Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1 - 19)




  1. Good morning, Mr O'Donnell. May I welcome you and your colleagues to this session on the pre-Budget report. Could I ask you to introduce yourselves.

  (Mr O'Donnell) Certainly. I am Gus O'Donnell, the managing director of the Treasury in charge of macroeconomic policy and international finance. On the far left is Nicholas Holgate, who is the director of Welfare reform; next to me, on my left, is Adam Sharples, who is the director of public spending; on my right is Alex Gibbs, head of tax policy; and next to Alex is John Kingman, who is the head of productivity.

  2. Thank you very much. I will just lead off with a general question. Can you tell me what degree of uncertainty you were working under for the pre-Budget Report, given the current economic situation, and to what extent the Treasury has sought to address these uncertainties in the policies and in the forecasts in the pre-Budget report.
  (Mr O'Donnell) Certainly. I know it is a cliché of forecasters to say we are entering a period that is more uncertain than usual. Quite often that is not the case but actually for this forecast it certainly was. What happened, particularly post the tragic events of September 11, if you look at the spread ( the range of forecasts for 2002) was that suddenly the standard deviation of those forecasts increased by about 40 per cent, so there was a big increase in the range of uncertainty about what would happen next year. That does make forecasting much more difficult. So the big change post-September 11 was a slight reduction in the forecast level but a very big increase in uncertainty. In terms of how our policies respond to that, clearly I would say that probably our forecasts for next year should be regarded as having a wider error band around them than normal. It also means that it is more important than ever that we adopt a cautious approach to managing particularly the public finances. Our procedures allow us to do that because we build in caution in a whole range of ways; for example, by using the bottom end of our opportunity range of growth forecasts and also by the NAO audited assumptions which build in a degree of caution. The degree of caution built in was much higher at PBR time simply because of changes to things like equity prices.

  3. The Treasury forecasts have always been seen to be conservative, in that you have attained those quite comfortably, and there has been comment on that. Given the projected growth forecast next year of 2¼ per cent, do you feel very confident that that can be reached?
  (Mr O'Donnell) I think there are two parts of the forecast that you need to distinguish. First of all, there is the forecast of the economy, where our forecasts attempt to be central, in the sense that we operate a range but the centre of that range is our best-guess as to what is going to happen to the forecast. It is certainly true there that we are slightly more optimistic than the consensus, but it is really a very small margin between us and the consensus, particularly if you think about that wider error band that I was mentioning because of the greater uncertainty. It has turned out, if you look back at pre-Budget reports, the 1997, 1998 and 1999 ones, that certainly in all those three cases our central economic forecast was slightly above the independent consensus forecast, and that turned out to be the correct place to be. The forecast for this year, the pre-Budget report for the year 2000, we were slightly more pessimistic than the independent consensus, and, again, that turned out to be the right place to be. I think at this point you need to put up one of those little stars, like they have in those adverts for financial companies, that says "Past performance may not be a guide to future outturns" because it is a very uncertain period and this is a particularly difficult time for forecasting. That is the economic forecast. On the fiscal forecast, as you rightly say, things have turned out better than we thought. That is not unexpected because we do not go for central fiscal forecasts; we actually attempt to be cautious and we expect the outturns to be slightly better than we forecast. As I say, that degree of caution is built into the way we do our forecasts and we hope that that will happen through time, that things will be slightly better.

Dr Palmer

  4. You expect growth to "move temporarily above its trend rate from the middle of 2002" and a further rebound in 2003. What will happen to growth in the first half of 2002?
  (Mr O'Donnell) We do not publish quarterly numbers but certainly we would expect there to be a slowdown there.

  5. In growth or . . . ?
  (Mr O'Donnell) In growth, that is right—in the light of a slowdown in the world economy most certainly.

  6. Would you actually think it quite likely that there will be a slight decline in the first half?
  (Mr O'Donnell) I would think that unlikely. Certainly that is the view of the consensus, the IMF, the OECD and the National Institute.

  7. The IMF, OECD and especially Goldman Sachs are predicting an overall growth rate next year of about one per cent less than the central Treasury forecast, so they are looking at 1.4 to 1.8. You are saying today that they are predicting positive growth in the first half. Just trying to make the figures come together, does that mean that you think that the Treasury is predicting a stronger rebound in the second half than they are?
  (Mr O'Donnell) I would stress that the differences between these numbers—you know we are talking about 2 , the IMF is 2.1, independent consensus 1.9—are really small compared to, you know, the difficulty of forecasting in a world environment where we are seeing the first synchronized downturn that we have seen for the big three areas since 1974. So I would not put too much store in these relatively small differences in forecasts.

  8. Just to clarify, there is a difference between the brief that I perceived and what you have just said, that the independent consensus is around 1.9. I have figures of 1.7 for the European Commission, 1.8 for the IMF, 1.7 for OECD, 1.4 for Goldman Sachs.
  (Mr O'Donnell) The Treasury publishes an independent consensus which puts all of them together, like Goldman's, JP Morgan's and all the rest of them. That November publication showed an average of 1.9 per cent.

  9. Given the shallowness of the slowdown that you predict, the relative shallowness, what factors would you expect to cause the above trend growth in 2003?
  (Mr O'Donnell) If you think about what the nature of this slowdown is, basically it is a slowdown caused by exogenous factors. It is a world slowdown. The US, Japan and the Euro area are all slowing down at the same time. That has hit our export markets quite hard and so that causes a slowdown. Also, on top of that you have the effects of September 11th and their impact on business confidence. What we would expect to happen is particularly for investment decisions to be delayed—it is not that they will be cancelled, but they will be postponed for a while. Because of this increase in uncertainty, because of the higher risk premium people will wait to see what will happen. For a while we would expect slower growth, and then, towards the second half of this year, as some of these uncertainties are resolved, we would expect a pick-up. Also policy is kicking in. The Monetary Policy Committee started cutting interest rates in February. They have cut interest rates now by 200 basis points; seven times. That sort of monetary policy response should lead through to a response in the economy over the 18 months to two years post those changes. So monetary policy should start to kick in and the fiscal policy will be supporting that through that period, so that is why we would expect a recovery through the second half of next year.

  10. It is not true that interest rates in real terms are actually still quite high because of the low rate of inflation?
  (Mr O'Donnell) You have got 4 per cent nominal interest rates and inflation is not that far away from target. If, as the markets expect, inflation is over the medium term 2½ per cent, we are talking about 1½ per cent real rates, so that is, I think, quite low.

Mr Tyrie

  11. Could you say a little bit about the US situation. First of all, how big is the impact of what might happen in the United States on the UK economy? Is it the biggest single factor?
  (Mr O'Donnell) No. When we do world export markets we weight them altogether. The Euro area is about 50 per cent of our tradeables so the Euro area accounts for more, I would say, than the US. How big an effect will it have? We are bound to be hit by a US slowdown, particularly, as I said, through the effect on our export markets. We were expecting the US to slow down and our budget forecasts were built around a slowdown in the US, but obviously the effects of September 11th were not something that we forecast so it has turned out to be rather bigger than we thought. But we are assuming that there will be a sort of v-shaped recovery, with main areas of the world recovering in the second half of next year. So the US, yes, does have a big impact but we are assuming again that the impact of policy feeds through. Whereas the MPC started cutting rates in February, the Fed started cutting rates in December 2000. They have had 10 interest rate cuts and they have cut interest rates by 440 basis points and they are now down to 2 per cent. If monetary policy works, we would expect that to cause quite a big turnround, and, on top of that, they are having discretionary fiscal loosening.

  12. Does it not give you some cause for concern and make you just a little bit sleepless at night the thought that you have put out a forecast of 2½ per cent at a time when the world's three biggest economies have all decided to go south: one of them is already and has been for a decade in serious recession and America is going to join it and we have got a bad reports in the FT today about Germany. There has never been a time, has there, where Britain has avoided getting itself into difficulties when these three have been in recession?
  (Mr O'Donnell) As I said at the start, this is the time when, asked to do a forecast, you might want to answer "Pass" because there is a much higher degree of uncertainty now. But certainly we are thinking that economic policy works. The monetary policy responses we have seen in the Euro area, through the European Central Bank, and by the Fed, and the fiscal actions that have been taken will turn things round. Japan is a special case I think. What I have said about policies turning things round does not apply in Japan—I mean, they are almost attempting to explain to us why all these curiosities in economics text books are in fact true. They have got a Keynesian liquidity trap, so they cannot lower interest rates, and on the fiscal side they are proving that Riccardian equivalence actually holds, that when they try and stimulate through fiscal policy consumers offset it, and so we end up with a situation where neither policy is particularly effective. So we would not assume that there will be a big turn round in Japan. Overall, though, I would expect those other areas to come back and we have had very aggressive, very early policy responses. That is what we expect to happen. I would not take forecasts to the nearest point very seriously, but it is true that the OECD, the IMF and the rest all think that the UK will be the fastest growing G7 economy next year, and I think that result is rather more robust.

  13. There have been reports in the newspapers over the weekend that a lot of the fiscal relaxation in the United States is going to get tangled up in wrangling up on the Hill. If that does not materialise, how will that affect your forecast? What weight do you attach to the fiscal as opposed to the monetary action that has been taken in the United States?
  (Mr O'Donnell) I put a lot more weight on the monetary than the fiscal side for two reasons. First of all the monetary loosening has happened, it is definite, it is there. They have already cut interest rates to 2 per cent and I think you can already see areas in which that has affected the economy. On the fiscal policy front, I am personally not a believer in fiscal activism, that you can actually manipulate fiscal policy and fine tune it to manage unexpected events. Whilst I think fiscal policy will be overall supportive, we have not factored in that bigger packages will come through, and also, even if they come through, you do have to accept that there may be some offset in the economy.

  14. You are saying that your forecast is predicated on the view that the fiscal package in the United States does not materialise.
  (Mr O'Donnell) No, I did not say that. What I said was that I think fiscal policy actions will not have as much impact as some people are thinking. We are expecting there will be some sort of fiscal stimulus that will come through, but I think the more important element for US recovery is monetary policy.


  15. What are you doing to address current account deficit?
  (Mr O'Donnell) We are trying to increase the productivity of the UK economy, I think is the long-run answer to that, which I think is the best, and by having a macro framework that is stable. I think part of the problem has been caused by particular exchange rate relationships and there is a limit to what we can do there. If you look back on it over the last three years, what has happened is that sterling has fallen against the dollar but the euro remains very weak, and that is the real problem in terms of our current account deficit. If the euro were to move back to what might be a more sustainable long-term level, then that would help certainly.

  16. Tax receipts as a share of GDP are now projected to be 0.7 and 0.9 percentage points lower in this and the next financial year respectively compared with the Budget forecasts. Does this indicate the sensitivity of the tax base to changes in the economy? How much of the decline in forecast receipts is due to cyclical, and how much to structural, factors?
  (Mr O'Donnell) The tax/GDP ratio is affected actually on the numerator and the denominator. If we take the GDP numbers first of all, the Office For National Statistics, when they published their Blue Book in the autumn, revised the GDP numbers really very substantially, back to 1992. They changed the path of UK economic history somewhat and those GDP numbers revised GDP upwards. The tax numbers on the other hand, our tax receipts estimates, have been revised down, so you end up with a lower tax/GDP ratio there. In terms of the second part of your question, which was about how much of the revision is due to different aspects of the cycle—

  17. The cycle or structural factors.
  (Mr O'Donnell)—if you look at table 2.4 in the pre-Budget report, page 23, there is a decomposition there of the factors behind the changes to our receipts comparing the Budget forecasts with the pre-Budget report forecast. We have split it down into the impact because of a different GDP estimate, and then the impact due to audited assumptions (the NAO audited assumptions) and financial companies. There the GDP effects are, in 2001-02, we expect, due to the GDP changes, about one billion; in 2002-03 about two billion; and the other factors are mainly to do with these more cautious NAO audited assumptions. Because of the rules we have on how we forecast, for example, equity prices, that creates a reduction in our revenue forecasts. For example, when we did the budget, the NAO assumption for equity prices going forward is that we have to assume that wherever they are they will carry on forward in line with money GDP, and they were up there at Budget time. The bubble bursting in equities has meant they have come down quite a way and we have to assume now that they have moved to that lower level. That means that we automatically have lower forecasts of stamp duty receipts, capital gains tax receipts, inheritance tax receipts. It feeds through in some ways to corporation tax receipts as well. So this extra caution that is built in has the impact of lowering our receipts numbers, and we have decomposed it in table 2.4.

Mr Fallon

  18. Can we turn to public expenditure and perhaps give Mr Sharples an outing. Can we just deal with the preparation point. At what point were the health department told of the Chancellor's conclusions to be announced on the Tuesday?
  (Mr Sharples) I do not know exactly at what point. As you will appreciate, discussions on preparation of a package of this kind take place over a number of weeks leading up to the announcement. This is an iterative process that goes on over several weeks.

  19. It is possible the Health Secretary did not know on the Monday what was going to be announced on the Tuesday.
  (Mr Sharples) I cannot comment on precisely what point the Health Secretary was aware of these changes. As I say, this is an iterative process which goes on over several weeks leading up to the announcement.

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