Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor David Miles

  Monetary policy has been loosed significantly in the period since the terrorist attacks on 11 September. Interest rates were cut by a quarter of a per cent in the unscheduled meeting on 18 September, by a further quarter of one per cent in October and by a half per cent in November. The sharp falls in confidence indicators in the US, and in the UK, and the more general signs of slowing growth within Europe, have promoted the Bank to cut rates substantially. One would imagine that there is a good deal more uncertainty now about the outlook for output, and to some extent for inflation, than was the case in the summer. As the Inflation Report notes (on page iv)

    "Considerable uncertainties surround these projections . . . the possibility that the slowdown in the international economy may be deeper or more prolonged is a downside risk"

  And on page 54:

    ". . . the imbalances within the UK economy remain acute and continue to pose a threat to the outlook . . . While interest servicing pressures have been eased by the recent cuts in interest rates there remains a possibility that households could raise precautionary savings rate at some point over the forecast period to rebuild balance sheet positions . . . Indeed although there are substantial downside risks to consumption growth and to output and inflation from this source there is also a significant probability that household spending growth could remain stronger for longer than currently projected. Recognising the uncertainty surrounding the prospects for aggregate private final demand and that there are risks to both stronger and weaker spending in the short to medium term, the Committee concluded that the risk to growth and inflation from this source were relatively evenly balanced".

  What is surprising is that in spite of this recognition of substantial uncertainty, particularly about output, the spread of possible outcomes considered likely by the MPC is actually remarkably small. Table 6a on page 56 shows that there is perceived to be less than a 1 per cent probability that over the next two years annual growth in output might turn negative. There is judged to be less than a 10 per cent probability that output growth would be less than 1 per cent. Given the substantial downward movements in many indicators of confidence in the UK, it seems strange to think that the probability of a decline in output at some time over the next few years should only be one in one hundred. I think it would be worth asking members of the MPC why, given the tone of the Inflation Report, the assessed probability of a recession (an actual fall in output over a one year horizon) is perceived to be so tiny. To cut interest rates from the already very low level of 4.5 per cent by 50 basis points to 4 per cent, as was done at the November meeting, suggests a rather substantial weakening in perceived inflationary and demand pressures and probably a big rise in risks. Yet the distribution of perceived plausible outcomes to GDP is very small.

  It is also rather surprising in the light of the sharp falls in confidence and substantial numbers of announced redundancies that the overall profile to GDP growth over the next few years is now very similar to the August projections. As the Bank notes this reflects countervailing forces from lower interest rates, on the one hand, and of a substantially weaker outlook for the world economy and significantly lower asset prices on the other.

  A final rather surprising observation is made on page 56 that:

    ". . . the centre of gravity on the Committee is that risks to output growth are evenly balanced and weighed slightly to the up side for inflation".

  It does seem strange to see the probability of output being substantially above 2.25 per cent (roughly the average for the projection over the next two years) as equal to the probability that it should fall significantly below this.

  One factor that may be particularly important here is that the perceived amount of capacity in the UK may now be significantly greater than in August. The latest official data indicates that the non-residential capital stock in the UK is now estimated to be very significantly larger. This means that the level of output consistent with normal capacity utilisation—in other words the output potential of the UK—is significantly greater than was thought. Clearly this is a positive factor, both in terms of inflation (it reduces inflationary pressures) and in terms of potential growth. It would be interesting to ask the MPC representatives just how much more capacity they felt might now exist relative to their view in August.

  Finally, there are some important issues raised by the decision to have an unscheduled meeting of the MPC on 18 September. The decision was taken at that meeting to cut interest rates by 25 basis points. It was agreed that it was virtually impossible to assess only one week after the terrorist attack what the impact might be upon output, demand and inflationary pressures. The decision to cut interest rates seems to have been taken largely as a result of a determination to signal to the markets that the MPC was responsive to the obvious risks generated by the attack. On page 42 of the Inflation Report it is noted:

    "Discussion moved as to whether the appropriate cutting rate should be 25 or 50 basis points; most members favoured a reduction of 25 basis points. This would signal the Committee's responsiveness to the change in economic conditions."

  In some ways it is rather strange to see the role of a cut in interest rates merely being a signal of the fact that the MPC is responsive to events. This may seem like nitpicking since surely it was quite justified to ease monetary policy somewhat in the light of the extraordinary events. I think the issue really is about the word "signal". One might argue that calling an unscheduled meeting and deciding to cut interest rates, without really having much idea as to what the impact of the attacks would be, especially when another meeting was scheduled for just a couple of weeks ahead, gives rather a worrying signal. It would be worthwhile, I believe, to quiz the MPC members on precisely what signal they thought they were giving. It would also be useful to ask them what the criteria is for calling special meetings. Meetings are scheduled to take place at one month intervals. The conventional wisdom is that movements in interest rates do not really have their full impact on the economy for up to 18 months to two years ahead (although of course they will have some impact almost immediately). In the light of this what is to be gained by making a decision a couple of weeks early?

19 November 2001

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