Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 300-319)



  300. Presumably, what Dr DeAnne Julius has been saying is that there are, at least, some changes in the labour market which mean that it is safe to cut rates. You do not believe that.
  (Professor Nickell) I believe that there have been lots of changes in the labour market which explains why, for the last year or so, we have been in a situation where unemployment has been at its lowest level for a generation, and there has been evidence of considerable excess demand in the labour market without earnings and wage settlements taking off. Yes, I think that there has been a big change in the labour market over the last 15 years. The issue as far as the rate cut in December, January and February is concerned—the issue for me—was not really a labour market issue, except to the extent that over the period December, January and February there was a sort of build up of evidence that the labour market was on the turn, so to speak. Whereas previously employment had been rising rapidly, by December the rate of growth in employment had fallen to below the growth of the population of working age, and by February the rate of growth of employment had fallen to zero. So the labour market had certainly slowed down. I think the key thing for me was that whereas in December and January domestic demand and domestic demand prospects seemed to be relatively buoyant, by February we had our first real piece of evidence that domestic demand was actually slowing as it would have to do to make room for prospective increases in expenditure by government. So because the fourth quarter growth of GDP was considerably lower than previous quarters, while some of it may be a special case, there was in February real evidence of declining GDP growth and that is the thing that tipped the balance for me.

Sir Michael Spicer

  301. Governor, I wonder if I could begin by asking you whether the MPC takes its inflation forecast at all seriously?
  (Sir Edward George) I do not think we can take it too seriously, Chairman. That is our remit.

  302. You do take it seriously?
  (Sir Edward George) Controlling inflation is our remit and, therefore, the forecast is a very important part of the process. It does not seem to me that we can actually take it too seriously.

  303. It is an important part of the process but you do not take it too seriously?
  (Sir Edward George) No. I do not see how we can take it too seriously.

  304. The reason I ask is because if one looks at the fan charts which you produce in the Inflation Reports, first of all it compares between Inflation Reports and the fan charts show a risk profile which, in many cases, varies very much between forecasts. Yet, mysteriously and magically, the central forecast always ends up on 2.5. If one takes another example, on page 66 of the latest Inflation Report, where you unusually, for obvious reasons, produce two inflation forecasts based upon different interest rates, again the risk profiles compared are very different. Again, magically, bang, we get 2.5 again. Is not the whole thing becoming a bit spurious? It seems to me a bit unrealistic.
  (Sir Edward George) You have to bear in mind, as far as our own forecast is concerned, based on unchanged interest rates, that we combine the Inflation Report process and the forecast process with our policy decision, so that we do as we did this time, we adjust the interest rate in order to produce a forecast which is consistent with achieving our target. It can be either side of 2.5 per cent, but you would actually expect that over the kind of forecast horizon. As far as showing what would happen under other interest rate conditions is concerned, we use the market interest rates and that actually shows, I think, on this occasion that the market interest rates are lower than our constant interest rate assumption. That shows that inflation actually would rise above 2.5 per cent in two years' time.

  305. I wonder if I could ask Mr Bean, who is responsible most directly for the forecast, about this. The Governor has just said that you feed in, in this case, alternative different interest rates and see what the effect of that is. Actually, you do not, do you? One of the criticisms of the forecasting system in terms of its credibility is that on the whole you keep the existing interest rates you have got and feed those throughout the system and do not make allowances for any potential changes in interest in the future?
  (Mr Bean) What is certainly true is that the projections that we look at—and I think it is important to look at these not as forecasts of what will happen, but as conditional projections—are conditional on a particular path of interest rates. The forecasting process is conducted on the assumption that interest rates stay unchanged over the forecast horizon from where they are. Now, to the extent that inflation at the end of the horizon is a long way from where the target is, there is an implication that interest rates will need to differ at some stage from the benchmark projection we have put in. In the case, for instance, of this forecasting round, the forecasting round was actually conducted most of the time on the assumption of unchanged interest rates of 6 per cent. Then, of course, they were actually changed at the February meeting and the forecast was closed with interest rates at that new lower level. And we do, as the Governor says, also look at what the inflation projections would look like with the market interest rate assumption. But what we do not have is an extensive examination of the alternative interest rate profiles that might generate particular inflation profiles, or particular out-turns for inflation at the end of the horizon.

  306. Mr King, I wonder if I could put the question to you. In that case, it is absolutely inevitable, is it not, that the forecast will be inaccurate because you are feeding in inaccurate data. You are feeding in an assumption that interest rates remain static over a two-year period, and that is almost inevitably not going to be the case.
  (Mr King) I think of a forecast as a probability distribution rather than a point estimate. If you insist on thinking of it as a number then every forecast anyone ever makes is going to be wrong. You have to think of it as a probability distribution. I think, as Charlie said, the key point about the process is that we did carry out this forecast round by saying "Let's make a conditional projection; what would happen if interest rates were to remain unchanged at 6 per cent?" We then had a look at the fan chart and the central projection was below the target of 2.5 per cent. I think what matters to most members of the Committee is the balance of risks. It is not just the central projection, it is the entire shape of the fan chart. We then adjusted policy so that the fan chart did indeed, in terms of the central projection, come close to 2.5 per cent. So I think what is perhaps missing from the perception which outsiders have is that we look at the fan charts and the different levels of interest rates, we set interest rates at a level such that the fan chart looks as if the central projection is coming back to 2.5 per cent. That is precisely what we are supposed to do, as the Governor said. In fact, it is not always true that the central projection is 2.5 per cent. Last August we published a projection where the central projection was above 2.5 per cent, and because of the balance of risks, and because of the desire to see what was happening to the labour market we explained carefully, both in the report and in the associated press conference, why, despite the fact the central projection was not exactly on 2.5 per cent we had not changed interest rates. Indeed, further, we published in November a box in the Inflation Report explaining why in general terms one should not expect any mechanical link between the central projection and the policy decision.

  307. That is very interesting. Before I come to that point, if I may, just picking up a point about the probability distribution, part of what I am trying to say is that you produce a variety of probability distributions, risk analyses and so on, and yet the central projection, on the whole—you have picked on one exception—always seems to come back to 2.5 per cent.
  (Mr King) It should come back to 2.5.

  308. There seems to be a certain amount of artificiality about it.
  (Mr King) I do not think it is artificial. It is our target. It would be most peculiar if it were the case that our forecasts were all over the place and bore no relationship to 2.5 per cent.

  309. So it is a target, not a forecast.
  (Mr King) No, it is a projection under the current level of interest rates, which you would expect, in most circumstances—though not all—would have the property that inflation would tend to move back towards the target at around that horizon. As I said, we spelled out in the box in November why there would be cases—and this happened on a number of occasions, not just last August—where the central projection could be away from 2.5 per cent. As Charlie said, there would then be a presumption of thinking about a rate change but not immediately, and not if the balance of risks were heavily skewed on one side rather than the other, and not if we were concerned about the path of inflation before two years or after two years. All of these considerations are relevant. Perhaps we have more explaining to do in order to show the link between the outlook for inflation, which is the fan chart (not just the central projection but the entire fan chart), and the policy decision. For a long time now we have been trying to point out in speeches or in answers to questions that there is no mechanical link between the central projection in the fan chart and the policy decision.

  310. If there is no direct relationship between interest rates and the forecast—
  (Mr King) I did not say that. I said there is no mechanical link between the central projection, which is only one part of the fan chart, and the policy decision.

  311. If there is no direct relationship between the central projection, which is what everybody basically looks at—
  (Mr King) I hope they will not. The whole point of the fan chart was to get away from that. We talk about the balance of risks.

  312. If they do not look at the central projection and look at the outer rims of the fan chart, and only take the outer rim seriously, you are saying that 4 per cent inflation may be something which we are heading for.
  (Mr King) There is always some probability of inflation being at that level, of course.

  313. Essentially, the central projection must be the key indicator.
  (Mr King) It is one part of it, and I think the balance of risks around the central projection is the key part. Of course, the central projection is important, but it is not the be-all and end-all of the process.

  314. But it is highly critical and important.
  (Mr King) It is not a sufficient statistic for the policy decision.

  315. But it is still very important. To say that there is no mechanical relationship between the central forecast and the input of interest rates does put into some sort of question the whole point of the exercise.
  (Mr King) With great respect, I do not think it does, Sir Michael. The point is that we are focusing here, and your question is about, the central projection on precisely a two-year horizon. That is a single number. Policy must reflect the entire distribution of possible out-turns for inflation. That is what constitutes the inflation outlook. So the balance of risks around that, and the path of the central projection before and after the two-year horizon, are all important ingredients in deciding whether or not to change the policy as appropriate.

  316. Given this unpredictability which you point to and which is represented in the fan chart, given the fact that we had a witness yesterday, Mr Kohn, from the Federal Reserve Bank of America who said that all forecasts are inaccurate, is it not therefore true (and perhaps I could address this to the Governor) that what you are really doing in terms of interest rate policy is taking very short-term factors like—I do not know—balancing the effect of the American economy down-turn against tight labour markets, for example, and taking on policy based on what you see outside the window, to a very large extent, projecting forward in as an intuitive way as you can. That is really the essence, and all the paperwork and the Inflation Report concentrates, perhaps rightly, on short-term factors rather than these, perhaps, rather arcane long-term forecasts.
  (Sir Edward George) I just think that is a total misperception, if I may say so. Of course, there are a huge number of factors that go into reaching policy decisions. That certainly includes short-run developments, but we are not looking at short-run developments simply for their own sake and responding to those on a kind of day-by-day basis, which is what very often influences financial markets. We are actually looking at those short-run developments for what they tell us about what is actually happening in the economy in a longer-run sense. We have as a benchmark the forecast that we made some time before, and we are measuring the incoming data against that benchmark and saying how is the thing performing in relation to what we would have expected to happen? Or what we assumed or projected might happen? If we were to simply respond to what we saw out of the window at any particular moment in time, we could adjust interest rates every day. I do not think that would be a very sensible way to run policy. What we are then doing is actually trying to look at the kind of underlying trends and developments in the economy; we are looking at what is happening to the different components of demand. On some of those things we know more than we do on other things. We have information, for example, about what the Government intends on public expenditure. We have a lot of past experience of past behaviour, what is affecting consumer spending, what is affecting investment spending? It is not a straightforward predictor of what is going to happen in the future, but by actually looking at the behaviour in the past you can establish relationships which show a kind of average behaviour and you can look at the latest data to try to understand what might be happening in the current situation, and what the risks are on either side. So you put all of those things into the forecasting process, trying to measure the demand side influences, and then you have to look at what you think is happening on the supply side too. You have to look at what is happening internationally as well as what is happening domestically. So all of those things have to go into the formation of a view about what you think is the most likely thing to happen in the economy. That really is the centre of gravity that we reflect in the fan chart and what are the risks around that projection. All of those factors influence our individual judgments about what we need to do to interest rates in order to keep on track to hit the inflation target.

  317. Given the unpredictability your colleagues have pointed to, you would argue, would you, that you, as experts, have some greater insight into the future than us mere mortals who do just use intuition?
  (Sir Edward George) I would certainly argue that as a matter of process we have built into our policy process more systematical analysis than people who just look out of the window, yes.

  318. That gives better answers?
  (Sir Edward George) I think it reduces the risk of bad answers. Of course, you can still get bad answers because it is not a kind of precise science world we are living in.

Mr Kidney

  319. Mr King, Members want to cover lots more subjects, but I want to pursue Sir Michael's points in a little more detail in a different way. If we can start with Table 6A, which is on page 67, this shows the probability range for the future path of inflation over the next year. According to this, at the end of this year there is a 25 per cent probability that inflation will be less than 1.5 per cent—that is more than 1 per cent below the target—and at the other end of the range there is a less than 1 per cent probability that it will be over 3.5 per cent—that is to say more than 1 per cent above the inflation target. The first question I would like to ask you is, starting from the target of 2.5 per cent, is it your view that missing the target below by more than 1 per cent and missing the target by above more than 1 per cent of the target—do each of those carry an equal cost or is one less costly than the other?
  (Mr King) No, I think, in terms of our objectives, we are equally concerned about deviations above or below. In terms of policy setting, the initial starting point makes quite a big difference, because if you start below the target there is actually very little you can do to influence inflation over the first 6 to 12 months of the forecast horizon. So it is actually more important to look further ahead. That is where we can influence the outcome. So I think the fact that the probability that inflation may be below 1.5 per cent exceeds the probability that it will be above 3.5 per cent is not directly relevant to the question of setting policy today, when you know there is a long lag between the impact of changing policy and its effect on inflation.

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