LONDON (MktNews) - Monetary Policy Committee member Sushil Wadhwani said Tuesday that declining capacity constraints, falling employment growth and more benign pipeline price pressures suggest that RPIX inflation will most likely fall to around 2% a year from now.
In a speech delivered to Bank of England regional contacts in Norwich, Wadhwani said "...inflation is "most likely" to be "around 2%" a year from now, and likely to remain around that level for at least another year, i.e. we are most likely to undershoot the target over the most relevant policy horizon".
Wadhwani is an arch-dove on the MPC and has voted for an interest rate cut at every meeting since December last year. Minutes of the July MPC meeting, released last week, revealed that he voted for an immediate repo rate cut of 25 basis points to 5%. The other eight members of the MPC favoured unchanged rates.
Although Wadhwani noted that RPIX inflation could rise above 2.5% in the short-term, if the recent erratic movements in food prices persisted, he argued that such a move would be less relevant to the policy debate and he continued to press the case for lower interest rates.
Wadhwani also expressed surprise that inflation expectations had pushed higher in recent weeks, noting that markets seemed to be particularly worried about the recent rise in RPIX inflation to 2.4% in May.
"However, a significant fraction of that increase in inflation is directly attributable to transient factors like food prices," Wadhwani said.
He added that if food prices remained unchanged over the next year (a conservative assumption as most forecasters expect them to fall), other things being equal, this would subtract around 0.7 percentage points from the RPIX inflation rate in June 2002.
More generally, Wadhwani added that it was difficult to see why inflationary concerns had intensified given recent falls in oil and metal prices, weaker import prices, and pricing evidence from the CIPS survey.
"This diminution in pricing pressure should affect RPIX inflation over the next two years," he noted.
Turning to the labour market, Wadhwani suggested that falling profitability and prospective falls in employment growth suggest "declining wage growth over the next year or so." He added that it was important not to project ahead recent outturns for regular pay growth as this was a lagging indicator.
On the real economy, Wadhwani said that a significant fraction of the UK economy had weakened in recent months. For example the CIPS survey indices for both services and manufacturing were now weaker than at any time since early 1999.
"Overall, the published data and projections suggests that the growth rate of GDP has decelerated to a below trend-trend rate since the fourth quarter of 2000, with the last quarter (2001 Q2), perhaps, even weaker than the preceding two quarters," Wadhwani said. He added that falling capacity utilisation, deteriorating profit expectations and an ongoing re-evaluation of the profitability of investments in the information and communications technology sector were consistent with a subdued outlook.
Moreover, Wadhwani noted that "it is also likely that there is an ongoing inventory correction."
Turning to the exchange rate, Wadhwani repeated earlier comments that sterling is overvalued and likely to fall at some point. However, he cautioned that this is a view that many have held for some time.
He also repeated previous arguments that it might be better for the MPC to try and aim-off to hit the inflation target. "If one were interested in minimising the volatility of inflation around an inflation target, then, the correct policy response to a high, overvalued exchange rate is to keep interest rates a little lower than what might be necessary to achieve a 2.5% inflation rate at a two-year time horizon," Wadhwani said.
He cautioned that keeping monetary policy tighter now in case sterling should fall sharply would only exacerbate the problems by pushing the exchange rate even higher in the short-term.
On the global economy, Wadhwani said that this played an important part in his policy judgements, adding that there is a clear risk that the global slowdown could turn out worse than expected.
On the US, Wadhwani said "Although some of the recent survey data has pointed to some improvement, sentiment is still at a relatively low level. Deteriorating profitability appears to have led to a significant reduction in capital spending. Importantly, it is historically rare for a recovery from an investment-led slowdown to be quick and sharp."
He added that forecasts for growth in continental Europe were being revised down and that the Japanese economy might already be in recession again.
"Overall, the rather indifferent outlook for the global economy does not bode well for a small, open economy like the UK, Wadhwani noted. Indeed, given the deteriorating international and corporate outlook, Wadhwani said that it was "quite remarkable" that retail sales, consumer confidence and house prices had continued to rise this year.
Still he expected to see some deceleration in consumption growth as survey evidence seems to suggest employment growth will ease in due course.
In a move to head-off a possible future interest rate hike, Wadhwani argued that the current momentum in the consumer sector was not a good reason to hike rates.
Such a policy would also bear down on corporate investment and thus cost the economy by reducing the level of operating capacity. He added that in the present circumstances it was easy to envisage a position where a deterioration in company financial balances could cause a significant corporate retrenchment. Also further gloomy news from overseas could actually lead consumers to re-evaluate future economic prospects.
"This could lead to a significant rise in the savings ratio and a pronounced slowdown in GDP growth. Of course, the existence of this risk does, other things being equal, actually favour a cut rather than a rise in interest rates now," Wadhwani said.