Memorandum submitted by Professor Andrew Scott, Department of Economics, London Business School
SUMMARY OF REPORT
The picture presented of the economy is one where external demand is weak, albeit expected to recover during 2002, and investment also expected to show only weak growth. The only source of growth comes from consumption, particularly consumer durables. The strength of this consumption growth so late in the cycle is implicitly seen as a puzzle but the committee believes that the recent reduction in equity values and the slowdown in earnings growth should be sufficient to lead to a consumer retrenchment. Given this strength in consumer demand, lowering interest rates seems inadvisable. Raising interest rates are suggested if consumption does not slow down on its own accord but the risk of raising rates now is that it may lead to a sharp contraction in demand which would lead to a fall in sterling and inflationary pressures. The result is interest rates on hold but a `watch' put out on consumption numbers. Since the report the most recent retail sales numbers are suggestive of a consumer adjustment and if this trend is backed by further statistics it would suggest that the immediate risk of higher interest rates has passed.
Two Speed Economy
Much has been made in the press regarding the differing performance of the manufacturing and service sector. However this is easily explained. With manufacturing accounting for around 60 per cent of UK exports and the world economy growing only slowly the manufacturing sector will obviously struggle. With a substantial part of the service sector focusing on non-tradeables, as the UK economy continues to grow reasonably well this supports the service sector. Note there is little the MPC can do to alleviate pressures in manufacturing. That requires an improvement in world economic growth which is not influenced by UK interest rates.
However, there is another dual feature of the economy which the report focuses on in detailthe huge difference between goods inflation and service inflation (see Chart 4.8goods inflation = 0 per cent, services = 4 per cent). Service sector inflation is invariably higher than goods inflation. Service sector productivity gains tend to be less than in manufacturing and so in order for service sector earnings to grow at the same rate as manufacturing wages, prices of services have to rise faster than those for goods. However, this normally produces service inflation around 2 per cent above goods inflation. The current 4 per cent differential is extremely high. This implicitly suggests concern that service sector wages may be rising too fast.
As shown in Chart 2.2, consumption growth accounts for the vast majority of current GDP growth (around 90 per cent). Particularly striking is the dramatic increase in durable consumption growth (see Table 2.B). Related to this is the strength of the housing market. As shown in Figure 5.1 the house price/income ratio currently stands at 5close to historical highs. Houses are a durable good so this high price-income ratio is a symptom of strong consumer durable demand. But high house prices also help fund equity withdrawal which can be used to finance durable purchases.
Strong durable growth (and low savings) can be produced by some combination of I) low interest rates II) high expected earnings growth III) high wealth IV) low durable prices. Currently only I) and IV) still hold so the Bank expects consumer spending to slow and savings to rise as consumers cut back on their borrowing. If consumption continues to grow strongly (and house prices remain high) without strong income growth then consumer debt would be too high (leading to fear of a sharp correction and falling exchange rate) and inflation at risk.
There are signs that savings rate of consumers is increasing but to what level do MPC members think it needs to adjust given the fall in wealth and slowdown in earnings growth? To what level does the house price-income ratio need to fall to for this adjustment process to be complete?
Two areas of concern regarding fiscal policy occur to me whilst reading this report.
(a) The MPC focus frequently on the risk of a sharp decrease in consumer borrowing (increase in savings) potentially leading to a sharp fall in sterling. Might not an increase in government spending offset this risk to sterling?
(b) Public sector earnings growth is now higher than private sector earnings and is rising fast. Does this present any inflationary problems?
Chart 1.2 is displayed in a prominent position and is used to suggest that monetary indicators have a useful role to play in predicting future inflation. This seems to be a persistent theme in recent Bank publications but seems to represent a slight departure from early days of inflation targeting. It also strikes a chord with the ECB's policy of giving special emphasis to monetary targets in its setting of interest rates.
It would be interesting to know what status the different committee members gave to this monetary indicator and any similarities they perceived with the ECB.
On page 45 the report states that as arguments can be used in both directions they assume that the trend rate of growth for the UK has remained unchanged. This idea is further supported by several references to a belief that investment will remain flat over coming quarters due to over optimism during the previous boom and excessive capital accumulation.
However clearly some of the MPC believe the trend growth rate has increased. In the past this has been due to New Economy/Technology factors. But this report raises an additional factorimmigration which leads to faster labour supply growth and so faster GDP growth.
This suggests that the trend rate of growth is either unchanged or increased. By assuming it is unchanged the committee may be following convention but run the risk of overestimating inflation risks. Either the committee is right about trend and inflation comes in on target or they are wrong and stronger trend growth produces lower inflation. There is potentially a bias here towards undershooting.
The GDP and inflation charts show a somewhat unusual combinationthe inflation forecast is skewed upwards while GDP growth is skewed downwards. I assume this is based on the belief that a sharp slowdown in GDP growth will trigger consumer adjustment, higher savings and so a fall in savings.
Given the issues outlined in the report these forecasts are understandable. I would just note two points:
(a) There would appear to be no probability of an outright recession (e.g negative GDP growth). 1 per cent growth seems as bad as it gets.
(b) The MPCs estimates of the upside risk of inflation is high. The only reason for this is I assume the fear of sterling devaluation. I don't want to accuse the MPC of tilting at windmills but with concern over the world economy, with consumers expected to retrench and some arguments expressed that trend growth may have increased I am a somewhat surprised at the extent to which the inflation risks are skewed on the upside. It is these skewed inflation risks that seem to persuade the MPC of the need to hold rates but the skewed downwards GDP forecast might suggest the need for lower rates.