Examination of Witnesses (Questions 40-59)
RT HON SIR EDWARD GEORGE, MR MERVYN KING, MR CHRISTOPHER ALLSOPP, MR CHARLES BEAN AND PROFESSOR STEPHEN NICKELL
THURSDAY 28 FEBRUARY 2002
40. Mr King, I would like to look at this question of inflation forecasts in more detail. The central projection, as I understand it, is that you will be below target for the whole of the two-year horizon, but in your November Inflation Report you reminded us that "The Committee's remit is to aim for inflation of 2.5 per cent at all times." How do you reconcile those two things?
(Mr King) The central projection is only one aspect of the distribution of possible outturns, and it is not one that we would necessarily expect to occur if there were upside risks. If you look at the projection we have now, the central projection defined as the single most likely outcome is marginally below the 2.5 per cent target, and less than 0.2 percentage points below the target, which is a negligible figure in comparison with, for example, the change in inflation that occurred between December and January, which is a one-month change. It is rising at the two-year horizon, so we would expect it to carry on, to go through the target as you look further ahead, and there are upside risks. In fact, if you take the expected inflation rate two years ahead, the mean of the distribution, that is just as far above the target as the central projection is below it. I think the outlook for inflation, which is summarised by the whole of that chart, raises the question what is the appropriate policy response? I think it would be possible, if you wanted to take into account none of the risks to inflation and just look solely at the central projection, you could probably argue for either a small reduction in interest rates or no change. If you felt you wanted to take into account all the risks to inflation and look at the expected inflation rate at the horizon, you could probably argue for a marginal increase in interest rates. If you wanted to take into account some of the risks but not all of them, no change. These differences between the mean and the mode, the most likely outcome, are absolutely trivial in comparison with the month to month fluctuations that arise through movements in petrol prices, seasonal foods and so on. The broad picture is inflation close to the target, marginally picking up from a level that we think will be a little bit below for much of this year. Though of course the latest number was above the target, I just do not think it is possible to read great significance into this.
41. Nonetheless, if the central projection is met, it will have meant that by the end of 2003 we will have been below the target almost continually, without interruption, for the whole of the five-year period you have been operating.
(Mr King) The fact that within five days of publishing a forecast the actual outturn was above the target I hope will put it into perspective.
(Sir Edward George) I am bound to say, Chairman, that if one thinks that one can get closer to the 2.5 per cent number more consistently than we have been, I do not think you understand the problem that we are confronted with.
42. Nevertheless, your colleague Kate Barker is quoted this morning as saying that projecting inflation running below target means you have to think very hard about why you are not cutting rates.
(Sir Edward George) I absolutely agree with that, and that is what we do.
43. Governor, when we met last time to discuss the Inflation Report, I remember the Committee was giving you and Mr King grief about your projections of the risks of a recession and the fact that they looked extraordinarily low. Since we met the prospects for the world economy if anything seem to have got marginally better, yet when we look at your eight quarter ahead expectation of GDP growth, you seem to have almost doubled the probability that it might be less than one per cent; in other words, you have done what the Committee was suggesting and increased the risky odds that there might be some more dramatic slowdown. Does that not look slightly odd given what has happened to market interest rates since we spoke?
(Sir Edward George) I think that is a mathematical reflection of the forecast that we have, and the explanation is the past data rather than the forward projection. Again, we are talking in tiny numbers, but the past data were rather weaker than we had anticipated in November, and that is the starting point for the forecast, and that is what produces this arithmetic thing. We are talking about tiny numbers.
44. The Bank of England now thinks, in February 2002, compared with November 2001, that the risk of a dramatic slowdown at the eight quarter period is twice as high as it was in November.
(Sir Edward George) Because of what we learned between November and February about the changes in the numbers.
45. When we saw our advisers earlier on this week, Roger Bootle said that he thought that one very odd thing about the Inflation Report was that we have this looming decision in front of us about entry into the euro, which will have a dramatic effect on the exchange rate, inflation and pretty much everything else. Yet in spite of the huge detail in this Inflation Report, there is almost no discussion at all about that issue and the risks and the policy issues surrounding entry into the euro. Is that not odd?
(Sir Edward George) Perhaps you would care to tell us what we should assume about the debate on entry into the euro. I do not think we have any better idea than anyone else.
46. Let me put it this way then. Do you not have any discussions at all with the Chancellor of the Exchequer or the Treasury representative, Gus O'Donnell, who attend your MPC meetings, about these issues? Have you not discussed this with the Chancellor at all?
(Sir Edward George) We have all kinds of discussions with all kinds of people, but not such discussion as would actually cause us to have a view about what is likely to happen on that subject.
47. Although we joke about this, you will understand that it is quite a serious issue for the MPC. Not only do you need to consider what the risks and implications of euro entry might be, but presumably you are also working closely with the Chancellor to make sure that the combination of monetary and fiscal policy steers us to a position where we are more likely to meet the five economic tests. Are you really saying that you have not discussed at all with the Chancellor how we are going to meet the tests, in particular, how we are going to get interest rates to converge with the European Union?
(Sir Edward George) The MPC's remit has nothing to do with the question of euro entry. Let me be very clear. The MPC's remit is very specific, and it is to aim to achieve the inflation target set by the Chancellor at all timesto aim to do that, and that is what we do.
48. Has the MPC never discussed the issues surrounding entry to the euro and the implications for your forecast?
(Sir Edward George) No, we have not. We discuss the risks to the exchange rate as part of our forecasting process, but we do not discuss the issue of euro entry.
49. How can you discuss the risks to the forecast for the exchange rate if you do not discuss the issue of euro entry, which is surely the biggest factor in determining what the exchange rate will be over the next two years?
(Sir Edward George) Perhaps you would like to tell us what assumption we should make about the exchange rate. There is no assumption that we can sensibly make.
50. I would have hoped that your relations with the Chancellor would have been somewhat better than mine, and that you might be able to discuss this issue.
(Sir Edward George) You had better ask the Chancellor if he has a view on that question. I certainly would not, and I would have thought that it was extremely difficult to make a judgement about that. Of course the exchange rate is relevant to the euro debate, and of course it is a major issue in the immediate question of UK euro entry, because I think most people would think that the exchange rate would be unsustainable if we were to enter at the current rate of, in deutschemark terms, 3.20-3.21 today. Of course we are conscious of that, but there are these great decisions which have to be taken by the Government, and ultimately by the public, and so you have two things. One is what is going to happen to the exchange rate in the normal course of events, taking all the influences that might bear on that, and the second is what will happen to the political decision about whether or not we shall go to a referendum on entry. The second question we have nothing to say about.
51. You have a member of the Bank of England staff attached to the Treasury.
(Sir Edward George) He is seconded to the Treasury, and he is not working for the Bank in that role.
52. What work is that official doing for the Treasury?
(Sir Edward George) I do not know. We were just asked if we would send somebody who was familiar with econometric models to work for the Treasury, and that is what we have done.
Chairman: I can detect that we are heading for a brick wall, and we have a lot to discuss this morning.
53. I think it will be surprising to people, Governor, that you are not discussing these issues with the Chancellor in view of how important they are.
(Sir Edward George) I may be discussing them with everybody. I thought the question you asked was about the MPC.
54. Let me ask you one more question about your attitude on these questions, since it does not seem to be a major issue figuring in your calculations or those of the MPC. There was an article in The Economist that you may have read last month looking at the issue of the euro and the effect it would have on the economy of the country, and ranking various people in the Cabinet and so on as major players according to what their views were on the euro. You had the "let's go for it" group, which included the Prime Minister and others; you had the "the time isn't right" group; and the last category was the "dead against" group. You were the only member of that group. Would that be a fair characterisation of your position?
(Sir Edward George) I have not seen the article. I would not believe everything you read in the newspapers! I do not think this is relevant to the discussion we are having today. My position has been absolutely clear ever since I became Governor, which is that I see it as my role to draw attention to the pros and cons. I describe myself as a euro-pragmatist. I point out, as I did from last summer, that the current level of the exchange rate is an immediate obstacle to the issue.
55. Governor, you made what I think are widely regarded as somewhat Delphic utterances on the subject of interest rates. You said that you would caution against placing too much weight on the short-term inter-bank interest rate futures curve as an indicator of the likely course of official short-term interest rates. Would you say that the market, which I think in general is expecting a one-way bet on interest rates, is wrong, and that interest rates could easily move either way?
(Sir Edward George) I did not regard that comment as Delphic at all. I thought it was a model of crystal clarity. The comment was made about the steepness of the interest rate curve in a specific market, which was the inter-bank futures market, and I was pointing out to a group of bond investors that from the steepness of that curve, you cannot read directly across to the implications for our policy rate, the rate that we decide in the MPC. The reasons for that are twofold. One is that it is an inter-bank curve, and the other is that there is in the steepness of the rise, term premia. People, because they are uncertain about the future, will be more cautious in taking positions because of the uncertainty which increases as you go forwardhence term premia. The reason that I made the comment was that there had been a good deal of press speculation, which is about as reliable as the Economist article which Mr Laws refers to apparently, that there was bound to be a dramatic rise in interest rates, and I was pointing out to these people that they should be careful how much weight they put upon the steepness of this particular curve, which was not a true reflection of market expectations of what was going to happen to our official rate.
56. As you will be aware, the amount of new investment by large companies in Britain is pretty low at the moment, and clearly one reason for that is this widespread expectation that interest rates are bound to go up fairly rapidly. Would you like to reinforce what you have just said to suggest that that is not necessarily the case?
(Sir Edward George) If you look at the forecast, which is based upon constant 4 per cent interest rates, you see what our current expectation is. If you look at the alternative projections on market interest rates, you see that we would clearly then be on the downside of our own forecast. So I think you can draw your conclusions from that. I would somewhat take issue with what you say about business investment. Business investment as a proportion of GDP is actually at a significantly higher level than it was in the 1980s right up until the 1990s, and what we are seeing is a decline in business investment which is fairly modest compared with that really quite strong increase that took place before. So if you talk historically, business investment remains relatively strong, though it is weakening, and we anticipate that it may weaken a bit further. I am not at all clear that the particular fear of a rise in interest rates is a major factor. The bigger factor is the state of demand.
57. Mr Bean, you have voted with the majority during recent MPC meetings to keep rates unchanged since December. What is your view of the opinion of Mr Allsopp and Dr Wadhwani in their recent calls for a 25 basis point cut?
(Mr Bean) I would rather comment on my own views than the views of my colleagues. My assessment of the economic outlook is pretty well represented by what is embodied in the best collective judgment in the fan charts. My view has been that although inflation is a little below target, the underlying rate over the next year or so, it is picking up towards the end of that period towards the target. I should say that I am one of the members of the Committee who is particularly concerned about the potential build-up of household indebtedness, and I am concerned that were this to continue at a very high rate, that might lead to problems further down the road. I should emphasize that I am not in the position of saying that we need to take immediate action to rein it back or anything like that, but it makes me want to err on the slightly cautious side in terms of stimulating consumer demand further, which has been growing at very rapid rates relative to income over the last few years, and the latest GDP data for the fourth quarter confirmed that consumption is continuing to grow strongly.
58. If the deceleration in consumer demand which Sir Edward described as a potential scenario happens, would you say that you would feel there was more scope for a further quarter per cent cut?
(Mr Bean) Yes. I see very much what we are trying to achieve is an appropriate balance between what is happening to domestic demand and what is happening to the recovery in world demand. Our central projection has domestic demand decelerating at roughly the same time as the world is recovering, and that is the "Goldilocks" scenario. One can envisage risks on both sides to that, particularly with regard to consumption; that consumption may slow more sharply than we have in our central projection, in which case it will be necessary to cut rates further to sustain consumer demand, but it is also quite possible that consumer demand may stay too strong while the world has recovered, in which case we may need to take action to try and rein consumer demand back. But at the present time the balance looks about right.
59. Mr Allsopp, in December and in February you voted for a 25 basis point rate cut, but in January you voted for no change. What accounts for this variability?
(Mr Allsopp) I do not think the variability is very great. In January we were faced with quite a lot of still rather new information about the world economy and so on. My main argument for no change there was really basically a "wait and see" type of argument. The real question is why I voted last time for a quarter per cent cut, and had also previously done that. My position is extremely simple, that given the projection that we were showing that we have for inflation, with inflation below target for quite a long time, there is a prima facie case, if you are bothered about the symmetry of the reaction and its transparency, for a quarter per cent cut. My starting position was that I would need quite good arguments, given that, not to go for the quarter per cent cut. I would add to that that I am probably a little bit below the fan chart. You can put me in table 6b in terms of some of the inflationary pressures looking forward. That is just reinforcing the point that I started off in a position where there was a presumption that, if one were looking at inflation and not at anything else, one would tend to go for the slight further small cut. Really, it was a question of whether I could find good arguments, given that starting position, for delay, and I have to say I did not find arguments for holding off particularly convincing. GDP growth at the moment is below trend, and we have a policy of trying to offset. It is not that growth was particularly high now; it is actually quite low. It is mentioned indeed by some of the people who took the no change vote that one of the main risks to consumption given what is happening to the imbalances is that consumption falls off quite quickly later on. If you put those two views together, that one is slightly below growth at the moment and that probably the main risk looking forward is downwards, it does not add up to a very coherent argument for delay. Indeed, if it stimulated consumption a little bit in the short run, it is almost smoothing. I did not regard the argument on the imbalances ground as being completely convincing. The other thing, which has already been mentioned, and it is an extremely important point, is that the fan chart does have an upside risk to inflation built into it. That risk, as everybody knows, and it is quite clear from the Inflation Report, is a risk to the exchange rate, and I am one of those people who thinks that we should face the risk to the exchange rate, if it happens, when it comes about; in other words, although there is something built into the fan chart which suggests that measured inflation might be higher if the exchange rate goes down, then there are all sorts of other things that may have happened if we get to that point. To start with, I am one of those who think it would not be a bad thing if the exchange rate were lower. The question of how you react to an exchange rate change, whether you accommodate a bit of the terms of trade change and be very careful not to allow the expectational effects to come through, I think are important issues that need to be thought about. I am not saying the risk that is in the fan chart is not there, but it is not something I would build into the policy decision, or I did not want to build that into the policy decision last time. All that added up to a logical case on grounds of symmetry and transparency that, given my position, I came out in favour of a small cut.