Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1-19)




  1. Can I give a formal welcome to all of you. I believe that Chris Pissarides is coming at 10.30 and, Roger, you have to leave by 11.10; so we will get on with matters. Can I ask you to introduce yourselves for the record.

  (Mr Barr) I am CiaĞran Barr, Chief UK Economist, Deutsche Bank.
  (Mr Bootle) I am Roger Bootle from Capital Economics
  (Mr Scott) I am Andrew Scott, London Business School.
  (Ms Rosewell) I am Bridget Rosewell, Volterra Consulting and economic adviser to the British Retail Consortium.

  2. Thank you all very much. I have a general question to ask of all of you to begin with and that is to ask, what are the main challenges the MPC faces over the coming months?
  (Mr Barr) I think it runs through the inflation report and also the latest minutes which are part and parcel of the inflation report. There is a constant theme of the UK consumer and where that is going to lead us over the next year or two. We have seen unprecedented strength in the consumer for a long period of time, co-existing with a very weak corporate sector as you all know, manufacturing in particular. That imbalance in the economy is posing quite significant headaches for the MPC going forward. I think what they are trying to judge is whether the consumer is going to slow of its own volition at the same time as hopefully the rest of the economy picks up in line with the global economy, or whether they actually have to start setting monetary policy to engineer that consumer slowdown. The problem with dealing with some of these unknowns is, do you go too far? Do they tighten too quickly. Does that lead to doing too much too late and so on? I think that is really the major policy issue that is facing the MPC. One final point before I pass over to Mr Bootle on this topic is whether there is genuine inflation in the system as a result of this consumer strength. I think the January inflation figures came as a shock to most. I am still quite optimistic on inflation, quite sanguine, but if there is genuine inflation pressure in the system co-existing with a strong consumer, then that is definitely the major policy issue going forward.
  (Mr Bootle) I think I agree with more or less everything Mr Barr said. The main issue for the MPC is the strength of consumer spending and what view it should take on whether that is going to ease of its own accord or not. In many ways, I think this issue has replaced the exchange rate as a major source of uncertainty. For a long period, the MPC argued that there was a big fall of the exchange rate out there at some point or other in the future; it could not tell when this was going to happen and indeed, in some cases, if it was going to happen. This was the main question, the source of uncertainty. That is still there to some extent but it has moved off-stage. What has moved centre stage to take its place is this question about the consumer. The difficulty for the Bank is that it is quite clear that the strength of consumer spending is unsustainable. That is not the issue. The issue is, is consumer spending going to ease back of its own accord or is it going to need a big kick from the Bank of England? If it is going to ease back of its own accord but the Bank nevertheless gives it a big kick, then of course it could end up with a very weak economy indeed. There is another issue which I think has not received enough attention which I would like briefly to refer to and that is the question of Britain's potential membership of the euro which does not feature at all in the inflation report and it seems to me, bearing in mind Britain's monetary history, which is after all one of great periods of instability and changes of regime, the fact that we may or may not be facing a referendum in the not too distant future within the MPC's forecasting horizon is a very significant issue and one understands the difficulties and uncertainties of addressing this. Speaking from my own slot outside the MPC, I see it as the basic question and the potential threat to the stability of this regime.
  (Mr Scott) I do not want to give you the picture of three economists agreeing but I have to say that I concur with my colleagues that consumption clearly is the main concern certainly at the moment for the MPC and I think that is also linked in with their concern about the exchange rate. One of the things that I do find slightly puzzling in their forecast is how skewed on the upside the inflation range is and that seems to be justified by their concern that a sharp consumer retrenchment would bring about a fall in sterling. I think the big issues are the strength of the consumer, will they adjust on their own, will they need higher interest rates to provoke an adjustment or, if they do adjust, will it be very pronounced and will that run a risk of sterling falling? I think there are a couple of others which have perhaps been glossed over a little in the report. It is taken for granted that the world recovery is happening nicely, that the USA is going to do all right and that Europe is going to be doing OK. I am not sure that we can take that quite as much for granted, certainly not in Europe. If, however, the world economy is picking up and if we are near a turning point, then I think that the question which is also at the back of their mind is how fast we will grow when recovery picks up again, and that goes back to the debate amongst the MPC members about whether or not you believe in supply side change or not and whether the trend growth has changed. I think that is the other issue.
  (Ms Rosewell) Boringly, I have to agree with my colleagues as well! I think that the issue on the consumer side is not just, will unsustainable growth in spending moderate but what impact this is having on inflation, because it is after all inflation for which the MPC had a target. I think myself that the difficulties of getting seasonal adjustment right in December and January for what is happening to sales and indeed what is therefore happening on the inflation side suggest to me that the surprise up-tick in inflation in January may well be overdone. In other words, they are getting the split wrong between what is happening on the volume side and what is happening on the prices side. Certainly from talking to retailers, what they are saying is, "Yes, in January we did not do as much discounting as we did in the previous January." That is partly because sales were strong in the Christmas period and also because of previous experience; stocks were much lower and therefore there was less left over to experience the discounting of the January sales, and so that has been less important than it was a year ago. I do not view that as saying anything fundamental about what is happening to inflation as I view the January figure as an aberration in that sense and the continued pressure as far as retailers are concerned, certainly in goods, things that are sold in shops, is that people go shopping and expect to pay no more than what they paid before and probably to pay less than they paid before for a given set of goods. Within that, of course there are things which are going up and things which are coming down due to life cycles in products and so on. Nonetheless, there is no sign, in spite of the strong sales, of any acceleration in retail prices. They are pretty much flat. Spending growth seems to go on at a remarkably steady rate, indeed an unprecedentedly steady rate as far as the results from retailers are concerned, but with no increasing pressure on prices that one can really identify. So, if it is unsustainable, it is unsustainable in the sense but it still is not unsustainably generating price increases. So that is rather a difference from previous experience and raises in my mind a question about what we mean by unsustainable growth. The second part of that is whether that is in fact partly to do with exchange rates. If the exchange rate falls, then import prices will rise and that will generate price increases willy-nilly as far as goods prices are concerned or indeed services as well, and one of the things we discovered is that, certainly when the exchange rate rose, it seemed to have less impact than expected. It is not quite clear any longer what sensitivity to exchange rates is and we do not really know, because a decline in sterling has not happened for such a long time, what would actually happen to prices. Thirdly, I very much agree with Mr Scott that I think that the part one ought to continue to worry about rather more than the inflation report does or indeed anybody is doing at the moment is the world economy. We somehow seem to have slid through the post 11 September period and indeed a war with much less reaction either by world markets or indeed world economies than we saw in 1991 with the Gulf War. I am still somewhat surprised by that. Although in some ways it was a much more shocking thing to happen because it was so much closer to home, nonetheless the impact seems to have been less severe than it was on that occasion. I am not sure that any of us really understand why that is the case and I do not know if my colleagues have any views on that. Nonetheless, that risk of recession seems to have receded. There are signs of pick-up in the US. There is much less worry about recession than there was and I retain a sort of niggling worry that that revival of optimism is misplaced and that we will find that the consumer loses confidence because interest rates after all are not going to go on falling, unemployment is indeed picking up and, from it all looking OK, it could tip over the edge onto the other side.

  3. We can see the double dip in the USA.
  (Ms Rosewell) That is a possibility, yes. We still have the backwash from Enron, we have other major failures from companies, we still have lots of profit warnings, we still have jobs being lost. There are real things going on out there which nonetheless are not being reflected in the general sense of where the economy is going and I just find that a little surprising.

  4. Mr Pissarides, welcome. We asked what the major challenges facing the MPC over the coming months are. All the Panel are agreed on the issue of consumer debt and exchange rate was mentioned before you came in. Would you like to contribute an answer to that question?
  (Mr Pissarides) Yes, I would agree with that in that the two main challenges are: the imbalances in the economy and the buildup of consumer debt viewed against the decline in business investment; and the second challenge is to get the international economy right because I thought that the November report was more optimistic than was justified at the time but, since then, there have been signs of recovery. So, reading through the February report, I get the sense that the MPC are not sure as to whether they should continue with the same optimism that they showed in November given that they were a little bit too optimistic at the time or whether they should revise downwards. There certainly have been signs that the international economy has been recovering and the challenge is to see where that is going to go. Personally, reading the signs in the US economy and to a lesser extent Europe, I do not really see a double dip coming to the US economy that you have just mentioned. I think the Enron failure is big but the US economy can absorb that kind of failure easily enough, especially in the light of the speed at which it has absorbed the 11 September attacks and the war in Afghanistan. Again, it does not surprise me that the shock was not as big as the Gulf War because this time the war was not about oil, a major resource. The loss was horrible in terms of human life but, in terms of economics, it was certainly not as big as the potential loss of losing some of the very major oil supplies in the world. So, I do see the world economy recovering. Whether the MPC sees it in that light or not is a different matter. Reading the February report, I can see that they are seeing but at the same time they are not very sure about it. The main concern that is justified as being the main concern—I am concerned myself—is the way the British economy has been going. Are the imbalances in the economy because consumer spending has been growing and consumer debt has been growing? The danger there is that banks, in their keenness to lend to consumers, are not very careful about the quality of the loans they are giving and there is the potential of a buildup of bad loans which will eventually cause problems to the banking sector and that would be the worst case scenario where we could get into a banking crisis with the stock market not being able to recover as a result giving rise to a downward spiral in the financial markets. That is the real challenge that is facing the MPC. The question then is whether they can do much about it with their interest rate policy. Obviously reducing interest rates would aggravate this situation because it would put more liquidity into consumer hands. On the other hand, it would help business investment and it might help the recovery of the stock market, ie reducing business costs and increasing profitability. So, it is a real challenge.

Mr Tyrie

  5. Some of the information to back up what you are saying is on page 5, Chart 1.4 and Chart 1.5. The numbers are ambiguous, are they not? I would be interested to hear from anybody on this. It does not appear that the scale of the problems is as yet serious as it was in 1989 and in 1990 not remotely as serious. That is my first point and I would like your comments on this as to whether I am getting this right. Secondly, in any case, what turned that period into a crippling debt overhang for consumers was very high interest rates. Even if interest rates have to rise, and even if they doubled though I think that is highly unlikely but let us suppose that they did, they would still be at half the rates they peaked at in the last cycle. Therefore, should we be taking the Inflation Report's general view as right that although there is some cause for concern as something to watch, there is no cause for alarm—I think that is a fair summary of what they are saying here—or do you agree with Mr Pissarides that there is quite a lot to be concerned about?
  (Ms Rosewell) I do not agree with Mr Pissarides. I think that the level of interest rates and the exposure as far as the ability to service debt is concerned, which is illustrated in Chart 1.5 and indeed the mortgage variant of that chart that I produced in my note, suggests that, as is said there, the capital is increased. Nonetheless, the ability to service all of this has not actually risen since the mid-1990s as interest rates have come down. I agree with you that we are not going to go back to a period of interest rates at 15 per cent in the next couple of years, or even 10 per cent in that period. If they went up by one point, that would be a fairly substantial increase. So, that would not tremendously change people's ability to service those debts. The other possibility of course is that banks, as Mr Pissarides suggested, have become much slacker about the credit scoring and willingness to lend rules that they apply. Most banks and building societies remember only too vividly the escalation in arrears that they saw in the early 1990s and most are not yet operating the kind of credit rules that they did in the late 1980s. In other words, they have not been relaxed as far as they were on those occasions. Yes, unsecured lending has increased quite substantially, but the interest rates on that would be 8 per cent or 9 per cent but it would have been 20 per cent back in the early 1990s. Again, the exposure is nothing like that exposure and I do not think that we need to be worried about it quite as much. Just while we are on it, I also disagree with Mr Pissarides about the difference between the Gulf War and the war in Afghanistan. Yes, it is certainly true that, in 1991, it was a war about existing oil supplies rather than a war about potential oil supplies which is actually what at least some of the action was about, but one of the interesting things in 1991was that, when that actually happened, everybody dusted out their old models of what happens when you get a rise in the oil price and the 1973 and 1979 oil crises and none of these were of any use whatsoever because in fact the oil price did not increase. The difficulties in the early 1990s were caused just as much by people being unwilling to get on aeroplanes and being unwilling to sign contracts and not knowing what was going to happen and the shock which reverberated out from that, which is very similar to what happened post 11 September in that people did not get on aeroplanes and people did not sign contracts. Somehow we managed to muddle through that in a different way.


  6. Does anyone else wish to comment?
  (Mr Barr) May I just make two points on this consumer debt issue leaving aside the war aspect referring to Chart 1.5. It was quite interesting to me in that, if you look at when this capital gearing increased, a lot of it is post-MPC, and one of the things I have argued about in my note is this kind of recapitalisation effect that we are calling it which is something that one of the former MPC Members used to discuss. Basically, it is the idea that when the MPC was made independent, it kind of fundamentally changed consumers' outlooks on the future. It made us all expect lower interest rates going forward, both nominal and one could even argue perhaps in low real interest rates. In terms of the consumer, if you look since 1998, mortgage rates on new loans, so not the kind of standard variable that we see in all the ads but actually the rate that people are paying on new loans, has been in a very tight range with an average of 6 per cent. People's expectations in the mid-1990s were for much higher rates going forward because of the experience of the 1970s and 1980s. So, I think that one way in which people have reacted to this is just to assume that we are going to have mortgage rates staying at 6 per cent for the foreseeable future and, as a result of that, they have said, "We can borrow much more" and then what you get, because most of that goes into housing, it is inelastic supply, is that you basically bid up the value of house prices and bid up the mortgage debt. Now, you can argue that you should eventually reach this nice higher equilibrium at which point the whole process should practically dissipate. What is unclear is whether consumers have actually gone too far by borrowing excessively and pushing house prices up too far, and I think one thing about this chart that needs to be borne in mind about the income gearing aspect is what level of interest rates we are at at the moment. Interest rates are averaging close to 4 per cent in the fourth quarter; incoming gearing in line with this average is stemming from the mid-1990s. The problem is that, if rates start going up, you are going to push income gearing up, not as significantly as we had in the late 1980s, we are not going to have a doubling of interest rates, but it is how consumers respond to that. I was quite encouraged by the latest minutes which suggested—and seemed to bear in mind that the MPC are aware of this—two sentences, that we need to be aware that sensitivity to higher interest rates may have increased from this debt; secondly, it may be the proportional change in interest rates that matters rather than the absolute change in interest rests, which kind of gives me a little confidence that they are not going to push rates up too excessively.
  (Mr Bootle) First of all, a few words to back up what Ms Rosewell was saying. I very much agree with her that I do not think the consumer spending or consumer debt situation is anything like as alarming as Mr Pissarides's comments earlier on, alleged it was and I have just a few points to make in that regard. The whole context of the late 1980s was totally and utterly different. What you had then was several years, one building up on another, of strong economic growth and of strong house prices right from the beginning of the 1980s. What you had this time of course was strong growing increase in house prices over the last few years following a period of considerable weakness and moreover a history in the last few years of economic growth being OK but not by any manner or means spectacular. Inflation has been of course much lower, the current count deficit much lower; it is a completely different situation. The main thing I would like to say is that I think we should draw a distinction between being worried that there could be some sort of consumer crunch with all sorts of unpleasantness to do with bad debts, negative equity, bad bank loans and so on and so forth on the one hand and the idea that consumer spending might slow on the other. They are not the same thing. It is quite possible, it seems to me, that there could be an outturn over the next year or two wherein consumer spending does slow without all these nasty effects and that in and of itself is an issue for the Bank, quite apart from whether there are going to be blow-ups, bad debts, negative equity and all the rest of it. It is a forecasting and therefore a policy issue for the Bank whether it should believe that consumer spending is going to slow of its own accord or not. I do not think we should equate the two.
  (Mr Scott) I think that is a good distinction to draw as well. I think that Mr Pissarides's made a good point—and I am not sure that we should raise the spectre of Japan; that seems a long way away from where we are right now. I think Mr Pissarides's emphasis was not so much on the quantitative but more the quality of lending and this time in the business cycle is always the time that we should worry about that. My hesitation in the US, for instance, is not denying that we have seen a recovery but, if it is a recovery, it is the shortest on record and there are still potentially some bad debts lurking around that we may not yet know about and that may slow things down. Although the lending numbers here are not as dramatic compared to the 1980s, I am a little worried that we have become hardened veterans and say that it was much tougher in the 1980s. It was awful in the 1980s, so I do not want that as my yardstick whenever there is a problem with the consumer. I am not normally one to stress house prices, but I am very worried because, on page 8, we see Chart 1.11, the ratio of house prices to average earnings, and that sort of level is extremely high and can be justified either by changes in the way that the banks are lending money, either because of their rates or because consumers are expecting fast growth, and where this imbalance comes in the economy is clear if you look at the investment numbers: they are not expecting big productivity gains and big income growth but the consumer is obviously buying houses at a rate that makes them think either that interest rates will remain unusually low or that their income is going to start growing fast. I think that is the issue to focus on. Although the Bank is worried about a slowdown in consumption, their reasoning seems to be that if there is a sharp slowdown in consumption, then that would trigger inflation through the current and capital account owners because there would suddenly be a big increase in UK savings leading to weakening of sterling. I think that is where they are concerned. Whether it is a collapse or a credit crunch or whether there is a slowdown in consumption, it seems at the moment that consumption is based upon unrealistic income expectations.

  Chairman: I am hoping to have every Member ask their questions before 11.10 when Mr Bootle has to leave.

Mr Ruffley

  7. The growth GDP projections are for the next two years roughly similar to the long-term average. They do not seem to take account of the uncertainty which you have all alluded to. Where would you recommend that we hone in on specifically when we have the MPC in front of us to pick apart the weaknesses in those GDP projections, that is the weakness in the assumptions they are making? It would be quite helpful to get a feel on what we should programme.
  (Mr Bootle) I suppose I would question them mainly on the world economy and on the nature of Britain's response to it. Exports have been weak recently but, in the context of how weak world economy has been, I think they have held up pretty well in the circumstances. I think one question ought to be whether they have given sufficient regard to the possibility that the lags are much longer than one would have ordinarily expected and that exports could end up being very weak, that margins have been squeezed sufficiently and that eventually the effect comes home. Over and above that, the points that my colleagues have been raising about the possibility of further weakness in the world economy. I agree with the cautionary remarks of Mr Scott and others. It seems to me that it is far too early to take for granted the recovery of the world economy, not least because so much attention has been devoted to the United States which, as far as our goods trade at least is concerned, is of course nothing like as important as the rest of the European Union. Although there have been some encouraging signs recently, it remains the case that by and large the performance of the European Union has been pretty poor as against the confidence of both Duisenberg and Commission officials who expressed six months/one year ago immediately after 11 September that performance had been far worse, so it seems to me that this is an area of considerable weakness. If Europe should turn out to be very weak this year, as it might readily do even if the US does recover a little—and I am by no means convinced about that—then that will be a further blow to our exports.
  (Mr Scott) The weakness for me is that there is no analysis on Europe in this report. It says that America looks better and Europe is going to do better, but there is no real evidence or justification for that. We focused on consumption and the idea that the Bank thinks that is slowing down. I think also it is worth focusing on investment because a bit of a theme running through this is the old economy people saying that firms over-invested in all that IT stuff and so are not going to do much investment for a long period of time. If consumption is slowing down and if exports remain weak, then you can see why the growth forecast is skewed downwards.
  (Mr Barr) If I could add to that. Just on the investment and coming back to the point of what you could probe into with the MPC, is the actual corporate sector because everyone focuses on the consumer which is very topical, but one thing that is below the surface in this is that the UK corporate sector is actually not in a fantastic position right now. If you look at profits, they are falling at the fastest rate since the last recession. The net rate of returns are probably little better; the variable is constantly trending down; it is the lowest since 1993; I am sure that that is something that Bridget Rosewell has been picking up. It is not a particularly healthy environment out there for UK corporates. If you look at the equity market and what is happening there with profitability and profit margins, it may be one area that just holds us back from recovering in line with the upswing that the Bank of England expects on things like investment, labour market and so on because the corporate sector is under caution.
  (Ms Rosewell) One way to address that is to ask about timing. They do have continued downturn for a little bit and then a turnup in the summer. Can it really happen that quickly is one way into those topics in terms of equity markets and investment and all those underlying things on the corporate side as well as the world economy. How quickly can it feed through? I very much agree about Europe.

Dr Palmer

  8. Mr Bootle, you stressed the impact of a possible referendum campaign. I think it is generally anticipated that if a referendum were proposed with the indication that the exchange rate that we entered at would be lower than today, the market would to some extent price that in. How do you expect the Bank would react to the impact on the economy and on inflation and so on of the lower exchange rate?
  (Mr Bootle) I suppose it depends very much on the context and that is really why I raise the issue. It seems to me that we are living in a compartmentalised world which the Bank more or less accepts by not saying anything about it, that is to say compartmentalised in time. There is this period now when we have the MPC and we have the inflation target and the euro is just cast to one side and we carry on and, at some point or other, the euro may descend on us and there is going to be a massive challenge in terms of adjusting to the exchange rate and it is quite possible that the terms of reference—this may be likely—of the MPC are going to be altered in the context of all this. The Bank keeps referring to the confidence of the public and the markets and about the current regime and looks at this market, that market and the other market to ascertain what has been built in with regards to the expectation of inflation and interest rates, and yet the big thing which is going to upset, potentially surely, is the thing on which they have nothing whatsoever to say. I presume that if the terms of reference remain the same, that the exchange rate fell in the way you describe, they would raise interest rates as if the pound had fallen for any other reason. I cannot think there would be a good reason to behave differently unless they were so instructed. So you would then end up with a situation under which monetary policy would be tighter, I suppose, to offset the fall of exchange rate. So, momentarily, one element of convergence, as it were, would go the other way: exchange rates would come right but interest rates would be unconverged. The alternative of course would be to instruct the MPC not to behave in that way so that interest rates remain, as it were, converged and the exchange rate was converged, in which case you can be pretty sure that the thing that would diverge before too long would be inflation, potentially.

Mr Laws

  9. This is another question for Mr Bootle before he leaves and it is really picking up on Dr Palmer's question. In your note to us, you criticise the fact that the inflation report has nothing to say about the huge import initiative looming over the horizon but, if we raise this with Eddie George when we see him later this week, my guess is that he will say, "If you tell me what politicians are thinking about, then I can put something intelligent in the inflation report." Do you think we can expect the Bank to put something intelligent into its formal processes of analysis to take into account this prospect?
  (Mr Bootle) I think the Bank is in a very difficult position and, if I were in the Governor's shoes, I guess I might be saying nothing about it at all, but you are not in the Governor's shoes and I do not think you should allow him to get away with that.

  Mr Laws: What can we ask him to put in his report?

  Chairman: Give us a good question.

Mr Laws

  10. What could reasonably be expected to be in an inflation report?
  (Mr Bootle) What should be in an inflation report is a different question. With regard to what you can get him to say, I think you could ask him at what point it would be reasonable for an assumption about euro entry to become a central part of the forecasting process. "After all, Governor, is it not the case that, if we were to go in, this whole set-up would change?" The regime would change but also one would presume a number of key variables would change including the exchange rate. The market has to form an opinion of that. The point that I think this Committee should be questioning the Governor and the MPC on as we go forward, assuming this remains a live issue, is the whole question of the transitional process. Assuming that a referendum were called and passed, how do we move from this regime to the next regime without causing substantial instability? It seems to me to be extremely odd and remarkably British, if I may say so, that somehow or other this big issue is just pushed to one side.
  (Mr Pissarides) I wonder if I could add something. The impression I get is that the MPC is hoping that the euro will appreciate against foreign currency, that sterling will stay the same against the dollar, and therefore the markets would reach a level of euro/sterling exchange rate that would be good enough for entry. So one point that you could ask the Governor is whether they do have any forecasts of the euro exchange rate and what they think of the market forecasts that are published regularly in The Economist with a summary of what differing market forecasts think about the euro and whether he thinks that is a good forecast for exchange rate changes during the transition period that was mentioned earlier on or whether he thinks that there would be a need for other step changes in the exchange rate.

  11. Were you suggesting that the bank officials would have any forecasts that are not simply based on the market projections forward rates?
  (Mr Pissarides) They should have their own view; the Members of the MPC should have their own view of where the euro is going. Whether they do it in the form of econometric models or by reading many forecasts and reaching consensus I do not know, but it seems to me that it is so important to know where the euro exchange rate is going in relation to both the dollar and sterling that I am surprised that they do not make more of these forecasts in their report and say whether they think that the time to the referendum the euro-sterling rate will correct itself. We have to bear in mind that however soon the referendum comes, it is a long time in terms of financial markets. Even one year from now, the euro should appreciate in value if these forecasts are correct and it is important to know whether they think that the appreciation which takes place in the forecasts is enough.
  (Mr Barr) May I just disagree with both of my esteemed colleagues and make myself popular! It is actually very well known how we will join in technical terms in that it would all kick off after the referendum. I do not think the market would move sterling of its own volition until after a "yes" vote. I think there is too much uncertainty for them to take that bet. Then the Bank of England is made fully independent and, yes, as Mr Bootle said, they may have to keep interest rates higher than they would otherwise be if sterling was going to depreciate, but that is a temporary inflation issue. We have seen what happened with Greece joining for example and Ireland as well. It is a temporary transient inflation, I am more sanguine on the technical level on which it could be done.


  12. Germany?
  (Mr Barr) Again, I think a lot of the pick-up in inflation that we have seen in Europe is explained by short-term factors, food and so on and so forth, and it is beginning to drop out. The only other thing that I would say on the exchange rate is that I disagree as well that they should build in a forecast. They became so unstuck in the early days of independence with their forecasts of the exchange rate. You can argue that one of the reasons why certain parts of the economy, such as the industrial sector, were suffering is because interest rates were just too high because the Bank kept forecasting that sterling would fall. As regards the best forecast, I would agree with Wadwhani who changed the way this was done in the Bank of England: assume pretty much that it stays where it is. If it falls, then you react. Otherwise, you could be setting monetary policy wrong, and I think they did, for a couple of years.

Mr Beard

  13. Is there a possibility of an interaction between these two factors that have been promulgated in the discussion so far? One because of the fall of the pound either because of the referendum or for some other reason and this high level of personal indebtedness where eventually that is going to come to a stop and presumably depress consumer demand. If it depresses consumer demand on its own account that is one thing, but is not the possibility of the fall in the exchange rate going to multiply that and lead to higher interest rates and further depression? Is there a possibility of a vicious circle leading to . . . leading to what? What would be the economic consequences if those two did interact?
  (Mr Bootle) I think in many ways the fall of the pound, as it were, is the solution that is waiting to happy rather than a problem lying over the horizon. The imbalance in the British economy is partly because the pound is too high and that is not only responsible for the weakness of manufacturing, it is also partly responsible for the strength of consumer spending. It is something that is boosting the purchasing power of earners in this economy. If the pound were to fall, I think you are right, it would interact with the over-exposed nature of consumers in several ways. First of all of course, it would tend to push up prices in the shops. Other things being equal, it probably would reduce the growth of real wages, squeeze consumers. It would also tend to push up interest rates and that would then have all the consequences we discussed before. The other possibility is that it is the easing back of the consumer, the thing that was referred to earlier on by Mr Scott, which prompts the fall of the exchange rate and then, if you feed in what you have just described, namely the exchange rate, acting against the interests of consumers as well, you have the beginnings of a vicious circle. I have to say that it is not one that particularly alarms me. At some point or other, I think the evidence is that we have to run this economy with a much lower exchange rate and I do not regard the possibility with a great deal of horror. On the point about the exchange rate, if I may just raise this very briefly because it also refers to a previous question and answer that I gave maybe somewhat misleadingly where I said that I thought the MPC would react in the same way to a fall of exchange rate, it does matter quite how that fall of exchange rate has come about and this relates to Mr Pissarides's remarks about the euro strengthening. There is a world of difference between the pound coming to a level against the euro at which entry may be possible without a euro recovery on the one hand and, on the other hand, the pound coming to that point in the context of a general euro recovery because, in the first case, the pound is coming down against the dollar as well and then the inflationary consequences are much greater and then one could expect the Bank to respond, in normal circumstances, much more strongly.
  (Mr Barr) Governor George has made that point as well.

Mr Laws

  14. Just to come back to this issue of the exchange rate, this still seems to hold a particularly important place in the Bank's analysis. In the statement of Mervyn King pronounced on 13 February in the inflation report press conference, somewhat surprisingly, all of his reference on growth seemed to be downside and seemed to be at great risk of consumer "pruning" leading on to higher inflation. The only mechanism through which there is risk of inflation targets, they all seem to be coming from the risk of the exchange rate falling significantly and it is therefore the sort of dual question—it is the same one as we had last time—which is, is the Bank worried too much about this exchange rate fall that we all think it is out there over the horizon and the effect that that would have on inflation and the associated question is, is it surprising that they do not see any risk apparently that the consumer "prune" will continue with low interest rates and that house prices will move up and that actually there will be a risk of inflation on the other side?
  (Ms Rosewell) I think the point on the consumer side of things is partly that we have seen very considerable strength in consumer spending without much acceleration, if any acceleration really, in inflation, while the exchange rate has remained pretty strong against the euro though it has come down against the dollar. Under those circumstances, if consumer spending maintains its current rate of growth, which I think is very unlikely . . . After all, we had a two point change in the interest rate over the last year and that is not going to happen this year with the best will in the world. That is on the unlikely side of things. So, if that is the case and if we have had that strong growth, there is only one way for that to go and that is for it to moderate. If the growth that we have seen has not generated an acceleration in inflation, then why should there be a particularly strong risk of continued consumer spending growth weakening somewhat, however little that might weaken, fostering further inflation now? So you are really left with the exchange rate as the major risk on that front. Then the issue is, if you did get a fall of sterling against the euro or indeed a further fall of sterling against all those currencies, how big would the inflation effect actually be compared with the trade effect and the revival in manufacturing? I think that the experience over the last three or four years makes that a very hard bet to call and that is certainly one of the things that ought to be worrying the MPC. If sterling collapses, what happens to inflation? I do not think any of us have a very good handle on that.

  15. Would the five of you be concerned that even the Bank appears to accept that the growth risks are on the downside and therefore, if they are exaggerating even the probability of a big fall in exchange rate or the impact of that on inflation, then they will end up running to tightened monetary policy?
  (Ms Rosewell) It is exactly what they did, as Mr Barr was pointing out, at the beginning of their tenure. Admittedly they had less confidence then, so probably they do not need to be as macho now as they needed to be in 1997, so they probably have a lot more confidence and that risk is rather less than it was in 1997. Nonetheless, that is a risk, that they run it too tight.
  (Mr Scott) This is the point that I made in my submission because it is a rather unusual combination, downside risk to GDP and upside risk on inflation, and there is an intellectual consistent story. Remember, here we are talking about deviations from central forecast on the most likely outcome. However, there is a slightly curious one when it runs to the following which is, if there is a sharper downturn in the economy than you are expecting, consumers will realise that the game is up, they will suddenly realise that they have borrowed too much and they try and save which means that there will be less money coming into the UK and that means that sterling will weaken, and that will trigger the inflation risks. So, it is a kind of odd way of generating inflation. It is not a runaway consumer boom, it is actually consumers retrenching that generates inflation. I do think that really is emphasising too much the upside risks to inflation. With an economy that has been growing at a modest pace for so long and with inflation already below 2.5 per cent, to upgrade your inflation forecast so much from November to February on the top part seems amazing. If you think about the other risks you are talking about, that perhaps the world economy will not be so strong, there is still an opinion somewhere in the MPC that the productivity growth is higher because of new technology and that we can grow faster without risking inflation, with investment being so weak with the manufacturing centres, it seems strange to pick on that one feeling, that one concern, of a sharper slowdown in economy through consumer retrenchment would generate that inflation. I find it very strange. It is not that the central forecast is wrong, but to shift the focus of probability so far up.
  (Mr Barr) It is a bizarre combination. It seems to me that you have a very sharp consumer slowdown and let us not forget the central projection for consumption is to slow to what they say is a little below long-run trend rates over the forecast period. Long-run trends are about 2.7 for consumption since 1955, so you are talking 2.5 per cent. It is a sharp slowdown from where we are today. That sort of aggressive slowdown is going to feel pretty grim for retailers. So, to suggest that we are going to slip further below that as a downside risk is going to be a big, big slowdown. OK, the exchange rate falls—I am not sure that it would but let us say that it does—to me the inflation just does not come through. In a way, it is a kind of rerun of September 1992. We had a massive fall in exchange rate; most of the city economists said, "Here comes the inflation"—the person on my left Mr Bootle did not and he was correct to say that—but no inflation came through because the risk of cost push inflation was offset with the fact that demand was collapsing, so it gets absorbed in margins, it does not feed through to second round, it effects in wages and so on. To me, it is nonsensical to have downside growth risk feeding through to upside inflation. I think that one of the weaknesses of the Inflation Report is that it is a kind of compromise document and you can see just how much of a compromise that downside risk and upside risk in inflation was when you look at the Minutes and how various Members of the Committee just do not agree with that risk projection and I think that is one of the weaknesses.

Mr Beard

  16. The gist of what you have been saying is that, if the exchange rate fell, that would be a cure for some of the imbalances in the economy. How important are those imbalances and is there anything else that the MPC could be doing to rectify them other than waiting for the exchange rate to tumble down?
  (Mr Bootle) I am not sure that the imbalances are all that horrible. To some extent, the issue depends upon whether you think the scenario of real consumer trouble or bank trouble is going to ensue from the buildup of debt. If you do not think that is likely on any great scale, I am not so sure that this is a massive problem. Indeed, imbalance is very much an economist type word. You do not find men in the street worrying about imbalances. Given that the Bank of England is targeted with achieving inflation of 2.5 per cent not with targeting balance, I am not sure myself that it is all so awful. Indeed, if you are presented with an imbalance from the rest of the world or shock from the rest of the world like the world economy being weak and you, the Bank of England, are targetted with the objective of hitting inflation at 2.5 per cent and, subject to that, keeping the economy and the recovery going, I do not see how you can do that without having some sort of imbalance. In many ways, I think this complaint is a little like willing the ends but not the means. Given what they have at their disposal and given the problems, they have almost got to over-emphasise consumer spending. Chairman, as I have to go in a couple of minutes, may I briefly make one further point which is that, so far, we have not said anything specifically about the inflation forecast; we have not done so in any great detail. I would just like to record the view, as I said in my note, that it seems to me that yet again the Bank is probably over-estimating, even in the central numbers, the inflation outlook and that, on its own projections where inflation is below the target for the next two years, we will have had inflation more or less continuously below the target for the best part of five years. I think that this really is beginning to build up to a case that the Bank is systematically biassed in its interpretation of the target and, just to emphasise that point, it seems to me that it is quite remarkable that the inflation forecast is not much different in its shape or level from the one that appeared in the November Inflation Report and yet the changes to the economic forecast made since November you would think would have pushed the inflation numbers down. Global growth has been revised down, UK growth has been revised down, oil prices are lower and the pound is higher. What is it that has enabled the Bank to stick with the same inflation numbers? I have a nasty suspicion that the Bank has effectively manipulated the forecast to prevent it from being in the position of having to cut interest rates again and it does not want to be in that position for precisely the reason that we have been talking about. That is to say, it does not want to stoke up the imbalances, stoke up consumer spending and consumer debt, but the logic of what it thinks about the world economy and the UK economy ought to have it, I think, forecasting a lower inflation rate than it has.


  17. Two Members of the Committee did vote for a reduction of 0.25 per cent, and is there a case of real tension within the MPC?
  (Mr Bootle) I think that is a question you ought to ask them rather than us.

  18. I mean from your contacts and your understanding.
  (Mr Bootle) One's understanding is that, yes, there is and indeed I think the part in this report which has now become almost ritualistic is quite significant where it says that some Members preferred alternative assumptions about the risks, the state of the world economy et cetera. I still think it is rather odd that they are pushed to one side, as it were. So there is a central view which one understands does not incorporate their views of the risks and then there is them. There is something that remains a little unsatisfactory about that.
  (Mr Scott) On that, I think there is a problem in how you reflect a consensus in this Committee, the MPC. You have to be a little careful between whether the Bank is biassed and always looking at the worst or is actually deliberately setting a margin of error. So in effect, although it has a 2.5 per cent central target, it is really going to be two per cent because, if it hits 2 per cent, everyone is happy and, if it goes for 2.5 and it is 3, then people get unhappy. I do not think it is a bias on how they are actually reading the numbers. I think it may be that they have an average forecast which is right. It is a question as to how you actually respond to that forecast and whether you worry about an asymmetry between an under-performance and an over-performance and I think that is what is happening, a sort of precautionary motive. You are building in a bit of slack just in case inflation turns out to be higher than you are expecting.
  (Ms Rosewell) I think it is quite interesting in that there is one point somewhere at the beginning in the summary/overview where they say they expect inflation to drift back to the 2.5 per cent target. It is not at all clear where this drift is actually going to come from given the discussion of all the sort of building blocks that are happening. Whether that is something to do with the drift down in the exchange rate is not at all clear and, in any case, the one thing we do know about exchange rates is that they do not drift, they make sharp changes. I rather agree, that suggested to me this rather precautionary bias. The use even of those sorts of words, that inflation is somehow just naturally going to drift back to the target that they just happen to have, seems to me to be implausible in the extreme and I think that that is in fact because they are running internally at a rather lower target.
  (Mr Barr) If they have this bias, this precautionary slack built in, part of the reason for that comes back to the exchange rate issue. They always expect the exchange rate to fall and, as a result, they always expect import price inflation to pick up and the inflation risks are on the upside, and that is why every inflation report recently always does this towards the very end of the forecast and that is their way of saying, "Here are the risks coming through that we see a lower exchange rate." My own preference would be that they just assume that the exchange rate stays where it is. You get time to adjust your foreign exchange rate. If we all go back to our offices and the exchange rate is down 10 per cent, fine, then the MPC can adjust monetary policy. They should not be trying to secondguess it. The one thing that will happen when you talk to the MPC on Thursday and you bring up this issue of whether there is a bias or if they have undershot the target for too long is that Mervyn King will definitely draw attention to the fact that, in January, inflation jumped to 2.6 per cent and the increase was more than the kind of differences we are talking about here in this bias or whatever. There is something in that, it does move very sharply about. I would not go as far as Mr Bootle with the criticism of bias, but it is true that we could be looking at four or five years of sub-target and I do put a lot of steer on the fact that they are looking at the exchange problem and one problem that they have with the exchange rate is that, with the revaluation or whatever you want to call it in 1996, sure, it probably has gone too far and you only have to look at conditions in the manufacturing sector to tell us that, but it was too weak before. In 1996 and that period, the exchange rate was far too low and it is difficult knowing where the bit in the middle is but I think that, against that background, you have to assume that it should just stay where it is because it has been there for some years now.

  19. The Governor said he was not terribly bothered about the imbalances in the economy. Do you all share that view? One of the implications of one imbalance now is that you have this high level of consumer debt but lower levels of investment. Is that not bound to affect productivity in the longer run and is that not worrying?
  (Mr Barr) If I can say a little more about imbalances. As I said earlier in the discussion, I do believe in this recapitalisation effect. At least part of this increase in debt and increase in house prices was an understandable and rational economical reaction to what we can all perceive as permanently lower interest rates and a removal of the volatility that was associated with interest rates and inflation prior to MPC independence. So a lot of this buildup in debt and prices to me is perfectly sustainable. But does it continue, that is what we have to ask ourselves. Do not look at where we are today but ask, what if this continues over the next six months to a year because I firmly believe that at some point it will become unsustainable. Part of the problem is consumers in aggregate are beginning to keep the current rate of growth going just by borrowing. Employment is not growing any more. Real income growth is not that strong beneath the surface and I think that my worry would have to be that that is what is keeping consumer up. Perhaps for very good reasons. At some point, if it just stops, you could have a rapid slowdown. The tool to deal with that, to my knowledge, has not really been discussed and we get into political judgments here, which is probably not the time and the place. The tool to deal with all of this, if you have a problem with these imbalances continuing, is not monetary policy but it is fiscal policy. If you want to slow the consumer without, as you say, hurting investment, hurting productivity, you do not raise interest rates because that will continue to put pressure on the corporate sector but you target some tax rises in the April budget at the consumer. There is a discussion about tax rises going on already but it is a very political issue with regard to public spending, the Health Service and so on. However, to my mind—put it in for what it's worth—there is a good economic reason why you might want to if the consumer shows no signs of slowing.
  (Ms Rosewell) I think that one of the things you could certainly ask the Bank is how they are beginning to factor in the plans and the information that they have from the Government as to what fiscal policy is going to be in the coming Budget since there is all this discussion out there in the public domain about how we must all expect tax rises. I certainly agree with CiaĞran that one way to stop consumer spending is to take more money off them in the form of taxes, and then it is immediately noticeable, particularly if it is changes in taxes which come through very quickly in April. I think that there is a risk on the downside here that since employment is not rising and unemployment is rising, since we have got no further reductions in interest rates, you can stop consumers in their tracks with a completely marked loss of confidence in going out and spending, and particularly in taking more debt on, which then would not generate a recovery in business investments, but if consumers stop spending, people do not go and invest in businesses because the economy begins to turn down. Interest rates are only a very small part of the reason why you might undertake an investment and most of it is to do with what you think the demand for the product is going to be. In looking at that, most businesses will be looking at what consumers are doing, whether it is consumer business or business-to-business business, and at the end of the day it is what consumers are doing which will generate the sales which will keep the economy going, so there is a big downside risk if you stop the consumer in his tracks as far as business is concerned and, therefore, I am less worried about these imbalances than some people are.


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