MEMORANDUM BY MRS BRIDGET ROSEWELL, SPECIALIST
ADVISER TO THE COMMITTEE
THE CURRENT
POLICY STANCE
The current stance of policy is becoming increasingly
restrictive. Although the February meeting reduced the repo rate
by 0.25 per cent, when this is set against world conditions, it
looks increasingly out of line. The argument remains that conditions
in the UK show relatively strong growth, but it is hard to see
any indicators that are actually strengthening, while inflation
is below target.
Household spending is fairly good, but rising
more slowly than in 1999; the labour market shows low unemployment,
combined with evidence of skill shortages, but earnings are only
increasing by 4.25 per cent. Financial markets are flat, and investment
growth has also peaked. Nothing has changed the view taken last
quarter that the economy is slowing. If it is the case that it
takes 2 years for interest rate cuts to feed through, now is the
time for such cuts to be made.
The only caveat is that the government may come
galloping to the rescue with an expansionary Budget next month,
though this is not factored into the Bank's outlook overtly.
THE US ECONOMY
Moreover, the risks to economic performance
are heavily weighted to the down side. In particular the US economy
is still very vulnerable. The indebtedness of both consumers and
businesses means that even a return to more stable behaviour,
without rebuilding balances, is likely to reduce the growth rate
substantially. The US is a huge and flexible economy—this
is a benefit in the upturn but equally applies in a downturn.
It is my judgement that the US downturn is likely
to be short lived—but it is also likely to be sharp. This
will impact financial markets and confidence which will need counteracting
monetary policy. The apparent stand off in the Monetary Policy
Committee between hawks and doves runs the risk that this reaction
will be too little too late.
INFLATION AND
RISK
The central forecast for inflation in this month's
Inflation Report requires that inflation rise by nearly one point
during 2002 in order to bring the target back on track. The range
around this is from 1 per cent to 3.75 per cent. It is hard to
see what justifies this range or how the risks have been assessed.
On p67, we are told that "certain Committee members prefer
to make different judgements from those incorporated in the fan
charts", as a result of which the profile could be up to
0.5 per cent lower than in the central projection.
These paragraphs remain obscure on several re-readings.
It is hard to see what purpose the fan charts are fulfilling when
we could in fact have a multiplicity of such charts—one
for each member of the Committee. If the charts represent "general
uncertainty" this could reflect previous forecast errors,
rather than any particular judgements. The quantification of judgement
calls is however central to the policy process about which we
know essentially very little, except from the statements made
by members outside the Committee process.
UNDERSHOOTING THE
TARGET
It can be argued that the reliance on general
uncertainty rather than judgement calls means that there is still
over reliance on historical relationships, of the kind that are
encapsulated in standard models. On this basis the strength of
the economy should already have led to much higher inflation than
we are seeing. In one sense, the whole discussion in the Report
is about the meaning of current indicators and whether something
different is happening than what history implies. Therefore the
challenge is to locate the current situation in the evolution
of the economy. The Report fails to do this.
The reliance on history is the fundamental reason
why the inflation rate continues to overshoot and to surprise
by its weakness—and also why it is always expected to return
to its target rate in two years time.
The alternative "stories" by which
this may not happen should be more clearly spelled out, otherwise
the description of the economic situation which comprises the
bulk of the Report is not very helpful as an elucidation of the
decision making process.
20 February 2001
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