Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor David Miles, Imperial College, University of London

  My comments on the latest Inflation Report are, to a large extent, a response to the very interesting paper by Sushil Wadhwani that was sent to me by the Treasury Committee ("The MPC: some further challenges"). This paper contained a provocative analysis both of the immediate inflation outlook in the UK and some substantive comments on the overall performance of the MPC over the past five years. Dr Wadhwani shows that actual inflation in the UK has consistently been somewhat lower than the central forecasts made by the MPC. Dr Wadhwani shows some simulations which suggest that had interest rates been slightly lower over the past few years output would have been marginally higher and inflation somewhat nearer the target of 2.5 per cent. I do not believe that it was Dr Wadhwani's intention to suggest that the MPC's performance, so far, has been poor. In fact, he points out that in terms of output, unemployment and inflation the performance of the UK economy over the past five years has been remarkably successful. Nonetheless, in using the term "bias", and in showing simulations of what might have happened had interest rates been lower, the paper does give the impression that the MPC has done rather less well than it might. I do think this is somewhat misleading.

  Purely in terms of the economic out-turns it really is remarkable how successful the MPC has been. Inflation has stayed just under 2.5 per cent for most of the last four years. Chart 2 on page iii (in the over-view) of the May Inflation Report shows inflation since the beginning of 1998. The annual rate of inflation has not been more than half a percentage point from the central rate of 2.5 per cent. Of course, inflation has fairly consistently turned out to be under 2.5 per cent. Had this been accompanied by stagnant output and rising unemployment then I think a case could be made that the MPC had consistently adopted too tight a monetary policy. But in fact GDP growth over this period has been above the long-run trend. And unemployment has fallen fairly consistently. Chart 3.5, on page 24 of the Inflation Report shows that unemployment is now lower than it has been for at least 20 years. Chart 3.6 on the same page shows that unemployment in the UK is now lower than in any other G7 country, for the first time in over 40 years. On comparable measures, UK unemployment is now slightly lower than US unemployment.

  Finally, the new monetary arrangements in the UK have been stunningly successful in driving forecasts and expectations of inflation in the private sector toward the target rate of 2.5 per cent. Chart 6.8 on page 52 shows the distribution of inflation forecasts by private sector independent economists. It is striking how narrow the range of forecasts for inflation over the next year are; the great majority of forecasts are that inflation will be very close to the 2.5 per cent target. Forecasts of inflation over a longer time horizon also show that people now anticipate inflation remaining very close to the target. Chart 1.11 on page 7 of the Inflation Report suggests that in financial markets inflation anticipated between five and 10 years ahead is now very close to 2.5 per cent.

  In the light of this one's overall judgement on the MPC's performance should be that it has done a remarkably good job. It is true, however, that the inflation forecasts made since Bank independence have been slightly higher than out-turns. But it is important to note that it is only possible to construct a measure of the forecasting mistakes for forecasts made between Q3 1997 and Q4 1999. In other words, we are really only looking at forecasts made over a two-year period. So one should not get the impression that for five years the MPC has consistently overestimated inflation.

  A second strand to the paper, by Dr Wadhwani, concerns house prices. He argues that it would be useful for the Monetary Policy Committee to give a clear signal that they would, other things equal, react to a housing market bubble if one clearly emerged. What has been happening to house prices, and to levels of household debt, clearly are something the MPC is very concerned with. Chart 1.5 on page 5 of the Inflation Report shows how substantial the increase in household debt has become. The ratio of UK aggregate household debt to total income is at an all time high. It is also substantially higher than in the United States, where savings rates and debt have moved dramatically in recent years. Whilst interest payments on debt relative to income do not look particularly high in the UK this is, of course, largely a reflection of the unusually low nominal interest rates that currently exist. If interest rates were to increase by one or two percentage points at some time over the next few years, the ratio of interest payments by the household sector to its income could rise by up to 50 per cent. The strong growth in lending in the UK has been both a causal factor behind, and a response to, very high increases in house prices. House prices relative to earnings are now very substantially higher than the average over the last 20 years. For the country as a whole house prices relative to earnings are still lower than at the peak at the end of the 1980s, though for some areas (the South East and London) prices are already close to the bubble levels of 1989.

  It is in this context that the message from Dr Wadhwani's paper should be read. But I do believe there is something of a tension in his arguments. On the one hand he argues that monetary policy has consistently been tighter than it could have been; he also argues that the boost to demand from recent announcements of tax and spending increases is lower than the Bank Inflation report suggests. The implication of these observations is that monetary policy might now be loosened somewhat. But given the house price situation and the very high levels of household debt it seems to me that there are very great dangers in further reducing interest rates. Surely you would give all the wrong signals to households were there to be a reduction in the cost of borrowing against their houses. A stronger case can be made that in order to prevent an even bigger build-up in household debt, and an even greater increase in house prices above sustainable levels, a signal should now be given by the MPC in the form of a small increase in interest rates.

May 2002

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