MONTHLY MONETARY MEETING:
6 MAY 1997

1. The Chancellor of the Exchequer and the Governor of the Bank of England met, together with officials, on 6 May, to review monetary developments.

   Monetary and Economic Developments

2. Latest monetary and economic data (reviewed by officials before the meeting) confirmed that material cost pressures remained moderate, although labour costs continued to increase. There were continuing signs that activity remained strong, with growth strongest in services and demand concentrated on the consumer side.

   Inflation Indicators

3. Underlying inflation (RPI excluding mortgage interest payments - RPIX) fell by 0.2 percentage points in March, to 2.7 per cent, due to a fall in food prices. All-items RPI inflation fell by 0.1 percentage point, to 2.6 per cent.
4. Most other indicators confirmed that material cost pressures remained moderate:

   • sterling non-oil commodity prices rose by 0.3 per cent in March, but were 4.9 per cent lower than a year ago. The oil price had recovered to $17.9 per barrel;

   • sterling's effective exchange rate index remained high but had fallen back slightly, from 99.3 before the last meeting, to 99.1⁽¹⁾ currently;

   • total non-oil import prices fell by 2.5 per cent in the three months to February compared to the previous three months, and were 5.2 per cent lower than a year earlier. Non-EU import prices fell by 0.3 per cent in the three months to March on the previous three months;

   • producer input prices for manufacturing (excluding food, beverage, tobacco and petroleum industries) rose by 0.4 per cent in March; but compared to a year earlier they were 6.7 per cent lower. The CIPS manufacturing survey input price indicator was unchanged in April;

   • producer output prices (excluding FBTP) rose by 0.1 per cent in March; but the annual inflation rate was unchanged at 0.5 per cent. The CBI survey output price expectations balance fell in April.

   However, in line with other indicators pointing to further labour market tightening, the annual growth rate of underlying average earnings rose in February, to 5.0 per cent, from 4 3/4 per cent in January (revised down from 5.0 per cent). IRS median pay settlements were unchanged at 3.0 per cent in March.

   Monetary and Financial Indicators

5. No new M0 data had been released since the last meeting, but provisional data for April suggested another low increase. M4 grew by 1.0 per cent in March after rising by 1.4 per cent in February. The annual growth rate of M4 and M4 lending fell, however, to 11.2 per cent, and 9.0 per cent, respectively.
6. The Halifax house price index rose by 0.3 per cent in April, giving an annual increase of 6.6 per cent. The Halifax index rose by 0.4 per cent in April, and was 8.9 per cent up on a year earlier. Housing market transactions continued to rise; in the three months to March particulars delivered (which lag actual transactions) were 1.1 per cent up on the previous three months, and 26.3 per cent higher than a year earlier.
7. Short-term interest rates were little changed in the US and Japan since the last meeting, but had fallen by around 10 basis points in Germany. UK short-term interest rates had risen by around 20 basis points; but forward rates implicit in short-sterling futures contracts had fallen at all maturities beyond June.
8. 10-year bond yields had fallen by almost 20 basis points in the US and by over 10 basis points in Germany, but had risen by over 20 basis points in Japan. In the UK, yields on conventional gilts had fallen at all maturities (by up to 30 basis points). Since the last meeting inflation expectations implied by the gilt yield curve (calculated by the Bank from the difference between the yields on conventional and index-linked bonds) had fallen by around 10 basis points for both 5 years ahead and 10 years ahead⁽²⁾.

   Activity Indicators

9. In the US recent data continued to suggest that output was growing above trend. The preliminary estimate of GDP growth in Q1 was 1.4 per cent (not annualised), following growth of 0.9 per cent in Q4. Industrial production rose by 0.9 per cent in March, after rising by 0.6 per cent in February. In Japan industrial production fell by 1.5 per cent (not annualised) in March, following a fall of 3.7 per cent in February.
10. In Germany the latest estimate of GDP growth in Q4 was 0.1 per cent, leaving it 1.4 per cent up on a year earlier. Industrial production rose by 0.5 per cent in March, after rising by 2.0 per cent in February. In France the latest estimate of GDP growth in Q4 was 0.2 per cent and 1.5 per cent up on a year earlier.
11. The preliminary estimate of UK GDP growth in Q1 showed that whole economy and non-oil GDP both grew by 1.0 per cent, and were 3.0 per cent up on a year earlier. Service sector output grew by 1.2 per cent in Q1, and was 3.9 per cent higher than a year earlier.
12. Most other activity data were consistent with output growth continuing at or above trend, and indicators of business confidence and consumer demand remained buoyant:

    • major business surveys continued to point to continuing growth in activity. The BCC survey for Q1 implied strong growth in services, but less buoyant growth in manufacturing. This weaker result for manufacturing was backed up by the April CIPS survey which showed slightly weaker growth in output and orders, than in March. However the CBI survey showed stronger orders for manufacturing;

    • retail sales volumes rose by 0.3 per cent in March; and in the latest three months they were 4.4 per cent higher than in a year earlier;

    • and latest survey indicators in the retail sector indicated strong, but slightly weaker, growth: consumer confidence fell slightly in April, but remained on an upward trend; and the March BRC survey showed slightly weaker sales growth;

    • claimant unemployment fell by 41,100 in March, to its lowest level since September 1990, and the unemployment rate fell to 6.1 per cent; but the figures were still distorted by the introduction of the Job Seekers Allowance. The Winter Labour Force Survey showed a smaller fall in unemployment, down 111,000 in the quarter (compared with a fall of 184,000 in the claimant count over the same period), and employment rose by 135,000. Unfilled vacancies at Jobcentres rose by 3,500 in March, to a new record high.

    Summary of discussion

13. The Governor said that it might be useful to set out the Bank's view of the background to the economic and monetary situation, before turning to the latest data. The UK economy was entering its sixth year of expansion. Following departure from the ERM in September 1992, a re-balancing of policy - involving an easier monetary and a tighter fiscal stance - had led to a lower real exchange rate and a shift of resources from domestic consumption to net exports. That had led to an export-led recovery in 1994 and 1995. Since then the pattern of recovery had changed. Although exports had held up much better than had been expected last year, given the weakness in many major export markets and the rise in sterling's exchange rate, net trade as a whole was no longer making a significant contribution to output growth. Instead the primary stimulus to growth had become the strength of final domestic demand, which had risen by about 3 1/4 per cent during 1996 compared with less than 1 per cent during 1995.
14. As a result, real GDP had accelerated during the course of last year, rising by 0.8 per cent in Q4 and by 1.0 per cent in the first quarter of this year. This above-trend growth was stimulated primarily by consumption, which was now growing at around 4 per cent a year.
15. Those rapid growth rates of demand and output had been foreshadowed by an acceleration in broad money, which had grown strongly for the past eighteen months. The twelve-month growth rate of M4 had risen from around 5 per cent into double figures over the past two years, and was inconsistent with the inflation target in the medium term. That monetary growth had led to an acceleration of, first, domestic demand and, then, output. If unchecked, this expansion would lead, in due course, to higher inflation. But the other major development of recent months had been the rise in sterling, which, since August, had appreciated by 18 per cent on the effective index. That had affected disproportionately those sectors of the economy most exposed to external trade, especially manufacturing. Higher interest rates would help to curb the expansion of domestic demand but they might also lead to a further rise in sterling, thus exacerbating the imbalance between the tradable and non-tradable sectors of the economy. That was the policy dilemma.
16. Turning to the recent data, the Governor said that cost pressures early in the supply chain remained generally subdued. Falling oil and other fuel prices in March had partly offset the effects of rising world commodity prices on the Bank's sterling commodity price index; it had risen by 0.3 per cent in March but was still 4.9 per cent lower than a year earlier. Prices of the non-fuel imported elements of the index - metals, foods and non-food agriculture - had been rising since December. And the premium of one-month over six-month Brent crude prices had fallen below zero in April, suggesting that oil prices might remain broadly stable.
17. Manufacturers' costs were weak, although rising commodity prices again appeared to have had some impact. Input prices had fallen by 0.5 per cent in March, but the index excluding the food, drink, tobacco and petroleum industries had risen for the first time since October 1996. Manufacturing unit labour costs continued to decelerate: their annual growth rate was 2.6 per cent in the three months to February, having fallen steadily from 4.6 per cent in September. And manufacturing output price inflation remained very low: the twelve-month rate continued its decline in March, falling to 1.0 per cent; excluding excise duties, it had fallen to 0.3 per cent.
18. But, in contrast, costs and prices in the service sector showed signs of inflationary pressure. The new CIPS survey for the service sector suggested that employment, input costs and output prices were all rising.
19. The Governor noted that the pass-through of sterling's appreciation to retail prices in Q1 had so far been less than the Bank had expected. RPIX inflation was 2.7 per cent in March, down from 2.9 per cent in February. That reflected the relatively limited pass-through into import prices; they were broadly flat between November and February. Given that response of import prices, the extent of the fall in retail price inflation since the turn of the year did not seem too surprising. The pass-through was still likely to materialise later in the year.
20. There was continued evidence of the strength of the domestic economy. Total output had risen by 1.0 per cent in the first quarter of 1997, and the output of the service industries had increased by 1.2 per cent. Although no breakdown was yet available, the GDP figure was consistent with a fourth consecutive monthly rise in manufacturing output in March.
21. Strong growth in consumption was likely to have continued in the first quarter of 1997. Retail sales - which accounted for around 40 per cent of total consumption - had risen by 1.0 per cent in Q1. Consumers' expenditure on services - which accounted for nearly half of total consumption - had risen by 1.5 per cent in 1996 Q4, and evidence from the BCC and CIPS/NTC surveys suggested that growth remained strong in 1997 Q1.
22. Non-oil export volumes had fallen by 0.8 per cent in February, while import volumes had risen by 0.2 per cent. More timely data for trade with non-EU countries showed a fall in both exports and imports.
23. The Governor said that the labour market had tightened further. The winter 1996/7 Labour Force Survey (LFS) recorded a 135,000 rise in employment, the largest increase since the quarterly series began in spring 1992. LFS unemployment had fallen by 111,000 in Winter 1996/7, the largest fall for more than two years.
24. Claimant unemployment had fallen by 41,100 in March. The administrative effect of the Job Seekers Allowance (JSA) was estimated to have reduced claims by around 4,000 that month. There had also been a short-run incentive effect, as the JSA had removed those who were not genuinely unemployed from the stock of claimants. The claimant count had fallen by 73,000 more than the LFS over the same period and may have reflected both those effects. But the LFS data suggested that a considerable part of the fall in claimant unemployment over the past few months had resulted from the unemployed finding work, rather than from changes to the benefits system.
25. Total hours worked had fallen by 0.5 per cent, but that may have been as a result of problems with the seasonal adjustment of such a short series. The annual rate of increase - 1.0 per cent in the year to winter 1996/7 - may have been a better guide to the increase in labour demand. Other indicators confirmed that labour market activity had increased. Vacancies had risen by 3,500 in March to 275,100, the highest stock ever recorded, and surveys had indicated increasing skill shortages.
26. The Governor pointed out that wage settlements had been broadly stable at just over 3 per cent. Three-month employment-weighted mean and median settlements were unchanged in March on the previous month, at 3.1 per cent and 3.0 per cent respectively. But whole economy underlying average earnings growth was 5 per cent in the year to February, up from 4 3/4 per cent in January (which had been revised down by 1/4 percentage point). The increase had been most marked in services. Manufacturing earnings grew by 4 3/4 per cent in February, for the third consecutive month, while service sector earnings grew by 5 per cent in February, up from 4 3/4 per cent in the previous month. Financial sector bonuses were still influencing underlying service sector earnings growth; taking the effect of bonuses into account, earnings growth in February was probably between 4 1/4 per cent and 4 1/2 per cent, and even higher in the private sector. Earnings growth around this level was around the maximum consistent with the current inflation target.
27. M4 and M4 lending continued to grow rapidly in March. The twelve-month growth rate of M4 was 11.2 per cent, about the same as last month, which was the highest since 1990. And shorter-run growth rates suggested it would rise further: the six-month annualised growth rate was 12.9 per cent in March. This acceleration followed a period of 18 months when underlying M4 growth was between 8 per cent and 10 per cent.
28. Notes and coin had risen by 0.5 per cent in March after a small increase in February. But provisional data for April suggested another low rise. That may have reflected falling goods price inflation, rather than slow retail sales volume growth.
29. The Governor then turned to consider what this analysis of the present situation implied for future inflation. Inflation was expected to fall below 2 1/2 per cent during the course of the year, as of course it should following a sharp rise in the exchange rate, to have any hope of hitting the inflation target two years ahead. The authorities could not rely on hitting the target only because of a favourable one-off shock to the price level. More important for monetary policy was the prospect two years ahead. Here was the dilemma. The high exchange rate was a serious concern for exporters. Business surveys suggested that export orders had been affected and, although there had been little sign yet of an impact on orders and output, a wedge was likely to open up between the growth of domestic demand and the growth of output. Nevertheless, domestic demand growth was sufficiently strong - at around 4 per cent a year - that overall output growth was likely to remain above trend despite weakening net trade. That would lead to a further tightening of the labour market, and, in due course, upward pressure on retail price inflation. Unless the rate of domestic demand expansion moderated soon, there would be a real threat to the inflation target over the medium term. That was why the Bank concluded that, as it had argued for several months, a tightening of monetary policy was necessary. Given the strength of the recent data on the domestic economy, the Bank's judgement now was that there would need to be an interest rate rise of 1/2 per cent certainly before the summer. And there was a case for doing that today.
30. But there was a difficult tactical judgement about whether to implement that immediately, or in successive steps. In part, that judgement turned on the possible impact of an immediate move on the exchange rate. Financial markets were clearly expecting some rise in interest rates. They were anticipating a rise of the order of nearly 1 percentage point by the end of the year. So a rise in rates would not come as a surprise. But, particularly in the light of the announcement which the Chancellor would be making that morning on the status of the Bank of England, there was a possibility of an exaggerated market reaction to the full 1/2 point move that the Bank judged to be necessary on the basis of the economic analysis. Given that the new Monetary Policy Committee would be making its decisions with effect from next month, there was probably little to be lost in deferring the second 1/4 point so that the Monetary Policy Committee could take account of exchange rate and other developments before deciding on the scale of the policy adjustment that was required.
31. The Governor said that taking all of these considerations into account, the Bank recommended that morning a rise in interest rates of 1/4 percentage point.
32. In discussion the following points were made:

    • output was currently around its trend level; and it was growing above trend. In the first quarter GDP grew at an annual rate of 4 per cent, and manufacturers' confidence remained relatively buoyant. Strong demand was concentrated in the personal sector, and would be boosted as building society and other windfalls (totalling around 27 billion Pounds on current estimates) started to come through. Rapid growth of personal sector M4 and house prices confirmed this picture;

    • demand pressures were being reflected in the labour market. Earnings growth overall had accelerated to 5 per cent; and in the private sector earnings growth was over 6 per cent. There were reports that some firms were facing recruitment difficulties;

    • the strong exchange rate, if it continued, would have a negative effect on output growth and inflation. But the expansionary pressures on output were strong. And the relatively small effect so far of the exchange rate on prices had been surprising;

    • there was a strong economic case for an immediate interest rate rise. But the choice between a 1/4-point and 1/2-point rise was finely balanced, and complicated by the possible market reaction to the announcement that the Bank in future would have operational responsibility for setting interest rates.
33. The Chancellor said that the advice of the meeting had been very clear, and it confirmed the overall picture of the data that he had formed over the previous few days from the published statistics, and Treasury and Bank papers.
34. The Chancellor said that in his judgement the Government had inherited a situation in which, in the absence of corrective action, inflation would overshoot its inflation target next year.
35. He said he was particularly influenced by the forecasts that he had seen for eighteen months ahead and by what informed them:

    • the recent rapid growth of consumer spending which had grown by 4 per cent over the last year. The so-called 'windfalls' from the building societies meant that consumer confidence was likely to remain strong;

    • with GDP growing faster than its underlying rate, there was a real risk that this could stoke inflationary pressure;

    • house prices were rising at an annual rate of 6 to 9 per cent, and were rising particularly rapidly in the south east;

    • the recent pick-up in average earnings, which were currently growing at 5 per cent a year;

    • and the rate of broad money growth which had been above its monitoring range for over a year.
36. The Chancellor said that against these pressures, he clearly needed to weigh:

    • the current strength of sterling, particularly against the Deutsche Mark, where it had appreciated by more then 20 per cent over the last year;

    • the subdued level of producer price inflation, the disappointing level of manufacturing activity, and the weakness of industrial investment, all of which were also largely associated with sterling's strength.
37. The Chancellor said he understood the difficulties that many manufacturers faced as a result of the current strength of sterling. And he was also concerned about current levels of investment and high levels of structural long-term unemployment, and was determined to take action in the forthcoming Budget that would encourage more balanced economic growth. However, he said that if inflation was allowed to accelerate, stronger remedial action would be necessary later, which would discourage investment and exports further.
38. The Chancellor said that he wanted a stable and competitive pound over the medium-term, consistent with the Government's objective of price stability. But he was convinced that it was in the interests of industry that his commitment to low inflation was delivered in practice.

    Conclusion

39. Summing up, the Chancellor said that, looking at all the evidence, the case for an immediate tightening of policy was overwhelming. He also accepted the argument that interest rates may need to rise soon by a further 1/4 per cent. But in order to make for orderly foreign exchange markets, given the institutional changes to monetary policy-making that he was also announcing that day, he had decided that the right thing to do was to raise interest rates by a 1/4 per cent, as the Governor recommended. He believed these announcements would together bring policy back on track to meet the Government's inflation target.
40. The Bank announced a 1/4 per cent increase in interest rates, to 6 1/4 per cent, at 11am that day.

    H M Treasury

1. As of opening on 06/05/97

2. Measured as the average over the five working days before each meeting. These estimates are likely to overstate inflation expectations because the inflation risk premia are lower for index-linked gilts than for conventionals. However, changes in them should provide a guide to changes in expectations.