What is the UK’s non-inflationary trend rate of GDP expansion? The Office for Budget Responsibility (OBR) suggests 2.35% per annum. The Bank of England, naturally, refuses to reveal its estimate. The view here is that trend growth is below 2%, possibly 1.8-1.9%.

The OBR bases its 2.35% figure on trend productivity expansion of 2.0% and a projected rise in hours worked of 0.35%. On first inspection, the 2.0% productivity assumption looks reasonable. GDP per hour rose by 2.0% per annum between 1997 and 2008, years in which capacity utilisation in the economy was probably similar – the unemployment rate averaged 6.4% in 1997 versus 6.2% in 2008.

Measured productivity expansion over 1997-2008, however, is likely to overstate future potential, for two reasons. First, growth was artificially boosted by an outsized contribution from “financial intermediation” due to the credit boom. Financial intermediation accounts for 8% of GDP and productivity in the sector rose by 5% per annum over 1997-2008 versus an increase of 1.75% in the rest of the economy.

Financial intermediation GDP correlates with inflation-adjusted bank lending to the private sector. Output has slumped with credit since the financial crisis and – in contrast to the rest of the economy – has yet to recover, consistent with the view that part of the prior increase represented a bubble. Despite a larger cut in hours worked than in other sectors, productivity in financial intermediation is now a drag on the economy-wide trend.

A reasonable – optimistic? – expectation is that credit will revive and expand in line with overall GDP over the next 5-10 years. In that case, productivity growth in financial intermediation might converge with the rest of the economy, suggesting a trend rise in output per hour of 1.75% rather than the OBR's 2.0%, based on experience over 1997-2008.

A second reason for doubting the OBR's extrapolation is the recent revelation that the Office for National Statistics (ONS) underrecorded clothing inflation over 1997-2009, implying that it may have overestimated real GDP expansion. According to the Bank of England, the increase in the CPI for clothing may have been understated by 5.5 percentage points per annum, with double the impact on the RPI. With the RPI used to deflate consumption, this suggests that GDP growth was overstated by up to 0.4 percentage points, based on a 3.5% share of clothing spending.

In practice, the distortion should be smaller because the ONS calculates GDP incorporating output and income as well as expenditure data while its real GDP calculation is based partly on volume information, not only nominal inputs deflated by prices. A plausible guess is that GDP growth was overstated by 0.2-0.3 percentage points over 1997-2009, an error that will have fed into estimates of trend productivity expansion by the OBR and others.

The underrecording of clothing prices coupled with “phantom” financial-sector output gains due to the credit bubble, therefore, suggest that current trend GDP expansion is 1.8-1.9% per annum rather than the 2.35% estimated by the OBR. This would be consistent with recent evidence: unemployment has fallen slightly over the past year while survey-based measures of capacity utilisation have risen despite GDP growth of only 1.8% in the year to the first quarter, or 2.0% excluding volatile oil and gas production.

This is bad news for policy-makers. Trend expansion of 1.8% rather than 2.35% implies a GDP “pie” that is 5% smaller in 10 years’ time. Future economic expansion, in other words, may contribute less than hoped to reducing the fiscal deficit and consumer gearing. The inflation-growth trade-off, meanwhile, is likely to be less favourable than the MPC has assumed – consistent, of course, with recent experience. Interest rates may need to be raised despite “unsatisfactory” economic expansion – if the Committee wishes to adhere to its remit.

The May Inflation Report confirms that the MPC is no longer setting monetary policy in accordance with its remit.

The key measure of whether the MPC is on track to meet its target is the mean inflation forecast based on unchanged policy. The mean forecast takes account of the balance of risks around the mode or central projection – as should the MPC if it is doing its job. The mean forecast, in other words, summarises the whole fan chart*.

The Bank withholds its forecast numbers until a week after publication of the Inflation Report. This results in media attention focusing on the central projection, which is easier to estimate from the fan chart than the mean and has been significantly lower in recent Reports.

In February, the mean forecast for inflation in two years’ time assuming unchanged policy was 2.48%, representing the largest overshoot of the target since February 1998 and clearly signalling the need for higher interest rates.  Based on chart 5.13 on p.47 of the May Report, the current two-year-ahead mean forecast remains at about 2.5%. The central projection is again below the mean but has risen from 2.08% to about 2.25%. So neither measure is consistent with the 2% target.

The chart below compares the path of the mean forecast estimated from the May fan chart with the published numbers from the February Report. The forecast has been raised in every quarter until the end of 2012 – average inflation over the next two years is now 3.5% versus 3.3% in February. The MPC's remit is 2% inflation “at all times”, not just at the two-year horizon.

A year ago, the view here was that inflation, far from heading for an undershoot as the MPC claimed, would remain above 2% for the foreseeable future, implying a need for policy tightening. The Bank now accepts this prospect but still the MPC remains inert. Many, including the Chancellor, will support the Committee’s approach but the pretence that policy is being set in accordance with "inflation targeting" should be abandoned.

*The Bank’s own advice is that “it is more appropriate to compare outturns with the MPC’s projection of the mean, rather than the mode or median”. See “Assessing the MPC’s fan charts”, Bank of England Quarterly Bulletin, Autumn 2005, p.332.



UK economic news remains reassuring and at odds with the unremitting gloom purveyed by the media and propaganda organisations such as the British Retail Consortium (BRC).

The Monster index of online job vacancies rose by an annual 14% in April, up from 9% in March, despite a fall of 8% in public sector openings. A seasonally-adjusted version of the index tracks combined output of the services and industrial sectors (which account for 93% of GDP) and remains on an upward trend, implying that the economy is continuing to recover despite data volatility caused by the weather, holiday effects and unreliable ONS estimates of construction output – see first chart.

Rising employment is also suggested by last week's Royal Institution of Chartered Surveyors (RICS) commercial market survey, showing an increase in demand for space in the first quarter – second chart.

The RICS housing market survey for April, released this morning, reported a rise in both activity and price balances. The net percentage of surveyors expecting higher prices remains heavily negative but – at least when asked by their industry body – estate agents have a surprising tendency towards pessimism: the current reading has been associated with inflation historically – third chart.

Reflecting holiday effects, BRC retail sales soared by an annual 6.9% in April, a figure as meaningless as the 1.9% March slump, which was a cause of much celebration by the gloomsters when reported a month ago – see previous post. The average of the current and year-before annual changes strips out holiday distortions and is a better guide to the underlying trend: April's 3.3% result was in the middle of the recent range, consistent with a subdued but not suicidal consumer – fourth chart.

The OECD's leading indices for March confirm a loss of global economic momentum suggested much earlier by monetary trends – see January post.

The first chart shows the six-month growth rate of combined industrial output in the G7 and emerging "E7" economies together with a forecasting indicator derived from the OECD indices, which incorporate a wide range of economic and financial inputs. The indicator peaked in December and fell again in March, suggesting that output will slow into the summer, based on the usual 3-7 month lead.

Monetary trends are signalling a slowdown rather than anything worse. G7 real narrow money is still expanding and the lower rate of increase recently reflects higher inflation, with nominal growth boosted by the Federal Reserve's QE2 securities purchases – second chart. A reversal is possible after QE2 ends at mid-year but this would affect the economy only from early 2012.

Interestingly, the recent decline in the forecasting indicator has been due to the G7 rather than E7 component – third chart. Within the E7, the OECD indices are signalling a slowdown in Brazil, India and Russia but continued strength in China. Chinese resilience, however, is at odds with recent monetary trends and, if correct, implies further policy tightening, which would increase the risk of a "hard landing" later in 2011.

A post in March suggested that commodity markets would cool as emerging-world growth slowed in response to monetary tightening. Industrial commodity prices remain closely correlated with E7 industrial output – see first chart.

The timing of the correction, however, seems partly to reflect central bank liquidity operations. A post last week noted that G7 bank reserves were no longer rising, with the Fed temporarily sterilising its QE2 purchases (by requesting that the Treasury hold more cash in its Fed account) and the Bank of Japan allowing the post-earthquake liquidity boost to unwind. These trends are confirmed by the latest data – second chart.

Commodity bears may need to exercise caution near term since QE2 has yet to complete and the Fed could choose to “unsterilise” its recent purchases if weakness extends to equities and credit markets, resulting in a generalised tightening of financial conditions. For the moment, however, events are probably playing out to the Fed’s satisfaction. Inducing a correction in commodities, indeed, may have been an intention of Chairman Bernanke’s refusal to entertain QE3 speculation at last week’s press conference – consistent with the recent cessation of liquidity injections.



The consensus narrative is that a rise in UK interest rates has been pushed back by "disappointing" economic news. The consensus rate view may be right as the MPC diverges further from its remit but the interpretation of recent economic data is questionable – the balance of news suggests that growth is continuing at or slightly above its trend or potential rate:

• The first-quarter GDP figures released last week imply that output of the industrial and services sectors – which account for 93% of the economy – rose by 0.8% between November and March, or 2.4% annualised. (This comparison removes the distorting effect of December's bad weather.) The March level was 1.3% above the 2010 average, consistent with output growing by about 2% in 2011.

• Business surveys indicate further respectable growth in services and manufacturing. The PMI services new business index rose to a 13-month high in April and is above its long-term average. The PMI manufacturing new orders index fell sharply but remains consistent with growth and may have been depressed by Japan-related supply disruption and holiday effects. A weighted average of the two indices declined slightly in April but is at a level historically associated with solid expansion – see first chart.

• Capacity utilisation continues to rise in both services and manufacturing, according to the Bank of England agents' survey, suggesting above-trend expansion.

• The construction sector depressed GDP over the winter but the first-quarter estimate implies a strong rebound in March. Construction is unlikely to act as a major drag for the year as whole, judging from construction new orders, which were 8% above their 2010 average in the fourth quarter.

• Labour market trends are consistent with growth at or above potential, with unemployment stable and aggregate hours worked over December-February 1.1% higher than six months earlier.

• Slumping consumer confidence and downward pressure on real household disposable income may be yesterday's story. Real income could rebound strongly in 2012, reflecting recent higher pay settlements, a mechanical drop in inflation and further employment gains. The relative performance of retail stocks, which leads consumer confidence, has picked up since the start of April – second chart.