Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Mr Roger Bootle, Capital Economics

  1.  The November 2003 Inflation Report generally supported expectations that November's interest rate increase will be followed by further rises over the coming months. In particular, the Monetary Policy Committee's central projection for RPIX inflation remained slightly above the 2.5% target throughout the two year forecast period and is rising towards the end of the period. This has been seen as a strong signal that the MPC itself expects rates to have to go up further.

  2.  However, it is worth bearing in mind that this forecast is predicated on a very optimistic view of the likely strength of the economy next year, with the MPC raising its forecast for GDP growth in 2004 to close to 3.0%. This is around 0.5% higher than the current consensus forecast amongst outside forecasters and is in line with the Chancellor's own much-derided forecasts. Admittedly, there have been signs of stronger activity in recent months, but it is not clear why the MPC should be significantly more optimistic than other forecasters.

  3.  My own view is that the MPC's optimism will turn out to be misplaced. Although there have been signs of an upturn in overseas demand, there are still major uncertainties facing global activity and the UK's external sectors have yet to show any visible improvement in response to stronger overseas activity, or indeed to the depreciation of sterling since the start of the year. Accordingly, while I expect the growth of net exports to accelerate over the next year, it may fall short of the MPC's expectations.

  4.  Meanwhile, I expect the growth of household spending to slow more sharply than the MPC's latest projection, which suggests that spending will continue to grow at its trend rate. The result is that, while the MPC's optimism towards growth will support further rate rises over the next few months, it could soon become clear that growth itself is unlikely to meet the Committee's expectations.

  5.  The MPC's upbeat growth forecast, together with the concomitant increase in inflationary pressures means that setting interest rates in accordance with the aim of hitting the inflation target chimes in with the objective of cooling down the housing market.

  6.  While targeting asset prices directly is not part of the MPC's brief, it has become clear from the MPC minutes and elsewhere that some members are very concerned about the housing market and the associated build-up of household debt, and the risk of a major downward adjustment to borrowing and spending in the future.

  7.  If growth does disappoint next year and inflation prospects look subdued but the housing market still looks uncomfortably strong the MPC would face an acute dilemma. The MPC needs to be asked how it sees its role in those conditions. Would it put interest rates on hold even if this would cause house price inflation to bowl along, thereby risking a serious adjustment later? Would it be prepared to raise interest rates even though the result would be inflation undershooting its target in two years' time? Would this still be compatible with seeking to hit the inflation target over a longer period? On this loose interpretation, isn't a policy of targeting asset prices always expressible in terms of an inflation objective over a longer time period?

  8.  Of course, the inflation outlook is muddied by the forthcoming switch to the harmonised index of consumer prices (HICP), likely to take place at the time of the Pre-Budget Report on December 10th. With the target for HICP likely to be set at 2.0% and the HICP currently at 1.4%, this is likely to leave inflation comfortably below its target. This change could well have no immediate impact on the path of monetary policy, but it will surely have a significant impact eventually. At the very least, the switch to HICP would be compatible with a lack of urgency to push interest rates up aggressively.

  9.  Accordingly, it was disappointing that the November Inflation Report did not include any analysis of the likely effects and implications of the switch to the HICP for monetary policy. The Inflation Report was written as though the switch was not going to take place. Is this because the switch has not yet been made and we still do not know the target? Is there still some uncertainty about the new target? Or does the MPC really believe that there are no implications from the switch? Or does it believe that although there are possible implications monetary policy should be set on broad lines and should not be unduly influenced by technical considerations to do with the target variable? The Bank should surely present a full discussion and analysis of these issues—in the next Inflation Report, if not before.

18 November 2003

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