Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 40 - 49)



  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.

Mr Cousins

  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 likely.

  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 worse.

  43. We should ask all our experts where they stand on the euro.
  (Mr Bootle) That is a completely different issue!

Mr Tyrie

  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 difference—0.1 per cent—you 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.

Mr Laws

  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.

Mr Tyrie

  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.

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