Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 50-59)




  50. Good morning, Governor, to you and your colleagues. It is my pleasure to welcome you to your first session of the new Parliament. For the sake of the shorthand writer, would you identify yourself and your colleagues.

  (Sir Edward George) Thank you, Chairman; it is a great pleasure to be here. On my far right is Sushil Wadhwani, next to him is Ian Plenderleith, then Mervyn King who is the Deputy Governor with responsibility for monetary analysis; Kate Barker is on my left and Chris Allsopp is on my far left.

  51. There are a number of areas which we will take up this morning, not least the recent policy decision for the inflation and growth forecast as well as the public financial projections and the outlook for international policy exchange rate. May I start by a general question. Since your last appearance before the Committee, much has happened within the world not least 11 September but, as you know, things were happening before 11 September as well. Could you explain how the MPC has reacted to these events and what you think as to how the UK economy is shaping up.
  (Sir Edward George) The things that have happened have been very largely international and, before 11 September, I think it was very clear that the global economy was experiencing a substantial slowdown: it had been particularly marked in the United States but, in the summer, it was becoming apparent the Euro zone and Japan also was going through a protracted period of weakness. At the same time, we had this persistent weakness of the euro, strength of sterling against the euro, whichever way you like, so that we were subjected to those international effects. I think that our view as of 11 September was that we were around the low point in terms of the global economy, that we would not see much growth in the second half of this year but that, going into next year, we would see very gradual pickup, certainly in the United States but also in the Euro zone. The 11 September really could not have come at a worse time because of that kind of context and the impact of 11 September has been to deepen the slowdown and prolong the slowdown so that now we are looking towards negative growth in the second half of this year, perhaps extending into the early part of next year, with a pickup delayed probably until the middle of next year, though possibly the pickup may be a little stronger than we had anticipated earlier. So, that makes life extremely uncomfortable for us. One might have expected that, with the kind of pattern of growth in the world economy, you would have seen the euro recover somewhat, that is something that we have been looking for for some time, but that has not happened either, so we are exposed to these very cold winds blowing from abroad. Our reaction has been very much to try to offset those cold international winds by sustaining demand in the United Kingdom. In this environment, that means consumer demand because business demand is obviously influenced by the international environment to a much greater extent. Up until the third quarter, we have been reasonably successful in seeing strong growth in consumer spending and that has actually protected the UK economy as a whole from the external influences. The point is that neither we nor government can directly address the causes of these dampening influences and so we have to try and offset them and that is essentially what we have done operating, since 11 September, very much in the context of the damage to confidence which that produced: business confidence but, as I say, that is influenced by the world environment, but also consumer confidence which had been particularly important in sustaining the UK economy over the past several quarters.

  52. We took evidence last week from a number of economists and it was generally felt by all of them that the Bank's consideration of the future is a little optimistic and that they felt it was on the downside. One in particular, Roger Bootle, mentioned that whilst the MPC felt that risks to growth were balanced and the risk to inflation was on the upside, he was very firmly of the view that risk to both was on the downside. Would you comment on that.
  (Sir Edward George) Chairman, it is very well known that every economist has two points of view on everything, so it is not surprising that you will get different opinions from different economists. Indeed, here we disagree about details. I think it is important to know precisely when people are making their forecasts and what are the factors that are influencing them. It is perfectly possible that what Roger Bootle says is right, but we can only take our own best view which is what we do and that is reflected in the Inflation Report.

  53. Talking about economists with different points of view, can I turn to Dr Wadhwani. In your recent speech in Edinburgh, you criticised the Bank's model. Why do you think it is wrong and why do you think that the Bank have not adjusted their model in the way you suggest?
  (Dr Wadhwani) Chairman, I think my speech was not quite phrased in the way that was couched in your questions, although it is true that some of the newspaper coverage was couched in that fashion. What I was trying to do in that speech was essentially justify my view that the risks to inflation were on the downside and why my personal projection for inflation was lower than the best collective projection. It is natural, as the Governor, has said for economists to disagree about issues that are necessarily uncertain, but the main point that I was making was that, in my personal opinion, some of the forecasting errors that we have seen in the past should essentially be addressed in a particular way and I was pointing to that evidence of forecasting errors as evidence that, in the past, we have potentially over stated inflationary pressures and that we might still be doing so, and my favourite explanations for that were that it is possible that we have paid insufficient attention to the impact of globalisation and the global dis-inflation on domestic inflation and also that capacity utilisation might be lower than we had thought until recently. These are all very uncertain issues. I think it is perfectly reasonable for people to disagree on these issues and I was just raising these issues, I was not in any sense criticising anybody. I should also say that these are issues for ongoing debate and for ongoing research, and I was essentially just saying that this was something we were looking at rather than criticising anybody.

  54. You are generally known as what could be described as a dove on the Committee and, if we look at the trend of your recommendations, there is a view that the MPC have caught up with you three months later in terms of what they are going to do. If they had caught up with you at that time and there was not the three month lag, where would we be now with the economy?
  (Dr Wadhwani) What I should say, Chairman, is that I have never liked the term "dove" because it sort of implies that I am somehow genetically predisposed to voting that way while I like to think that when I decide to vote in a particular direction, I am making judgments on these uncertain issues. If you look at my track record, ever since I joined the Committee, I have voted with the majority on all occasions but one until December 2000. It is really only since December 2000 that I have tended to vote for more significant interest rate cuts. That change in stance or that change in behaviour was driven very much by a judgment, a judgment made in a very uncertain climate, that it was likely that the international slowdown would be quite acute, and that judgment was made on the basis that, when bubbles burst, historically the slowdowns that occur after the bursting of the bubble tend to be quite long lived, in part because you get an investment overhang which takes a while to work off. These are all very difficult judgments to make and it is perfectly reasonable for people to disagree on the basic judgments let alone timing. Therefore, I would not make too much of the time lags that you may have observed. Obviously, with the benefit of hindsight, if we had essentially cut rates at the pace I desired, it is possible that we may have needed to do less now. That is always the standard argument for preemption, but that it very much a statement made with the benefit of hindsight.

  55. Before passing on to my colleagues, do any of the witnesses share Dr Wadhwani's concerns?
  (Sir Edward George) I am not sure that I see that question in that way. With regard to "concerns", I think we all have the same concerns, we are all trying to do the same thing. I think that, as Dr Wadhwani said, it is really judgments and, on the whole, these are pretty marginal judgments compared with most times in the past. I think that the range of opinion is very narrow. You referred to other forecasters/other economists in your opening question, and I was just checking with the account of other forecasts in the Inflation Report and, if you look at those—and that is an assessment of quite a significant number of forecasters, 23 I think—the differences are actually pretty narrow between them and actually between the average and our own view really very small indeed. Of course, we are always all the time trying to get things better, trying to make better informed judgments and, in that sense, I think we all share Dr Wadhwani's concerns, but the precise judgments is where we have differences and I think it is a very good thing that we do because that is the point of having a committee of nine individuals who can bring to bear these differences of view in order to produce something which is not out on a limb.

  56. Kate Barker, did you wish to come in on this?
  (Ms Barker) In one sense, I think that what I want to say has already been said by the Governor, which is that obviously we all share one of the concerns that Dr Wadhwani raised regarding whether there is something that is not quite right in the model. We all want to get it right while, in the background, in some sense we recognise that we are never going to achieve that fully and the idea that there is some perfect model of the economy that we are going to find is clearly a myth. I certainly share that concern. More specifically, at the moment and through this year, I have also shared Dr Wadhwani's concern about the global economy and the potential for the weakness of the global economy to have perhaps a slightly greater effect on the UK and, in that sense, I shared his concern and shared that risk that was identified in the inflation report.

Mr Laws

  57. Governor, I want to look at the recent decision to cut interest rates in November and the aftermath of that. Obviously the rate cut was welcome and perceived to be a response to the global slowdown in growth and the implications of that for inflation, but I think people were a little surprised by the tone of some of the inflation report when it came out and some of the comments that Mr King made which were quoted in the newspaper and at the press conference afterwards. You probably have a copy of the November inflation report and can I just take you to the overview at the beginning of it and page iv because, right at the end of that overview, there are two sentences that stand rather strangely together. In the middle of the last paragraph, it is noted, "Without further action, there was a risk that inflation would significantly undershoot the target over the next two years and that activity would be lower than necessary" and presumably that is the reason why you cut rates as a group. However, if you look at the end of the paragraph above that, there is a rather different tone because it says, "In the Committee's judgment, the overall risks to growth are roughly balanced, although the overall risks to inflation are on the upside", which seems odd. Do those two sentences stand happily together? Can you reconcile them for me?
  (Sir Edward George) If you take the second sentence and its comment on growth and you compare that with the risk that activity would be lower than necessary, that is without further action. I do not have any difficulty in reconciling with the central expectation. I think the view of the Committee was that, given the action that we had taken, the risks to activity were neither upside nor downside.

  58. Is that not slightly odd? Are you saying that the Committee decided to cut interest rates because you were concerned that inflation might undershoot but that, now you have cut interest rates, your concern is that inflation is on the upside?
  (Sir Edward George) No. As you know, there is always a distinction between the kind of central projection which is the centre of gravity on the Committee and the risks around that projection. The distinction technically is the mode and the mean of the projection and that is a factor which is always there. What we did was to take the action that we did. Not mechanically in response to the forecast but informed by the forecast and informed by our individual views of where we were around the forecast and reached the conclusion that what we needed to do in order to produce an inflation projection over the two year period as a whole was to reduce interest rates. That actually is designed also to protect us from an unnecessary weakening in activity because what we were really trying to do was to keep demand in line with the underlying supply, so I do not find that there is any inconsistency.

  59. Is it your view now that the risks to inflation are on the upside?
  (Sir Edward George) The reason why we built in the risk to inflation in that way is very much on a view about the exchange rate. We have been consistently puzzled by the sustained weakness of the euro and the strength of sterling against it. We think that is not a situation which is likely to persist in the long term, but we have no means of actually judging when that is likely to happen, when a recovery in the euro is likely to occur, so we cannot build it into a kind of central projection but we can have that risk reflected and, if that were to happen and if it were to be sudden and significant, then you would get an inflationary impulse coming from that factor and I think that is the reason why, among all the risks, that pushes the inflation risk onto the upside.
  (Mr King) Can I just direct you to Table 6.A on page 56 which I think answers your question exactly. As the Governor said, before the policy change was made, the outlook for inflation was that, even under the central projection, it would clearly undershoot the target looking two years or so ahead. Having made the 50 basis point cut in interest rates, the central projection was itself still slightly below the target but with the risk on the upside to that, leaving the overall balance of risks remarkably even. If you look at Table 6.A, the top panel of that table headed "RPIX Inflation" in the final row, the outlook for inflation in the fourth quarter at 2003, looking ahead two years, if you look at the probability of inflation falling into different ranges, between 2 and 2.5 per cent, 24 per cent, and 2.5 and 3 per cent, 22 per cent, so very even around the target of 2.5. If you go out a little further to the 1 and 1.5 per cent on the downside and 3 to 3.5 on the upside, 16 per cent in both. So, having made the rate cut, the balance of risks to inflation is actually pretty even.

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