LONDON (MNI) – The following is the full text of Bank of England
Monetary Policy Committee member David Miles’ 2012 written annual report
to the Treasury Select Committee.

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Report to the Treasury Select Committee

Professor David Miles, External Member, Monetary Policy Committee

26 June 2012

Voting record

In the last year I have voted to hold Bank Rate at 0.5%. In October
of last year, and in February of this year, I voted to increase the size
of the Bank’s asset purchases. From March 2012 onwards I have been in a
minority voting to further extend the size of asset purchases beyond
325 billion.

The economic situation remains difficult. Output has barely grown
for a year and a half and is estimated to have contracted slightly in
the first two quarters of this year. Having dropped substantially from
its peak of 5.2% in September 2011, inflation has still remained above
the inflation target and was 3.0% in April 2012. Despite above-target
inflation, I have consistently voted for a very expansionary monetary
policy stance. Let me explain why.

Most of the rise in inflation over the past few years, and much of
its more recent fall, has reflected: increases in energy and other
commodity prices, in VAT, and the depreciation of sterling. These have a
temporary though nonetheless quite long-lasting effect on inflation;
they do not reflect underlying domestically generated inflation
pressures. The impact of these temporary forces on inflation is already
waning. Monetary policy should not attempt to fully offset these sorts
of temporary inflation pressures because output would become too
volatile. This is recognised in the MPCs remit.

Inflation might have been even higher had domestic price pressure
not been weak. The reason for weak domestic price pressure was that a
substantial degree of spare capacity opened when GDP declined during the
banking crisis. Unemployment has risen substantially and investment has
been weak.

I had expected this downwards pull on inflation from spare capacity
to be somewhat stronger than it turned out to be. One reason may be that
the economys capacity has been damaged by more than I had thought. This
is what surveys of firms suggest. Another may be that there is indeed
significant spare capacity, but that it has had less impact on
inflation. There is probably some truth in both explanations.

If spare capacity has a more limited impact on inflation, a lot of
spare capacity is needed to reduce inflation quickly and a lot of
spare capacity means underutilisation of capital and more unemployment.
But at the same time stimulating demand will put less pressure on
inflation. So the price of bringing above-target inflation back down
quickly is high, while the cost of more expansionary policy which
means a slower trajectory of inflation coming back to target has
fallen.

There is another reason behind my votes for a more expansionary
monetary policy. The longer output lies below potential, the more likely
it is that potential output itself declines perhaps permanently.
Workers lose some of their skills during long spells in unemployment.
Long-term unemployment has already picked up during the crisis. The pool
of qualified labour from which firms can hire then risks shrinking. In a
situation where weak demand is likely to be having a negative impact
upon productive capacity the cost of having a tighter monetary policy to
bring inflation back to target fast will be some long lasting damage to
incomes.

I do not feel comfortable with the prolonged and substantial
overshoot of inflation above its target level. But that does not mean
bringing inflation back to target very rapidly is or would have been the
best thing to do.

The outlook

There are reasons why demand should recover. Monetary policy
remains very expansionary. Households real income should stop declining
as inflation falls further. Both the household and business sectors have
reduced their financial leverage, and once they have reached their
targeted leverage ratios, saving ratios could fall back, boosting
investment and consumption growth.

But there are very substantial risks that demand stays weak.
Deleveraging may still take some time. Domestic demand faces headwinds
from the external environment, tight credit conditions, and the fiscal
consolidation. The possibility of a significant economic and financial
disruption within the euro area continues to pose the greatest threat to
the UK recovery.

The MPCs central forecast, which I believe is plausible, is for
demand growth to remain subdued in the near term, and for an only gentle
recovery afterwards. If so, the degree of spare capacity in the economy
would continue to pull down on prices, so that CPI inflation is likely
to fall back to the MPCs target. We continue to face the problem of
balancing risks: risks that we overestimate the degree of spare capacity
in the economy and that inflation remains above target for longer,
versus the risk of prolonging the recession and undershooting the
inflation target if monetary policy is not sufficiently expansionary.

There is a risk that a protracted period of high CPI inflation
could lead to higher inflation expectations becoming entrenched. But
even if inflation expectations rise, wage growth might not pick up in
the presence of high unemployment.

Explaining monetary policy

Since I presented my previous report last year, I have given six
public speeches, focusing on the challenges monetary policy is facing
and discussing the interaction between monetary policy and the real
economy. Their messages were widely reported.

To present my views on monetary policy to the wider public, I have
given several interviews (to Dow Jones, The Orcadian in the Orkney
Islands, The Times, BBC Radio Cumbria, Cumberland News & Star, ITN,
Reuters and Reuters Insider, CNBC and Bloomberg).

I have met numerous investors from banks, pension funds and
insurance companies to obtain first-hand information on the
effectiveness of asset purchases.

In the last twelve months I have made visits to many of the regions
of the UK, including Scotland, North West England, Yorkshire & the
Humber and the West Midlands, where I spoke to many companies.

I have spoken at a number of schools and universities to explain
how monetary policy in the UK is being set. I also published a
Discussion Paper on Demographics, house prices and mortgage design.

-London newsroom: 4420 7862 7491; email:
drobinson@marketnews.com/wwilkes@marketnews.com

[TOPICS: M$$BE$]