Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor Sheila Dow


  1.  Compared with the February Report, the Bank's two-year projection of GDP growth is now more optimistic (in spite of the worse-than-expected out-turn for 2001 Q4 and 2002 Q1) and is expressed with greater confidence (a narrower spread). The two-year projection of inflation is similar to the February projection (in spite of the unexpected jump in inflation in the first quarter) and is also expressed with greater confidence. While the upside and downside risks appear now more evenly balanced for the growth projection, the upside risks are expressed as being greater in the inflation projection. Nevertheless the MPC decided not to raise interest rates.

  2.  The Budget was a key development since the last Report. The overall impact of the increase in government expenditure, financed by increased NI contributions, is judged to be expansionary since some of the NI contributions increase would have been saved anyway (the balanced budget multiplier). This is a reasonable argument, although the magnitudes involved depends not only on the import leakage, and on savings behaviour, but also on the extent to which the effect of NI contribution increases are absorbed by profits, wages, or prices. These considerations lend some uncertainty to this important element in the optimistic growth forecast. But the expectation of some inflationary effect of the NI changes lies behind the higher upside risk in the inflation forecast.

  3.  The second key issue is still the strength of the economic turnaround. The signals continue to be mixed about global and domestic demand, and the downside risks were reinforced by the first quarter 2002 GDP figure of zero growth which was published after the Report. While this figure may well be revised in due course, there is a widespread view that the growth projections are over-optimistic. The Inflation Report itself sees non-governmental sources of growth in demand as picking up gradually (eg exports) or being tentative (eg business investment). While consumer demand continues to be strong, there is uncertainty as to whether that source of growth has now peaked. On the logic of earlier Reports, if the growth forecast is over-optimistic, the inflation forecast is understated (lower growth in imports would keep sterling, and thus import prices, high). But it remains debatable what the balance of effect on prices would be between higher (import) costs and weaker demand, given spare capacity.

  4.  The other key issue remains the structural imbalances within the economy. The divergence between consumption, export and investment expenditure, and between the manufacturing and service sectors, is a continuing cause for concern in terms of how and when they unwind, and the consequences for output and inflation. The projections are based on continued strength in the housing market and thus in consumption. There had already been signs that house price rises may be peaking, due in part to saturation of the rental market by buy-to-rent properties. But subsequent survey data suggest a continuing housing boom.

  5.  It is difficult for the Bank to address the structural imbalances because it only has the one interest rate tool. The imbalances are also problematic in that, if as expected the divergences do reverse, whether or not because of monetary policy action, the outcome could be highly unstable. In a worst-case scenario, for example, a collapse in property values would have devastating effects not only on aggregate demand but also on social welfare and on financial stability. The Bank has to bear in mind, not only the primary objective of the inflation target and the secondary objective of supporting Government economic policy, but also the objective of financial stability. The current attractiveness of housing as an investment is due to the relative absence of attractive alternative assets, so that much of the price increase is due to speculative activity. Awareness of the fragility of the current situation may well explain why the MPC left interest rates unchanged in spite of their optimistic growth forecast (Minutes, p.10).

  6.  Given the fragility of the current situation, it is crucial that the cause and nature of the imbalances be well understood, in order to predict the potential for instability and the effect of monetary policy action. The analysis in the Report is in general at a high level of aggregation. We turn now to consider how far a regional perspective can shed some light.


  7.  The Report makes passing mention of regional disparities, in its discussion of unemployment (section 3.2), but concludes that the downward trend in UK unemployment has also reduced regional disparities. The more disaggregated travel-to-work-area data are introduced into the discussion, and used to emphasise this point. But even travel-to-work-areas can cover widely disparate local labour markets. Also, with greater labour market flexibility, disparities are as likely to appear in regional earnings data as unemployment data. In fact regional disparities in GDP per capita have proved to be remarkably persistent at levels which are the highest in Europe (see the November 2001 HMT Report on Productivity in the UK).

  8.  Regional disparities themselves make it more difficult to achieve simultaneously low inflation and low unemployment with one interest rate. The current concerns with structural imbalance are long-standing concerns for regions to which a uniform UK monetary policy is not ideally suited.

  9.  The effects of the April Budget will have different regional effects. The tradeables sector is likely to be hardest hit by the NI contributions increase, since it will be more difficult to pass on in higher prices. Further, the regional composition of the additional NHS spend remains to be seen; but we know that, for Scotland, the Barnett formula ensures a relatively small proportion of the spend.

  10.  Much of the long-standing pattern of regional disparity is due to the regional sectoral pattern, with lower growth rates associated with greater reliance on manufacturing and exports; this particular source of imbalance is not a new one. Another source of disparity is differentials in wealth levels which tend to be self-reinforcing. The combination of reliance on unstable external demand for output and relatively low wealth encourages financial conservatism; this manifests itself in a relative unwillingness to be financially exposed by illiquid portfolios and debt-financed expenditure. This kind of behaviour is also the rational response at a UK level to periods of uncertainty and can explain, for example, PNFC's financial behaviour (Chart 1.8).

  11.  It is therefore important also to consider the regional pattern in financial structure. There has been a worry that a rise in interest rates might cause too rapid a reversal in consumption spending. However, while the February Report had addressed the issue of household debt exposure, the June Report does not express any particular concern about this. But we do not have good regional data on borrowing. Consumer spending has been strong throughout the UK, implying that borrowing against increased wealth has been a general phenomenon. But it is possible that the aggregate data mask pockets of financial fragility which would be hard hit by any interest rate rise.

  12.  The Report (Chart 1.18) refers to annual rates of regional house price inflation, where again the conclusion offered is one of convergence. As with the labour market data, these regional aggregates themselves mask significant sub-regional disparities. But in any case regional disparities are already emerging again in the quarterly house price data, with increases already having turned round in some regions such as Scotland; the Scottish retail sales indicator also shows a correspondingly greater slowdown in consumption growth. The issue of whether or not to raise interest rates now is a matter of timing, raising rates if necessary in order to make the housing market peak, but not if the peak is occurring naturally. But a rise in rates addressed to accelerating national house prices would hit some regional markets where the peak had already occurred.

  13.  Thinking in terms of regional composition therefore gives pause for thought as to the likely impact of the rise in interest rates anticipated by the MPC, whenever it occurs. The conventional wisdom is that interest rate changes have their fullest impact after two years. But if the timing is wrong, there could be a major immediate impact, stalling the recovery in its tracks for some parts of the UK at least. An interest rate rise designed to curtail the consumption boom where it is continuing and discourage wage increases in the non-tradeables sector could inhibit the resumption of growth in regions which had already experienced a fall in consumer demand due to pessimism about wealth as the housing market weakens. This is one of the reasons why regional disparities have not been eroded in the past. But if the housing/consumption boom is more generally fragile, the effect of a rate rise on inflation could be more generally immediate.

  14.  In the absence of more complete regional data, much of this discussion has to be theoretical. It would be helpful to have regional breakdowns of financial data, such as the Lending to Individuals data produced by the Bank, in order to get a better idea of regional financial structure. Also, while the Inflation Report presents a consolidation of the Bank's Agents' reports, it would be helpful if the focus were shifted to highlighting any regional differences. There is some concern about the reliability of survey data, eg on investment intentions, since these provide the strongest case for an economic turnaround. But the Bank's Agents are in a good position to provide high-quality information on regional conjunctures. At a time of such uncertainty, such information would be highly valuable.

June 2002

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