Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1 - 19)




  1. Good morning, gentlemen and welcome to the Committee. I see that our female witness is missing; hopefully she will come soon and join the Panel. Could I ask you to identify yourselves for the record, please.

  (Mr Bootle) I am Roger Bootle from Capital Economics.
  (Professor Miles) I am Professor David Miles, Imperial College.
  (Mr Walton) I am David Walton from Goldman Sachs.

  2. Can I thank you for your separate submissions to the Committee; they were very helpful to us in our deliberations. Mr Bootle, in your submission to us, you mention that this was the most hawkish inflation report that we have seen for some time in two respects. First, that inflation was forecast to be 0.1 per cent above the 2.5 per cent target at the end of the Bank's two year forecasting horizon and that contrasts with the last two reports in which inflation had been forecast to undershoot its target by 0.1 per cent to 0.2 per cent or so. Also, the statement by the MPC that it stands ready to contain inflationary pressures further ahead was a clear break from previous statements that have balanced inflation concerns against the need to guard against continued weakness in activity. Mr Walton made the same point about the hawkishness of the inflation report. Can I ask for your comments on the MPC's judgment on that.
  (Mr Bootle) I continue to believe that the MPC is in severe danger of over-estimating inflation at the two year horizon. That after all has been the record now for some considerable number of years and I am particularly concerned this time round by the process through which the MPC has reached this result because I think that most of us examining the news over the last few months would have thought that there was not that much justification for a rather more hawkish inflation stance. The only real justification for it, it seems to me, is the more upbeat GDP forecast from the Bank, which is considerably more bullish than the previous one, but that too strikes me as being particularly odd. It looked odd before the latest GDP figures produced for Q1 but, since then, I think it looks even more peculiar and demanding. So, I am of the view, which I have held for some time, that the Bank is in danger once again of over-estimating the inflationary risks.

  3. Mr Walton, what are you comments on that, please?
  (Mr Walton) The reason it was more hawkish was really as Mr Bootle said, that the MPC does expect the economy to start to pick up quite strongly in the near future and that, with above trend growth for most of the next two years, at some point that will lead to a rise in inflationary pressure and inflation then picking up to miss the target. I do not have any great problems with the MPC's growth forecasts. This morning we had industrial production numbers which I think showed the first sign that the economy is actually starting to recover quite well and I think we probably will see above trend growth over the next two or three quarters at least. I guess that my point of departure with the MPC would be that I think there is probably a little more slack in the economy than the MPC seems to think in the inflation report. We have had two quarters in which the economy has not grown and that should give the economy a little room to enjoy a period of above trend growth before the MPC should feel that they need to tighten policy. I think the general tenure of the report is that, if we do go through a period of above trend growth, then at some point that will take up the slack and that you will need to see policy moving back to a more neutral position from a position at the moment which is still quite accommodating.

  4. Professor Miles, you referred to Dr Wadhwani's report in which he said that inflation in the UK has consistently been somewhat lower than the central forecast by the MPC and he shows some simulations which suggest that had interest rates been slightly lower over the past years, output would have been marginally higher and inflation somewhat nearer the target of 2.5 per cent. Can I begin with asking you for your comments on that and then go on to Mr Walton and Mr Bootle.
  (Professor Miles) I think one needs to get both the actual record on inflation, and the record of inflation forecast from the Bank, in the longer term context of uncertainty and volatility in inflation. I am really struck by a chart that comes very close to the beginning of the Inflation Report on page iii which shows what has happened to inflation pretty much in the five years since the Bank was made independent. Whilst it is true that the actual outturns have, more often than not, been under the 2.5 per cent target, I think what is striking about it is just how very small the deviations have been and inflation has not been outside the range of 3 per cent to 2 per cent, so it has been within half a per cent. Nonetheless, it is true that inflation has undershot the central part of the target range and also the Monetary Policy Committee's forecast of inflation two years ahead has consistently been slightly more than actual outturns. If all that had happened in the context of a stagnant economy, high interest rates and rising unemployment, then I think there would be something to the case that the Bank had really not performed terribly well. Clearly what has happened is that unemployment has fallen to an historically very low level, lower than at any point in the last 25 years—I think unemployment now is lower on a comparable measure than it is in the United States—and output growth over this period has actually been slightly above trend and interest rates are at their lowest level in nominal terms for decades. I must admit that I felt there was a danger of what Dr Wadhwani had written being slightly misleading in suggesting that the Bank had consistently got the story wrong and had had much tighter monetary policy and higher interest rates than they needed. Also, I do not quite share the view of my colleagues about the "hawkishness" of the current inflation report. Again looking at chart 2 on page iii right at the beginning of the report, the forecast is that inflation does remain less than 2.5 per cent for most of the next two years—that is the central part of the forecast—and then just moves back up to it at the two year horizon. After all, their decision has been to leave interest rates at an historically extremely low level despite the fact that the housing market seems to me to be showing very clear signs of overheating. So, I would not call that a hawkish stance and I would not call it a particularly hawkish outlook.

  5. What are your comments on the Wadhwani analysis and the Bank's somewhat optimistic targets for growth as some see it?
  (Mr Walton) Hindsight is a wonderful thing; if you always knew with certainty what any policy measure is going to lead to in terms of growth and inflation, that would be great. However, given the uncertainties, to have had inflation so consistently close to 2.5 per cent albeit slightly below, it is very difficult really to be critical of the way in which the Monetary Policy Committee has acted over the last few years. If we are talking about differences of 25 basis points, I think those are too small to have a debate over. Had the point been that if interest rates were going to be 100 basis points lower, you would have had a better outcome on inflation and growth, that is another matter but, for 25 basis points, it really does not seem worth debating.
  (Mr Bootle) I think I largely agree with my colleagues that the Bank has been too bearish about inflation but, quite frankly, the differences have been absolutely minuscule. Had this Committee or its advisers been presented several years ago with the prospect that the inflation target would be undershot by this sort of margin, we would all have thought that that would have been a fantastically favourable result. However, I would just take issue with David Miles's point about the Bank's achievement being even better given the growth and unemployment performance. I see it really rather the other way. If inflation turned out to be lower on the basis of weak growth and high unemployment, it would in some sense have presented less of a challenge to the Bank's way of thinking its outlook. The fact that inflation turned out to be lower, albeit marginally, in the context of strong growth and low unemployment means that there is more strength to Sushil Wadhwani's remarks in saying that the Bank has a tendency to over-estimate inflation. That is saying something about the inflationary tendency of the economy which the Bank has tended to place too high in relation to what has actually turned out in the event.

  6. Are you saying that there is nothing fundamental to debate here, that we are really debating the margins?
  (Mr Bootle) Yes.

Dr Palmer

  7. I would like to explore Mr Bootle's remarks a little further. Are you saying that you think a gross fall in unemployment could have been greater if the Bank had been a little less pessimistic about the inflationary potential of the economy?
  (Mr Bootle) In that respect, I completely agree with what Sushil Wadhwani said, but it seems to me, as all of us have said a moment ago, that we are really talking about pretty small amounts.

  8. Exploring your earlier remarks, you said that you thought the Bank may be over-estimating the potential GDP growth leading them to be a little over-cautious or over-hawkish. Suppose they were right about the GDP growth; would you then feel that their policy was appropriate?
  (Mr Bootle) Policy being appropriate is a slightly different question from what is going to happen to inflation. I prefer to answer it in relation to what is going to happen to inflation. My position is both that I think that the Bank is being too optimistic about growth, but also that it is being too pessimistic with any growth forecast about the likely consequences for inflation. In other words, I suspect that what will happen over the next year or two is a repeat of what history tells us has happened over the last several years, namely whatever the growth numbers, inflation has turned out to be lower than the Bank and a number of other commentators have expected.

  9. Which is the point Mr Walton was making, that the economy probably has enough slack to cope with a little more growth.
  (Mr Bootle) I think that is one part of it—and it is an important part—but there are other questions of the sort that Mr Wadhwani has spoken of a number of times in the last few years that are also relevant to do with the innate tendency of the economy to produce price rises and wage rises rather than respond to increases of demand by increasing output. He has argued and indeed I have argued on a number of occasions and there have been some fundamental changes in the behaviour of the economy in that respect, so that it is fundamentally less inflationary than it was.

  10. In a recent speech, Mervyn King said that he did not feel it was necessary for the imbalances in the economy to be corrected in the form of allowing more scope for exports and for public spending growths at the expense of a measure of growth in private demand. He stressed that it did not necessarily mean a cut in private demand. What does the panel feel would be the best way of achieving such a correction, if they agree that a correction is needed? Does it imply a somewhat higher interest rate policy than would be necessary purely to deal with inflation?
  (Professor Miles) I think that is right. I think the natural way to have a switch in the composition of demand with more demand coming in the form of demand for UK goods from overseas, in other words more exports, and less domestic consumption, which is really what he is talking about, is for the exchange rate to be slightly lower and for interest rates to be slightly higher. I think that would seem the most natural mechanism. Of course, that is a very difficult thing to try and engineer because the exchange rate is something of a will-o'-the-wisp. If it were possible to engineer such a situation, it would also have a beneficial knock-on impact on the housing market, as I have mentioned already, where it seems to me that there are some seriously worrying signs emerging.
  (Mr Walton) I think the MPC has generally taken the view that the best way to keep inflation stable is to try and keep growth in the economy overall at somewhere around a trend rate, somewhere around 2.5 per cent to 3 per cent and then the composition of growth as being a second order consideration, and it has been very successful in achieving quite a high stable rate of growth, but there has been a side-effect which is that the composition of growth has been very imbalanced. Over the last five years, you have seen consumer spending grow by 4 per cent a year, year in year out in each of those years, and the external sector has acted as a drag on the economy. That has not damaged the inflation performance but there is a question as to whether or not these imbalances are sustainable. Clearly, they have been sustainable to date but I think there is a tendency over time for the imbalances to correct and a combination of the pound being a little lower, as it is at the moment, perhaps offset at some point by interest rates being a little higher, would offer an opportunity to help to try to correct some of these imbalances. I think it is very difficult for the MPC themselves to really have too much control over this because, as David Miles said, the exchange rate is not something over which they have had any great control. The fact that the euro is now recovering and that has led in turn to a weakening in the exchange rate does offer over the next period an opportunity perhaps for some of these imbalances to begin to be corrected, and that is probably a healthy thing at the end of the day because, while these imbalances exist, there is always the risk that at some point you can see a rather more severe adjustment which would just be that much more difficult to manage.

  11. Is there not a risk that an increase in the interest rate would actually reverse that adjustment in the exchange rate?
  (Mr Walton) Absolutely and I think this is a very delicate balancing match. Ultimately, I think what we are seeing is that the euro is just strengthening against both the dollar and against the pound and UK monetary policy was not that effective in stopping the pound from strengthening when the euro was very weak and probably UK interest rate policy is not going to have that much effect the other way round either. I think there would be a bit of a danger if, at the first sign of exchange rate weakness, the Monetary Policy Committee reacted to that by raising interest rates. That would probably not really send the right signal, given that ultimately the MPC would probably like to see the exchange rate a little lower and the interest rate a little higher in order to help turn round some of these imbalances.

Mr Cousins

  12. There seem to be slightly varying views about the prospects for growth in the economy. Mr Bootle's view seems to be at variance to certainly Professor Miles's or Professor Dow's views expressed in her own paper of the varied regional effects of the prospects for growth and I just wonder if we can reconcile those views. Is there a common view about the risks to growth in the economy?
  (Professor Dow) First of all, may I apologise for my late arrival[1]. I did not hear the earlier two presentations but I agree absolutely that the situation is very delicate at the moment and much of the optimism in the inflation report came from forward looking surveys and, since then, there has been a variety of evidence which has given very conflicting signals. The weakness in investment and the high liquidity holdings of non-financial companies is a good indicator that there is a great deal of uncertainty in the economy, which means that there is definite scope for a halting to the growth process rather than a sharp pick-up.

  13. Mr Walton and Professor Miles seem to take a contrary view.
  (Mr Walton) The nature of forecasting is that we can all have different views and probably our views have not that great potential. If you look at our forecast relative to historic outturns, it is probably not as great as it seems. However, it does seem to me that we have a situation where the world economy is recovering; there is some doubt as to just how strong and how sustainable that recovery is. That obviously offers some risk for the UK outlook. We also have a situation where UK economic policy is actually really quite stimulative. Fiscal policy has been expandatory now for the past year or so and will continue to be expandatory and interest rates are below any reasonable estimate of a neutral level and now if the exchange rate is beginning to depreciate, that is providing quite a lot of domestic policy support. To my mind, a combination of a recovering global economy together with a pretty accommodative policy stance suggests that the most likely outcome is as the MPC says, which is a period of above trend economic growth. That will be allowable for a time but, once the slack is taken up, then policy will probably need to be tighter in order to make sure that inflation does not then rise above the Government's 2.5 per cent target.
  (Mr Bootle) On that issue, I take a slightly different view. In my paper, I stress the importance of the recent published numbers from the ONS and I do think that the Bank needs to be challenged on this. We are at a very difficult and delicate position. I agree very much with what David said a moment ago; I think the differences between us are actually not that great. The point I am making is that according to the official numbers, the economy has now been at a standstill for six months. So, to be forecasting a movement to above trend growth within a pretty short order is asking quite a lot of the economy. In fact, it is asking for a substantial acceleration. Maybe the Bank does not fully believe the official numbers published by the ONS—there are lots of people who do not—and I think they need to be pressed on this. Bearing in mind the uncertainty about the official numbers, what practice does the Bank adopt? Does it simply operate on the basis of estimates put out by the ONS or does it assume that they may well be proved in the fullness of time to be slightly wrong? If it does operate on the basis of the official numbers, quite why does it believe that the economy should move from standstill, which it has been over the last six months, to a period of above trend growth? That seems to me to be quite a substantial issue and it is reminiscent, dare I say it, of previous occasions in our economic history which have proved to be extremely difficult when the statistics let us down. At the peak of the Lawson boom, there were some massive reporting errors on the stats side. I do not want to prejudge exactly what the position is now, but I think it would be very helpful for us to know and for you to know what attitude the Bank is taking with regard to the question of the accuracy of the figures.
  (Mr Walton) The only thing that I would add is that the numbers we had this morning on industrial production do show that the level of production in April is 1 per cent above the first quarter average and also when we had the April retail sales numbers, those were substantially above the first quarter average. So, unless the picture is going to turn down very suddenly again in May and June, it is almost guaranteed now that we are going to see the resumption of above trend growth, at least in the second quarter. It does not tell you anything about beyond. I think we are in a position where we are seeing a sudden turnaround and this is not unusual. The US, for instance, had a couple of quarters of declining output in the middle of last year and then saw very strong growth in the final quarter of last year and the first quarter of this year. So, if suddenly things start to turn, particularly when you have had global downturn being driven through the industrial sector, which tends to be the most cyclical of sectors, then quite often they can turn quite sharply and that is what we are seeing at the moment.
  (Professor Miles) May I just make one observation here because it seems to me that the Bank is rather open-minded about what might happen on the real side of the economy. I am very struck by chart 6.1 on page 43. These are the probabilities of outcomes for the growth of GDP. If you look a couple of years ahead there, the last point on the graph, the spread of possible outcomes is very wide, ranging from a possibility of GDP growth only being 1 per cent and at the other end being almost 5 per cent. There is quite a contrast between that picture and a picture that comes a couple of pages further on at page 47 which is the projections for possible outcomes on inflation. The spread of uncertainty about inflation is quite significantly smaller than about real GDP growth and that is comparing a nominal number, nominal inflation, with a real number, real GDP growth. I think that the MPC are not firmly of the opinion that growth will increase very sharply; I think they recognise the fact that there is a huge amount of uncertainty. Even if you kept interest rates at 4 per cent, they are still saying there is a good chance that growth two years from now will be well beneath trend. If you take trend as 2.5 per cent, they are saying that there is quite a lot of probability there that growth will actually be well under 2.5 per cent even if interest rates stay as low as 4 per cent.

  14. It is the case that, notwithstanding the chart on page 43, which you are absolutely correct in saying has widespread possible growth forecasts, the pitch that is then taken, or the spin, if I can use that word today, that is put on it at page 44 is that migration means that growth prospects are good, that prospects for earnings growth are good and that employment remains high because firms have retained staff rather than dismissing them, and that is all a favourable growth spin. Do you accept the spin on page 44?
  (Professor Miles) I am not sure that I would describe it as "spin".

  15. It is a term of art!
  (Professor Miles) I think they are saying that their central projection is that growth will increase and move up to a level of about 3 per cent. I do not find that implausible against the background of expansionary fiscal policy and it is a projection, as is indeed the picture on page 43, based on an assumption of unchanged interest rates. Unchanged interest rates would be 4 per cent nominal interest rates which are at historically extraordinarily low levels. So, to predict a pick-up in growth to just above trend in an environment of very low interest rates and expansionary fiscal policy seems to me pretty realistic as a central projection.

  16. Yet the implications of your view in your paper, Professor Dow, is that these very things—employment retention and growth in migration - might lead to a sudden downward correction in economy bearing in mind that Mr Bootle's threat of a reprise of the Lawson boom is impossible because the trade cycle has been abolished by the present Government, a fact we shall always bear in mind.
  (Professor Dow) I think the chart to which our attention was drawn is very telling. The fact that there is such a disparity in the growth projections reflects uncertainty on the part of the MPC. We are discussing various possibilities here. This also must be embodied in the decision making of people out there in the economy. Firms trying to decide whether to go ahead with major capital projects are also implicitly considering whether the rate of growth is going to slide to 1 per cent or go up to 4 per cent and that in itself can have real economic consequences as we have seen. The way that the Bank can perform a useful function is by sending a message which narrows down the uncertainty to help decision makers but if the bottom line is that there is a lot of uncertainty, then that has real economic consequences.
  (Mr Walton) May I just add one thing, which is that the job of the MPC at the end of the day is to make sure that we do not get the extremes of the distribution, that the way they have tried to keep inflation on target is to keep growth reasonably close to trend. Obviously they can make mistakes and growth, for all manner of reasons, could turn out to be higher or lower, but the basic aim of policy essentially is to keep growth somewhere in the middle of that distribution. If it looks as though growth is suddenly going to dip much lower, then policy will be eased. If it looks as though growth is going to be a great deal faster, then policy will be tightened. This chart that is in the inflation report is a reflection of uncertainty, that is for certain, but it does not mean to say that the MPC has no say in what the final outcome will be over the course of the next two years because they have a policy instrument which is really quite effective at trying to make sure that the extremes in the distribution are not seen.


  17. Has the Budget affected your views on the outlook for interest rates?
  (Professor Dow) The upside risk in the inflation forecast is attributed to the effect of rising NIC contributions and therefore we can see a direct impact and certainly the additional aggregate demand from increased spending must also have added to the growth forecast.
  (Mr Walton) In my submission to you on the Budget, I did say that I thought the Budget did nothing to help the re-balancing of the economy and that actually the Budget was expansionary. By the end of this Parliament, you had an extra £17 billion or so of spending increases and that was matched by about £8.5 billion of discretionary tax rises. So, there was an easing in the Budget. The tax increases only come in from next year; this year there was actually a net tax cut. So, the Budget itself is helping to support domestic demand. Therefore, if there is any need for policy at some point to slow the economy, it is going to rest very much on the Monetary Policy Committee rather than with fiscal policy. That said, the MPC is also concerned that there is an additional effect over and above the demand effects from the Budget, which is the increase in national insurance contributions and the fact that that may have a knock-on effect to a wage and price setting behaviour, so that essentially if companies try to pass on the increase in employer's national insurance contributions to employees, employees may themselves respond by trying to increase wages. I personally thought that the MPC made a little too much of that. This does not actually kick in for another year; a lot can happen over the course of the next year. It may well be something to worry about at some point, but it seemed to me that the MPC was putting a little too much weight on that in this particular inflation report and it is going to be very difficult to determine the effects of the national insurance contributions in the data for wages calculations.

  18. In the MPC minutes, they did say that householders might adjust consumption in anticipation of the additional tax burdon before tax changes took place. Is that a little optimistic?
  (Mr Walton) It might be.

Mr Laws

  19. I just want to look at what is going on within the MPC itself, so I suppose this section may focus a little more on the two market watchers than the two academics, if I can put it in those terms. Before I begin, just so that we know the background to each of your thinking, could you just tell me in which month this year you think interest rates will rise and in which month you think they should rise.
  (Mr Bootle) My view has been that they would not rise before the end of this year although that is, as it were, an easy, broad brush expression and I think it should be consistent with the idea that they rise at the time of the November inflation report. I think you could say that five to six months is the period which I—

1   Note by Witness: I had been directed to the wrong building. Back

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