Memorandum submitted by Professor Christopher
Pissarides, London School of Economics
1. The November Inflation Report gives,
in my view, a well-balanced evaluation of both world and UK economic
conditions. No major revisions to the views expressed in August
appear necessary, but the downside risks appear less than in August.
Given the narrow vote in favour of no change in August, it is
not surprising to see a vote in favour of change this time.
2. The thinking behind the MPC's decision
appears to run like this:
a. RPIX inflation has been slightly above
target for much of 2003.
b. The global economy is showing signs of
recovery.
c. UK growth is approaching trend.
d. Equity prices are recovering.
e. The sterling effective exchange rate is
showing some signs of appreciation but has not reversed its recent
depreciation.
f. House prices and personal debt are continuing
to rise.
g. Business investment has been weak but
recently statistics have been revised upwards and profits have
picked up.
3. In these circumstances, a small rise
in interest rates can act as a brake on further upward forces
on prices, with little apparent downside risk.
4. There are two ways, which should be complementary,
in which one can approach the problem of evaluating the strength
of inflationary forces in the economy. One is to look at the balance
between nominal demand and supply in the economy as a whole. The
other is to look for bottlenecks in factor markets.
5. The Report does a good job at looking
at the strength of overall demand. Foreign demand is picking up,
domestic consumption demand remains strong and domestic investment
is picking up. I suspect this is the main reason that made the
MPC vote in favour of a rise in rates.
6. In my view, however, we get a better
idea of inflationary forces by looking at factor markets. Bottlenecks
may arise in both capital and labour markets, but with international
capital mobility and the less capital intensive service sector
providing the engine of growth in recent years, the labour market
is the key.
7. Key questions here are, is the unemployment
rate a good measure of inflationary pressures in labour markets,
should we look at the outcome of leading wage negotiations, should
we look at other things?
8. In this respect the Bank is doing well
assembling evidence on "labour market tightness." The
behaviour of unemployment and wages in the 1990s astonished observers—if
historical experience was the guide, inflationary pressures should
have built up years ago, certainly by 2000. They did not. Work
at the Bank on this issue is still untested but the following
important claims are made in the Report:
a. There has been more entry of workers from
outside the labour force when demand for labour picked up.
b. There has been more immigration, with
a large fraction of foreign labour recruited in the public sector.
c. Average hours of work have fallen, because
of the growth of part-time jobs, held mainly by women.
d. Per-person productivity is probably rising
faster than in the recent past.
9. The United States went through a similar
"surprise" period in the early 1990s, when employment
kept rising, productivity shot up and inflationary pressures remained
subdued. Even old hands like Greenspan were surprised by what
they saw. But to the Federal Reserve's credit, they allowed the
expansion to continue, despite their fears that it would not last.
10. In my view the biggest danger from tightening
policy now is that if there is a chance that the UK is embarking
on a similar "roaring" expansion, the MPC should avoid
stifling it with tighter policy before it takes root, and should
follow instead the Fed's policy of "forbearance." In
that respect, perhaps waiting a little longer before tightening
policy, until the evidence became clearer, would have been a better
option.
18 November 2003
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