Excerpts from the minutes of the Monetary Policy Committee meeting held on 4 and 5 June 2014:
Most members’ central view of spare capacity was that it remained in the range of 1% to 1½% of GDP in 2014 Q2. There was considerable uncertainty around the current level of slack, and a range of views on the Committee. That uncertainty had been reinforced by the contrasting trends in the economy since August 2013, when the Committee had set out its forward guidance strategy. On the one hand, output growth had been stronger, and unemployment had fallen faster, than had been anticipated by the MPC and most other forecasters. On the other hand, wage growth and inflation had been weaker. One possible explanation was that the effective labour supply was greater than previously thought.
The point at which slack would be fully absorbed would depend not only on its current level, but also on the speed at which it was used up. In the May Report projections, output growth moderated and productivity growth recovered gently, such that slack was absorbed only slowly: that was apparent in the projected flattening in the unemployment profile from late 2014. One indicator that slack had been eroded would be a sustained rise in real wages. There was, however, a risk that growth would not slow in the second half of the year so that, without a corresponding rise in supply, slack would be absorbed more quickly than had previously been expected. In that context, the relatively low probability attached to a Bank Rate increase this year implied by some financial market prices was somewhat surprising.
Overall, there had been little news on the month to change the view encompassed in the May Inflation Report central projections that, under market interest rate expectations, the economy remained on course to meet the MPC’s aim of absorbing spare capacity over the next two to three years, while keeping inflation close to the 2% target. It still seemed likely that when Bank Rate began to rise, it would do so gradually and to a level below its pre-crisis average rate. While the low level of Bank Rate could encourage financial imbalances, particularly in the housing market, the mitigation of such risks was best addressed using the macroprudential tools available to the FPC in the first instance. The case for raising Bank Rate gradually and cautiously was reinforced by uncertainty over its likely impact on the economy, following the long period at 0.5%, although it could be argued that the more gradual the intended rise in Bank Rate, the earlier it might be necessary to start tightening policy. If policy were tightened prematurely, however, that could be associated with considerable costs in terms of lost output. That was particularly important when the starting point was one from which interest rates could not easily be reduced.
The economy was starting to return to normal. Part of that normalisation would be a rise in Bank Rate at some point. The precise timing of the rise would depend on the outlook for inflation. That, in turn, would depend on the data flow, and in particular what that implied for the degree of slack, the prospects for its absorption, and the broader outlook for wages. For some members, the policy decision had become more balanced in the past couple of months than earlier in the year. In terms of the immediate policy decision, however, all members agreed that, in the absence of other inflationary pressures, it would be necessary to see more evidence of slack being absorbed before an increase in Bank Rate would be warranted.