Memorandum submitted by Professor Christopher Pissarides, London School of Economics
The February Inflation Report contains a mixture of optimistic and pessimistic projections and comments. They reflect partly conflicting views within the MPC and partly some inconsistencies between the projections of the November Report and the actual outcomes of the key economic variables in the UK and the world economy. The November Report was more optimistic than appeared warranted at the time. The outcomes since November have been a little worse than predicted in the last Report, despite new signs of recovery. The February Report deals with the difficult task of reconciling its own optimistic projections with the recovery signs that are only now beginning to appear.
On the one hand, the Report points out that there are signs of increased optimism in financial markets, particularly in the steepening of the yield curve, which reflects the expectation that interest rates will rise sooner than had earlier been factored in. It also points out resilient consumer demand at home and signs that the world economy is recovering. On the other hand, members of the MPC are surprised by the resilience of consumer demand and expect it to slow down, and see disappointing business investment projections.
These apparent imbalances are expected to lead to a worsening of economic performance in the immediate future but recovery in the medium term (late 2002 or early 2003). There are no new inflation pressures, except for recent house price rises, which are not expected to continue. The fact that interest rates were not changed at the February meeting hints that official interest rates may have bottomed out. It is interesting that in December two members voted for a reduction in interest rates but in January the vote not to change interest rates was unanimous.
The labour market was showing mild signs of slowdown at the time of the last Report. They have continued to be present in mild rather than accelerating form. Employment remains high by historical standards and the rise in unemployment has been small. Perhaps surprisingly, given the (only) moderate rise in unemployment, private-sector earnings growth is showing clear signs of decline. The decline was sufficient to offset any aggregate inflationary bias from the larger public-sector pay awards. The level of settlements that are being negotiated currently, the time of year when most pay awards are agreed, is crucial for the feasibility of the above-trend rise in public sector pay and the MPC's inflation projection. The Report indicates that settlements agreed so far this year have been moderate.
The Report's November projections for costs turned out to be too high. The growth in costs in both manufacturing and services remained below expectation because of a fall in the prices of raw materials and imported goods. The fall in the price of imports was especially sharp. Although these more-than-expected falls may appear to point in the direction of further reductions in interest rates, members of the MPC saw the impending recovery in the world economy and the imbalances in the UK economy as countervailing forces.
The imbalances in the UK economy are a major concern to the MPC. The main imbalances are: buoyant consumer spending versus falling investment spending. Services and housing are benefiting, export-oriented manufacturing is suffering. Consumer debt is building up, house prices are rising but asset prices have not yet shown clear signs of recovery. The risk from such imbalances is that consumer debt builds up to an unsustainable level and "bad loans" begin to make an impact on the banking system. A cut in interest rates would intensify this trend, as mortgage outlays decline and liquidity in private hands increases. This is a further reason why I think that interest rates may have bottomed out for a while.
17 February 2002