Select Committee on Treasury Third Report

2 The Economy

The recent past

5. After what the OECD has termed a "drawn-out period of fits and starts"[16] the global economy finally started to acquire momentum through 2003. Monetary and fiscal policy in many of the major economies continues to support growth and since the spring easing geopolitical tensions, steadier oil prices and recovering confidence have combined to produce sharp rebounds in the US and Japanese economies and added further strength to the recovery already under way in much of Asia. The OECD has revised upwards its spring forecast of 1.8% growth for the OECD area in 2003[17] and now expects growth of 2.0%. It expects the UK economy to enjoy growth close to the OECD average this year, some way behind expected growth of 2.9% in the US and 2.7 % in Japan, but well ahead of the 0.5% growth expected in the euro area.[18] We note the European Commission's comment that "the UK economy weathered the recent global slowdown well".[19] This is particularly notable in the face of the continued weakness in activity in its major trading partners in the euro area.

6. In spite of the clear signs of recovery in the global economy in recent months, risks flowing from the scale of current global imbalances remain. In particular, many commentators agree with the Treasury's assessment that "a sharp fall in the value of the US dollar would have significant implications for growth in those economies that are dependent on US trade, and might also hit US domestic demand by pushing up long-term interest rates and reducing household purchasing power."[20] In that context, the Committee is concerned that the recent fall in the dollar may jeopardise global recovery prospects, although some of the evidence we received on this point was generally reassuring. Professor Spencer told us that "provided that we can see the dollar adjusting in an orderly kind of way, as we have done fortunately so far, then it is not just US exporters that benefit…., but the European economy benefits in the sense that the stronger euro means that upward pressure on price inflation is reduced. Remember that the ECB has found it extremely difficult to cut interest rates in Europe because consumer price inflation has remained doggedly above its 2 per cent target."[21] Mr Cunliffe from HM Treasury also noted that the problems created for the eurozone by recent currency moves had to be set alongside the strong US growth performance and that "the effect is the net of those two and even though the euro has been strengthening against the dollar in the third quarter of this year, eurozone exports, particularly to the US, have strengthened particularly in the third quarter."[22]

7. In the 2002 Pre-Budget Report the Treasury forecast UK growth in 2003 of 2½ to 3%,[23] slightly above the average forecast from independent forecasters[24] at the time of 2.4%. In the last Budget the Treasury reduced the forecast to 2-2½%, consistent with the consensus view of independent forecasters at the time.[25] The Treasury currently estimates that the UK economy will have grown by 2.1% in 2003, near the average of independent forecasts.[26] In spite of UK growth emerging broadly in line with forecasts, recent months have been marked by significant revisions to the economic data. As the Governor of the Bank of England has remarked, these have tended to dissipate some of the "statistical fog"[27] that had previously surrounded the economy. As the Treasury notes,[28] the revisions have also served to reduce, but not remove, some of the imbalances that had appeared in the UK economy. Consumer spending growth has generally been revised down a little and fixed investment growth in recent years has been revised up. The net trade position has also emerged a little stronger after the revisions. Even so, comparing the Treasury's current estimates for 2003[29] with its forecasts at the time of the Budget,[30] two of the main areas of disappointment are fixed investment and exports. Looking at fixed investment, growth is now expected to be about half the 4¼-4¾% projected in the spring. For exports, meanwhile, the latest estimates point to a small fall this year rather than the small rise originally expected, although the disappointing trend in exports is offset in terms of the GDP arithmetic by a smaller rise in imports. In spite of a rather disappointing trend in fixed investment and exports, current estimates of UK economic growth in 2003 are consistent with the reduced forecast of 2-2½% growth published by the Treasury at the time of the last Budget.

8. As the world economy has recovered, the concerns about global deflation the Committee noted in the spring[31] have receded. The Governor of the Bank of England has indicated that the Bank has been engaged in a strategy in recent years of "stimulating domestic demand to compensate for weak external demand in the face of a strong exchange rate"[32] and this policy has been broadly appropriate to the circumstances. Throughout a volatile period in the world economy the Committee observes that the MPC has continued successfully to maintain UK inflation close to the target laid down by the Chancellor. Moreover, while maintaining inflation inside the target range, monetary policy has also been able to provide substantial support to growth by delivering historically low short term interest rates to the economy.

9. The Bank's pro-growth strategy has been supported by fiscal policy and Professor Spencer observed that "were it not for the strength of public spending as we go into [2004], I think [the economy] would still be growing well below trend…. As the PBR says, fiscal policy has supported monetary policy in keeping us going through this period."[33] The successful complementarity of monetary and fiscal policy has played a key role in delivering a UK economic performance over the past few years which the IMF describes as "enviable"[34]. Key tests for both monetary and fiscal policy nevertheless lie ahead as recovery emerges. As the IMF also noted, "the external environment is now improving, and macro-economic policies should tighten to rebalance external and domestic demand". Our expert witnesses broadly supported this view. Mr Walton noted that "the big challenge for policy now is to stop the UK economy from growing too fast as we go forward from here".[35] Professor Spencer noted that it would "be extremely tricky for the Monetary Policy Committee to be [as] adept at slowing this process down and rebalancing the economy as it has been adept in keeping the economy going through the world recession"[36] and that "if you believe in fiscal fine-tuning, it is now time to start tightening up on the public sector side".[37] As the global economy recovers it is vital that UK economic policy adapts as anticipated to the upswing, to avoid potential problems flowing from the current imbalances in the economy.

The outlook for the UK economy

10. After the Budget last spring we noted that "economic forecasters generally agree about the outlook for the UK economy in 2003" and that most "expect the recovery to gather pace somewhat in 2004, although the Treasury's forecasts stand out in terms of their optimism regarding the scale of the acceleration in UK growth anticipated".[38] As Table 1 shows, this remains broadly true although since the Budget the average of independent forecasts of UK growth for 2004 has risen from 2.4%[39] to the 2.6%[40] recorded currently. The Treasury's economic forecasts for 2004 and beyond continue to look more optimistic than most, although the gap between the Treasury's assessment and that of most other forecasters has narrowed, with most independent forecasters now a little more optimistic about growth in 2004 than they were in the spring.


11. As the Treasury observes, "while underlying consumption growth appears to have eased since the second half of 2002, it has continued to outpace increases in disposable income, thereby contributing to continued steady growth in demand for personal borrowing since Budget 2003."[41]

12. Many economists have identified the continued build up in personal borrowing as a potential source of instability in the economy, particularly given the role played in its build up by the housing market. The UK's position is far from unique. The OECD have warned that "in a variety of countries—including the United States, the United Kingdom and Australia—households remain highly indebted and may suffer large wealth losses, especially in the housing sector, should interest rates increase abruptly".[42] Treasury officials argued that such fears were misplaced. Mr Cunliffe told us that "when you look at the debt service to income ratios, the amounts of their income people are paying in mortgage payments or interest payments generally are low." [43] Although the Treasury also notes that "while mortgage equity withdrawal has increased, households [in aggregate] have simultaneously been building up their holdings of financial assets", there is no discussion in the Budget documentation of the distributional impacts or of the extent that the households purchasing the financial assets are the same as the households building up liabilities. In addition, the Bank of England has flagged that there is "evidence of large unsecured borrowing relative to income by a small proportion of individuals. This may not necessarily be a problem currently, although it could become one if these borrowers experienced adverse financial shocks, such as unexpected increases in interest rates or falls in income."[44]

13. When asked for the Treasury's view on the risks posed by the build up in personal debt should interest rates start to rise, we were told that "questions of how interest rate increases affect consumption are really questions for the Bank of England because short run demand management of the economy is their job and not ours."[45] The Governor noted that in aggregate the ratio of interest payments to income is running at "half the level that it was in the early 1990s, and again it will require a very, very dramatic rise in interest rates to get us back to where we were in the early 1990s in aggregate. From that picture, I think people have exaggerated the vulnerability of the economy to likely changes in policy" but "there are minority groups of households, if you look at households facing ratios of debt servicing to income of more than 40, 50%, where it would not require a very large increase in interest rates for those families to find themselves with the sorts of difficulties that they had faced ten years ago".[46] However it is plain that the Bank takes a very limited view of its role on the issue of how to respond to any problems created by the rise in personal debt levels if they do not have an effect on the economy in aggregate. Professor Nickell of the MPC told us "That is not to say that higher rates of bankruptcy, more families getting into difficulties and so on is not an extremely important issue. It is an issue which may concern many people in Britain and also some branches of government. It is an issue which you will be extremely interested in. It is just that there is little practical relationship to monetary policy."[47] While the probability of either a fall in house prices or a rise in interest rates on a scale that would create widespread problems for households should be viewed as very limited, we think it is nevertheless important for both the Treasury and the Bank of England to consider how policies could impact on individual households whose debt servicing ratios have become unsustainable.

Fixed capital formation

14. We noted earlier[48] that one of the areas of disappointment in the UK's economic performance through 2003 has been the trend in fixed investment. We highlighted in our report on the Budget[49] that the Treasury's optimism here was one of the more controversial aspects of its spring economic forecasts, with most forecasters expecting a much more modest recovery in fixed investment through 2003. In spite of fixed investment over the past year only growing at around half the rate originally expected by the Treasury, the Pre-Budget Report still expects a relatively robust 6-6½% rebound in fixed investment activity in 2004.[50]

15. In part the Treasury's optimism on the investment outlook is fuelled by a projected 30% rise in general government gross fixed capital formation, although much of this rise represents public sector investment originally scheduled for calendar 2003 slipping into calendar 2004. The effect is that general government investment spending is still expected to be near target over the financial year 2003-04, thanks to a large surge in spending in the first quarter of the calendar year/final quarter of the financial year.[51] The Government is currently engaged in a programme that implies a large increase in public sector fixed investment. This inevitably poses problems for managing a smooth flow of spending in this area. The persistence of a pattern of large surges in spending concentrated in the final few weeks of the financial year is not one that is conducive to efficiency and value for money in the spending of public money. Despite the welcome improvements in the control of public expenditure including allocating resources to departments on a three-year basis and giving them more flexibility to carry forward unspent resources, the NAO recently noted "a continuing bias to a higher proportion of both revenue and capital spending in the last two months of the year. Some departments lacked sufficiently complete information to ensure that expenditure was spent in a measured way throughout the year".[52] The Chancellor acknowledged that "I think [the Committee's] point about departments getting it right is taken on board."[53] Treasury officials also indicated that discussions with departments about ways of tackling the problem are underway.[54] The Committee attaches the highest importance to securing the best possible value for money in public spending. It is disappointing to note that, despite the welcome improvements to the control of public expenditure that have enhanced flexibility, many departments are still failing to manage their capital spending programmes as efficiently as they should. We recommend that the Treasury takes action to improve the planning and monitoring of public sector capital spending programmes within the financial year. We would welcome a report on any such action in the 2004 Spending Review.

16. Alongside the strong growth in public sector gross fixed capital formation, a recovery in business fixed investment is generally expected. Data revisions suggest that the trend here over the past couple of years has in any case been less depressed than once thought. Many outside forecasters nevertheless suspect that the Treasury's forecast of a 3 to 3½% rise in business investment in 2004 and a 5½ to 6¼% rise in 2005[55] may prove rather optimistic. For example, the Treasury's assessment that "with corporate profitability having risen over the past year and company balance sheets far healthier than during the late 1990s ICT boom, businesses are well positioned to step up investment as the global recovery gathers pace into 2004"[56] strikes a notably different tone to the Bank of England's view that "there may be a number of factors limiting the recovery in companies' investment spending. Capital gearing remains high, there has been little sign of pressure on physical capacity at this stage and pension fund deficits may be diverting cash away from other uses…..the [Monetary Policy] Committee expects business investment to continue recovering, albeit moderately."[57] Professor Spencer also expressed some caution on the outlook for corporate fixed investment, noting that "one of the reasons for our pessimism relative to the Treasury is that we remain concerned about the state of the company sector finances and the effect of pension fund deficits on business expenditure." [58]

17. The problems potentially flowing from large pension fund deficits surfaced in the course of our inquiry into the 2003 Budget. Our May report on the Budget noted that "the potential impact on the broader economy of the current weak state of many pension funds is a serious one that does not yet seem to have received the attention is deserves….We recommend that the Treasury should co-ordinate with relevant bodies the publication of aggregate data to enable the issue to be more readily quantified and assessed."[59] In its reply, the Treasury stated that "Pension funds' statistics are an important issue for the ONS and Government statistical service more widely. The recent report of the Review of Pension Contributions Statistics (conducted by a committee comprising academics, industry experts and officials from various Government departments) and subsequent action plan highlighted areas for improvement in the information available on pension funds. One of the action points was to consider whether a statistical digest or fact sheet could be produced, bringing together all available pension statistics. The action points are being taken forward by ONS, HMT, DWP and others."[60] There appears, however, to have been little or no progress in this area in recent months. While Mr Cunliffe noted that "There is information on pension fund deficits. As I recall, it is not easy to compile an aggregate figure."[61] When asked for a progress report on compiling aggregate figures, Treasury officials had little to add to the Treasury's original response to our Budget 2003 Report.[62] The Committee has noted, however, that private surveys continue to point to a multi-billion pound deficit in UK company pension funds, even though the scale of the problem has been reduced after the recent revival in the equity market.[63] The Committee is disappointed at the lack of progress on improving official pension fund statistics. The health of UK company pension schemes appears to be a major gap in the information flow into the Treasury's assessment of the economic outlook. Given its crucial impact on British households, we recommend that the Government show much greater urgency in ensuring the provision of regular and reliable official information on pension fund deficits. We further recommend that the Chancellor report on this issue expressly in the 2004 Budget.

The output gap

18. Central to the Treasury's broad economic forecasts is an assessment of the output gap that is notably higher than most forecasts. Treasury officials told us that "our forecast is based on the [assessment] that there is an output gap of around 1½ per cent in the economy and that output gap will close over two years. We have seen in the past when the economy is closing similarly sized output gaps, in the mid 1990s, for example, growth has been around 3½ per cent and in the 1980s it was higher. Of course the increase in the trend rate of growth has made it more possible that we can reach a rate of 3 to 3½ per cent." [64]

19. Many independent forecasters feel that the output gap is much lower than the Treasury suggests, but all our expert witnesses agreed that the output gap is, in practice, very hard to assess with any confidence.[65] Given the importance of the issue in assessing policy, however, not least because of the difficulties in dating economic cycles arising from data uncertainties, several commentators have suggested that transparency could be further improved by giving an authoritative, independent body the task of judging issues such as the dates of the cycle and the UK's cyclical position. The benefit would not be so much that the judgement made by such a body would necessarily be better than that made by the Government but that it would be seen to be independent.[66] One of the supporting studies published as part of the euro assessment looked at measures to improve the credibility and transparency of fiscal policy. The discussion paper argued that the more active fiscal stabilisation policy became, the greater was the "the case for enhancing independent surveillance. This could be achieved by increasing the role of independent analysis (e.g. for technical elements such as 'dating' the economic cycle) or strengthening the monitoring of fiscal policy, through existing structures such as the EU."[67]

20. Mr Balls, Chief Economic Adviser to the Treasury, argued that at least the Government's current approach made its assumptions about the output gap explicit, suggesting that "until 1997, government in the UK did not publish estimates of the output gap and they did not publish estimates therefore of the cyclically-adjusted fiscal balances, and so it was not possible to reach a judgment as to where you were in the cycle…. It is a strength of the system in the UK that there is now an open public debate about the trend growth rate, the level of the output gap, when the cycle started, when the cycle ended."[68] The Committee welcomes the improved transparency in recent years provided by the Treasury's explicit discussion of issues such as the output gap and the cyclical position of the UK economy. It encourages the Treasury to explore ways of further improving transparency, which may include closer involvement of outside bodies or experts in the judgements made.

The switch in the inflation target

21. In his June 2003 statement to the House on UK membership of the single currency the Chancellor stated that the Harmonised Index of Consumer Prices was "a better measure [of inflation], will improve the quality of our target, is in line with best international practice and is used by every other G7 nation but Japan, and by our neighbours in Europe";[69] as a result he had "written to the Governor of the Bank of England today stating that subject to confirmation at the time of the Pre-Budget Report I intend to change the inflation target at that time. The inflation target for Britain will be set on the consumer prices definition. I can confirm that pensions and benefits and index-linked gilts will be calculated on exactly the same basis as now."[70] The shift in the target measure of inflation was confirmed in the Pre-Budget Report, with the Chancellor announcing an immediate switch to a new target of 2% CPI[71] inflation, with the open letter system being triggered should inflation stray by more than 1% from this target.

22. The Treasury noted that "the rate for the new target is half a percentage point lower than the old target. The gap reflects the differences in the way CPI and RPIX inflation are measured, notably the formula effect, which means that CPI inflation tends to be lower than RPIX inflation on average. The level of the new target is set to be consistent with previous target in two years time, that is, the typical time horizon for monetary policy purposes",[72] although the current gap between the two measures is 1.3 percentage points, primarily reflecting the impact of rapid rises in housing costs. Housing costs and council taxes are excluded from CPI inflation but included in RPIX inflation.

23. Professor Nickell of the Monetary Policy Committee has argued that in spite of the current wide gap between the two inflation measures "in the long run, the stance of monetary policy would be unaffected and even in the short run there would be little noticeable difference".[73] Most of our expert witnesses seemed to agree with this assessment, with few expecting any dramatic impact in, for example, the labour market arising from the switch in inflation targets.[74]

24. In spite of this assessment from our independent experts, the Chancellor announced to the House that "because discipline in pay setting is essential in both private and public sectors, I have …. written today to Public Sector Pay Review Bodies informing them that our inflation target is 2 per cent."[75] However, there appears to be a ready recognition from the Treasury that even in the public sector it would be unrealistic to expect pay awards simply to follow the inflation target. The Chancellor confirmed to us that "I am not being prescriptive in announcing a pay policy"[76] and Treasury officials confirmed that "the Chancellor has written as a courtesy to the Pay Review Bodies to let them know of the change in the inflation target, so that is one of a number of factors which they can take into account in their recommendations, but the overwhelming issue for Pay Review Bodies is the need to recruit, retain and motivate workers in the appropriate sectors, and that is the key issue which the Government is directing the Pay Review Bodies to consider."[77]

25. The Governor of the Bank of England has, however, indicated that to switch inflation targets at a time when the gap was so wide did pose problems for the presentation of monetary policy. In September he told the Committee "on the latest reading, the difference between the [two inflation] measures was 1.5%, and, although this difference is expected to narrow substantially over the next two years, it may well remain at or above 1% well into next year. In such circumstances, the change in the target will need to be explained extremely carefully."[78] He expanded on this in November, telling us that this involved "explaining to people at large why it is that [inflation] is presently above the target and then suddenly it will appear below the target and yet from our point of view we do not see that as having major significance for monetary policy".[79] The Chancellor told us that, as the Bank had reported in the previous inflation report, "they will be setting interest rates based on their assessment of the likely level of inflation two years ahead…[at which time] the CPI is expected to be 2% and RPIX is expected to be 2.5%".[80] The Bank has yet to publish a formal projection for CPI inflation but the Governor made it clear to us in November that "the central view of the gap between RPIX and [CPI] inflation looking two years ahead is around half a percentage point" so that "looking two years ahead it does not make very much difference to monetary policy". Although the Governor of the Bank of England has indicated that he does not think the switchover will be of major significance for monetary policy, given the focus on inflation two years ahead, we note his comments regarding the need for care in the short term in explaining the switch in the inflation target from RPIX to CPI inflation and will scrutinise the progress made in enhancing public understanding of the change.

16   OECD Economic Outlook No 74, Preliminary Edition, November 2003  Back

17   OECD Economic Outlook No 73, Preliminary Edition, April 2003 Back

18   Forecasts based on OECD Economic Outlook No 74, Preliminary Edition, November 2003 Back

19   EU Commission Autumn Forecasts Back

20   Pre-Budget Report 2003, Box A2, p 174  Back

21   Q 6 Back

22   Q 96 Back

23   Pre-Budget Report 2002, Cm 5664, Table A2, p 158 Back

24   Forecasts for the UK Economy, HM Treasury, 20 November 2002 Back

25   Budget 2003, HC 500, Table B5, p 234 Back

26   Pre-Budget Report 2003, Table A8, p 197 Back

27   HC (2002-03) 1337 Q 44 Back

28   Pre-Budget Report 2003, paragraph A25, p 178 Back

29   Pre-Budget Report 2003, Table A10, p 200 Back

30   Budget Report 2003, Table B10, p 242 Back

31   Seventh Report of Session 2002-03, The 2003 Budget, HC 652-1, para 11 Back

32   Mervyn King, Speech to East Midlands Development Agency, Leicester, 14 October 2003 Back

33   Q 32 Back

34   IMF, United Kingdom - 2003 Article IV Consultation, 18 December 2003 Back

35   Q 9 Back

36   Q 9 Back

37   Q 32 Back

38   Seventh Report of Session 2003-03, The 2003 Budget, HC 652-1, para 13 Back

39   Forecasts forthe UK Economy, HM Treasury, April 2003 Back

40   Forecasts forthe UK Economy, HM Treasury, December 2003 Back

41   Pre-Budget Report 2003, para A71, p 190 Back

42   OECD Economic Outlook No 74, Preliminary Edition, November 2003 Back

43   Q 97 Back

44   Bank of England Quarterly Bulletin, Winter 2003, p 425 Back

45   Q 98 Back

46   26 November 2003, HC (2002-03) 1337 Q 85 Back

47   18 September 2003, HC (2002-03) 1114, Q 93 Back

48   para 7 Back

49   Treasury Committee, Seventh Report of Session 2003-03, The 2003 Budget, HC 652-1, para 16 Back

50   Pre-Budget Report 2003, Table A6, p 192 Back

51   Qq 106-109 Back

52   NAO Managing resources to deliver better public services HC (2003-04) 61 Back

53   Q 278 Back

54   Qq 109-111 Back

55   Pre-Budget Report 2003, Table A6, p 192 Back

56   Pre-Budget Report 2003, para 2.35, p 26 Back

57   Bank of England Inflation Report, November 2003, p 27  Back

58   Ev 71 Back

59   Seventh Report of Session 2003-03, The 2003 Budget, HC 652-1, para 17 Back

60   Government Response to the Committee's Seventh Report on The 2003 Budget, HC (2002-03) 1028, para 8  Back

61   Q 103 Back

62   Q 279 Back

63   Research by AXA Investment Management, for example, was quoted in the Financial Times, 1 December 2003, p 5 Back

64   Q 94 Back

65   Q 5 Back

66   Q 5, Q 46 Back

67   Fiscal Stabilisation and EMU, HM Treasury, June 2003, para 23, p 5  Back

68   Q 285 Back

69   HC Deb, 9 June 2003, col 408 Back

70   HC Deb, 9 June 2003, col 414 Back

71   It was announced at the time of the PBR that the ONS had retitled the HICP as the Consumer Price Index (see New Inflation Target: the Statistical Perspective, ONS December 2003) Back

72   Remit for the Monetary Policy Committee of the Bank of England and the New Inflation Target, HM Treasury, 10 December 2003 Back

73   "Two Current Monetary Policy Issues", speech 16 September 2003 Back

74   Q 80 Back

75   HC Deb, 10 December 2003, col 1063 Back

76   Q 363 Back

77   Q 255 Back

78   18 September 2003, HC (2002-03) 1114, Q 2 Back

79   20 November 2003, HC (2002-03) 1337, Q 61 Back

80   Q 355 Back

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