Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 320-339)



  320. I suppose you could say it is obvious that the greater risk now is to go below the target by more than 1 per cent because of where we are. What I am asking more generally is, where we are is below the target for 22 months running, and it leads to the suspicion that, maybe, in your mind at the beginning of this process, if you are going to miss the target it is better to miss it on the low side rather than on the high side.
  (Mr King) I can assure you that is not the view of any member of the Committee, and it is not the remit that we have been given. After all, it is true that we have been below the target for 22 months but we were at or above the target for 21 months before that. The average inflation rate over the lifetime of the Committee is 2.4 per cent. So I do not think there is any reason to suppose that there is a systematic bias in the way we approach it.

  321. In the management of risks around the forecast that has been the subject of your discussions with Sir Michael, if you have got to play safe, is playing safe being on the low side rather than the high side?
  (Mr King) I do not think so. Our objective is very clear, which is to keep inflation as close to 2.5 per cent as possible. If we deviate from that, either above or below, then we will miss the target and there is a risk therefore. We have a symmetric approach to this.


  322. Perhaps I could ask the Governor on this point, do you think you are going to have to write a letter to the Chancellor?
  (Sir Edward George) I have no idea, Chairman. If it goes below 1.5 per cent or above 3.5 per cent, yes.

  323. It is not likely to go above 3.5 per cent, at the moment, is it? If we are looking at probability—your own chart—it is more likely—
  (Sir Edward George) There is a much lower probability of it going above 3.5 per cent in the short term than there is of it going below 1.5 per cent. I would agree with that. I have to say that we are talking about extremely small numbers. Mervyn explained, we have been at 2.4 per cent over the lifetime of the Committee, and for some of that there were influences which were before the Committee came into operation. I have to tell you, if you had asked me to predict, I would have predicted that the variation in inflation around 2.5 per cent would be much greater, and I would have predicted that we would not have been as close to this after four years in any event. It has been consistently remarkably close. You do have to understand that this is not a precise science. Anybody who thinks that you can consistently keep inflation at 2.5 per cent really does not understand the problem. The variability of inflation, the unpredictability, is much greater than you would infer from just looking at the performance over the last four years.

Mr Kidney

  324. Can I ask on that, do you regard sending the letter as a failure or a calamity, or just one of those things?
  (Sir Edward George) It is a request that we should explain why. We should explain how long we expect it to last and we explain what it is we are doing to bring it back on target. I would be perfectly happy to write such a letter to explain those things.

  325. Mr King, just finally, when I asked about the cost of going below and above, in terms of the economy out there, is it a different cost if we are under the target by a lot compared to being over the target by a lot—to people in jobs and people in businesses?
  (Mr King) No, I do not think so, but I think what is important is that one does not try to generate a temporary boom or a temporary bust in order, quickly, to get back to target. That is why it is very important that thresholds of 1.5 and 3.5 are clearly understood not to be targets in any sense but part of the accountability of the Committee to explain why that has happened. It is the need consistently to look ahead, not just look at the next few months but further ahead, and set policy to bring inflation back to meet the target, not immediately but over a period to avoid sharp fluctuations in growth. As the Governor said, there will always be shocks to inflation, from both internal and external sources, that will move inflation in the short run away from 2.5—quite often it might be well away from 2.5—and the role of the Committee is to set policy to bring it back towards 2.5. The key test of the Committee's success will be whether people believe that the Committee will act in such a way as to bring inflation back to 2.5 per cent, notwithstanding the fact that these shocks, over which the Committee have no control, mean that inflation will from time to time move above and below the target. Once it has moved above or below, then because inflation is measured as an increase in prices over the previous 12 months, you are almost certain to be above or below for a period of more than a year. It would be a big mistake to think "It is below a couple of months, bring it back." That would be to create significant upward and downward movements in and out, which would be undesirable. So it is bringing it back to target over that longer horizon.

  326. Lastly now, you did say to Sir Michael perhaps there is a need to better explain how the risk judgments are made and how they affect the Inflation Report. Somebody described the Inflation Report to me as "looking tired". I wonder if you might think about the actual format and the process of putting together the Inflation Report in future. Maybe people do understand the chart that shows the fan of the inflation forecast path, but they do not understand how you weigh up these different risks and come to a Committee decision.
  (Sir Edward George) It is certainly true, Chairman, that the people engaged in producing the Inflation Report are tired!
  (Mr King) We do try always to improve what we do. You only stay at the frontiers by continuous improvement. There are always small changes being made to the Inflation Report to try to improve what we do in different areas, and that happens in almost every issue. The need to explain, I think, is not so much the link between our analysis of the economic data and the projections that we present but more, as Sir Michael suggested, the link between the projections and the policy decision. That, I think, is not so much the Inflation Report as the Committee explaining how it reaches its decisions. Maybe we can do more. I think you can never do too much explaining. This process, both in terms of objectives—I am very keen that we also keep explaining to people what the target is and why the target is so important—but also why the decisions that we have taken in particular months are aimed at hitting the target. I am sure that we can do more by way of explanation. I think it would be harsh to say we have done little by way of explanation; we have done a great deal compared with most other such organisations.

Mr Plaskitt

  327. Mr Bean, you, too, started to vote for reductions in rates in January, along with Dr Julius. What did you see in January that made you reach that conclusion?
  (Mr Bean) For me the key piece of information was what had happened in the US. When I joined the Committee back in October I was particularly concerned about the possibility of wage growth accelerating, and as last year went on and wage growth remained relatively benign, so I began to take a somewhat more relaxed view of that, and we have already had some discussion about what has been going on in the labour market. So, if you like, I had been swinging gradually more towards being willing to cut rates anyway. Then, as I say, the key event for me was the appearance of the sharp downturn in the US, which I felt was likely both to lower our central projection in the February forecast and, more particularly, worsen the downside risks. In the light of that, I felt that it was probably appropriate to cut rates in January. Now, there were arguments for waiting to do it in the context of a more full assessment of the implications of what was going on in the US, and the Governor has explained exactly the rationale for that. At that time I was also worried at the possibility that confidence in the UK might be affected by all the stories about what was happening in the US, and that once confidence slipped it might be difficult to get it back. So that in that case, given the fact that inflationary pressure seemed to be reasonably subdued and was currently below target, there was room to cut rates in a precautionary fashion.

  328. How worried are you now about the impact of the US narrow economy?
  (Mr Bean) I am still worried, as I think all the Committee are. I sign up pretty much to the forecasts embodied in the Inflation Report. And that has a significant downside skew to it associated with worries about how the global picture may develop although the central projection embodies a reasonably short-lived slowdown in the US. I think all of us on the Committee would subscribe to that as still the most likely outcome. But there is a significant possibility that downturn in the US may be more prolonged or deeper than our central case, so I still have some residual concerns. There are reasons for expecting the US downturn to be relatively short. From everything we know about the underlying pick-up in productivity in the US that still has some way to go, so the underlying fundamentals are reasonably good. The change in inventory-holding behaviour is likely to mean that any downturn now may be sharper than it used to be in the past, because the just-in-time inventory control means output is likely to bounce back very quickly. And the fact that the average life of capital goods has shortened with increasing investment in information and communications technology means that it is harder to postpone replacement investment than was the case in the past, so that the tail-off in investment that we saw at the end of last year is likely to be reversed. Then, on top of that, you have had a fairly prompt response by policy makers in cutting interest rates and, also, the likelihood of tax cuts from the Bush administration. So I think there are plenty of reasons to be optimistic and think that the US economy will bounce back towards the end of this year. But there is a significant probability that that will not happen.

  329. Do you think you, collectively, took an undue risk with the UK economy by, in fact, not cutting rates until last month?
  (Mr Bean) I would not say an undue risk. As I have already said, my view was that it was sensible to move in January, and that we already had enough information to make that feasible. But I would not have said that a delay was a significant risk. Actually, the Committee has spent quite a lot of time weighing up the pros and cons of moving now versus waiting, and I was fairly near the margin.

  330. Dr Julius, you wanted to start this process earlier. Do you think any risk has been incurred by not, in fact, moving rates until February?
  (Dr Julius) I think the timing question is always a difficult one. By the time February came round for me the question was whether we should move by a quarter or a half. So my view of the balance of risks had got more negative as time went on and I think that is true of most of the Committee, which is why we did move in February. There is always a risk on both sides, and so perhaps it is easiest for me to answer that question by explaining why I, in the end, did not vote for a half point cut in February. I felt that the uncertainty around what is happening in the US is actually very large, and that in another six months that uncertainty will be not entirely removed but it will be much less than it is now. The next six months are critical in terms of watching what happens both to US consumption and investment and stock markets etc, and the effect of the US on the UK. So given that one is likely to know much better in six months' time than now just how the future will roll out, that is a reasonable reason for waiting and seeing. I think there is also the question of how rapidly our own movements in interest rates affect the economy. This is a question none of us has a clear answer to. We, of course, have a forecasting model which has built into it behaviourial responses derived from past behaviour, and that leads us to think that it is probably 18 months to two years before an interest rate change actually has its largest effect on inflation. Personally I think it may be less than that these days, particularly when confidence channels are important and when asset price movements are important in investors' behaviour and in households' behaviour. It may be that interest rate movements by us have a somewhat quicker effect on the economy than they used to. Why does that matter? It matters because if one does believe that then it means that you can wait and see a little bit longer before you take interest rate decisions. So that even if one's view about potential risks facing the economy, facing our ability to bring inflation back up to target is fairly nervous, that does not necessarily mean that one should be taking a big move in interest rates now.

  331. In your view, does that analysis point to an increasing likelihood of more small changes rather than longer periods of no change?
  (Dr Julius) Not necessarily. I think we do have the duty, as well as the luxury, of moving rates as often as we see fit. We could move them every month. We do the Inflation Report and we look at where inflation would be two years hence and, in fact, over the whole period. We all recognise perfectly well that that is a useful analytical device to help us think about whether to move. It in no way suggests that we are planning not to look at policy and simply leave rates the same.

  332. Paragraph 34 of the February Minutes confirmed what you have just said, that there was some discussion about whether there should be a reduction by 50 basis points not just 25. You have clearly indicated that you were one of the people raising that possibility. Were you alone in arguing that?
  (Dr Julius) I think others would have to answer that for themselves.

  333. I will come on to that. Can I turn to Mr Plenderleith. You were not ready to see a reduction in rates until the February meeting. So presumably the arguments that we have been hearing from colleagues as to why they thought it was appropriate earlier were not impressing you. Why is that?
  (Mr Plenderleith) I thought they were very relevant arguments and I agree with quite a lot of the argumentation, but the balance I would strike amongst them is slightly different. I think through much of last year—through the first three-quarters of last year—whilst I was perfectly content to hold the level of 6 per cent rates that we were at, my expectation was that we might very well need to tighten further somewhere down the road because I was concerned about the build-up of pressures in the labour market and I was concerned that domestic demand, particularly consumer spending, was continuing to run quite strongly and, therefore, domestic demand was not showing the signs of moderations that we would need to see at some stage to make room for the planned increase in government spending over the next several years, and also because I was concerned that, the exchange rate of sterling having topped out in May as the Euro recovered through the second half of last year, we might see a more substantial decline in sterling, and that might lead to the need for some compensatory tightening in our stance at some stage. I was content to wait because I wanted to see how those possibilities panned out. As we approached the end of the year I think I changed my thinking, though not my view on the level of interest rates, in two respects. One was that I became more comfortable that we were seeing some degree of slowing in private and domestic demand and that became more evident in the fourth quarter GDP figures which we got early in the new year. Secondly, I became more comfortable that the pace of demand we were seeing in the economy and the degree of tightness of the labour market was not generating inflationary pressures such as one might have feared, that in some degree productivity gains were producing better output performance in relation to cost increases, and that was encouraging evidence of a better performance in the economy. Thirdly, as already alluded to, it became evident that we were seeing substantial slowing down of the US economy. Those seemed to me to be three factors that led me to feel that the balance of argument was shifting towards some easing of the stance, and that is why I voted in February for a cut of a quarter of one per cent.

  334. Mr King, you, too, did not vote for a reduction until the last meeting. What were your reasons for not considering it in December or January?
  (Mr King) I had been concerned right through last year about the strength of domestic demand, especially consumption, and the unsustainability of the growth rates that we have seen. We saw some slight evidence in February that in the fourth quarter there was a slow-down particularly in the services sector growth rate—from 0.9 to 0.7 per cent—which gave a bit of comfort that the slow-down we had expected was coming. Our forecast we made right through last year implied that if the central projection were to materialise then we needed to see the growth rate of consumption halve as a quarterly growth rate between the end of last year and the first half of this. We have not seen very much sign of that, but we started to see that in February. My main reason was the sign of a US slow-down. That was something we debated in January, and it became an issue in January with the Fed cut. The Federal Reserve, I think, needed to move between meetings because the one thing that was striking about the position of the US was the very sharp break in both consumer and business confidence, which fell very rapidly, and part of their move was designed to try to restore confidence. That does not apply to the UK. We have not seen any such break in confidence, either business or consumer. No doubt, as the growth rate of exports and orders slows down we will see confidence levels and expected order levels in surveys start to drift down during this year, but we have not seen that sharp break in confidence and, therefore, the urgency which was present in the US case was not present in our case. We could wait until February when we had an opportunity to balance what I thought was still strong domestic indicators against a proper appraisal of the extent of the US slow-down. In January we did not have any proper analysis or even data on the extent of the US slow-down, so I wanted to wait until the February Inflation Report.

  335. Mr Bean, did you consider a 50 basis point reduction in February, seeing as you did not get what you wanted to see in January?
  (Mr Bean) In the formal sense of turning it over in my mind and, also, if you like, the way I discussed how I was going to vote in Committee, I considered it but, at the end, came to the conclusion that only a quarter of one per cent move was appropriate at this time, partly because of the upward trend in inflation in the second half of the projection period, partly because during the next month or two we should get further information about the way wage settlements are developing in this country. I am still worried about the tightness of the labour market for although it has stopped getting tighter it is still historically at a very tight level and clearly, the outlook for inflation is tightly linked to what happens with pay settlements. Also, there are other things like the exact contents of the Budget which will become known over the coming month. So those arguments all pointed, to me, towards only moving a quarter point, even though I took into account the balance of risks.

Mr Fallon

  336. Governor, in the Minutes of the February meeting the Committee noted the external commentary that interest rate decisions might be influenced by the timing of the Budget or the timing of the election. What was that discussion?
  (Sir Edward George) On Wednesday afternoon of our two-day meeting we discuss what are the relevant issues before we come, on the Thursday morning, to actually take the decision on the policy. We always ask ourselves, having asked ourselves questions about the analysis, are there tactical factors that we need to take into account before we discuss the policy decision the next day. There had been quite a lot of suggestion that somehow we would be inhibited from moving either in the immediate aftermath of the Budget or ahead of an election. We discussed that. We reached the unanimous conclusion that, actually, that was not our remit; our remit was to achieve the inflation target and to do what was necessary for that and that we should be driven by the data and our analysis of the data and the prospect for achieving the inflation target. That is how we discussed it and that is, I think, what you will find reflected in the Minutes.

  337. So you were not discussing the external commentary, you were discussing the possible inhibition—
  (Sir Edward George) No, we were discussing the suggestion that we would be inhibited by this, and so we asked the question "Would we and should we be inhibited by this?" and we reached the conclusion "No. No."

  338. This was your last meeting before the Budget. Were you given by the Treasury any outline of the framework against which Budget decisions would be taken?
  (Sir Edward George) No, not on that occasion. We will be briefed on the overall Budget picture the day before the Budget, on Tuesday before our next meeting starting on Wednesday, which happens to be the same day as the Budget. We will be given an indication of what the overall fiscal position will be at that time.

  339. But your next decision will be the day after the Budget.
  (Sir Edward George) That is right, yes, but our meeting starts on the Wednesday afternoon, the same time as the Chancellor is talking to you.

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