Memorandum submitted by Professor Christopher
Pissarides, London School of Economics
Short-term interest rates and their expectation
over the near future have fallen. But uncertainty about the future
path of interest rates is now higher than in the summer and asset
prices are falling. This indicates that financial markets are
unsettled and further reductions in interest rates may be factored
into prices, so a quick recovery of stock prices through reductions
in interest rates is unlikely. The extent of the fall in asset
prices since its last Inflation Report surprised the MPC.
Household liquidity remains high. This may be
partly explained by the uncertainty surrounding asset markets,
with households remaining liquid to protect their capital. Overall
household financial wealth is weaker than in August because of
the fall in asset prices and because of signs that both income
from employment and house prices are weakening. Business confidence
is down and domestic investment is expected to be weak. The MPC
expects domestic demand to slow down across the board, but mainly
in business spending.
World economic growth was showing clear signs
of slowdown even before 11 September. Expectations worsened since
then because of the negative impact that the attacks and the war
are likely to have on trade (especially in services, such as tourism).
This development seems to be the determining influence behind
the MPC's recent actions.
The LFS definition of employment fell by 19,000
in the third quarter of 2001. The number of unemployed looking
for work has increased although the claimant count of unemployment
has been more stable. Employment fell for prime-age groups and
increased for the over 60s. Inactivity has risen too, especially
among younger workers. These changes show that inflationary pressures
in the labour market are easing.
During the expansion of the late 1990s wage
pressure did not build up because the expansion reduced mainly
long-term unemployment, which is not a strong inflation deterrent.
Basic wage growth remains largely unaffected by recent rises in
unemployment but bonus pay is falling. Public sector pay has been
higher than private sector pay, with public sector pay at an annualised
rate of growth of 5.7 per cent and private sector pay at 4.2 per
cent. With productivity growth expected to fall, wage growth has
to slow down if the inflation target is to be met. In the near
term this slowdown should come from falling bonus payments.
The cost pressures on manufacturing due to the
resilience of unit labour costs are likely to be offset by falling
oil prices (with the price of oil expected to be about $20 a barrel
or less), weaker raw material prices and weaker import prices.
Unit labour costs are showing more signs of weakness in services
than in manufacturing, a development that the MPC considers encouraging
because labour costs are a bigger fraction of overall costs in
services than in manufacturing. In view of these developments
the committee think that inflation will be in the range of two
to two and a half over the next three months.
The MPC cut interest rates by a cumulative 2
per cent since the beginning of the year, with cuts concentrated
in more recent months. The need for this came from the deteriorating
world economic situation and the absence of inflationary pressures
within the domestic economy. The Committee therefore thought that
it could partly offset the negative impact of the world slowdown
on the domestic economy without putting at risk its domestic inflation
target. Inflation is expected to be a little below target over
the next three months and output growth to be below trend. Exchange
rates are not showing signs of change and although some members
of the MPC are concerned that a depreciation in sterling may push
prices up, there would appear to be even further scope for interest