Examination of witnesses (Questions 140
THURSDAY 15 MARCH 2001
and MR CLIVE
140. But there is not a single reference to
it anywhere in this document?
(Mr O'Donnell) Like I say, we keep saying that our
framework is based around stable inflation and good, sound fiscal
policy, so the exchange rate emerges from that.
141. So you kind of missed it out?
(Mr O'Donnell) No. The exchange rate is a consequence
of our policies: not a policy objective. We do not have an exchange
142. I am aware of that. Now, the balance of
payments current account is estimated to deteriorate quite significantly
this year and next. Have you estimated the likely effect of that
on the stability of market value of sterling?
(Mr O'Donnell) I was replying to a question earlier
on the issue of the world slowdown and the impact that would have
on the UK and you are absolutely rightgrowth in our export
markets is due to reduce quite substantially, and that will have
the effect of producing a somewhat bigger trade deficit. As to
what that will do to exchange rates, when we do our forecasts
we use, as we have for many years, the illustrative assumption
of what we call uncovered interest rate parityessentially
that sterling will change relative to other currencies in line
with the interest rate differential between those currencies.
For example, in sterling versus another currency, if sterling's
interest rate was, say, 5 per cent higher than the other currency's,
we would be predicting a 5 per cent decline in the exchange rate
over that period. That is just using the illustrative assumption
because if we could predict exchange rates then we would make
vast amounts of money, and we cannot.
143. But the illustrative assumption is not
(Mr O'Donnell) It has been the same illustrative assumption
for as long as I can remember.
144. What was the American growth rate over
this year and next year that is behind your assumptions in this
(Mr O'Donnell) Next year we are assuming US growth
of 1.75 per cent.
145. What balance of probability are you putting
in for a prolonged downturn as opposed to a quick recovery?
(Mr O'Donnell) I think there are certainly downside
risks to that. Most people use the alphabet to describe what is
going to happen to America and you have these V-shaped or U-shaped
or L-shaped outcomes. I guess you would say we are in the kind
of "U" camp on that rather than the "V" camp.
146. Over the next two years?
(Mr O'Donnell) Yes.
147. To what extent do you think the UK economy
will be affected by the same factors that have caused the United
States drop in growth rate?
(Mr O'Donnell) What is hitting the US I think is partly
an equity market response which has had an effect on consumers.
That kind of response is not as big in the UK because simply household
direct holdings of equities are much lower so you do not get as
much of that. Also, they have had a period of substantially above-trend
growth so there is a necessary slowing for them. We are not in
that position; our estimate is that our output gap, the difference
being actual GDP and trend GDP, is relatively smallsmall
and positive but small. So I think that in the US you can understand
why there may well be a slowdown and, indeed, the Chairman of
the Federal Reserve thinks that some of the new economy gains
that push them up will also mean that that slowdown may be quite
rapid because companies can adjust their inventories very quickly,
and lots of the response mechanisms in the economy have been accelerated
so there will be quite a fast fall down, and also he thinks that
when it does turn up it could be a fast turn-up, but he is still
very optimistic about medium term prospects. They think the new
economy productivity gains have not worked their way through the
economy by any means yet and there is quite a lot more to come,
and you can see some signs of productivity gains in the UK. So
essentially I do not think a US fall translates one-for-one into
a fall in the UK because, for example, over half our trade is
with the EU, so we are not as dependent on trade there, but there
are other mechanisms like investment flows, equities, where there
are reasons just to be cautious, and I think the world certainly
presents downside risks for our forecast whereas on the domestic
side one can observe some up-side risks.
148. Your forecasts for the growth in the economy
assume it will grow at trend rate over the next three years. Is
the trade cycle not likely to intrude on this?
(Mr O'Donnell) One of the ways in which we get trend
growth right is we expect private consumptionwhich is strong
at the momentto start tapering off, so consumption growth
comes down. As that happens, growth in demand for import should
come down and we should find the trade deficitwhich widens
for a whilestarting to come back. On our forecast, anyway,
the trade deficit certainly does peak, as I said, for the current
account at 2.5 per cent of GDP but then starts to come back.
149. But in the sense of the trade cycle in
economic activity, is your assumption that the different fiscal
and monetary measures put in place have virtually cancelled it
(Mr O'Donnell) Certainly we would expect, if we were
observing the economy going below trend growth and there were
forecasts for that, we would expect policy to respond, yes, and
that is where the MPC will be looking at interest rate policy
to ensure that and on fiscal policy the automatic stabilisers
kick in to produce that effect. As I said, both policies have
room for manoeuvre so we can respond using both to ensure we stay
close to trend.
150. So the assumption behind the Treasury forecasting
is that effectively the trade cycle can be abolished and the reaction
from fiscal and monetary policy can cancel it out more or less
(Mr O'Donnell) Not that it can be abolished but that
we can reduce the amplitude. As it happens, going forward, we
expect to stay reasonably close to trend but we certainly do not
think that we will every year be on trend. There will still be
forecasting errors, let's be clear about that, but if the path
of the economy is more stable so the fluctuations around trend
are smaller, then that does make it slightly easier to forecast.
151. If we come back to the forecast and how
it is disaggregated, in table B3 you predict that real or household
disposable income in 2001 will grow between 4.25 to 4.5 per cent.
If that transpires, we are told it will be the biggest increase
in household spending since the boom of 1988. Is that worrying
you at all? I know it is election year but in economic terms is
it worrying you?
(Mr O'Donnell) No, because the statistics that would
reveal whether that is true or not will come out in the second
half of the year, if it is emerging. It does not worry me in the
sense that what we have here, as I said before, is a slowdown
happening from the net trade side. That is, as I say, taking out
about 1 per cent of GDP from our growth on the net trade side
so in order that GDP grows at trend we need there to be reasonably
strong domestic consumption. That is what we would expect to happen
this year, but it does need to slow down because households do
need to rebuild their savings ratio.
152. But is that not the concern though? You
are predicting that the savings ratio will actually increase a
little bit over the next two years but if that does not transpire,
given the trend at the moment is going the other way so you are
forecasting a complete change in the direction of where the saving
ratio is going, consumption will be growing even morepossibly
fasterthan in the 1988 boom, and we are told that boom
and bust is a thing of the past?
(Mr O'Donnell) And indeed, in terms of overall GDP
growth, what is important is to keep that close to trend. As I
have said, what we are observing here is a compositional change
and this is brought out very much by the difference between our
pre Budget report forecast and the current forecast. The world
has slowed down a lot more so our net trade composition will be
a lot worse so we need consumption to stay stronger for a while.
If domestic consumption is growing too rapidlyand, as I
said, there are downside risks on the world sideyou are
absolutely right, there is a upside risk there, and that is what
the MPC will watchI was going to say like hawks but I hope
like the appropriate combination of hawks and doves! They will
watch very closely and make interest rate decisions to ensure
that the path of overall economy and inflationary pressures are
kept under control, and I have every faith that they will do that.
153. But it is that composition of aggregate
demand that worries some of us. You are forecasting and enabling
there to be this large increase in personal consumption and then
we get figures this month on 9 March showing that production industries,
which is another possibly even more important part of aggregate
demand, are going down. Production industry output fell in the
last three months by 0.6 per cent; between December and January
manufacturing output decreased by 0.9 per cent and, if you look
at key industries, electrical and optical and equivalent industries,
there is a fall of 4.8 per cent. So in that key area of manufacturing
we are seeing output really coming not to a halt but going into
decline, and consumption go through the roof, and that is not
a really very healthy sustainable mixture of aggregate demand,
(Mr O'Donnell) I would not read too much into that
set of figures because, as you rightly pointed out, they are very
sector specific and if you look at them in more detail, you look
at the mobile phones effect there, the pre-Christmas and post-Christmas
effect is quite big and ONS were pointing out that these are rather
distorted numbers. Our prediction is that manufacturing growth
next year will be fairly robust and somewhat higher than it has
been in the past.
154. Would you describe 1.75 and 2 per cent
(Mr O'Donnell) Yes, for manufacturing output. This
is combined with strong productivity gains. Remember, compared
to its recent history, this is reasonably robust, I would say,
yes, and the services sector is growing quite strongly.
155. So if 2 per cent is robust for manufacturing,
how would you describe 4.5 per cent for consumption? Extremely
(Mr O'Donnell) That is spending versus output and
in the end these measures all have to come into line because GDP
measures through spending and output have to come into line. I
would not read too much into those monthly figures.
156. But I am concerned about this mixture of
aggregate demand. You give this picture, "All is rosy; do
not worry; we have it all under control", and we are seeing
consumption go through the roof and production falling, and those
of us who want to see a long-term sustainable development economy
are worried about the output of production industries.
(Mr O'Donnell) Like I say, we are forecasting that
output production industries will recover from those numbers and
that they will be seen to be rather distorted, and certainly that
is in line with what independent forecasters view as well. It
is not that we are coming up with an unusually optimistic or rosy
forecast; we are pretty much in the middle of the pack.
157. Is not this decline in the manufacturing
output now and the not quite so robust growth in manufacturing
output, which is the way I would describe it generously, behind
the fact that imports are increasing much faster than exports?
That was the case this year; you are forecasting it for next year;
you are forecasting it for the year after that. Is that not the
reason why we are seeing a huge decline in the balance of payments
position, because you have an imbalance in the economy?
(Mr O'Donnell) Like I say, the change in the forecast
since the pre Budget report time is that the world has slowed
down much more than the UK. It is difficult to be pressured because
the UK economy is doing rather better than, say, the US and Japan
and all these other areas. It is certainly trueworld growth
has been revised down quite substantially. There are problems
out there. The rest of the world is responding to this. They are
cutting interest rates in Canada, United States, Mexico, Brazil,
Japan, Hong Kong, Australia, New Zealand, the UKwe are
going through a period where we need some policy responses to
ensure that world growth stays at a reasonable level and during
that period, when the world slows down more than we do, we will
go through a period where we run a trade deficit for a while.
That is inevitable.
158. My question is not so much about the overall
level of aggregate demand for the UK and how that is relevant
to the other countries but the composition of that demand and
the fact that you, in the policies you seem to be pursuing, are
trying to make sure it is the consumer and not manufacturing industry.
(Mr O'Donnell) We have put in place policies to ensure,
like I say, a macroframework that is delivering macro-economic
stability and low interest rates, and you are seeing employment
carrying on rising and that shows
159. Not in manufacturing or agriculture?
(Mr O'Donnell)Overall employment carries on
rising, certainly within that total. There will always be sectors
that are falling and some that are rising. Manufacturing employment
has been falling ever since the 1950s.