Publication date: 23 July 2008 MINUTES…

 Publication date: 23 July 2008


                             MINUTES OF
                MONETARY POLICY
               COMMITTEE MEETING
                       9 AND 10 JULY 2008


These are the minutes of the Monetary Policy Committee meeting held on
9 and 10 July.

They are also available on the Internet
http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2008/mpc0807.pdf

The Bank of England Act 1998 gives the Bank of England operational responsibility
for setting interest rates to meet the Government's inflation target. Operational
decisions are taken by the Bank's Monetary Policy Committee. The Committee meets
on a regular monthly basis and minutes of its meetings are released on the
Wednesday of the second week after the meeting takes place. Accordingly, the
minutes of the Committee meeting held on 6 and 7 August will be published on
20 August 2008.
MINUTES OF THE MONETARY POLICY COMMITTEE MEETING HELD
ON 9-10 JULY 2008

1     Before turning to its immediate policy decision, the Committee discussed developments in
financial markets; the international economy; money, credit, demand and output; and supply, costs
and prices.


Financial markets


2     UK short-term interest rates had increased initially during the month by around 50 basis points.
But over the days prior to the meeting, short-term market rates had fallen back, following the flow of
weak activity data, heightened concerns over the housing market and the weakness in banks' equity
prices. Nevertheless, that left forward market interest rates still pricing in a high probability of one 25
basis point increase in Bank Rate during the year ahead. Market prices implied a negligible
probability of a rise in Bank Rate this month. In contrast to financial market participants, most City
economists continued to expect that the next move in Bank Rate would be down, though none of the
economists responding to a Reuters poll expected a change at this meeting.


3     Breakeven inflation rates derived from UK government bonds were about 50 basis points higher
three to five years ahead than at the time of the May Inflation Report. Smaller increases in breakeven
inflation rates had been seen in the euro area and the United States.


4     The main international equity indices had fallen significantly on the month. There had been
large falls in the equity prices of UK financial and construction companies. But most other sectors had
also fallen substantially. Markets were possibly beginning to factor in the prospective impact of
weakening demand and sharply rising costs on a wider range of companies.


5     Against the background of continued international financial fragility and deleveraging by
financial institutions, the process through which UK banks were raising capital was proving difficult.
At the same time, the decline in house prices and the prospective impact of a slowing economy on
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mortgage defaults would increase banks' regulatory capital requirements. Some banks' balance sheets
were also likely to be adversely affected by the deteriorating financial position of house-builders.
Given these factors, it was not surprising that credit default swap premia for financial companies had
risen during the month.


The international economy


6     In the euro area, GDP had been boosted by erratic factors in 2008 Q1, which were likely to
unwind in the second quarter. Business surveys had weakened through the first half of the year.
Taken together, these two developments suggested that euro-area GDP would probably record little or
no growth in 2008 Q2, though the underlying slowdown was less marked. HICP inflation rose to 4.0%
in June from 3.7% in May. The ECB had raised its official policy rate by 25 basis points to 4.25% on
3 July.


7     In the United States, a number of indicators were pointing to a much stronger outturn for GDP in
2008 Q2 than had been expected at the time of the May Inflation Report. That appeared to reflect to
some extent an earlier-than-expected boost to consumption from the tax rebates. But consumer
confidence had continued to fall. The housing market had remained weak: housing starts, new
building permits and new home sales had all declined. The labour market had eased further. Non-
farm payrolls had fallen by 60,000 in both May and June. The unemployment rate had remained at
5.5% in June. CPI inflation had picked up to 4.2% in May from 3.9% on the back of higher energy
prices, though the rates of increase in the headline and core personal consumption expenditure
deflators had been relatively stable at 3.1% and 2.1% respectively.


8     Japanese Q1 GDP growth had been revised up to 1.0% from 0.8%. But activity indicators were
pointing to weakness in Q2. CPI inflation had picked up to 1.3% in May, its highest rate in a decade.


9     Elsewhere in Asia, inflation was high ­ the result of rapid demand growth, which had been a key
factor underpinning the relentless rise in commodity prices in recent years. But those economies were
unlikely to grow at such a fast pace indefinitely. Output produced by energy-intensive technologies
would become less profitable. Moreover, rising commodity prices were worsening many of these
economies' terms of trade, which would depress demand eventually. It was also possible that the
authorities would take further policy action to bring their inflation rates under control. However, there
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was not much sign of any slowing in economic activity yet, and there was a good chance that these
economies would continue to grow strongly in the near term.


10    The slow response of oil supply to the rapid increase in demand had been an important factor
behind the increase in the price of oil during recent years. There was a legacy of insufficient
investment in new fields and refining capacity, so that new sources of supply had been slow to come
on stream as old fields ran down. A shortage of qualified personnel and capital equipment, together
with geo-political factors and regulatory constraints, had also hampered the expansion in supply.


11    The oil price had been volatile in recent weeks, but had ended the month some 10% higher in
dollar terms. Concerns about the security of supply in the Middle East and Nigeria seemed to lie
behind the most recent rises. Food and metal commodity prices had also increased during the month.


Money, credit, demand and output


12    The growth rates of broad money and lending had slowed sharply in the past few months. The
three-month annualised growth of M4 had virtually halved since July 2007, while the equivalent
growth rate of M4 lending had declined by a third. This was a possible sign of future weakness in
economic activity.


13    GDP growth for 2008 Q1 had been revised down to 0.3% from 0.4%. Upward revisions to
activity in 2007 had also made the current slowdown look sharper.


14    The latest monthly output data and survey indicators were pointing to a further slowing of GDP
growth in the second quarter. Manufacturing output had fallen by 0.5% in May, alongside a sharp
weather-related drop in energy-sector output. The CIPS/Markit activity indices for both
manufacturing and services had fallen further in June, reaching their lowest levels since 1998 and 2001
respectively, and the indices for new orders had fallen well below their `no change' level. Both the
CIPS/Markit and Experian surveys for construction had also been weak. The BCC survey for Q2
(conducted between the end of May and mid-June) had been markedly downbeat.


15    However, while the output indicators had been consistently subdued, the indicators for spending
were more mixed. The official expenditure figures suggested a much stronger picture than the output
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data. But the estimate of 1.1% for household consumption growth in Q1 was at odds with evidence
from survey indicators and the reports from the Bank's regional Agents. Moreover, real post-tax
labour income growth had been slowing sharply over the past year and had actually fallen in Q1. The
mismatch between official consumption data and the surveys looked even more marked in Q2.
According to the ONS, retail sales volumes had risen by 3½% in May, the largest monthly change
since 1979. Good weather and difficulties adjusting for bank holidays may have accounted for part of
the unusual strength. By contrast, the low retail sales balance in the CBI Distributive Trades Survey,
downbeat trading statements from large retailers, weak car sales, and the lowest consumer confidence
balances since 1990 all painted a much weaker picture for consumption in Q2.


16    As the determinants of consumption had clearly weakened and the surveys were giving a broadly
consistent message, it was likely that the official expenditure data were overstating the current strength
of consumer spending. But consumer surveys had not been well correlated with mature official
estimates of quarterly consumption growth in the past, so it might not be appropriate to discount the
official data entirely.


17    The housing market had continued to weaken rapidly. The average of the lenders' house prices
indices had fallen by 1.4% in June, and 4% on the quarter, which appeared to be the largest nominal
quarterly decline since the early 1950s. However, in the preview of the June survey from the Royal
Institution of Chartered Surveyors (RICS), the backward- and forward-looking price balances were
slightly less negative. Housing market activity had declined sharply. Mortgage approvals for new
house purchase had fallen again in May, to reach a third of their level at the end of 2006. Private
sector housing starts had fallen by 18% on the month in May, according to the National House-
Building Council. But the RICS new buyer enquiries series was less negative in June.


18    The weakening in the housing market accorded with the reduced availability of secured credit to
households as reported in the Bank's Credit Conditions Survey. The survey suggested that there was a
further tightening to come. Unsecured credit availability was also reported to have been reduced.


19    Business investment growth in Q1 had been revised down slightly to -1.8%. And the prospects
for the rest of the year were poor. CIPS/Markit capital goods orders had fallen sharply and the Bank's
regional Agents had reported that many contacts had been putting off investment decisions until next
year. Those contacts suggested that firms' reluctance to invest appeared to reflect mainly the
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prospective slowdown in the economy, alongside heightened uncertainty. Tighter credit conditions
might have been relevant for some businesses, but many appeared to have been unaffected so far,
probably because they had a cushion of retained earnings or access to already committed facilities
which they could draw down.


20    Net trade had been estimated to have contributed a substantial 0.5 percentage points to Q1 GDP
growth: export growth had picked up, while imports had fallen more sharply than in the previous
quarter. The latest data for exports in Q2 were mixed: export volumes were down in May, and
CIPS/Markit new export orders had fallen in June; but the BCC survey of manufacturers pointed to
healthy growth in export demand.


Supply, costs and prices


21    CPI inflation had been 3.3% in May, 0.3 percentage points higher than in the previous month.
The rise partly reflected base effects from falls last year in the prices of food and retail energy. In line
with the pre-release arrangements, an advance estimate for CPI inflation of 3.8% in June had been
provided to the Governor ahead of publication. That was higher than the Committee had been
expecting. The Governor's open letter to the Chancellor on 16 June had explained that inflation was
likely to rise sharply in the second half of the year to above 4%. If anything, the outlook for inflation
had worsened since then. But the magnitude and timing of rises in retail energy prices could change
the profile of CPI inflation over the coming months significantly, and these were extremely uncertain.
For example, if energy companies chose to pass increases through more slowly, that might result in a
smaller, but more prolonged, pickup in inflation. The extent to which CPI inflation was likely to rise
in the short term did not seem to have been fully appreciated by many outside commentators.


22    Some survey-based measures of household inflation expectations had also risen. The
Citigroup/YouGov survey had reported a rise in median one-year-ahead expectations to 4.6% in June
from 4.1% in May. There had also been a marked pickup in the Barclays Basix measures on the
quarter, for both one-year ahead and, perhaps more worryingly, two-years ahead. But the five-to-ten
year ahead Citigroup/YouGov series had edged down to 3.8% in June from 3.9% in the previous
month and had been around that level for much of the year.
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23    In part reflecting commodity price developments, non-labour cost pressures had intensified
further. Manufacturers' input prices had risen by almost 4% in May, pushing the twelve-month
inflation rate to nearly 28%. The CIPS/Markit index of manufacturers' input price inflation had
reached a new record high in June. These pressures were also evident further along the supply chain,
with manufacturers' output price inflation up sharply to 9.1% in May. The CIPS/Markit
manufacturing output price inflation index had edged up in June, also to a new high. The CBI Monthly
Trends Enquiry survey balance for manufacturers' expected prices had remained elevated, albeit down
slightly on the previous month.


24    According to the Labour Force Survey (LFS), employment rose strongly in the three months to
April. But there were signs that the labour market was turning down. The Workforce Jobs series had
painted a weaker picture of employment growth. Both LFS unemployment and the claimant count had
edged up. The number of recorded vacancies had decreased. And most of the employment surveys
had weakened; BCC employment intentions for services, for example, had been the lowest for 15
years. There had also been a number of high profile announcements of staff cuts, particularly in the
building and financial sectors.


25    There were few signs of rising labour cost inflation. Settlements were unchanged in the three
months to May at around 3¼%. The Average Earnings Index (AEI) and the experimental Average
Weekly Earnings (AWE) series had drifted apart again, with the AEI pointing to relatively stable
earnings growth of just under 4%, while the AWE measure had picked up to 4½%.


The immediate policy decision


26    The central projection in the May Inflation Report had been for inflation to rise to a little below
4% in 2008 Q4, before falling back towards the target. The Committee had identified two major risks
to that outlook. On the upside, there was a risk that rising CPI inflation would lift medium-term
inflation expectations and thereby lead to a more prolonged period of above-target inflation. On the
downside, the risk had been that weaker incomes and tighter credit would lead to a sharper and more
prolonged slowdown in the economy that would pull inflation below the target further out. On
balance, the risks to inflation had been to the upside. At the Committee's June meeting, most members
had concluded that the balance of risks to inflation in the medium term had moved further in that
direction.
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27    Since June, there had been more bad news for the inflation outlook. Gas and oil price futures
had risen again. The advance estimate of CPI inflation in June had been higher than expected. Some
survey-based measures of inflation expectations had picked up, particularly at shorter horizons. And
measures of breakeven rates of inflation at three- and five-year horizons had also increased. Against
that, earnings growth so far had remained relatively subdued. The near-term prospects were for a
higher rate of inflation than projected in the May Inflation Report and higher than the Committee had
believed at the time of the Governor's letter to the Chancellor in mid-June.


28    There had also been downside news during the month for activity, and hence for inflation in the
medium term. Equity prices had fallen, and the falls had been fairly broadly based across the sectors,
indicating a growing pessimism about the macroeconomic outlook. Higher energy prices would weigh
down on economic activity. The financial sector remained fragile. The latest Bank of England Credit
Conditions Survey had suggested that the credit tightening was continuing and that more was to come.
The housing market downturn had gathered momentum; house prices had already fallen by around 8%
since their peak. The GDP data for Q1 growth had been weaker than the Committee had expected in
May. Although GDP growth in Q2 might turn out to have been slightly stronger than expected, there
had been some very weak survey data towards the end of the quarter. Those, together with weakening
surveys of retail spending and reports from the Bank's regional Agents, suggested that growth was
continuing to slow. So the outlook for growth in the rest of the year would most probably be weaker
than the Committee had projected in May.


29    Against the backdrop of these risks to the inflation outlook, the Committee discussed the
appropriate level of Bank Rate. The higher than expected outturns for CPI inflation could mean that
there was more inflationary pressure in the economy than the Committee had thought. That might be
because pressures on supply capacity were greater, or because a weaker exchange rate was feeding
through more strongly to consumer prices.


30    Although it could do little to alter the path of inflation in the near term, the Committee could, by
raising Bank Rate this month, send a strong signal that it was focused on inflation and remained
determined to bring it back to target in the medium term. There was a risk that medium-term inflation
expectations might move significantly away from the target. If that were to happen, a more
pronounced slowing in activity would be needed to bring inflation back to target.
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31    However, there were also a number of arguments for maintaining Bank Rate at 5.0% this month.
The Committee had previously signalled that a margin of spare capacity would be required to reduce
the risk of medium-term inflation expectations rising. The upside news on inflation during the month
had made it necessary to have more spare capacity. But there had been downside news on economic
activity during the month too, so it was possible that a higher level of Bank Rate would not be needed
in order to generate that. An increase in Bank Rate in the current circumstances, when confidence was
low and the financial sector fragile, could impart a downward momentum to the economy that risked a
significant undershoot of inflation in the medium term. Keeping Bank Rate at 5.0% when the
economy was slowing was arguably already sending a strong signal of the MPC's commitment to
reducing inflation. A rate change this month would be a surprise at a time when credit and other
financial markets remained fragile, and any change in rates would be better communicated alongside
the Bank's August Inflation Report.


32    For all members of the Committee, the decision was a difficult one. There was a range of views
about the weights to place on different arguments. But all members agreed that, relative to the central
projection in the May Inflation Report, the path of inflation in the near term would be higher and the
slowdown in activity more pronounced. The discussions and analysis in the forthcoming Inflation
Report forecast round would help to shed more light on the implications of these developments for the
inflation outlook in the medium term.


33    Most members judged that the risks to inflation in the medium term were most likely to be
balanced by maintaining Bank Rate at 5.0% this month.


34    For one member, the arguments in favour of raising Bank Rate this month were most telling.
While acknowledging the downside risks to activity from the energy shock and credit crunch, an
immediate increase in Bank Rate was needed to keep medium-term inflation expectations anchored
and ensure the Committee's credibility in light of the current and prospective increase in CPI inflation.


35    For another member, the news on the month had reinforced the case for an immediate reduction
in Bank Rate in order to avoid inflation undershooting the target in the medium term. The activity data
had been uniformly gloomy and broad-based and activity now seemed likely to contract sharply in the
near term, possibly for several quarters. Long-term inflation expectations remained contained and
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domestically generated inflation remained low. As a result, there was little or no likelihood of a rise in
wage growth. So it continued to be important to look through the short-term spike in inflation.


36    The Governor invited the Committee to vote on the proposition that Bank Rate should be
maintained at 5.0%. Seven members of the Committee (the Governor, Charles Bean, John Gieve, Kate
Barker, Spencer Dale, Andrew Sentance and Paul Tucker) voted in favour of the proposition, and two
(Tim Besley and David Blanchflower) voted against. Tim Besley preferred an increase of 25 basis
points, and David Blanchflower preferred a reduction of 25 basis points.


37    The following members of the Committee were present:

Mervyn King, Governor
Charles Bean, Deputy Governor responsible for monetary policy
John Gieve, Deputy Governor responsible for financial stability
Kate Barker
Tim Besley
David Blanchflower
Spencer Dale
Andrew Sentance
Paul Tucker

Dave Ramsden was present as the Treasury representative.