Examination of witnesses (Questions 320-339)
TUESDAY 27 FEBRUARY 2001
THE RT
HON SIR
EDWARD GEORGE,
MR MERVYN
KING, MR
CHARLES BEAN,
DR DEANNE
JULIUS, PROFESSOR
STEPHEN NICKELL
AND MR
IAN PLENDERLEITH
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.
Chairman
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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