

5 5

4 4

3 3

2 2

1 1
+ +
0 0
– –
1 1

2 2
2006 07 08 09 10 11 12 13 2006 07 08 09 10 11 12 13

Charts 5.6 and 5.7 depict the probability of various outcomes for CPI inflation in the future. They have been conditioned on the assumption that the stock of purchased assets financed by the issuance of central bank reserves remains
at £200 billion throughout the forecast period. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the
darkest central band on only 10 of those occasions. The fan charts are constructed so that outturns of inflation are also expected to lie within each pair of the lighter red areas on 10 occasions. In any particular quarter of the forecast
period, inflation is therefore expected to lie somewhere within the fans on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions inflation can fall anywhere outside the red area of the fan chart. Over the forecast
period, this has been depicted by the light grey background. In any quarter of the forecast period, the probability mass in each pair of identically coloured bands sums to 10%. The distribution of that 10% between the bands below
and above the central projection varies according to the skew at each quarter, with the distribution given by the ratio of the width of the bands below the central projection to the bands above it. In Chart 5.6, the ratios of the
probabilities in the lower bands to those in the upper bands are approximately 4:6 at Years 2 and 3. The upward skew at Year 1 is smaller, and is also slightly smaller than the Year 1 skew in Chart 5.7. See the box on pages 48–49 of
the May 2002 Inflation Report for a fuller description of the fan chart and what it represents. The dashed lines are drawn at the respective two-year points.
 Section 5 Prospects for inflation 41

Chart 5.8 Assessed probability inflation will be above to fall significantly below the target in the medium term.
target There is a wider than usual range of views among Committee
members about the likely strength of these various influences
August Inflation Report
November Inflation Report on inflation, and the associated overall balance of risks.
Per cent
100 Chart 5.8 shows the Committee’s best collective judgement of
the probability of inflation being above the 2% target, and the
80 probability implied by the August Report projection. On
balance, the Committee judges that, conditioned on the
60 monetary policy assumptions described above, the chances of
inflation being either above or below the target by the end of
40
the forecast period are roughly equal. The most likely
outcome is for inflation to be slightly below target by 2013,
but relative to that most likely path, the risks are judged to be
20
skewed to the upside.

0
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Charts 5.9 and 5.10 show the spread of outcomes for CPI
2010 11 12 13
inflation at the one and two-year points, and the equivalent
The November and August swathes in this chart are derived from the same distributions as
Charts 5.6 and 5.7 respectively. They indicate the assessed probability of inflation being above spreads at the time of the August Report. The overall
target in each quarter of the forecast period. The width of the swathe at each point in time
corresponds to the width of the band of the fan chart in which the target falls in that quarter, or, distribution for inflation is higher than in August in the first
if the target falls outside the coloured area of the fan chart, the width of the band closest to the
target. The bands in the fan chart illustrate the MPC’s best collective judgement that inflation half of the forecast period, but by the year-two point, the
will fall within a given range. The swathes in Chart 5.8 show the probability within the entire
band of the corresponding fan chart of inflation being close to target; the swathes should not distribution is broadly similar. Chart 5.11 shows frequency
therefore be interpreted as a confidence interval. The dashed line is drawn at the two-year point
of the November projection. The two-year point of the August projection was one quarter distributions for inflation. Given the scale of the risks in both
earlier.
directions, the Committee judges that at both the two and
three-year points there is only a one-in-four chance that
inflation will be within 0.5 percentage points of the 2% target.

5.2 Key judgements and risks

There are substantial uncertainties around the outlook for

growth and inflation. The strength of growth will depend on
how much net trade supports demand, and on the extent to
which private sector net saving falls back following its sharp
rise during the crisis. The path of demand will be one key

Chart 5.9 Projected probabilities of CPI inflation Chart 5.10 Projected probabilities of CPI inflation
outturns in 2011 Q4 (central 90% of the distribution)(a) outturns in 2012 Q4 (central 90% of the distribution)(a)
Probability density, per cent(b) Probability density, per cent(b)
5 5
November November
August August
4 4

3 3

2 2

1 1

0 0
2.0 1.0 – 0.0 + 1.0 2.0 3.0 4.0 5.0 6.0 2.0 1.0 – 0.0 + 1.0 2.0 3.0 4.0 5.0 6.0

(a) Charts 5.9 and 5.10 represent cross-sections of the CPI inflation fan chart in 2011 Q4 and 2012 Q4 for the market interest rate projection. They have been conditioned on the assumption that the stock of purchased assets
financed by the issuance of central bank reserves remains at £200 billion throughout the forecast period. The coloured bands in Charts 5.9 and 5.10 have a similar interpretation to those on the fan charts. Like the fan charts,
they portray the central 90% of the probability distribution. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in 2011 Q4 and 2012 Q4
would lie somewhere within the range covered by the histogram on 90 occasions. Inflation would lie outside the range covered by the histogram on 10 out of 100 occasions. The grey outlines in Charts 5.9 and 5.10 represent
the corresponding cross-sections of the August 2010 Inflation Report fan chart, which was conditioned on the same assumption about the stock of purchased assets financed by the issuance of central bank reserves.
(b) Average probability within each band; the figures on the y-axis indicate the probability of inflation being within ±0.05 percentage points of any given inflation rate, specified to one decimal place. As the heights of identically
coloured bars on either side of the central projection are the same, the ratio of the probability contained in the bars below the central projection, to the probability in the bars above it, is given by the ratio of the width of
those bars.
42 Inflation Report November 2010

Chart 5.11 Frequency distribution of CPI inflation based factor determining the margin of spare capacity in the
on market interest rate expectations and £200 billion economy, and therefore the downward pressure that exerts on
asset purchases(a) inflation. But the outlook for inflation will also depend on the
2012 Q4 degree to which productivity recovers, on the sensitivity of
2013 Q4
Probability, per cent
wages and prices to the slack in the economy, and on the
100
extent to which inflation expectations remain anchored,
despite a prolonged period of above-target inflation.
80

By how much will net trade support growth?

60 The depreciation of sterling since mid-2007, together with a
continued global recovery, should provide a boost to exports
40 throughout the forecast period. The level of sterling should
also encourage some substitution away from imports towards
20
domestically produced goods and services. Together, those
effects should support some rebalancing of the UK economy
away from public and private consumption and towards net
0
<0.5 0.5–1.5 1.5–2.5 2.5–3.5 >3.5 trade.
CPI inflation (percentage increase in prices on a year earlier)

(a) These figures are derived from the same distribution as Chart 5.6. They represent the
probabilities that the MPC assigns to CPI inflation lying within a particular range at a So far, however, the support to growth from net trade has
specified time in the future.
been smaller than expected, reflecting both weakness in the
United Kingdom’s share of world exports, and also resilience in
import growth. The lower exchange rate does seem to have
boosted UK goods exports (Section 2), but the share of world
services exports appears to have declined. Exports of services
are more difficult to measure than those of goods, and so
these data need to be interpreted with care. But it is possible
that they reflect a shift in global demand away from some
types of services — for example the provision of financial
services — in which the United Kingdom has tended to
specialise. In that case, the unexpected weakness of services
exports may prove persistent.

The magnitude of the boost from net trade will also depend on
the strength of the global recovery. World demand has
continued to recover, with robust growth in China and many
other emerging economies, and a healthy rate of expansion in
Germany and some of its neighbouring countries. But risks
around the strength of global growth remain, including the
fragility of the recovery in the United States, and concerns over
fiscal sustainability in some European countries.

Overall, the Committee judges that although some of the

recent surprising weakness in net trade is likely to persist, net
trade should provide support to growth throughout the
forecast period, moving the current account towards balance.

To what extent will a fall back in private sector saving

offset the fiscal tightening?
The recession was associated with a large rise in private sector
financial saving. That reflected both a significant increase in
the household saving rate, and also substantial corporate
sector surpluses, as businesses cut back their spending on
investment and inventories. Total private sector saving has
fallen back somewhat during the early part of the recovery, as
some of the increase in household saving has been reversed.
 Section 5 Prospects for inflation 43

Financial and energy market assumptions starting point for the August projections. Under the MPC’s
usual convention,(1) the exchange rate is assumed to be
As a benchmark assumption, the projections for GDP growth broadly unchanged in 2012 Q4, and is lower throughout the
and CPI inflation described in Charts 5.1 and 5.6 are forecast period than assumed in August.
conditioned on a path for Bank Rate implied by market interest
rates (Table 1). In the period leading up to the MPC’s The starting point for UK equity prices in the MPC’s projections
November decision, the path implied by forward market was 2956 — the average of the FTSE All-Share for the fifteen
interest rates was for Bank Rate to remain at 0.5% until working days to 3 November. That was 8.4% above the
2011 Q2. Bank Rate was assumed to rise thereafter, with the starting point for the August projection. In the long run, equity
path 0.5 percentage points lower, on average, over the wealth is assumed to grow in line with nominal GDP; in the
remainder of the forecast period than assumed in the August short run, it also reflects changes in the share of profits in GDP.
Report.
Energy prices are assumed to evolve broadly in line with the
paths implied by futures markets over the forecast period.
Table 1 Conditioning path for Bank Rate implied by forward
Average Brent oil futures prices for the next three years were
market interest rates(a)
around 4% higher (in US dollar terms) than at the time of the
Per cent August Report. Wholesale gas futures prices were around
2010 2011 2012 2013
1% higher over the forecast period. There is considerable
Q4(b) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
uncertainty about the scale and pace of the pass-through of
Nov. 0.5 0.5 0.5 0.6 0.7 0.8 0.9 1.1 1.2 1.4 1.6 1.7 1.9 changes in wholesale energy prices to the prices of gas and
Aug. 0.5 0.6 0.7 0.8 1.0 1.2 1.4 1.6 1.9 2.1 2.2 2.4 electricity faced by households and companies. But following
(a) The data are fifteen working day averages of one-day forward rates to 3 November and 4 August 2010 the rise in domestic gas prices already announced by one
respectively. The curves are based on overnight index swap (OIS) rates.
(b) November figure for 2010 Q4 is an average of realised spot rates to 3 November, and forward rates major supplier, together with an assumption that other
thereafter.
suppliers will announce price increases in due course, the
The November projections are conditioned on an assumption November projections are conditioned on a benchmark
that the total stock of asset purchases financed by the creation assumption of around a 10% rise in domestic gas prices in the
of central bank reserves remains at £200 billion throughout coming months. In contrast, the August projections were
the forecast period, the same total scale of purchases assumed conditioned on a 5% rise in gas prices, although they
in the August projections. incorporated a risk of a somewhat larger rise.

The starting point for sterling’s effective exchange rate index

(ERI) in the MPC’s projections was 79.5, the average for the (1) The convention is that the sterling exchange rate follows a path which is half way
between the starting level of the sterling ERI and a path implied by interest rate
fifteen working days to 3 November. That was 2.7% below the differentials.

But the strength of domestic demand growth over the forecast

period will depend on the extent to which a further decline in
private sector saving offsets the reduction in demand
associated with the fiscal consolidation.

The Committee’s central judgement is that private sector

financial saving is likely to fall further over the forecast period,
enabling continued growth in final domestic demand even as
fiscal policy tightens. The corporate sector financial surplus
may fall back somewhat, as improving business confidence
and a gradual improvement in credit conditions fuel a recovery
in business investment. And the household saving rate is likely
to remain below its peak reached during the recession, in part
due to the substantial stimulus from monetary policy.
Together with an increase in real income growth as the
recovery continues, that is likely to mean that consumption
continues to recover gradually, with growth picking up to
around its historical average rate by the latter part of the
forecast period.
44 Inflation Report November 2010

There are some upside risks to the path of private domestic

demand. It is likely that some of the rise in household saving
during the recession reflected increased uncertainty about
future incomes. Much of that uncertainty may dissipate as the
recovery continues, so that consumption grows more rapidly.
And it is possible that business investment could also recover
more strongly, for example as companies reinstate projects
that were put on hold during the downturn.

Overall, however, the Committee judges that the risks around

the most likely path of private domestic demand are skewed
significantly to the downside. Continued balance sheet
strengthening in the financial sector may mean that credit
conditions are slower to improve, restraining borrowing and
slowing the recoveries in investment and consumption.
Household spending may weaken as some households adjust
to the implications for their future incomes of the fiscal
consolidation. And there may be greater downward pressure
on consumption over the coming years if households revise
more sharply upward the amount they wish to save, for
example because of concerns about levels of debt, future
credit availability, or future pension provision.

How much downward pressure will the low level of

demand exert on inflation?
Output is likely to remain some way below a continuation of
its pre-recession trend throughout the forecast period. How
much downward pressure that exerts on inflation will depend
on the evolution of spare capacity, both within companies and
in the labour market, and on the sensitivity of costs and prices
to any persistent margin of economic slack.

How much spare capacity is there within companies?

Employment fell during the recession, but by much less than
output. That has left productivity far below a continuation of
its pre-recession trajectory, and suggests that many companies
are currently operating with significant spare capacity.

But some other indicators — for example, recent increases in

employment and survey measures of spare capacity — point to
a more limited degree of slack within companies. Those survey
responses may reflect some companies only reporting their
spare capacity that is immediately operable: during the
recession, they may have temporarily suspended some
capacity, for example through the mothballing of some plant
and equipment, or by cutting the number of hours worked by
some staff, in order to reduce overall costs. But it is also
possible that the recession was associated with a period of
slower growth in underlying productivity, and so weaker
growth in the overall potential supply capacity of the economy
(Section 3).

The Committee’s central judgement is that some of the

reduction in the supply capacity of the economy, relative to its
pre-recession trend, is likely to prove persistent. Nonetheless,
Section 5 Prospects for inflation 45

the Committee judges that substantial spare capacity within

companies remains, including some capacity that has been
temporarily suspended, but which could be brought back into
use as demand strengthens. That would mean increased
demand and output could be met through a recovery in
productivity, with only limited growth in employment, and
without significant upward pressure on prices.

There are significant uncertainties around the supply capacity

of the economy, however, and so around the degree of spare
capacity available to businesses. And if demand remains weak,
there is a risk that there could be a larger reduction in the
economy’s supply capacity, relative to its pre-recession trend.
That could occur if businesses eventually decide they need to
reduce their scale of operations permanently, and scrap plant
or capital equipment. Or they could cut employment
significantly further. That could adversely affect future labour
supply, if some people lose, or are unable to acquire, the skills
sought by employers.

How will wages evolve?

Wages have grown more weakly than prices over most of the
past two years, as companies have adjusted to increases in
other costs, such as higher costs of imports; as productivity
has fallen; and as unemployment has risen. A key determinant
of the outlook for inflation in the medium term will be the
extent to which wage growth remains subdued as the recovery
proceeds.

The Committee’s central judgement is that earnings growth is

likely to pick up gradually over the forecast period as demand
recovers, some businesses bring capacity back into use and
increase the hours worked by their staff, and productivity
revives. But wage growth is nonetheless likely to remain
below its pre-crisis average rate in view of the likelihood of
persistent slack in the labour market.

There are, however, risks to inflation in both directions from

the evolution of wage growth. To the downside, wages may
prove much more sensitive to the degree of labour market
slack. In that case, earnings growth may remain very weak
even as productivity recovers, resulting in greater downward
pressure on inflation in the medium term.

But the downside risks to inflation stemming from spare

capacity in the labour market may be smaller if the recent
subdued growth in earnings largely reflected temporary
weakness in productivity growth, rather than higher
unemployment. In that case, wage growth could recover more
rapidly as productivity rebounds, even in the face of persistent
labour market slack.

And there may also be upside risks to inflation associated with

the future evolution of real wages. Companies’ profit margins
may still be below sustainable levels, following past increases
46 Inflation Report November 2010

in non-wage costs and the period of low productivity. In that

case, a further sustained period of elevated price inflation,
relative to nominal wage growth, might be needed to restore
those margins. And that adjustment would need to be all the
greater if productivity remained weak.

Will commodity prices increase further, and will

inflation expectations rise?
Inflation has been highly volatile over the past three years, in
part reflecting movements in energy prices, the sterling
exchange rate and VAT, but has been above the 2% target for
all but six months of that period. And it appears likely to
remain above the target throughout 2011, as the forthcoming
rise in VAT takes effect, and as businesses rebuild profit
margins and pass on increases in import prices.

In addition to those factors adding to inflation in the near

term, there is a risk that commodity prices will continue to
rise. That would cause further increases in companies’ costs,
and lead to higher inflation over the forecast period.
Commodity price rises might follow from a continued recovery
in the global economy, and in particular from further robust
expansion in emerging economies, where production tends to
be relatively commodity-intensive.

That would also exacerbate the risk that the prolonged period
of above-target inflation might cause companies’ and
households’ expectations of future inflation to increase. That
could feed into price and wage-setting decisions, offsetting the
downward pressure on prices from spare capacity.

5.3 Summary and the policy decision

Output is continuing to recover from the deep recession of
2008–09 (see the box on page 48). But the strength of the
recovery in the medium term will depend on the extent to
which private sector net saving falls back as the fiscal
consolidation proceeds, and on the boost to net trade from the
global recovery and the past depreciation of sterling. The
range of views among Committee members over how much
those forces will support demand is wider than usual. The
Committee’s best collective judgement is that, conditioned on
market interest rates, four-quarter growth is a little more likely
to be above its historical average rate than below it for much
of the forecast period. Even so, the large fall in output during
the recession means that some spare capacity is likely to
persist over the forecast period.

CPI inflation is likely to remain above the target for a further

period, given the forthcoming rise in VAT and increases in
import prices. Further ahead, inflation is likely to fall back.
But the extent of that fall will depend on the evolution of
productivity growth, on the sensitivity of wages to any
persistent slack in the labour market, on the evolution of
global commodity prices, and on the degree to which inflation
 Section 5 Prospects for inflation 47

expectations remain anchored. There is a wider than usual

range of views among Committee members about the
influence of those forces, and therefore the outlook for
inflation. The Committee’s best collective judgement is that,
conditioned on market interest rates, the chances of inflation
being either above or below the target by the end of the
forecast period are roughly equal.

Charts 5.12 and 5.13 show the GDP and CPI inflation
Chart 5.12 GDP projection based on constant nominal projections for the next two years under the alternative
interest rates at 0.5% and £200 billion asset purchases
assumption that Bank Rate is held constant at 0.5%. There is
Percentage increases in output on a year earlier
8 little difference between projections conditioned on constant
Bank estimates of past growth Projection
7
rates or market interest rates, reflecting market participants’
6
5 expectation that interest rates will remain low for some time.
4
3
2
In evaluating the outlook for growth, the Committee will focus
1 on: the evolution of private sector and external financial
+
0
– balances, and the forces that are driving them; the impact of
1
2
the fiscal consolidation on corporate and household spending;
3 developments in financial markets and the banking sector,
4
ONS data including the growth of money and credit; and the pace and
5
6 composition of the global recovery.
7
2006 07 08 09 10 11 12
In monitoring those factors likely to affect inflation, the
See footnote to Chart 5.1.
Committee will, in addition, focus on: evidence regarding the
evolution of productivity and supply, and the associated
Chart 5.13 CPI inflation projection based on constant margin of spare capacity in the economy; the response of
nominal interest rates at 0.5% and £200 billion asset earnings and prices to that spare capacity; the path of
purchases commodity and energy prices; and measures of inflation
Percentage increase in prices on a year earlier expectations.
6

5
At its November meeting, the Committee judged that the
4 recovery was likely to continue. The outlook for inflation in the
near term was higher than previously expected, in part
3
reflecting higher import prices. But inflation was still likely to
2 fall back in the medium term, reflecting the continuing
1 downward pressure from the persistent margin of spare
+ capacity. In the light of that outlook, the Committee judged
0
_ that maintaining Bank Rate at 0.5% and maintaining the stock
1 of asset purchases financed by the issuance of central bank
2
reserves at £200 billion was appropriate to meet the 2% CPI
2006 07 08 09 10 11 12
inflation target over the medium term. But the prospects for
See footnote to Chart 5.6.
inflation remained highly uncertain and the Committee stood
ready to respond in either direction as the balance of risks
evolved.
48 Inflation Report November 2010

Output in previous recoveries to play an important role in the first year as the pace of
de-stocking eases (Chart B). And inventories have accounted
Following sharp falls in 2008 H2 and 2009 H1, 2010 Q3 saw for around half of the increase in output in the first three
the fourth consecutive quarter of positive output growth. This quarters of this recovery.(2) But beyond the first year in the
box compares the current recovery and the MPC’s projection past two recoveries, once stocks had reached desired levels,
for GDP with the recoveries from the previous two recessions. stockbuilding added less to growth and it is unlikely to play a
significant role later in this recovery.
Output is estimated to have increased by 2.8% over the first
year of the current recovery, which is somewhat faster growth Chart B Contributions of expenditure components to
than during the first year of both the 1980s’ and 1990s’ changes in GDP in recoveries(a)(b)
recoveries (Chart A). But the Committee judges that the pace Net trade(c) Household consumption(d) GDP
of growth in the second and third years of this recovery is likely Government consumption Change in inventories(e)
Investment Other(f)
to be a little slower than in those previous recoveries. Percentage points
14
After three After one year After three years
quarters 12
Chart A Projection of the level of GDP based on market
interest rate expectations and £200 billion asset 10
purchases and comparison with previous recoveries(a)(b)(c) 8
Indices: pre-recession peak in GDP = 100
115 6

110
2
+
0
1980s’ ONS data 105 –
1990s’ ONS data 2

4
100 Current 1980s 1990s 1980s 1990s
ONS data
(a) Chained-volume measures at market prices.
(b) Recessions and recoveries are defined as in Chart A.
95 (c) Goods and services, excluding the estimated impact of missing trader intra-community
fraud.
Current ONS data (d) Includes non-profit institutions serving households.
(e) Excludes the alignment adjustment.
90 (f) ‘Other’ includes the alignment adjustment, the statistical discrepancy and chain-linking
8 4 – 0 + 4 8 12 16 20 errors.
Quarters from pre-recession peak in GDP
(a) Chained-volume measure at market prices.
(b) See footnote to Chart 5.5 for further details of what the fan chart represents.
(c) The pre-recession peak in GDP is defined as the final quarter before the start of the recession
Consumption and investment accounted for the majority of
estimated using the latest ONS data. Recessions are defined as at least two consecutive
quarters of falling output (at constant market prices). And the recoveries are assumed to
growth in the second and third years of the 1980s’ and 1990s’
begin in the quarter that follows the trough in output.
recoveries. Net trade contributed to the latter part of the
The fall in output in this recession was larger than those in 1990s’ recovery, but it was a drag on growth in the 1980s’
previous recessions, and it is likely that output will take longer episode following the appreciation of sterling during that
to return to its pre-recession level.(1) The current vintage of recession. Government spending provided some support to
data show that output remained below its pre-recession level those recoveries, particularly in the 1980s.
for around three years following the 1980s and 1990s
recessions, although initial output estimates had suggested The circumstances surrounding recessions and recoveries are
that those recessions had been deeper. The MPC judges that often different, so it is difficult to draw direct comparisons
the probability of output being back to its pre-recession peak from past experience for the current episode. For example, the
by the same stage in this cycle — that is, by mid-2011 — is Committee judges that, because of the depreciation of sterling
around a third. Indeed, the Committee’s fan chart implies that prior to this recession, net trade is likely to make a larger
there is a small probability that output will not even have contribution in the second and third years of this recovery than
reached its pre-recession peak by the three-year forecast in past recoveries.
horizon. But the range of possible outcomes is large: there is a
similar probability that output will have grown sufficiently
strongly to return it to a level consistent with its pre-recession
trend.
(1) Comparisons to the pre-recession peak in output in the 1980s recession are sensitive
to how that peak is defined. This box defines the pre-recession peak as 1979 Q4, the
The expenditure mix of past recoveries final quarter before the start of the recession. But the level of output was higher in
There are some common trends in the expenditure 1979 Q2, and using that definition the fall in output in the current recession looks
more similar to the 1980s.
components of demand in UK recoveries. Stockbuilding tends (2) An expenditure breakdown is not yet available for 2010 Q3.
 Section 5 Prospects for inflation 49

Other forecasters’ expectations Chart B Distribution of GDP growth central projections

one year ahead
Every three months, the Bank asks a sample of external Expectation for 2011 Q3 in August 2010
forecasters for their latest economic projections. This box Expectation for 2011 Q4 in November 2010
Number of forecasts
10
reports the results of the most recent survey, carried out during
October. On average, CPI inflation was expected to be above
the 2% target in 2011 Q4, but to fall back below the target over 8

the following year (Table 1). Compared with three months ago,
the distribution of central views about inflation at the one-year 6
horizon has narrowed (Chart A), but more forecasters now
expect inflation to be above the target. 4

Table 1 Averages of other forecasters’ central projections(a)

2

2011 Q4 2012 Q4 2013 Q4

CPI inflation(b) 2.5 1.8 1.9 0

0.5 1.0 1.5 2.0 2.5 3.0 3.5
GDP growth(c) 1.8 2.3 2.5 Range of forecasts(a)
Bank Rate (per cent) 0.9 2.0 2.9 Sources: Projections of 21 outside forecasters as of 22 July 2010 and 23 outside forecasters as of
Sterling ERI(d) 81.9 82.4 83.0 21 October 2010.

(a) A projection that is on the boundary of these ranges is classified in the higher bucket.
Source: Projections of outside forecasters as of 21 October 2010. For example, a 2.0% projection is included within the 2.0% to 2.5% bucket.

(a) For 2011 Q4, there were 23 forecasts for CPI inflation, GDP growth and Bank Rate and 17 for the sterling ERI.
For 2012 Q4, there were 21 forecasts for CPI inflation, 20 for GDP growth and Bank Rate and 15 for the expected level of Bank Rate was lower than three months ago.
sterling ERI. For 2013 Q4, there were 19 forecasts for CPI inflation, 18 for GDP growth and Bank Rate and 15
for the sterling ERI. On average, the sterling ERI was projected to appreciate a little.
(b) Twelve-month rate.
(c) Four-quarter percentage change.
(d) Where necessary, responses were adjusted to take account of the difference between the old and new ERI
measures, based on the comparative outturns for 2006 Q1. The Bank also asks forecasters for an assessment of the risks
around their central projections for CPI inflation and GDP
Chart A Distribution of CPI inflation central projections growth (Table 2). On average, respondents thought that there
one year ahead was around a 75% chance that inflation would be above the
Expectation for 2011 Q3 in August 2010 target at the one-year horizon, a higher probability than three
Expectation for 2011 Q4 in November 2010
Number of forecasts months ago. Further out, forecasters thought there was a
10
slightly greater probability that inflation would be below the
target than above it. Consistent with the downward revision to
8
their central projection, on average, forecasters attached a
40% chance to GDP growth being above 2% at the one-year
6
horizon, compared with around 50% three months ago.

4 Table 2 Other forecasters’ probability distributions for CPI

inflation and GDP growth(a)
2 CPI inflation
Probability, per cent Range:
<0% 0–1% 1–1.5% 1.5–2% 2–2.5% 2.5–3% >3%
0
1.0 1.4 1.8 2.2 2.6 3.0 3.4 3.8 4.2
Range of forecasts(a) 2011 Q4 1 3 7 15 25 31 19

Sources: Projections of 21 outside forecasters as of 22 July 2010 and 23 outside forecasters as of

2012 Q4 3 10 17 26 24 13 7
21 October 2010. 2013 Q4 3 9 15 26 25 13 8
(a) A projection that is on the boundary of these ranges is classified in the higher bucket.
For example, a 1.8% projection is included within the 1.8% to 2.2% bucket.
GDP growth

On average, external forecasters expected four-quarter GDP Probability, per cent Range:
<-1% -1–0% 0–1% 1–2% 2–3% >3%
growth to be 1.8% in 2011 Q4. Compared with three months
ago, the average expectation is 0.2 percentage points lower, 2011 Q4 3 7 19 33 29 11

and the distribution of central projections has broadened 2012 Q4 3 6 14 27 30 19

2013 Q4 3 6 11 26 31 23
(Chart B). GDP growth was expected to be 2.5% at the
three-year horizon, unchanged from three months ago. Source: Projections of outside forecasters as of 21 October 2010.

(a) For 2011 Q4, 23 forecasters provided the Bank with their assessment of the likelihood of twelve-month CPI
inflation and four-quarter GDP growth falling in the ranges shown above; for 2012 Q4, 21 forecasters
A majority of forecasters expected Bank Rate to have risen by provided assessments for CPI and 20 forecasters provided assessments for GDP; for 2013 Q4, 19 forecasters
provided assessments for CPI and 18 forecasters provided assessments for GDP. The table shows the average
2011 Q4 and to increase further by 2013 Q4. But the average probabilities across respondents. Rows may not sum to 100 due to rounding.
50 Inflation Report November 2010

Index of charts and tables

Charts Household balance sheets 22

A Household financial assets, residential buildings assets
Overview 5 and financial liabilities 22
1 GDP projection based on market interest rate B Household equity withdrawal and net acquisition of
expectations and £200 billion asset purchases 6 financial assets including deposits 22
2 Projection of the level of GDP based on market interest C Burden of unsecured debt 23
rate expectations and £200 billion asset purchases 7 D Distribution of loan to value ratios on mortgagors’
3 CPI inflation projection based on market interest rate outstanding secured debt 23
expectations and £200 billion asset purchases 7
3 Output and supply 27
4 Assessed probability inflation will be above target 8
3.1 GDP and sectoral output 27
3.2 Indicators of construction output growth 27
1 Money and asset prices 9
3.3 Indicators of aggregate output growth 28
1.1 Bank Rate and forward market interest rates 9
3.4 Survey measures of capacity utilisation by sector 28
1.2 International ten-year spot government bond yields 11
3.5 Labour productivity by sector 29
1.3 UK five-year nominal and real interest rates, and implied
3.6 Operational capacity and output in the UK automotive
inflation, five years forward 11
industry 29
1.4 Selected European ten-year government bond spreads 11
3.7 Employment in previous recoveries 29
1.5 International equity prices 12
3.8 Quarterly changes in the Workforce Jobs measure of
1.6 Sterling investment-grade corporate bond spread and
employment 30
yield 12
3.9 Surveys of employment intentions and measures of
1.7 Sterling non-bank investment-grade corporate bond
employment 30
spreads less CDS premia 12
3.10 Annual changes in employment 30
1.8 International nominal effective exchange rates 13
3.11 Contributions to changes in the participation rate since
1.9 Property prices 14
the start of the recession 31
1.10 Debt issuance by the major UK lenders 14
3.12 Flows from unemployment to employment 31
1.11 Major UK banks’ CDS premia 14
1.12 New mortgage rate, Bank Rate and estimate of marginal 4 Costs and prices 32
funding cost 15 4.1 Measures of inflation 32
1.13 Sterling loans to PNFCs 15 4.2 CPI goods and services 32
1.14 Credit Conditions Survey: overall corporate credit 4.3 Stylised illustration of the contribution of changes
availability and terms on loans to large PNFCs 15 in VAT to twelve-month CPI inflation 33
1.15 Loans to individuals 16 4.4 Stylised illustration of the contribution of import
1.16 Average quoted interest rates on new household prices excluding fuels to CPI inflation 33
borrowing 16 4.5 CPI passenger transport by air, oil prices and capacity
1.17 Broad money and bank credit 17 utilisation in the airline sector 34
1.18 Sectoral broad money 17 4.6 Energy prices 34
4.7 Commodity prices 34
2 Demand 18 4.8 UK import prices and foreign export prices 35
2.1 Stockbuilding by sector 18 4.9 Indicators of output prices 35
2.2 Public sector net borrowing 19 4.10 Employees’ compensation, labour productivity and
2.3 Financial balances by sector 20 the unemployment rate 37
2.4 Contributions to four-quarter growth in real household 4.11 Market-based indicators of inflation expectations
disposable income 20 and selected forecasters’ inflation expectations 37
2.5 Household saving ratio 21
2.6 Indicators of consumer confidence 21 5 Prospects for inflation 38
2.7 Business investment to GDP ratio 21 5.1 GDP projection based on market interest rate
2.8 Capital expenditure by company size 24 expectations and £200 billion asset purchases 38
2.9 IMF world GDP growth projections 24 5.2 Frequency distribution of GDP growth based on
2.10 US household indicators 25 market interest rate expectations and £200 billion
2.11 Ratios of UK exports to UK-weighted M6 imports 26 asset purchases 39
2.12 Cumulative contributions of services trade to GDP 5.3 Projected probabilities of GDP growth in 2011 Q4
growth since 2007 Q2 26 (central 90% of the distribution) 39
2.13 UK imports and import-weighted demand 26 5.4 Projected probabilities of GDP growth in 2012 Q4
Nominal demand and income 19 (central 90% of the distribution) 39
A Counterparts to growth in gross final expenditure on 5.5 Projection of the level of GDP based on market interest
a quarter earlier 19 rate expectations and £200 billion asset purchases 40
 Index of charts and tables 51

5.6 CPI inflation projection based on market interest rate Other forecasters’ expectations 49
expectations and £200 billion asset purchases 40 1 Averages of other forecasters’ central projections 49
5.7 CPI inflation projection in August based on market 2 Other forecasters’ probability distributions for
interest rate expectations and £200 billion asset CPI inflation and GDP growth 49
purchases 40
5.8 Assessed probability inflation will be above target 41
5.9 Projected probabilities of CPI inflation outturns in
2011 Q4 (central 90% of the distribution) 41
5.10 Projected probabilities of CPI inflation outturns in
2012 Q4 (central 90% of the distribution) 41
5.11 Frequency distribution of CPI inflation based on
market interest rate expectations and £200 billion
asset purchases 42
5.12 GDP projection based on constant nominal interest
rates at 0.5% and £200 billion asset purchases 47
5.13 CPI inflation projection based on constant nominal
interest rates at 0.5% and £200 billion asset purchases 47
Output in previous recoveries 48
A Projection of the level of GDP based on market interest
rate expectations and £200 billion asset purchases and
comparison with previous recoveries 48
B Contributions of expenditure components to changes
in GDP in recoveries 48
Other forecasters’ expectations 49
A Distribution of CPI inflation central projections
one year ahead 49
B Distribution of GDP growth central projections
one year ahead 49

Tables
1 Money and asset prices 9
1.A PNFCs’ equity and debt issuance 16
1.B Indicators of housing market activity 17

2 Demand 18
2.A Expenditure components of demand 18
2.B Public spending 20
2.C Surveys of investment intentions (plant and machinery) 24
2.D Final domestic demand in the United Kingdom’s major
trading partners 25

3 Output and supply 27

3.A Selected indicators of labour market pressure 31

4 Costs and prices 32

4.A Private sector earnings 36
4.B Survey measures of households’ inflation
expectations 37
New survey evidence on prices and wages 36
1 Companies’ reported and expected changes to
prices and wage costs 36

5 Prospects for inflation 38

Financial and energy market assumptions 43
1 Conditioning path for Bank Rate implied by forward
market interest rates 43
52 Inflation Report November 2010

Text of Bank of England press notice of 9 September 2010

Bank of England maintains Bank Rate at 0.5% and the size of the Asset Purchase Programme at
£200 billion
The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%.
The Committee also voted to maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion.

The minutes of the meeting will be published at 9.30 am on Wednesday 22 September.

Text of Bank of England press notice of 7 October 2010

Bank of England maintains Bank Rate at 0.5% and the size of the Asset Purchase Programme at
£200 billion
The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%.
The Committee also voted to maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion.

The minutes of the meeting will be published at 9.30 am on Wednesday 20 October.

Text of Bank of England press notice of 4 November 2010

Bank of England maintains Bank Rate at 0.5% and the size of the Asset Purchase Programme at
£200 billion
The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%.
The Committee also voted to maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion.

The Committee’s latest inflation and output projections will appear in the Inflation Report to be published at 10.30 am on Wednesday 10 November.

The minutes of the meeting will be published at 9.30 am on Wednesday 17 November.

 Glossary and other information 53

Glossary and other information

Glossary of selected data and instruments Symbols and conventions

AWE – average weekly earnings. Except where otherwise stated, the source of the data used in
CDS – credit default swap. charts and tables is the Bank of England or the Office for
CPI – consumer prices index. National Statistics (ONS) and all data, apart from financial
CPI inflation – inflation measured by the consumer prices markets data, are seasonally adjusted.
index.
CPIY – consumer prices index excluding indirect taxes. n.a. = not available.
ERI – exchange rate index.
GDP – gross domestic product. Because of rounding, the sum of the separate items may
LFS – Labour Force Survey. sometimes differ from the total shown.
Libor – London interbank offered rate.
M4 – UK non-bank, non-building society private sector’s On the horizontal axes of graphs, larger ticks denote the first
holdings of sterling notes and coin, and their sterling deposits observation within the relevant period, eg data for the first
(including certificates of deposit, holdings of commercial paper quarter of the year.
and other short-term instruments and claims arising from
repos) held at UK banks and building societies.
OIS – overnight index swap.
RPI – retail prices index.
RPI inflation – inflation measured by the retail prices index.

Abbreviations
BCC – British Chambers of Commerce.
BHPS – British Household Panel Survey.
CBI – Confederation of British Industry.
CFO – chief financial officer.
CIPS – Chartered Institute of Purchasing and Supply.
EU – European Union.
FISIM – Financial Intermediation Services Indirectly Measured.
FTSE – Financial Times Stock Exchange.
GfK – Gesellschaft für Konsumforschung, Great Britain Ltd.
HBF – Home Builders Federation.
IMF – International Monetary Fund.
LTV – loan to value.
M6 – Canada, France, Germany, Italy, Japan and the
United States.
MPC – Monetary Policy Committee.
MTIC – missing trader intra-community.
NBER – National Bureau of Economic Research.
OFCs – other financial corporations.
ONS – Office for National Statistics.
PNFCs – private non-financial corporations.
PwC – PricewaterhouseCoopers.
RICS – Royal Institution of Chartered Surveyors.
S&P – Standard & Poor’s.
VAT – Value Added Tax.
© Bank of England 2010
ISSN 1353-6737
Printed by Park Communications Limited