Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 120 - 139)



  120. How confident are you that the factors you have referred to concerning the under-prediction of revenue will, in fact, continue?
  (Mr O'Donnell) The caution that we build in means that we will, on balance, tend to carry on that way. Going forward, we have the cautious GDP forecast which is below the consensus forecast; we assume under the unemployment assumption that whenever the markets forecast unemployment is going to rise we use that market forecast, so we have in there a forecast of unemployment rising. Already that forecast is somewhat out of date with the figures we received this week so, on that side, things will come in better than we thought. Consumption—it is too early to say but what little indications we have from retail sales figures today shows that the consumption path may come in around where we think, maybe slightly higher. At the moment, therefore, what small indications we have suggest that our caution will be maintained going forward.

  121. Could I just ask you how much you attribute the differences in the forecasts that I have just mentioned between last year's Budget, the pre Budget report and this Budget to luck and how much to judgment? Your previous answer rather claimed the credit for both luck and judgment, and I am attempting to distinguish between the two.
  (Mr O'Donnell) Essentially we use our econometric model but, in the end, all economic forecasts require a fair amount of judgment. The fact that we got it spot on I regard as partly a consequence of luck, certainly. There are forecast error margins and, on average, we know how close we will be. We certainly would not expect to get it exactly right every year so yes, a certain amount of luck, if you want to call it that. On average we are hoping that we will be able to improve our forecast performance as we reduce the volatility of the economy. So I would hope our forecast errors going forward will be somewhat lower than they were based on the past.

  122. You did say that, whereas others were predicting a recession as a result of the Asian and Russian financial crises, you did not and you got it right. If we look at the present situation, you have already in answer to our Chairman referred to the possibilities of recessionary effects outside any forecasts that you are making in the Budget, although they do not form part of the forecast?
  (Mr O'Donnell) No, they do. We have revised down our forecasts of world growth substantially. Between the pre Budget report time and the Budget we were obviously able to have the information from the US about the US Q4 GDP numbers, and it was quite apparent to us then that the US was slowing down quite rapidly, and our forecast for the US which we have used in the Budget which was, at the time we made it, below the consensus forecast for the US. So we revised down our US forecast substantially, and our forecast for Japan substantially as well. The Euro area we did not change very much but I would say certainly the evidence since we made those forecasts has been consistent with there being a slowdown in the US and a much weaker outlook in Japan, but that is built in.

  123. But continuing growth in Britain at trend levels?
  (Mr O'Donnell) Yes. A slight slowdown in the UK, that is right. Basically what is behind our UK forecast, if you compare it with, say, even the pre Budget report forecast, is much slower world growth—and the effect of that is that the net trade position worsens—off-set by domestic demand which has remained rather stronger than we thought. The overall effect of those two factors is that our GDP forecast is unchanged but that does hide a compositional change—you are right; we are saying that domestic demand is somewhat stronger and that is because employment has been stronger and consumption has stayed quite robust and investment numbers have been revised up substantially by ONS for the past—we think that level may be maintained going forward—but all this is off-set by net trade which basically takes about one percentage point off our growth forecasts.

  124. So your predictions for future revenues do depend upon the British consumer continuing to spend large quantities of money? "IKEA rules, OK"!
  (Mr O'Donnell) We have reasonable consumer spending in there although it does slow down as households in our forecast start rebuilding their savings ratio which is quite low. Partly that is because we think some of the wealth effects, particularly through equities which is a relatively small effect for the UK but will matter, start to unwind.


  125. And, of course, that does have an impact on the balance of payments—?
  (Mr O'Donnell) Indeed.

  126.—Which deteriorates over the forecast period?
  (Mr O'Donnell) It does, that is right, and that is a consequence of our exchange rate assumptions but also, because the world is slowing down, our export market growth has slowed down quite substantially exactly as I said.

  127. Is that sustainable? I was asking earlier about public finances.
  (Mr O'Donnell) Indeed. We have highlighted some of the risks to our forecast in the Red Book and we have put in a chart showing what has happened to the household financial position, companies' financial position and the trade deficits. We do think the trade deficit will worsen and will have a current account that will move to a peak of around 2.5 per cent of GDP but then will come back as consumption comes back as households rebuild their savings. All in all, therefore, we think that is a reasonably sustainable level. History would suggest this is sustainable but it does require these changes to take place and it is certainly an area of risk that we highlight in our forecast.

Mr Cousins

  128. Are your forecasts for public spending capable of withstanding the British consumer taking his or her credit cards away?
  (Mr O'Donnell) If there were a big reduction in consumption below what we have here, then I think you would find that the MPC would be the first people to respond, so the consequence of that would be cuts in interest rates which would, hopefully, lead to that fall in consumption being mitigated somewhat and possibly somewhat higher investment. But that is the response mechanism there will be.

Mr Davey

  129. All our four witnesses on Tuesday said that the fiscal stance had been loosened and fiscal policy was now quite expansionary. Three were quite worried about this. Mr Dicks told us that if the Chancellor announced this month in the Budget all the measures that were coming into effect in April it would be described as a bonanza; he said that, if you look at the whole package of measures and their impact on the economy this year, it is far from prudent; it is risky and expansionary. What do you say in reply to those comments?
  (Mr O'Donnell) I could give you a list of quotes from other city analysts that said the reverse. Essentially what I think you have from city analysts is them saying, "This Budget was very predictable"—Goldman Sachs, Barclays Capital, for example—because basically the whole is driven by the fiscal rules. What is happening is we have observed some changes during the year but we announced in the Budget 2000 a fiscal path going forward, we said in the pre Budget report that we would stick with that, and in Budget 2001 we are sticking with it, we have locked in that fiscal tightening and it will be at least as tight going forward as it is now. In that sense, therefore, what is happening to the fiscal path is completely predictable. The MPC are very aware of that; they were aware of the measures introduced in Budget 2000 and of the consultation measures and the MPC will make up their own minds what they think the impact is of this on the Budget. They have already made up their minds because they discussed this extensively at their meeting just after the Budget. I cannot tell you what was in that meeting because it will be announced in the minutes shortly, but Professor Nickell has given an on-the-record statement about that saying that he thought the Budget was hardly surprising.

  130. You use the word "predictable" but you have not denied that it was expansionary. What addition to overall aggregate demand do all the measures taken together in April actually add?
  (Mr O'Donnell) My view is that the Budget basically puts us back on the fiscal path we were on before. What has happened is we have an unanticipated fiscal tightening this year again. Things were tighter than we had expected, and what we do is simply move back to the path, so the fiscal path going forward is exactly the fiscal path that we predicted at Budget 2000 time—well, slightly tighter, to be honest.

  131. I am slightly worried that we are going to go back to golf again which I do not really want to revisit.
  (Mr O'Donnell) I am quite happy to do a golf analogy, if you want one!

  132. Let's not go that way. You say the fiscal stance in 2000/2001 was tighter. Moving back to your path, you are going to have to loosen a little bit to get back to your predicted path. Given the caution and prudence in your assumptions, is it possible that when we look at what has happened in six months or a year's time we have the same argument—that the fiscal stimulus will appear to be smaller than it looks today?
  (Mr O'Donnell) Quite possibly. If you look back on what has happened, since the introduction of the Monetary Policy Committee, cumulative fiscal tightening has been around 4.5 per cent of GDP, so it is true that, where people are making the mistake is they are comparing an outturn with a plan based on cautious assumptions and, if you do that, you will get a big change. The truth is we, as I said, expect fiscal outcomes to be rather better than those numbers so yes, you can get dramatic numbers by doing this but it is not a very sensible way to look at what we are going to do. We will probably deliver tighter fiscal paths than are laid out but they give us a band.

  133. I understand why you are doing it and we have had this discussion in this Committee before but does that not mean that, when we look at your numbers in the Red Book, we should say, "That is not what is going to happen—they even think that themselves; it is going to be completely different from that so let's get the real numbers and change them", because you have just said to me that you expect it to be different from what you are predicting?
  (Mr O'Donnell) No. What we are saying is—and I will say this again—that we believe fiscal policy is asymmetric; the costs of trying to tighten policy are much higher than the costs of loosening it and, therefore, we think we should institute a bias in the way we do this. What we do, therefore, is use central economic forecasts but then a set of cautious assumptions to produce these numbers. The City can then go away—we are very explicit about all of the assumptions we use—and calculate their own numbers as they wish—and they do. That is why they came out with rather bigger surplus numbers than we had. I have no problem with that—they need to make assumptions. For example, when we go forward, we do the projections on the assumption that all departmental money is spent. As you say, outsiders are free to make other assumptions and we make assumptions on unemployment based on market forecasts and on interest rates based on market forecasts, so city analysts can use a different set of assumptions and come up with different numbers.

  134. What you have said really boils down to this: that you are making these cautious predictions to make sure you do not have to make difficult decisions on cutbacks to the planned programme so it makes fiscal policy easier for you, the Treasury, to operate but outside people looking at what you are doing should assume that it will not turn out in the way you are saying?
  (Mr O'Donnell) Well, we do not want to get into a situation where we have to have emergency cutbacks on things like public spending. We want to preserve public spending plans because we have given people three years' money and we want them to be able to plan within that horizon.

  135. It sounds to me like this is a "rabbit out of the hat" policy: you are building in an ability for the Chancellor to have rabbits?
  (Mr O'Donnell) We are building in recognition of the fact that, when we use central forecast, curiously enough we tended to build in excessive optimism and that led to problems in the past and we are trying to avoid the errors made in fiscal policy previously by erring on the side of caution.

  Chairman: I personally think that is quite a good thing.

Mr Fallon

  136. You did not make any reference at all this year to exchange rate policy. Why was that?
  (Mr O'Donnell) There has been no change in it, that is why. The government's macroeconomic framework is to deliver macro-economic stability with, on the monetary side, having the MPC target, the symmetric target of 2.5 per cent inflation and, on the fiscal side, a fiscal policy driven by the golden rule and the sustainable investment rule. What we hope is that by delivering stronger macro-economic stability that will be the right policy to deliver exchange rate stability. If you look at what has happened, sterling has fallen somewhat against the dollar but the euro has still remained rather weak.

  137. What was the last Red Book that did not mention either sterling or exchange rate policy?
  (Mr O'Donnell) I have no idea.

  138. So it is unusual?
  (Mr O'Donnell) Well, ever since the period of inflation targeting, the exchange rate has been treated in exactly the same way so this is something that goes with an inflation targeting regime.

  139. But if you do not even mention it, it sounds as if you do not really care?
  (Mr O'Donnell) We do.

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