Examination of Witnesses (Questions 40
TUESDAY 20 NOVEMBER 2001
40. Could I ask you for your comments as well,
David Miles, but in the context of this question. Some members
of the Bank of England seemed quite worried about the exchange
rate falling but there seems to be a lack of conviction amongst
our experts here that the pound is necessarily going to weaken
soon. Also the over-valuation seems to be against the euro and
not against other currencies and, as Roger suggested, there is
also considerable evidence that the pound has declined in a major
way without there being serious domestic inflationary impact.
One thinks in particular of 1992, although in different circumstances.
Does this mean therefore that the fear that the pound is suddenly
going to fall in a big way and create a major domestic inflation
situation is over done?
(Professor Miles) I guess one of the differences with
1992 is that in 1992 the economic slowdown has created unemployment
which was very much higher. There was obviously lots of spare
capacity, and the UK is not in the same position right now. In
terms of what are we over-valued against, it is pretty obvious
it is against the euro and not against the dollar or indeed other
currencies. This is a euro issue, and one of the problems for
the Bank is there is nothing they can do about it. I suspect that
even if they did not have an inflation target and were told "set
interest rates at levels you think right to move the exchange
rate" I do not think it would work. When one teaches students
about monetary economics you say that central banks have control
over exchange rates if they want to use it, they cut interest
rates and that causes people to move out of that currency into
other currencies. However, if one looks at the empirical evidence,
and indeed at what has happened in the US over the last year,
there have been huge cuts and has the US dollar depreciated substantially
against other currencies? No. The problem for the Bank is they
do not know why sterling has been so strong against the euro and
there are not entirely convincing stories about that. They cannot
do anything about it and they have just got to sit and wait and
that is the worry.
41. One or two of you have spoken about the
possibility of dollar depreciation. What do those who did mention
it think the dangers of that might be? Given that a lot of the
wealth of Russia, again a lot of the accumulated savings of the
Japanese are all expressed in a dollar denominated form, it could
have quite a shock on other economies.
(Professor Pissarides) I would agree with that, that
it will be a shock, partly because of that but also for more fundamental
reasons. I do not really think a depreciation in the dollar is
42. You do not?
(Professor Pissarides) It might happen because in
financial markets, especially in foreign exchange markets, there
is now more uncertainty but I do not think there will be a depreciation
in the dollar. And the reason I say that is if you look at it
against the other currencies individually, is the dollar going
to be worse than the yen? There is no reason to think that. I
think the euro is under-valued and will come up so the dollar/euro
exchange rate will change because of the euro. Is there any reason
why the US and UK economies would diverge so much as to cause
depreciation of the dollar? No, I do not think so.
(Mr Bootle) There is disagreement on this. I personally
do see scope for the dollar to fall without remotely pretending
that I can predict when or by how much. This is the dreadful thing,
we cannot begin to forecast it. I think the signs for the dollar
to need to fall are pretty clear and the US current account deficit
is the most obvious one. I agree with the conclusion that the
euro is the only big currency that it can go up against. I think
the big danger in that is the loss of competitiveness for Europe
and that spreads the recessionary forces from the United States
to Europe. One of the encouraging things about both Britain and
America is the performance both countries have had over the last
couple of years against the backdrop of a fundamentally uncompetitive
exchange rate whereas the performance of Euroland is against the
backdrop of a fundamentally competitive exchange rate. These things
do go into reverse and correct and so for Britain and United States
there is in prospect, I think, the chance of competitiveness getting
better and in Euroland there is in prospect the chance of it getting
43. We should ask all our experts where they
stand on the euro.
(Mr Bootle) That is a completely different issue!
44. Just one very brief technical thing. I just
want to ask about the 2.5 per cent target. This is one of those
questions where I really do not know the answer, I was thinking
about it this morning. If we were to have a sustained recession,
is targeting inflation at 2.5 per cent the right rate and is it
always the right rate at any time? There are these studies that
suggest 2.5 is really far less because of the substitution. There
have been American studies suggesting you only have to take off
1.5 per cent to take account of this substitution effect and some
say much more than that. Roger, I know you have done some work
on that. For example, particularly at the point where you turn
into recession, which is where we are now, there is likely to
be (indeed you can already see some of it) some very heavy discounting
and I am wondering the extent to which, particularly now with
the growth of virtual shopping, one is going to be able to pick
up the extent of this. In other words, should we just assume that
the 2.5 per cent is the right target wherever we are in the cycle?
(Mr Walton) We can never say precisely what the optimum
target is but I think 2.5 per cent is not bad, and given you have
got it, there is no great merit in changing it and certainly no
great merit in changing it in a small direction one way or the
other from the point of view of credibility. From the point of
view that you probably want to have reasonably stable but positive
inflation through time, it is quite hard to say that this is the
wrong target to have. Maybe 2.4 might be the optimal one.
45. It is that range of difference0.1
per centyou think these effects will come through in?
(Mr Walton) We never know precisely whether we are
measuring prices correctly. We know there is some tendency in
most developed countries for prices to be over-estimated. We also
know in the way the Retail Price Index is constructed there is
a bigger bias than there is in countries like America (and that
is to do with the geometric weighting in America versus the arithmetic
weighting in the United Kingdom) but to have something which is
slightly higher in one country on the definition that is targeted
seems quite sensible.
(Professor Miles) There are two questions. One is
"might one want to change the target because of mismeasurement
issues that may have become worse", and there is a separate
question "should you change the target because you happen
to be beneath it and have been consistently beneath it so we take
the opportunity, why don't we move it down to two given we have
been around two?" I do not know the answers to these questions.
But conceptually they are very different reasons for thinking
about changing the target.
(Mr Bootle) I thought there was also a sub-text to
the question to do with how you responded to the target rather
than actually changing it, in the sense if it is true that discounting
is greater in the downswing you might have a pretty good idea
that mismeasurement was greater. So although you might not want
to change the target you might be a little bit more generous in
interpreting what the figures said because you might get a pretty
good idea that inflation is generally lower than recorded to a
greater extent than would normally be true.
46. I was asking whether that was the view,
that it is true that those inaccuracies are going to increase
in this recession.
(Professor Pissarides) Given the way it is measured
I think it would be pretty dangerous to reduce the target because
of the weighting and index measurement. I think the answer to
your question is rather than whether 2.5 is exactly the precise
rate whether one could maybe have a little bit more flexibility
in the target. The flexibility should be in the upward direction
rather than the downward. If there is a deeper recession I would
allow the target to go up to 3 rather than 2.5 even for a very
short period of time. It might help or at least it certainly would
not hurt, but I would be concerned given the way we measure the
index, if we were to bring it below 2.5 per cent.
47. In the old days we used to have these good,
old-fashioned balance of payments crises in the UK and the pound
used to plunge and we used to watch out for each order of jumbo
jets. Now we are running this huge balance of payments deficit
which the Bank are worried about and which seem likely to remain
very large, but nobody is particularly responding to that in the
foreign exchange markets and none of you seem particularly worried
that there will be any collapse in sterling or sharp decline in
sterling in the near term because of that. Why is that?
(Mr Walton) It is partly because the current account
deficit is not that large. In the late 1980s we had a current
account deficit in 1989 of just over five per cent of GDP; this
year it looks as though it is going to be 1.7 per cent of GDP.
That is within the normal range of circumstances in the UK. If
we were running a deficit of five per cent of GDP we would be
more concerned about the risk of the pound falling.
(Professor Pissarides) Any deficit pressure is because
of jumbo jet sales. There has been a temporary increase in defence
equipment and civil aircraft that inflated it.
48. I have got a final question then. How has
the addition of Kate Barker to the MPC altered the balance of
the Committee, ie, hawkish or dovish?
(Mr Walton) Kate Barker replaced DeAnne Julius and
I think DeAnne's voting track record suggests that she was one
of the more dovish members of Committee. It is probably too early
to say whether Kate Barker is going to turn out to be more dovish
than DeAnne Julius.
49. Good reply, David.
(Professor Pissarides) I do not know the person.
Chairman: That question stumped most
of you. Can I thank you for coming to the Committee this morning.
It was fascinating and we look forward to maintaining our relationship.
Thank you very much.