1. finance
2. bank

Section F
Recap
In Section B we set out in general terms how a change in Bank Rate affects inflation
over a period of time. We discussed how it leads to changes in spending and how this
influences output and, in turn, the rate of inflation. Section D expanded on this
discussion. This section will add to this material by looking at different aspects of the
economy and how we monitor developments to judge the future path of inflation.
The diagram on the next page illustrates the basic features
of the transmission mechanism – the route by which an
interest rate decision influences the rate of inflation. It
portrays how the rate of inflation is the product of the
degree of inflationary pressure within the UK economy,
Key points
• Bank Rate affects other interest rates – such as
mortgage rates and bank deposit rates. At the same
time, policy actions and announcements affect
expectations and confidence about the future course
of the economy. They also affect asset prices and
the exchange rate.
• These changes in turn affect the spending, saving
and investment behaviour of individuals and firms in
the economy. Higher interest rates will tend to
encourage saving rather than spending, and a higher
value of sterling in foreign exchange markets –
which makes foreign goods less expensive relative to
goods produced at home.
Bank of England and The Times Interest Rate Challenge 2014/15
and the influence on domestic prices from import prices.
The diagram will refresh your understanding of what has
been discussed earlier and provide a quick reference point
as you are looking at the material in this section and the
data that accompany it.
• The level of demand in money terms relative to the
supply capacity of the economy – in the labour
market and in product markets – determines
inflationary pressure in the economy. If the demand
for labour exceeds the supply available, there will
tend to be upward pressure on wage increases,
which some firms might pass through into higher
prices charged to consumers.
• Exchange rate movements have a direct, though
often delayed, effect on the prices of imported
goods and services, and an indirect effect on the
prices of domestic goods and services that compete
with imports and use imported materials and other
inputs.
Section F Recap
73
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Section F Recap
74
Exchange rate
Expectations/
confidence
External demand
Domestic demand
Total demand
Import
prices
Domestic
inflationary
pressure
Inflation
Having a good feel for the transmission mechanism will help the teams to identify how information and signals from different aspects of the economy might
influence future inflation.
Official
Bank
Rate
Asset prices
Market rates
The transmission mechanism of monetary policy
Section F
Money and financial markets
The amount of money and credit
An old song has it that ‘money makes the world go round’.
It certainly turns the wheels of the economy and it is
central to thinking about inflation. As Section B explained,
inflation represents the rate of decline in the value of
money. Without money, there would be no inflation.
As we explained in Section C, the UK authorities no longer
attempt to target the growth in the money supply as a
means of controlling inflation. But the money supply does
play an important role in the transmission mechanism and
as an indicator of economic conditions. And, ultimately,
the control of inflation implies the control of monetary
growth. The box on the next page discusses this.
Narrow money – notes and coin
Notes and coin in circulation in the economy are referred
to as ‘narrow money’. Growth in the amount of notes and
coin in the economy provides one indication of how much
household spending might be rising. That is because notes
and coin are still an important means of payment, despite
the growth in the use of debit and credit cards. If people
withdraw notes from cash machines, they are likely to use
them for spending in the near future.
An increase in notes and coin in circulation in a particular
month might signal a rise in the value of retail sales. Data
for notes and coin are released ahead of retail sales data.
Note that we have said the value of retail sales, not the
volume. Money will reflect the value of expenditure,
ie. the price and the volume. It is a nominal variable, in
the way we explained in Section E.
Broad money – money in bank and building society
accounts
Notes and coin only represent a small part of what we call
‘money’. Money in a wider sense largely consists of what is
held in bank and building society accounts. ‘Broad money’
is the term used to describe the amount of money held in
these accounts plus notes and coin in circulation.
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The measure of money that captures this definition is
called M4. As well as aggregate M4, data are also available
for the money held by different sectors of the economy –
households, companies and financial institutions other
than banks.
Alongside the amount of money deposited, there are also
data for the amount of lending undertaken by banks and
building societies. Again, these are available for the
economy as a whole – known as M4 lending – and for
individual sectors. In particular, there are data covering
lending to households. These are divided into secured
lending, ie. lending backed by assets such as housing, and
unsecured lending, such as credit card debt. Loans secured
on housing represent around 84% of personal debt.
We can look at the growth of bank deposits and lending
both for the whole economy and for different sectors, to
see if they provide any indications about future demand.
Households
Household spending power is likely to be related to the
size of individuals’ bank and building society accounts.
Higher growth in household deposits might reflect an
increase in savings. But it could also signal a future rise
in consumer spending growth.
On the borrowing side, households can borrow from
banks and building societies to supplement their income
in order to help finance spending or to buy a house. Data
on household borrowing can provide information about
current and future consumer spending.
Private non-financial corporations (PNFCs)
Companies’ deposits and borrowing data can provide
similar insights into their investment behaviour. For
example, companies may build up bank deposits or
increase borrowing to finance investment in new
equipment and buildings.
Section F Money and financial markets
75
Money and inflation
The amount of money in the economy and the level of
prices are positively related in the long run. Without
money, inflation could not exist. And, across many
countries, persistently high rates of money growth
have usually been associated with high inflation.
money growth of 4.5% per year would be broadly
consistent with annual growth in economic activity of
2.5% – around the historical average in the
United Kingdom – plus inflation of 2.0% per year, in
line with the inflation target.
Excess demand is likely to be accompanied by strong
growth in the amount of money deposited in banks
and building societies, and the amount of lending
undertaken by banks and building societies. Consider,
for example, what happens if Bank Rate is reduced.
Banks are likely to reduce the interest rates they
charge on their loans to individuals and businesses.
In addition to boosting spending directly, this is also
likely to lead to increased demand for loans which,
if met, will increase the amount of money in bank
deposits. So a change in Bank Rate is likely to result
in a change in both bank deposits and bank lending.
In practice, however, the relationship between money
and inflation has not been stable. Money growth has
been influenced by many other factors, including
financial innovations – such as the introduction of
credit cards – changes in banking regulations, and
developments in international capital markets. The
effects of these changes have not always been easy
to predict accurately. So rules of thumb like the one
above have not usually been useful guides for policy.
Although money and inflation are clearly linked
over the longer term, the usefulness of money as
an indicator of inflationary pressures in the short to
medium term depends on there being a predictable
relationship between money and the value of
spending. For example, suppose money grew at the
same rate as the value of spending over time. Then
Nonetheless, data on bank deposits, bank lending and
cash are helpful in providing indications about both
current and future spending in the economy. They
can corroborate other data or sometimes give leading
indications of spending behaviour since the figures are
released earlier than GDP data. In particular, data on
deposits and lending to households and companies
can provide useful clues about consumer spending
and company investment.
Other financial corporations (OFCs)
Credit conditions
Financial institutions other than banks and building
societies – such as life assurance and pension funds –
also have bank deposits. The deposits of OFCs may rise
or fall in response to their financial market activities –
for example, financial institutions might switch to holding
money rather than other assets in order to carry out
financial transactions such as purchasing company shares.
Such changes might influence asset prices, but often they
may have little to do with future spending and investment
in the wider economy. Whatever the reason, because the
behaviour of financial institutions can cause large
movements in the aggregate measure of M4, it is
necessary to monitor the data for OFCs before drawing
conclusions about the significance of the growth in broad
money more generally.
In addition to providing indications about future spending
and investment, monetary data can also be used to assess
conditions in the banking sector. There may be
circumstances in which the banking sector reduces or
increases the amount of lending it undertakes. For
example, losses on bad loans either in the United Kingdom
or overseas might restrict the ability of the banks to lend.
This is what happened in 2008 when the turmoil in
financial markets that originated in the US mortgage
market disrupted the supply of bank credit to households
and firms in the United Kingdom. This is sometimes
referred to as a ‘credit crunch’, which can reduce spending
and investment and lead to lower inflation. The opposite is
a ‘credit boom’, which might result in an increase in
spending and investment, and lead to higher inflation.
The Bank of England’s quarterly Credit Conditions Survey
gives up-to-date information on lending developments
in the United Kingdom.
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Section F Money and financial markets
76
Key data: money and credit
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Notes and coin
M4
M4 lending
Consumer credit
Financial market interest rates
Interest rates – the cost of borrowing – are important
determinants of both the demand for, and the availability
of money and credit. By examining interest rates on
savings, such as deposit account rates, and the cost of
borrowing, such as mortgage rates, you can better
understand how Bank Rate decisions made by the MPC
might be affecting spending and saving behaviour in the
economy.
Market interest rates may not change immediately or by
the same amount as changes in Bank Rate. At any point
in time, other factors might be influencing interest rates.
For example, increased competition amongst financial
institutions might result in lower mortgage or credit card
interest rates. The speed and extent of the pass-through
from Bank Rate to market rates will affect the impact of
MPC policy decisions.
The amount by which some market interest rates change
following a change in Bank Rate will also depend on the
extent to which a policy change is anticipated by financial
markets, and how the change affects market expectations
of future policy. If a change in Bank Rate is expected,
market interest rates might change beforehand. It is
possible to observe interest rate expectations by looking
at different financial market prices. Newspaper articles
about MPC interest rate decisions usually refer to what
financial markets expect to happen, and the MPC
discusses market expectations at its meetings.
Short-term interest rates
When Bank Rate changes, this is quickly transmitted to
other short-term interest rates in the money markets –
such as the rates charged by banks when they lend to
other banks. Short-term market interest rates are
important as they tell us about the cost to financial
institutions of obtaining funds that can then be used
to provide loans to customers such as mortgages and
overdrafts.
An alternative source of funds for banks is savings deposits
placed with them by customers. The rate on these deposits
will typically move with Bank Rate set by the MPC. So
movements in Bank Rate set by the MPC are important for
both savers and borrowers.
Long-term interest rates
Households and firms in the economy often want to
borrow money for long periods of time. One way to
borrow in this way is to take out a sequence of short-term
loans at short-term interest rates. Alternatively, borrowers
might want to fix the cost of borrowing in advance. Fixed
borrowing rates for long-term loans are called long-term
interest rates. These interest rates matter most to
individuals taking out fixed-rate mortgages or firms
looking to raise long-term finance for investment. One
way of observing changes in long-term market interest
rates is to look at the returns – or ‘yields’– offered on
government and corporate bonds which extend over long
time periods – for example five, ten or fifteen years.
Key data: interest rates
– Bank of England official Bank Rate
– money market rates (short rates)
– bond yields (long rates)
Bank Rate
The MPC sets the interest rate that is paid on deposits
held at the Bank of England by commercial banks and
building societies. This interest rate is known as Bank Rate.
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Section F Money and financial markets
77
Changes in long rates
Long-term interest rates tell us about financial market
expectations of future inflation and interest rates.
As such, they provide an indication of the credibility
of monetary policy, ie. the extent to which financial
markets believe that the MPC will achieve its target.
In practice, short and long-term interest rates are
likely to be closely related, with long-term rates being
an average of expected short-term rates over the
period of the loan. So if the MPC is expected to raise
short-term interest rates in the future, the current rate
for long-term borrowing might be higher than the
current short-term rate to reflect the expected higher
future cost of funds. And if short-term rates are
expected to fall in the future, long-term interest rates
might be lower than short-term rates.
The exchange rate
Exchange rates are particularly important financial prices.
They measure the price of one country’s money in terms
of another. Consequently, they depend on factors both at
home and abroad, including domestic and foreign interest
rates. Changes in interest rates in the United Kingdom
may affect the exchange rate between sterling and, say,
the euro. But so may changes in interest rates set by the
European Central Bank. It is important to bear in mind,
however, that interest rates are not the only influence on
exchange rates. They will also reflect the demand for, and
supply of, goods and services, and any other factors
affecting international transactions in goods, services or
assets.
Although monetary policy does not aim to achieve a
particular level for the exchange rate, it has to take into
account how changes in the exchange rate impact on
inflation prospects. In Section D, we explained that a
change in the value of sterling can have a direct influence
on inflation through changes in import prices, and an
indirect effect through its impact on demand for exports
and imports. But the nature and size of these effects will
depend on the reasons for a change in the exchange rate.
This means that, while short-term rates largely depend
on the MPC’s interest rate decisions, long-term
interest rates also depend on market expectations of
economic developments and monetary policy in the
future. So long-term interest rates can and do vary
without any change in current Bank Rate, as financial
markets continuously revise their expectations about
future Bank Rate and other variables, including
inflation. A rise in Bank Rate could generate an
expectation of lower future interest rates, in which
case long-term rates might fall.
Although a change in Bank Rate almost always moves
other short-term interest rates in the same direction –
even if some are slow to adjust – the impact on
long-term rates can go either way.
UK goods, it might be a reflection of rising demand. It is,
of course, often difficult to know what has caused the
exchange rate to change. But it is important not to view
changes in exchange rates and interest rates in terms of a
simple mechanical relationship. Some of the possible
effects on import prices and the composition of demand
are discussed in the box on the next page.
Bilateral and effective exchange rates
You can look at the pound’s exchange rate on what is
termed a ‘bilateral’ basis – the exchange rate between
two currencies, such as the pound relative to the US dollar
– and what is termed an ‘effective’ basis.
An effective exchange rate is an average of different
bilateral exchange rates, weighted according to the
importance of each one to a country’s trade. The sterling
effective exchange rate index (ERI) reflects the pattern
of UK trade with its 48 main trading partners. The
sterling-euro exchange rate has a weight of 46.2% in
the ERI.
For example, an appreciation of sterling might reflect an
increase in demand for UK goods and services. So rather
than a higher exchange rate reducing demand for
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Section F Money and financial markets
78
You can also look at other exchange rates to shed light
on movements in sterling. For example, you can see if a
change in the rate between the pound and the euro has
been similar to the exchange rate movements between
the dollar and the euro. This might help to explain what
has caused exchange rate changes. Other exchange rates
also help us to assess future economic conditions in the
United Kingdom’s main trading partners.
Key data: asset prices
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£/$ exchange rate
£/€ exchange rate
$/€ exchange rate
sterling ERI
FTSE all-share index
FTSE 100 index
Other asset prices
Asset prices – such as share prices and house prices – can
also provide information about future developments in
economic activity and inflation. Rising house prices might
reflect how confident consumers are feeling about the
future. Falling house prices might indicate the opposite.
The housing market is discussed under ‘Demand and
output’. Share prices will reflect investors’ expectations of
companies’ future profits. In this way, they can provide a
useful barometer of expectations and confidence in future
economic developments. You can monitor UK share prices
by looking at the Financial Times Stock Exchange
(FTSE) indices.
The exchange rate and import prices
Import prices are an important component of many
firms’ costs and of final consumer prices. An
appreciation of sterling – a rise in its value relative to
other currencies – will tend to lower the prices of
imported goods and services, and a depreciation will
tend to increase them. The effects may take many
months to work their way through the supply chain
and into retail prices. Import prices are discussed
under ‘Costs and prices’.
The exchange rate and demand
Depending on the reasons for a change in the
exchange rate and whether it is sustained, a lower
exchange rate will tend to make foreign goods more
expensive relative to goods produced at home. This
can affect the composition of total demand in the
economy, which could have implications for output
Bank of England and The Times Interest Rate Challenge 2014/15
growth and inflation. A fall in the relative prices of
UK output might encourage a switch of spending
towards home-produced goods and services away
from those produced overseas. For any level of
overall demand, domestic production will be higher
and imports lower. This may therefore increase
inflationary pressure relative to what it would
otherwise have been.
The exchange rate has its biggest impact on the
manufacturing sector, which accounts for around 45%
of UK exports. But other sectors, such as agriculture
and service industries like tourism and consultancy,
are also affected – for example, foreign holidays can
become more expensive and UK holidays relatively
cheaper if the pound falls in value. Exports and imports
are considered under ‘Demand and output’.
Section F Money and financial markets
79
Section F
Demand and output
We have already said a great deal about demand and output in earlier sections.
Section D explained why it is important to look at aggregate demand and output in
the economy. This part of Section F looks in more detail at the main components of
demand and output, and some relevant data series. It does this by working though
the different measures of total economic activity – Gross Domestic Product (GDP).
GDP – three measures in one
The rate of growth of the economy is a key piece of
information that the MPC considers when it is setting
interest rates. GDP data provide the most comprehensive
measure of economic growth. They capture different
aspects of economic activity – such as how much is
produced in the economy and how much is spent. Most
of the time you will see references to GDP as a single
measure of economic activity, but there are in fact three
approaches: one for total output – GDP(O); one for total
expenditure – GDP(E); and one for total income – GDP(I).
Each provides a different way of arriving at the same
figure – GDP.
The three measures of GDP are equal in principle. GDP(O)
is the total output of goods and services; GDP(E) is the
total expenditure on that output; and GDP(I) is the total
income generated by producing that output. But, in
practice, the measures always differ to some degree. This
happens because it is not possible to measure everything
perfectly, and different information is used to construct
each measure. And, for initial estimates, data sources are
often incomplete.
The published measure of GDP combines information
from the output, expenditure and income measures. For
the initial estimates of GDP, the output measure tends to
have the largest influence. Output data are thought to
provide the most accurate initial indication of economic
activity. So, for early estimates of GDP, adjustments are
often made to the expenditure and income measures. If
the latest data show GDP rising by 0.5% in the most
recent quarter, that will tend to reflect the measured
growth of output.
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But, in terms of assessing demand conditions in the
economy, most attention is devoted to the expenditure
measure and its components. The main components of
expenditure provide the framework for assessing demand
conditions and most economic forecasts, including the
MPC’s, are organised around them. The income measure
receives less attention, though some parts of it provide
important information.
GDP is most commonly expressed in chained volume
measures, ie. in real terms. It is normal to measure output
in chained volume measures. Expenditure, which is
measured in current prices, can be deflated to provide
expenditure in chained volume measures. Income is
usually presented in current prices, ie. nominal terms,
though for the purposes of producing an average measure
of GDP, it is also deflated to provide a measure in chained
volume measures. Once you are using the data, all this
should become clearer.
Total output of goods and services –
GDP(O)
The output measure of GDP – GDP(O) – measures
everything that is produced in the economy. This is
not simply the value of every firm’s production added
together. This would result in counting some output
more than once because many goods and services are
incorporated as inputs into other goods and services – for
example, part of the output of firms producing tyres will
be included in the value of the output of car producers.
GDP(O) aims to measure what is called ‘value added’.
Section F Demand and output
80
GDP releases
Each quarter the MPC receives three sets of data
releases for GDP. Each successive one gives more
accurate and detailed information about economic
activity and its make-up.
• The first release is called the ‘GDP preliminary
estimate’, available around three weeks after the end
of the latest quarter. This provides an estimate of
GDP growth and output growth in the production
industries and the service sector. Because this
estimate is produced quickly, it is usually subject to
revision as more information becomes available.
• The second release is called ‘Second estimate of
GDP’. It is available about a month later, some seven
weeks after the end of the relevant quarter. It
includes a revised estimate of GDP growth for the
quarter and a breakdown of total output
by sector. It also provides estimates of total
expenditure in chained volume measures and
current prices, along with the main components of
spending, as well as total income in current prices,
along with its main components.
• The third release is called ‘Quarterly National
Accounts’. It provides details of any further revisions
to the previously released estimates and a lot more
detail about the different components of GDP. For
example, it includes a breakdown of consumers’
expenditure into a number of categories, a
breakdown of investment and inventories, and
information about personal and corporate income.
This is the difference between the value of what firms
purchase, ie. their inputs, and their output. Value added
measures each firm’s contribution to total output. But
measuring this from quarter to quarter is a difficult task
and so it often has to be approximated using sales and
other information.
Industrial production
Sectoral output
Surveys
The change in total output in each quarter is estimated by
combining the volume of output in each of the different
sectors of the economy. Manufacturing output accounts
for around 10% of the economy. Services output accounts
for around 78%. Other sectors include agriculture, energy
and construction.
A variety of surveys provide information about trends in
output. These include surveys from the Confederation of
British Industry (CBI), the British Chambers of Commerce
(BCC) and the Chartered Institute of Purchasing and
Supply (CIPS). Collectively, these and other surveys cover
all sectors of the economy, although there tend to be
more surveys for the manufacturing sector.
Each quarter, there are usually differences in the growth
rates of different sectors. Even average growth rates tend
to vary from sector to sector. For example, manufacturing
output has grown by less than other sectors over recent
decades.
It is often important to look at output in different sectors
to assess whether a change in total output reflects lasting
or temporary influences. Energy output, for example, is
often volatile from quarter to quarter because of the
weather. So it may be useful to consider the underlying
situation by excluding temporary effects. You might also
be interested in the balance of overall growth in the
economy. Different economic conditions affect sectors
differently. For example, manufacturing is more export
intensive, therefore factors such as the exchange rate or
foreign demand will affect manufacturers more than they
will construction or services output.
Bank of England and The Times Interest Rate Challenge 2014/15
Data covering the production industries are published
more frequently than GDP data. The Index of Production
is published monthly, consisting of output data for the
manufacturing, energy and water sectors. Industrial
production represents just under a fifth of total output.
Key data: output
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GDP
Index of Production
CBI Industrial Trends Survey
CIPS Report on Manufacturing
CIPS Report on Service
BCC Quarterly Economic Survey
Section F Demand and output
81
In addition to information about recent output, many
surveys ask companies about their orders and what they
expect output to be in the near future. This can give us
some idea about future trends in output and whether
the current situation is likely to continue or change.
A selection of survey data is included in the datasheets.
Total expenditure on goods and
services – GDP(E)
You’ll see the following identity or similar versions
in many textbooks:
GDP = C + I + G + (X-M)
where C is consumer spending (or consumption)
I is investment (including stockbuilding)
G is government consumption
The expenditure measure of GDP – GDP(E) – measures
total spending on UK produced goods and services.
Spending in the economy is made up of consumers’
expenditure, investment expenditure and spending on
stocks of goods by companies, government spending on
goods and services, and spending on imports and exports.
GDP(E) excludes spending on imported goods and services
as they are produced outside the United Kingdom, but
includes spending on exports by overseas firms and
consumers.
X is exports
M is imports
demand plus exports minus imports. The difference
between exports and imports is called the balance of
trade. GDP(E) is equal to domestic demand plus or minus
the balance of trade.
Final domestic demand
The proportion of GDP accounted for by each category
varies from year to year. Spending on some categories is
particularly variable – for example, investment spending
tends to fall as a proportion of total spending in economic
downturns. Generally, spending by consumers accounts
for around 65% of GDP. Government spending – both
central and local government accounts for just over 20%,
and investment accounts for 14%. The value of imports is
equivalent to about a third of GDP and the value of
exports about 30% of GDP. The amount spent on stocks
of goods can vary greatly from year to year, but tends to
be small on average.
Domestic demand and the balance
of trade
Combining consumer and government spending,
investment expenditure and spending on stocks gives
domestic demand. You will often see references to the
growth of domestic demand. This tells us about spending
in the domestic economy.
Some spending by consumers and firms will be on
imports, ie. not UK produced goods and services. Exports
might also include some spending on imported goods –
such as materials and components. Imports are therefore
subtracted from total spending. So total expenditure on
UK goods and services – GDP(E) – is equal to domestic
Bank of England and The Times Interest Rate Challenge 2014/15
You will also see references to final domestic demand.
This is domestic demand minus what is spent on
inventories (or stocks). Expenditure on inventories is
not final demand – rather it is intermediate demand by
companies, such as manufacturers and retailers. Changes
in the level of stocks can reflect changes in other
components of demand and also firms’ expectations of
future demand. They can also be large and volatile from
quarter to quarter, making changes difficult to interpret.
Each of the components of total spending is now
considered in turn, along with some of the factors that
influence them.
Consumer spending
In 2012, consumers spent over £1 trillion, in current prices.
The fortunes of the economy are therefore very much tied
up with consumer demand. Small percentage changes can
amount to billions of pounds.
Consumer spending largely depends upon household
income and wealth. It can also be affected by confidence –
how optimistic or pessimistic consumers are feeling – and
by interest rates, as we discussed in Section B. It is
possible to build up an impression of potential future
trends in consumer spending by looking at these factors.
Section F Demand and output
82
Income and spending
What people earn is the main determinant of what they
spend and so changes in income are an important part
of any assessment of demand conditions. Total spending
in the economy will be affected by wage increases and
other earnings, and the levels of employment and
unemployment. These data are considered under
‘The labour market’.
Consumers are unlikely to make spending decisions based
solely on their current income. They probably take into
account their likely income over time – their expectations
of future income as well as current income. So changes to
current income might only impact on spending insofar as
the changes are viewed as permanent or long-lasting.
Wealth in financial assets, like shares and bonds, largely
consists of what is held in pension funds and life assurance
policies. Higher share prices might reflect expectations of
higher future income from company profits. This might
boost current spending, though the implications for
inflation will depend on why share prices have risen.
For example, investors might expect higher company
profits in the future because firms are investing more
and increasing the economy’s productive capacity.
House prices are slightly different. A rise in house prices
increases the value of home owners’ existing houses. But
it also increases the cost of future house moves, for which
households might need to save. So rising house prices do
not necessarily result in higher consumer spending.
Spending and tax
Of course, consumers will spend out of their incomes after
taxes and other deductions have been paid. This is referred
to as disposable income. In this sense, changes in the
amount of tax paid are also relevant to consumer
spending. If the Chancellor increases income tax, this is
likely to reduce consumer spending, though the extra tax
revenues might be used to finance higher public spending,
so the overall impact on demand need not change.
Spending and saving
Consumers do not spend everything they earn – some
part of their disposable income will be saved. What part
of income is spent and what part is saved are important
economic decisions.
It is possible to look at past trends to get some feel for the
average proportions of income that are spent and saved,
and to see how these have changed. It is often useful to
look at the balance between household income and
spending. This is provided by a statistic called the saving
ratio. If consumers seem to be saving relatively little as a
proportion of their income compared with the past, you
might conclude that spending in the future will moderate
as consumers rebuild their savings. Alternatively, if saving
appears high, this might mean that spending will rise in
the future.
Wealth
Developments in household wealth – the value of the
assets that people own – also have a bearing on the
prospects for consumer spending. Most household
wealth consists of financial assets and housing.
Bank of England and The Times Interest Rate Challenge 2014/15
The saving ratio
Saving is what is left from personal disposable
income after spending. The difference between
income and spending is measured by the saving
ratio. It is the proportion of income that is saved
in a particular period. It is published alongside
estimates of personal income and expenditure as
part of the third release of GDP. If household
income is £150 billion in a quarter and spending is
£142.5 billion, then the saving ratio would be 5%,
ie. £7.5 billion as a proportion of £150 billion.
Because the saving ratio is the difference between
two very large totals, it is sometimes revised quite
substantially. Nonetheless, it can provide
indications about consumers’ current and future
spending behaviour.
But rising house prices might be accompanied by higher
spending insofar as they are influenced by the same
factors, such as confidence and expectations about future
income. If people are optimistic about the future, they
may increase their demand for houses as well as goods
and services. And higher house prices might also allow
households to increase the amounts they borrow, secured
on the increased value of their homes. The box on the
next page discusses some of the data the MPC considers
to assess housing market developments.
Section F Demand and output
83
Housing market turnover
The MPC regularly reviews a range of measures of
housing market activity and house price inflation from
official sources and surveys. This includes information
from different stages of the house-buying process –
such as estate agent enquiries, mortgage lending and
Land Registry details. Data on estate agent enquiries
from the Royal Institution of Chartered Surveyors
(RICS) and the numbers of people reserving new
houses from the House Builders’ Federation (HBF)
can provide information about future housing market
activity, and may be useful in giving an early indication
of changes in trends. Data on mortgage loan approvals
by banks and building societies provide information
about future lending for house purchase. They also
give an indication of housing transactions, measured
ultimately by Land Registry ‘land transaction returns’
data when house moves are completed.
House prices
The MPC also reviews a number of measures of house
price inflation such as those from the Halifax and
Nationwide. House price data are also available on a
regional basis. This can provide useful information on
regional conditions in the housing market, and help to
assess the picture in the United Kingdom as a whole.
Categories of consumer spending
Total consumer spending is split 45:55 between spending
on goods and services. Goods spending is divided into
what are called non-durable goods like foods and petrol,
and durable goods, like cars and computers. We tend to
concentrate on total spending but, as with other data, it is
sometimes beneficial to look at the underlying
components.
Retail sales
In addition to quarterly estimates of consumer spending
growth, monthly data are available for retail sales. Retail
sales data consist of spending on goods in shops and
through mail-order companies. The data measure
spending in different types of stores. These include stores
that sell mainly food, clothing, footwear or household
goods (which includes electrical retailers), and those that
sell a range of goods (such as department stores).
Retail sales volumes data are closely related to the
goods component of consumer spending in the quarterly
GDP data, and so they can provide an indication of
changes in spending month by month, in between the
quarterly estimates.
In addition to the official data, the CBI Distributive
Trades Survey provides information from retailers and
wholesalers about their sales, sales expectations, prices
and stocks. This is published ahead of the official retail
sales data.
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Variations in spending
Spending on different goods and services will
be changing all the time, depending on prices,
consumer tastes and other factors. But spending
on some items will vary to a greater degree than
others over the course of an economic cycle. For
example, spending on durable goods and some
services, such as eating out, tends to vary more
as economic conditions change than spending on
non-durable goods. Spending on essential items
like food varies less – we eat roughly the same
whatever the economic conditions! So changes
in overall consumer spending are likely to be
driven more by spending on durable goods and
other discretionary items than by spending on
essential items.
Consumer confidence
How optimistic or pessimistic consumers are feeling about
their own situation and that of the wider economy can be
an influence on their spending behaviour. Changes in
confidence are likely to reflect sentiment about factors
that affect spending, such as income and wealth. They
may also provide indications about what consumers think
about their future income, something that we cannot
observe directly. The MPC regularly considers data from
the GfK and YouGov surveys of consumer confidence.
Section F Demand and output
84
Investment
The amount of spending on new equipment and buildings
matters for both an assessment of demand conditions and
the economy’s supply capacity. Investment that increases
firms’ capacity will raise the economy’s potential output –
for example, a new piece of equipment might produce
more output in less time. This is one of the main ways in
which the economy grows over time. So if total demand is
growing strongly due to increasing investment rather
than, say, consumer spending, there might be less concern
about inflationary pressure because the capacity of the
economy would also be rising. However, the extra
demand could still put upward pressure on prices in the
short to medium term. As ever, it is necessary to judge all
these considerations together and take an overall view
based on the information available.
Total investment in the economy does not just consist
of spending undertaken by companies, ie business
investment. It also includes investment by government
and by individuals. Investment by individuals largely
consists of what is invested in housing. This accounts for a
quarter of total investment. Business investment accounts
for 56% of the total. Investment data are available each
quarter, initially as part of the second release of GDP.
More detailed data for business investment are also
published.
Changes in the amount of investment tend to be quite
volatile from quarter to quarter. This is often because
capital expenditure tends to occur in large ‘lumps’. For
What drives investment?
Firms invest so that they have the capital equipment
they need to allow them to produce goods and
services in a profitable way. How much they invest will
be affected by a variety of factors, such as their use of
existing capacity – their capacity utilisation – and
expected future demand and profits. Firms are more
likely to install new equipment and add to their
capacity when they are optimistic that they can
increase sales profitably. Investment takes time so
firms need to be confident about future demand.
Rising investment tends to be associated with
favourable economic conditions, when the prospects
for demand are good and a high proportion of
companies are operating at, or close to, full capacity.
Bank of England and The Times Interest Rate Challenge 2014/15
example, an airline might purchase a number of aircraft in
one quarter but then nothing else over the rest of the
year. Investment data are also prone to large revisions as
new information becomes available, often from annual
statistical inquiries.
It is also useful to look at other data to assess current and
future trends in investment, including information about
company profitability and borrowing. Surveys also provide
information about firms’ investment intentions and
capacity utilisation, as well as business confidence.
Inventories (stocks)
Inventories are stocks of goods held by companies, either
as materials and components for future production or as
finished goods for future sales. They can be seen as a form
of investment – spending today for revenue tomorrow.
Output can be thought of as sales plus or minus the
change in stocks. Changes in the level of stocks have
important implications for the pattern of both current
and future economic growth.
Firms will have some desired level of stock that they
want to hold relative to their output or sales. Better
management and control of both stocks and production
has meant that stocks as a proportion of output – what
is called the stock-output ratio – have been falling over
recent decades. But changes in stock levels from quarter
to quarter can be volatile and large. Such changes often
reflect temporary imbalances between demand and output.
Changes in technology are also likely to influence the
amount that firms invest. New technology might
enable more efficient, lower-cost production. And the
availability of finance within a company and the cost
of borrowing or raising external finance will also affect
investment. High levels of company debt and high
interest rates will tend to constrain investment.
Changes in investment tend to be more strongly
cyclical than GDP as a whole. Firms tend to cut back
their investment plans when economic activity is
weak – investment can fall sharply in recessions – and
increase spending when the economy is more buoyant.
Section F Demand and output
85
What can cause the level of stocks to change?
A rise or fall in stocks might reflect unexpected
changes in demand. If demand is higher than expected,
companies might run down stocks ahead of increasing
their output. If demand is lower than expected, firms
might see their stock levels rise. Alternatively, firms
might deliberately build up stock levels by increasing
output in anticipation of higher future demand, or
reduce stocks if they expect demand to fall. In a
recession, reductions in the level of stocks can
exacerbate falls in output.
If companies have reduced what they are holding in
stock to excessively low levels, it is likely they will
want to increase stock levels in the future. This will
add to the future growth in output. Alternatively, if
stocks have risen to high levels, firms are likely to
want to reduce them at some point.
Data on changes in the level of stocks for the economy as
a whole and the main sectors are included in the second
release of GDP. Rather than expressing these changes as
a growth rate, they are recorded in terms of millions of
pounds, from which the contribution of the change in
stocks to the change in overall GDP is calculated. This
contribution can be positive or negative. It is often difficult
to explain changes in the level of stocks in any particular
quarter and to judge the likely implications for future
demand and output.
Public spending
Government and other public sector spending on goods
and services is an important component of total demand.
Like any other part of demand, how much the government
is spending and plans to spend on goods and services will
affect the overall balance between demand and supply in
the economy.
MPC projections of public spending are based on the
government's published spending plans, and the MPC
monitors how actual spending compares with these plans
over time.
The overall total for public spending on goods and services
is the most important consideration, rather than the
particular ways in which the money is spent, although this
can also be of significance. Estimates are provided with
the second GDP release. In addition, monthly figures are
also available on the public finances.
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A large proportion of all the stocks in the economy is
held by manufacturers and distributors. Distributors –
retailers and wholesalers – hold stock ahead of sales to
customers, either as goods on the shelves in shops or
in warehouses. Manufacturers hold stocks of materials
and finished goods, and will also have unfinished
goods at different stages of the production process –
what is called work-in-progress. They might want to
hold stocks of raw materials in case of shortages or
disruptions to future supply, or in case they need to
increase production at short notice. They might hold
stocks of finished goods to meet short-term or
temporary fluctuations in demand rather than keep
changing output.
The cost of holding stocks will also be a consideration.
For example, if interest rates are high companies
might prefer to lower stock levels to reduce their
borrowing or increase their bank deposits.
Public finances
Each month, figures are published showing how much the
government has received in revenue – for example, from
income tax and VAT – and how much has been spent by
the different areas of government – such as health and
education. These data provide a check on the extent to
which government spending plans are being achieved.
The difference between expenditure and revenue will
determine the amount of borrowing the government has
to undertake. This is called the Public Sector Net Cash
Requirement (PSNCR). This will be negative, ie. in surplus,
when revenue is greater than expenditure.
Monthly movements in public spending and revenue can
be volatile, reflecting the timing of spending by government
departments and the receipt of revenue. Low spending in
one month might be reversed the following month. Over
time, however, the monthly public finance data do provide
an indication of trends in government spending and whether
it is growing more or less than envisaged by the MPC.
External demand
The balance of trade
The balance of trade in goods and services – the difference
between exports and imports – is an important indicator
of economic activity. Total spending in the economy will
include what is spent on imports; and total output will
include what is produced for export. So the balance of
trade measures the difference between domestic
production and domestic spending.
Section F Demand and output
86
When the balance of trade is negative, ie. imports are
greater than exports, the United Kingdom is purchasing
more from other countries than it is selling to them. A
more negative or less positive trade balance could
indicate that domestic demand is too high relative to
supply, which draws in more imports. But it could indicate
that growth prospects in the United Kingdom are
considered to be good and so investment spending is high,
drawing in imports of machinery and other capital goods.
If the balance of trade is becoming less negative or more
positive, that could indicate that demand overseas is
strong, enabling UK exports to rise. Changes in the
balance of trade therefore reflect both domestic and
external demand conditions.
Exports and imports
Although the balance of trade is a useful summary
measure, it is often more informative to look at trends
in exports and imports separately. They may provide clues
about different aspects of the economy. For example,
strong growth in export volumes might reflect growth in
the world economy, whereas strong growth in import
volumes might signal strong domestic demand growth.
Growth in exports and imports might also reveal
something about the competitiveness of UK producers,
both in domestic and overseas markets.
Data on the volume of exports and imports are available
on a monthly and quarterly basis. The monthly data
releases focus on exports and imports of goods. These
data are broken down into trade with EU and non-EU
countries. Trade with EU countries accounts for a large
part of the United Kingdom’s total trade, for example,
goods exports to the EU are 50% of UK goods exports.
The second GDP release provides details of total trade in
goods and services.
Key data: expenditure
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GDP
retail sales volumes
CBI Distributive Trades Survey
housing market turnover
house prices
GfK consumer confidence
PSNCR
import volumes
export volumes
The world economy
The exchange rate and competitiveness
The prospects for growth in the world economy
are an important consideration for monetary policy,
particularly growth in the United Kingdom’s main
export markets. Demand for UK exports is an
important component of overall demand.
The level of UK exports and imports will also be
affected by the exchange rate. It will influence the
competitiveness of UK exports and foreign imports –
a depreciation of the pound tends to make UK goods
cheaper abroad and imports more expensive; an
appreciation has the opposite effect.
The MPC looks particularly closely at the economies
of the euro area, United States, China and Japan. These
are the world’s largest economies. The MPC has to be
alert to any developments in the world economy that
influence demand for UK goods and services and the
prospects for the wider world economy.
The MPC considers a range of data on the main
overseas economies to provide indications about
current and future growth in demand for UK exports.
A key indicator in many countries is the growth in
GDP. But, additionally, labour market indicators are
also useful, and prices in overseas markets will be the
main determinant of UK export prices.
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Changes in the exchange rate are likely to take time
to influence prices and, in turn, exports and imports.
And the reasons for a change in the exchange rate
and whether it is likely to be a temporary or sustained
change will also influence the impact on prices and
demand. Of course, many other factors will affect the
competitiveness of UK exporters and firms that
compete in the domestic market with imports,
including wage costs and product quality. But the
exchange rate is certainly important, as exporters will
tell you. The exchange rate is discussed under ‘Money
and financial markets’.
Section F Demand and output
87
Total income from goods and services –
GDP(I)
The income measure of GDP – GDP(I) – measures the
incomes paid in the process of producing goods and
services. This includes incomes paid to employees and
profits retained by firms. It does not include incomes such
as unemployment benefits or interest payments because
these are transfers between different parts of the
economy, ie. they are not additional income.
Key data: income
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GDP
household post-tax income
wages and salaries
personal disposable income
saving ratio
Wages and salaries
The main source of income is that paid to employees.
This is referred to as ‘employee compensation’, estimates
of which are available with the second release of GDP.
The data are based on the monthly earnings data that are
discussed under ‘The labour market’. The largest part of
employee compensation is in the form of wages and
salaries. These data are published with the third release of
GDP along with estimates of post-tax disposable income
and the saving ratio. The relationship between income,
spending and saving was discussed earlier under
‘consumer spending’.
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Section F Demand and output
88
Section F
The labour market
Conditions in the labour market are another important influence on interest rate
decisions. They provide information about the balance between demand and supply,
and the extent of inflationary pressures in the economy.
Like other markets, conditions in the labour market
depend on the demand for labour relative to the available
supply – in other words, how many people firms want to
employ and how many people are available to work. Firms
will tend to demand more workers when wages are lower,
and more individuals will be inclined to seek employment
when wages are higher. This interaction will determine,
in a broad sense, the number of people in employment
across the economy as a whole.
Many factors will influence the demand for, and supply
of, labour. So it is necessary to keep abreast of all
developments in the labour market. An example is the
Government’s New Deal programme, which aims to
reduce unemployment. Month by month, the MPC
considers the levels and changes in employment and
unemployment, and the rate of increase in wages
and other earnings. Teams will need to monitor these
data closely.
Employment and unemployment
The numbers of people in work and out of work provide
important indications of the level and growth of economic
activity, and of the level of pressure on the supply of
labour and, in turn, wage increases and prices.
Unemployment
The unemployment rate is a key measure of the balance
between labour demand and labour supply. It can be
thought of as the number of people available and looking
for work, expressed as a proportion of the working
population.
The LFS measure is based on a survey of households and
reflects the number of people who are looking for, and
available to start, work. They need not be claiming social
security benefits, so the LFS measure and the claimant
count measure tend to be different.
Claimant count and LFS data are available on a regional
basis as well as nationally. This gives the MPC a guide
to economic activity and labour market conditions in
each region, and helps them to judge the extent to which
changes in unemployment are broadly based or
concentrated on particular parts of the country.
Unemployment and inflation
As we stressed in Section B, there is no permanent
trade-off between inflation and output, and the same
is true for inflation and unemployment. But, again, there
are important trade-offs in the short term. Unemployment
will vary with output growth in response to changes in
demand. When the unemployment rate is low, firms are
likely to find it more difficult to recruit new staff and retain
existing staff, who will find it relatively easy to find other
jobs. Consequently, firms may need to offer higher wages
to attract and retain labour. Low rates of unemployment
can be associated with higher inflation and vice versa.
But there is no particular rate of unemployment below
which inflation will always tend to rise. It is necessary to
monitor all the information available to determine when
labour is relatively scarce or relatively abundant, and
make judgements about the likely impact on wages and
other earnings.
Inactivity
Unemployment is measured in two main ways – the
‘claimant count’ measure and the Labour Force Survey
(LFS) measure. The claimant count is the number of
people eligible for, and claiming, social security payments
as a registered unemployed person.
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The number of people potentially available to become
employed is likely to be greater than the numbers
measured as unemployed. Unemployment does not
include some groups of people such as those registered
sick or other people who are not currently seeking work –
Section F The labour market
89
The ‘NAIRU’
Economists use a concept called the ‘non-accelerating
inflation rate of unemployment’ – the NAIRU – as a
guide to thinking about the relationship between
inflation and unemployment. This is similar to the
output gap concept discussed in Section D. But, rather
than output reaching a certain level beyond which
inflation starts to rise, the idea is that unemployment
falls to a level below which inflation starts to rise.
The level of the NAIRU cannot be determined with any
precision for the purposes of setting monetary policy.
Like the output gap, it is a useful conceptual tool. It is
easier to construct plausible estimates after the event
– ie. once we have observed inflation – rather than in
anticipation of it. And the rate of unemployment at
which inflation is likely to start rising can vary over
time. For example, if unemployment benefits are
reduced or the skills of the unemployed are improved,
the NAIRU might fall as more people are drawn into
employment. Changes in labour market legislation
over recent decades, and greater flexibility in
employment conditions, such as more part-time
working, might have reduced the NAIRU. But the level
is a matter of inconclusive debate. Consequently,
monitoring wage pressures is especially important.
are published more frequently than other sectors. The LFS
data are based on responses from households and
measure the number of people employed rather than the
number of jobs. Figures are available for both full-time
and part-time employment.
for example, retired people or parents who look after
young children. These groups are not in employment or
measured as unemployed. But they might enter the labour
market at some point, perhaps as their own circumstances
change or if changes in the labour market make working
more attractive or achievable. Some groups are, of course,
more likely to enter the labour market than others.
Hours worked
We describe this pool of people as economically ‘inactive’.
Inactivity is measured as the size of the adult population
minus the number employed and unemployed. The number
of inactive people is another measure of the pool of people
who are potentially employable. The participation of
women in the labour market has grown considerably over
recent decades. This is one of the reasons why we have
seen the growth in employment exceed the fall in
unemployment. Another factor is population growth,
which will be affected by migration flows in and out of
the United Kingdom.
It is also possible to look at data on the number of hours
worked, provided by the Labour Force Survey. This might
be more closely related to changes in demand and output
than the numbers employed. As demand rises, firms might
initially increase overtime working rather than recruit
extra people. And if demand falls, firms might be reluctant
to reduce the size of their workforce until they are certain
about the level of demand. Given the costs of recruitment
and redundancy, firms might want to retain staff during
periods of lower output growth and instead reduce the
number of hours worked. Equally, they might delay
recruitment until the need for it is clearly established.
So a rise in employment will not necessarily be matched
by a fall in unemployment if people are drawn into the
labour market from ‘inactivity’. It is therefore necessary
to look at unemployment and employment separately.
Employment
There are also two principal measures of employment in
the economy – a measure called ‘Workforce Jobs’ and the
Labour Force Survey (LFS) measure. Workforce Jobs data
are obtained from firms. They record the number of jobs
so the measure may overstate the number of people
employed because some people have more than one job.
The data are available both for the whole economy and
for individual sectors. Data on the manufacturing sector
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Employment intentions, vacancies, skill shortages
and recruitment difficulties
In addition to the official statistics, we can also look at
survey information on labour market activity, such as
that from the British Chambers of Commerce (BCC),
Confederation of British Industry (CBI) and Manpower.
Business surveys provide information about firms’
employment intentions – whether they intend to increase
or reduce the number of employees in the future. This
might tell us something about labour market activity in
the future and about firms’ expectations of future demand
– if they expect demand to rise or remain at a higher level,
firms are more likely to want to recruit extra people.
Section F The labour market
90
Employment and output
We would expect changes in employment to be
related to changes in firms’ output. As firms produce
more, they might need to recruit extra people. But the
growth in employment is unlikely to match the growth
in output, in terms of its timing or extent. Extra output
might be produced with relatively more equipment and
machinery rather than people, so we might see a larger
rise in investment relative to employment. Over time,
labour productivity tends to rise – less labour is needed
to produce a given amount of output.
Whether employment rises with higher output will
also depend on the amount of spare capacity available.
If firms are operating with spare capacity, they will be
able to produce higher levels of output without
We can also learn about the extent to which firms are
experiencing difficulties filling job vacancies. This might
tell us something about the balance between the demand
for labour and its supply, and therefore whether there is
likely to be upward or downward pressure on wage
increases. Firms often have difficulty recruiting people
with the right skills for available jobs. Some surveys ask
firms whether or not they are experiencing skill shortages.
These data can be considered, along with data on job
vacancies, to help build a picture of the demand for labour
and the extent of pressures in the labour market.
Key data: employment and
unemployment
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LFS unemployment
inactivity
Workforce Jobs
LFS employment
LFS hours worked
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necessarily recruiting additional people. More output
can be produced with the same number of people.
Again the productivity of labour increases.
But even when higher output requires more labour,
employment might not initially rise. Increases in
output might be gradual. Firms might wait for output
to increase by a certain amount before they decide
that it is worthwhile employing additional people.
Furthermore, firms might be uncertain about whether
demand will remain strong and whether the higher
level of output will be sustainable. Of course, some
firms are able to plan increased production, in which
case employment might rise ahead of output. But,
generally speaking, employment growth is likely to lag
behind growth in output.
Labour costs
Labour costs – which include wages and non-wage costs
such as pensions and national insurance contributions –
are a major component of firms’ total costs and are an
important influence on prices. The actual proportion will
vary depending on the activities of each business. For
example, in parts of the service sector, the proportion
is likely to be higher than in the manufacturing sector.
If demand for goods and services is rising strongly, firms
are likely to need to recruit more employees to increase
production. If their extra demand for labour exceeds the
supply available, firms may need to increase wages.
Wages are also the main source of income for most
people and therefore a key determinant of the amount
that they can spend. So the rate of increase in wages
provides a good indication of consumer spending in
the economy.
Wages, unit costs and productivity
Higher wages will be an additional cost to firms. But, even
with higher wages, if each employee produces more, ie. if
productivity is rising, then the cost of producing each unit
of output may still fall. And higher wage costs might also
be offset by lower costs elsewhere in their business. In
short, output might rise more than costs, thereby
lowering the unit costs of production.
Section F The labour market
91
But if wage increases add to firms’ unit costs and demand
conditions are favourable, some firms are likely to seek to
pass these increases on to customers as higher prices.
In this way, higher wages lead to higher inflation.
It is not possible to know what rate of increase in wages
will lead to higher or lower inflation. Productivity growth
will vary over the course of the economic cycle – output
might be rising strongly, lowering unit costs even if wages
are rising. Its trend rate of growth may also vary over
time, for example, in response to factors such as the
increased use of computers and the spread of information
technology. But it is difficult to separate the trend from
cyclical influences on productivity growth. You can
observe the current rate of productivity by looking at the
ratio of output to employment, but only informed guesses
can be made about the future.
Earnings and wage settlements
The main measure of the growth in wages is the Average
Weekly Earnings (AWE). Earnings include basic wages and
other earnings such as overtime and bonus payments.
We can look at data for total earnings and the contribution
made by bonuses and, separately, wage settlements.
Average earnings data are published each month, both
in terms of an annual growth rate and a three-month
moving average of the annual growth rate. The latter is
referred to as ‘headline’ earnings growth. The growth in
average earnings for the whole economy is also broken
down by sector – such as manufacturing and services –
and by industry. This allows us to compare sectoral
earnings data with other sectoral data, such as output and
employment, to judge the nature of demand and
inflationary pressure across the economy as a whole.
Data on wage settlements are available for both the
private and public sectors of the economy. By far the
most important months for wage settlements are January
and April because this is when most annual adjustments
to wage rates are implemented. However, compiling data
for these months is often delayed as wage negotiations
can take time to conclude.
Changes in the annual growth of earnings in individual
months can sometimes reflect a small number of
significant wage settlements, such as those for large firms
or public sector bodies; and bonus payments which can
vary considerably from year to year, both in terms of
amount and timing. Individual wage settlements and
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bonus payments will, of course, reflect specific company
circumstances as well as wider labour market conditions.
So you need to be careful before drawing conclusions
from the data. The ‘headline’ AWE figures smooth the
effect of month to month volatility in earnings growth.
Key data: wages and earnings
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Average Weekly Earnings
headline AWE
wage settlements
productivity
unit wage costs
Wage drift
Over the course of the economic cycle, the rate of
increase in basic wages relative to total earnings is likely
to vary. As demand and output rise, elements of total
earnings such as overtime and bonus payments tend to
increase more quickly than basic pay. In other words,
overtime and bonus payments increase as a proportion of
total earnings. The gap between total earnings growth and
wage settlements is referred to as wage drift. The extent
of wage drift is likely to be affected by the demand for
labour. Firms might find that some elements of wage drift,
such as overtime payments, are easier to change than
basic pay as economic conditions change.
It is also useful to consider the nature of bonus payments.
Bonuses paid to staff for good performance or the
profitability of a firm over the previous year might tell us
more about the past strength of demand in the economy.
Bonuses paid to retain staff might tell us more about
firms’ expectations of continued or rising demand in the
future. Of course, it might be difficult to separate these
explanations. And, whatever the reason for bonuses, they
add to the potential spending power of employees,
though some of the money might of course be saved
rather than spent.
Overall, earnings are an important part of the MPC’s
assessment of economic conditions – signalling both the
strength of future demand and inflation. Teams should
monitor the growth of earnings and their composition as
a key input into their overall judgement about the
economy and the inflation outlook.
Section F The labour market
92
Section F
Costs and prices
The MPC looks at the prices of goods and services at different stages of the production
process to help it assess the inflation outlook. Information on commodity, producer
and retail prices can tell us both about general inflationary pressure in the economy
and specific developments that might influence retail price inflation in the future.
The prices ‘pipeline’
Consumer prices represent the final price paid by
the consumer. They can be thought of as the end of
a ‘pipeline’ of costs and prices. The final price will be
made up of many different components of cost as well
as the retailer’s profit or margin. For retailers, the price
of an item will have to cover the cost of buying the
goods from the producer, paying staff their wages and
paying for other services required such as delivery,
rents and electricity. A similar breakdown applies to
producers. This will include the cost of materials and
components that they purchase from other firms.
Prices at one stage of the pipeline become costs for
the next stage – for example, oil prices are a cost for
petrol producers; petrol prices are a cost for haulage
companies; haulage prices are a cost for retailers. The
idea is a simplification and it is not meant to imply
that consumer prices are just the sum of all the various
costs in the pipeline. Prices are determined by the
Consumer prices
We have already said a great deal about consumer prices.
We explained in Section C that the Government’s inflation
target is currently specified in terms of the annual rate of
change in the Consumer Prices Index. We said that
monetary policy is not aiming to keep inflation exactly in
line with the inflation target every single month. Month to
month, the actual rate of inflation will tend to move up
and down. In Section D, we discussed how the current rate
of inflation might be a poor guide to prospects for the rate
of inflation over the next two years or so.
Bank of England and The Times Interest Rate Challenge 2014/15
interaction of supply and demand. If the cost of raw
materials rises, for example, producers or retailers
might accept lower profit margins rather than raise
their prices. They are more likely to do this if demand
is weak or because of competition. The degree of
competition in markets can affect how much cost
increases are passed on to consumers.
The effects of prices in the pipeline do not work in
just one direction. For example, an increase in oil
prices might show up first as an increase in producers’
material prices and then feed through to consumer
prices. But an increase in demand, perhaps due to a
rise in government spending, might first result in
higher consumer prices before higher demand puts
pressure on resources further down the pipeline,
resulting in a rise in oil and other material prices. The
MPC monitors price developments at all stages of the
‘pipeline’ to spot signals and clues about demand and
future inflation.
Components of the CPI
Although we are interested in the overall rate of inflation,
there may be instances when price changes in individual,
or groups of, components of the inflation index contain
useful information. In order to understand movements in
current consumer price inflation and to assess the likely
path of inflation in the future, the MPC regularly monitors
developments in the inflation rates of different
components. For example, some food prices can be
volatile, often reflecting factors like the weather. These
effects are usually temporary in nature, so they can
obscure the underlying trend in inflation from month
to month.
Section F Costs and prices
93
We might even want to look at the price changes of
individual components of the CPI if the inflation rate rises
or falls in a particular month due to specific price
movements. The Office for National Statistics often draws
attention to particular items that have had a significant
influence on inflation in a particular month. You then
need to decide whether the reasons are specific to the
item or items, or indicative of some wider influence that
may affect other prices over time. More generally, the
MPC pays particular attention to trends in inflation rates
for the ‘goods’ and the ‘services’ components of the CPI.
rate of growth of productivity in goods markets relative to
services markets. Goods are traded internationally to a
greater extent than services and capital equipment tends to
replace labour to a greater degree in the production of
goods compared with services.
So, if inflation is around 2.0%, we might expect to see
goods prices inflation below this rate and services prices
inflation above it. Of course, at any specific point in time,
goods prices inflation might be higher than services
prices inflation.
Domestically generated and imported inflation
Some prices go up – some prices go down
Individual prices are going up and down all the
time. If we were to look at the prices of every item
within the CPI then we probably would not glean
very much information about the overall situation.
Rather, we would learn more about the specific
characteristics relevant to the markets for each
product, and changes in consumer tastes.
Computer prices have tended to fall over time
as new technology has made new models better
and cheaper. Computer prices might fall whether
overall inflation is 2.0% or 5.0%. Conversely,
some prices such as those for education services,
like university and school fees, have tended to rise
more quickly than the overall rate of inflation.
These observations do not add much to our
assessment of the inflation outlook. But if there
was a change in these established patterns – which
might change the inflation rate for a period –
we would need to consider them more closely and
assess their significance.
Goods and services prices inflation
Looking at the inflation rates for goods and services prices
can often tell us about the nature of the forces underlying
the current rate of inflation, and provide clues about the
inflation outlook.
Consumer goods prices account for around 55% of the
Consumer Prices Index and services prices account for
around 45%. The goods component includes much of
what is sold in shops, and other items, such as cars and
petrol. The services component includes things like bus
fares, insurance premiums, cinema ticket prices, electricity
and hairdressers’ prices.
On average, goods prices inflation has tended to be lower
than services prices inflation. This mainly reflects a higher
Bank of England and The Times Interest Rate Challenge 2014/15
Prices will reflect both domestic economic conditions and
also international influences, such as the exchange rate and
demand conditions in overseas economies, which can affect
the price of goods imported into the United Kingdom. One
way of thinking about overall inflation is as a combination
of domestic inflation and imported inflation. The
UK economy is very open to international trade and so
domestically generated inflation corresponds to the rate of
inflation that would prevail in the absence of changes in
prices that are influenced by external factors. Goods prices
will be influenced by changes in the exchange rate to a
greater extent than services prices.
A fall in the exchange rate – a depreciation – will tend to
increase the level of prices, at least relative to what they
would otherwise be. This might mean that any downward
pressure on prices from weak demand could be offset to
some extent, or upward pressure from strong demand
could be exacerbated. An appreciation of sterling is likely
to have the opposite impact – reducing the level of prices.
So if changes in the exchange rate are influencing
inflation, we would need to assess what inflation might
be once these effects had worn off. This goes for any
temporary influence on inflation, although if changes in
inflation affect inflation expectations and, in turn, wage
demands, these influences can prove more persistent.
It is the job of monetary policy to ensure that this does
not happen.
Producer output prices
The prices charged by producers for finished products are
an important influence on consumer prices. They will be
influenced by the costs of production, including wages, and
also the prices of imports that feed into the production
process. They will reflect the balance between demand and
supply in the same way as consumer prices. There
is a close relationship between changes in producer price
Section F Costs and prices
94
inflation and consumer price inflation, and particularly
consumer goods prices, though this will vary depending
on factors such as the level of demand.
We can monitor producer prices by looking at the
Producer Prices Index. Producer output prices reflect the
prices charged by manufacturers to other sectors such as
retailing, business services and construction. They will also
include any taxes and duties levied on manufacturers’
prices, for example those on fuels like petrol. Changes
in duties set by the Chancellor in the annual Budget can
have an influence on the rate of inflation for producer
prices, as well as consumer prices. So we sometimes also
look at producer prices excluding tax effects to get a
better view of the underlying situation.
Producer input and commodity prices
Price indices are also available for the materials used by
manufacturers — what are called producer input prices.
Inputs are materials such as timber, fuels, metals, and
food materials. Of course, one firm’s input is another
firm’s output, so the producer input price index also
includes items like steel and plastics. The producer input
price index weights materials and components according
to their use as inputs by manufacturing firms. Many basic
materials are also included in indices of commodity prices.
Commodity price indices consist of what we call primary
products, such as oil and timber.
Producer input and commodity prices can rise and fall by
large amounts. Trends in material and commodity prices
are usually more volatile than the prices charged by
manufacturers and retailers. This has been particularly
noticeable in the recent past when consumer price
inflation has been relatively low and stable. Raw materials
are only a part of manufacturers’ total costs, so large
changes in these prices do not tend to lead to changes
in manufacturers’ output prices of the same magnitude.
They are likely to have some impact, particularly if price
changes are large and manufacturers think they will be
permanent. Large one-off changes in prices of
commodities like oil can have temporary effects on
consumer price inflation. But only if these effects resulted
in higher inflation expectations might any rise in inflation
be more persistent.
Changes in commodity and material prices
Commodity and material prices are sensitive to
changes in demand and expectations about future
demand. In the short term, supply tends to be fairly
fixed, particularly for commodities which are grown –
for example, rubber and wheat. If demand growth is
expected to rise, this might put upward pressure on
prices unless there are large stocks of commodities
available to increase supply in the short term.
Similarly, if demand grows more slowly, there will be
excess supply and lower prices. Changes in commodity
and material prices can also reflect movements in
exchange rates. Many commodities that are traded
Bank of England and The Times Interest Rate Challenge 2014/15
internationally are priced in US dollars so the price in
pounds will reflect the £/$ exchange rate.
Large price changes for individual materials and
commodities can often reflect specific events, such
as crop failures or processing problems in particular
markets or countries that are important suppliers –
for example, Brazil produces a large part of the world’s
total coffee crop. The oil price is affected by the
amount that major oil producers agree to produce
under arrangements set by OPEC (the Organisation
of the Petroleum Exporting Countries).
Section F Costs and prices
95
Import and export prices
Key data: costs and prices
The MPC also looks at import and export price indices
to track the effects of exchange rate changes and demand
pressures in both the United Kingdom and abroad, and
how these might affect consumer prices in the future.
Exchange rate changes will lead to changes in sterling
import and export prices. If prices in foreign currency
terms do not change, then an appreciation of the
exchange rate will lower sterling prices.
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consumer prices
producer output prices
producer input prices
commodity prices
oil prices
export prices
import prices
The timing and extent of any fall in import and export
prices might depend on the strength of demand. If
demand is strong, importers might choose to increase
their profit margins and perhaps sacrifice some sales
rather than reduce their prices in sterling terms. Similarly,
exporters might hold their prices and sacrifice sales. If, on
the other hand, demand is weak, importers might reduce
sterling prices instantly in order to boost their sales. The
MPC monitors export and import prices alongside data on
export and import volumes.
Bank of England and The Times Interest Rate Challenge 2014/15
Section F Costs and prices
96
Section F
Guidance for using the datasheets
The first set of datasheets will be available from 5 September 2014 on the
Bank of England website: www.bankofengland.co.uk/education/Pages/
targettwopointzero/default.aspx
Monthly datasheets
Data updates
The datasheets will provide you with some of the statistics
that have been mentioned in the discussion of different
aspects of the economy. They cover:
In addition to the monthly datasheets, the Bank will
produce Target Two Point Zero data updates immediately
prior to the regional heats, area and national finals. These
will cover key data released since the most recent
datasheet.
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money and financial markets;
demand and output;
the labour market;
costs and prices;
the international economy.
Some of the data are more important than others. You
should not feel that you have to use all the data. You will
need to decide which data you think are important for
your assessment of economic conditions and your interest
rates and quantitative easing decision.
The datasheets contain tables of the latest available data
so that teams can monitor the recent economic picture.
In addition, long-runs of data are available for a selected
number of key statistics. These will enable teams to
compare recent changes in data with previous experience.
The datasheets will be updated monthly as new data
become available, so the first set should only be used as
a starting-point. Teams will need to follow new data and
revisions to existing data as they become available.
The tables in the datasheets are in PDF format. The
long-runs of data are in Microsoft Excel format. You will be
able to download and use the long-runs of data if you
wish. Always make sure that you are using the latest
available data and do not forget revisions.
Many of the features of these data were discussed in
Section E but we did not provide individual descriptions of
the data series. Short descriptions accompany each of the
tables provided in the datasheets. Teams should make sure
that they understand what the data are before they start
drawing conclusions from them.
Bank of England and The Times Interest Rate Challenge 2014/15
All the data, including the long-run series and the updates,
will be available on the Bank of England’s website:
www.bankofengland.co.uk/education/Pages/
targettwopointzero/default.aspx
When you make your policy decision, data for the most
recent quarter or month will not necessarily have been
published for every data series. That is one of the realities
of setting interest rates. You have to make the best of
what is available. Teams are welcome and encouraged to
use whatever other data and information they think will
be useful and relevant to their presentation and interest
rate decision. Pick up The Times and other publications to
get some pointers about the current situation. There are
plenty of people offering opinions on the economy and
interest rates. Visit the websites of the organisations that
publish statistics. The Office for National Statistics has
much of its data on-line. You can obtain the latest
releases and briefings from their website:
www.statistics.gov.uk
Links to the key data releases can be found in the Data
section of the Target website. For ONS data, select the
data release you want to look at click on statistical
bulletin and then download pdf.
You may also want to look at some of the data and charts
included in the relevant parts of the minutes of the
MPC meetings and the Bank of England’s Inflation Report.
Section F Guidance for using the datasheets
97