Examination of Witnesses (Questions 1-19)
25 NOVEMBER 2004
PROFESSOR CHRISTOPHER
PISSARIDES, PROFESSOR
DAVID MILES,
PROFESSOR ANDREW
SCOTT AND
MS BRIDGET
ROSEWELL
Q1 Chairman: Good morning
and welcome everyone. Please identify yourselves for the sake
of the record.
Professor Pissarides:
Chris Pissarides, from the London School of Economics.
Professor Miles:
David Miles from Morgan Stanley and Imperial College.
Ms Rosewell: Bridget
Rosewell from Volterra Consulting.
Professor Scott:
Andrew Scott from the London Business School.
Q2 Chairman: Welcome and
thank you for coming along. May I start with a question to Bridget.
The MPC only narrowly avoided reaching the lower limit of its
permitted range around the target in September and having to write
an explanatory letter to the Chancellor. You warned us in May
that you felt the Bank may be tightening policy unnecessarily.
Do you think the below target inflation we have seen this year
falls into the category of avoidable policy mistake or was it
an acceptable error in uncertain circumstances?
Ms Rosewell: It
sounds like a "Have you stopped beating your wife?"
question! I think the borderline between what ought to be avoided
and what cannot be avoided is obviously a very narrow one and
hard to define. I think what we have been seeing is an international
situation which has been particularly hard to call, and continues
to be hard to call. Indeed it is that bit of the economic conjuncture
I am most concerned about at the moment. We have seen a much stronger
international position than probably we were expecting to see.
In other words, in spite of the strength of the oil price generating
economic weakness and the wobbles around the international political
situation, nonetheless economic growth in world economies is very
strong this year; and that produced an underlying position which
is rather different. That might also then have created an economic
position of the UK which was stronger, and where interest rate
increases needed to be put in place to slow all that down. That
is the bit which has not come through. Inflation has not come
through on the back of that international position in a way people
would have expected in the past. Indeed, if you read the Inflation
Report there are some words around what has been happening to
the exchange rate which say, "It might go this way and it
might go that way". Again, that is one of the parts of the
economy which is hardest to predict. I would say that the Bank
continues to be very focussed on what it sees to be its difficulties
in the domestic economy, and that has led it to be more cautious
than probably it needed to be.
Q3 Chairman: On the issue
of being too cautious, as we know it has typically undershot the
inflation target in the past. We have had a memorandum from Roger
Bootle which says, "With regard to the inflation outlook,
I broadly concur with the Bank's profile, although I think, not
for the first time, it is overdoing the inflation dangers".
Does anyone feel strong on that?
Professor Miles:
I would have said not. I can see certain risks to the upside,
possibly even more than are emphasised in the Inflation Report
where I think they argue the risks are somewhat asymmetric, that
is that there are more risks to the downside than the upside.
The one I would point to stems from potential movements in the
exchange rate, where sterling is in the somewhat unusual position
of being, on any plausible measure, substantially over-valued
against the US dollar, at a time when the US dollar itself is
coming under downward pressure and may indeed fall significantly
in the near term. That might mean that sterling, in order not
to become even more over-valued against the dollar, would need
to go down with the dollar and that would have some inflationary
impact and cost impact going forward. So this generates a risk
of a pick- in inflation pressures in the future. Another risk
is related to the puzzle as to why wage settlements have stayed
at such unusually low levels. There really has not been much of
an increase in wage settlements, even though measured unemployment
has fallen to probably the lowest rate in 30-odd years. The Bank
clearly is somewhat puzzled by why that has been the case. This
is one of the reasons why inflation has turned out to be somewhat
lower than they have been predicting for most of the last few
years. They keep thinking that we have reached a position of tightness
in the labour market such that wage pressures should increase,
and they have not yet. That must be a source of uncertainty to
the Bank and to most economists.
Ms Rosewell: One of the issues
in that is the way the Bank is looking at the domestic economy
and one of the things I think it would be worth asking them is
what their take is on what is happening to the output figures,
the GDP figures. When you look at the Inflation Report I almost
begin to wonder if they do not believe or think that the GDP figures
are measuring what is going on in the economy. They are much more
concerned about what they are calling the "resource take":
because of the difficulty of measuring public sector output, let
us look at what resources are being taken out of the economy.
One of the possible things going on in the wages front is if the
private sector is actually quite weak, and there is not much room
for expansion there. While the public sector is doing something
different, then you might see it as segmenting into 2 different
parts of the economy. It is not clear to me how far they think
that is really what is happening and it might be worth probing
them on that.
Q4 Chairman: Do you think
there will come a time when the MPC needs to cut rates to preserve
credibility, given it is undershooting regularly, even if its
forecasting models continue to forecast a rising trend in inflation
at some point in the future? Is it a credibility issue here?
Professor Pissarides:
No, I do not see a credibility issue. Like the 2 previous speakers,
I do not think the Bank is being over-pessimistic. I do not agree
with Roger Bootle's analysis in the memorandum he gave. I see
the world economic situation improving unexpectedly. I see the
money supply, which was not mentioned by my colleagues here before,
growing faster than usual. I see oil prices and allied costs going
up. The only part of the market which is subdued is the labour
market. If the labour market were to pick up then inflation would
take off. I do not see the need for the Bank to cut rates to improve
its credibility. I do not think it would make good economic sense
at the present time to cut rates. I think we are seeing many things
taking place both in the world economy and the UK economy. We
are not sure yet exactly what the implication will be for inflation,
and the best thing to do is to wait and see. We will probably
have to sit back and wait for 6 months before we know what is
going on.
Professor Scott:
I think on the issue of credibility it is actually quite healthy
to have a conservative central bank which gets very twitchy about
inflation. I think that is an inbuilt bias in the system. I think
we have to be a bit careful that the changes in the inflation
we are talking about, at least in the numbers, are really quite
small. The UK has been staggeringly boring economic-wise in the
last 3 or 4 years compared to everything else. We do tend to make
a lot about small changes. If you look at things like a very strong
world economy, oil prices, the GDP forecast and what that implies
for the output gap, it is clear that the Bank can make a case
for rising inflation. What is very interesting for me is a slight
tension, because if you look at the main inflation forecast beyond
2006 they have increased their inflation forecast; but the Report
is mainly about downside risks and why they do not need to do
much to interest rates at the moment. If you look at their forecast
on inflation, it does go above target after 2006. That forecast
is based around market expectations of interest rates. The obvious
implied assumption is that the Bank thinks rates are going to
rise faster than the market is forecasting. Yet all it talks of
are downside risks, and that is probably unnecessary. If they
are talking about inflation rising I do not think they are showing
an undue attention to it. If anything, their emphasis on the downside
risk shows they are reluctant to raise rates.
Q5 Mr Beard: They are
a long way from the target, are they not? 1.14.
Professor Scott:
0.6 is not a huge target, but monetary policy operates at such
a lag that a rise above target in two years' time is something
the Bank will need to be thinking about in setting interest rates
over the next 6 months if they seriously believe that. Everything
seems to suggest inaction rather than a rise in rates.
Q6 Norman Lamb: If I can
turn to some internal management issues. This summer the MPC switched
to using the implied interest rate in the money markets rather
than constant interest rates in constructing their central projections
for inflation and growth. Has that been a sensible development?
Professor Pissarides:
I think so. Even before they did it, in this place we raised this
point before that perhaps projections should be done on the basis
of market expectations. Although the Bank sometimes leads market
interest rates, it is very much a follower of market trends as
well and it is the right way of doing it—to follow and try
and push slightly in the direction you want policy to go. You
do not want to go totally against market expectations, because
then you are confusing markets and your policy is less effective
and market participants do not know what you are going to do next.
The policy of using the market expectation of the interest rate
instead of the constant one is the sensible assumption to make.
There is nothing magical about current rates that will continue
in the future. The future course of interest rates will be determined
to a large extent by market trends and partly by the direction
you want to push policy. They are reasonably saying, "We
do not want to indicate now where we will want to push policy
in the future, but we might as well take account of market trends".
Q7 Norman Lamb: Do you
all agree with that?
Ms Rosewell: Yes,
absolutely.
Professor Miles:
The timing, in a sense, has been rather good, in that at the moment
it so happens that market expectations are pretty much that rates
stay where they are. So there is not much difference in terms
of the picture between unchanged interest rates and market expectation.
How sensible the change is depends upon how sensible the market
expectations are. If you were in a situation where market expectations,
for some reason, generated a picture of projected inflation which
took inflation very far away from 2% it would put the MPC, the
Bank, in a rather strange position in showing the projections.
Q8 Norman Lamb: So expectations
can be irrational in some respects?
Professor Miles:
They could be. I think at the moment the situation is a comfortable
one because the expectations seem sensible given what they then
imply for the Bank's forecast. One could imagine a situation where
that was not true.
Ms Rosewell: Equally,
you could say that to produce a projection where you are saying
that the interest rates will never change that would also not
be true. That is also irrational because if the world changes
a lot then the interest rates will also change. You have got a
problem on either side of that.
Professor Miles:
I absolutely agree with that.
Q9 Norman Lamb: They have
also started to publish forecasts for three years out. Is that
sensible given the margins of error that inevitably exist in that
range of forecast?
Ms Rosewell: They
are not much different from the range of error on two years out!
If it is the case that it is still a two-year horizon on the speed
with which interest rates work through to the economy—and,
as Andrew was saying earlier, some material implies that it might
be a bit shorter than that, or the Bank thinks it is shorter than
that—then to have some idea whether you think you are going
up to the end of that period is sensible and gives some context
at any rate.
Q10 Norman Lamb: The House
of Lords Select Committee on Economic Affairs has been rather
critical of the Bank for lack of transparency, particularly in
not publishing its economic model. It points to the Treasury as
a model of transparency, making it available to the public, and
the fact that it is used by the ITEM club etc. Do you think there
is a strong case for the Bank publishing its economic model?
Professor Scott:
I think one of the issues is the way the Bank does modelling.
There is one core model but it does strongly emphasise that forecast
issues are new issues and that you have to use a range of different
models. I think the danger of just having one model that everyone
sees as being the Bank model which generates the forecast
would be quite misleading.
Q11 Norman Lamb: Is there
any case for secrecy? Should it just be in the open?
Professor Scott:
If you say, "These are all the models we produce. Here they
are", that gets rid of any problems of hiding things. I think
there is a danger people take the model far too seriously and
far too automatically. In a way it is easier for the Treasury
because the Treasury is not setting interest rates.
Ms Rosewell: The
Treasury has always produced its model and allowed its basic model
to be used for academic purposes and other purposes and, indeed,
the ITEM club. However, the version of the model that is being
used by the Treasury when they produce their own forecasts for
their own purposes is almost certainly not precisely the same
because it is always being worked on. All forecasts are a matter
of judgment as much as they are a matter of the model, in any
case. That is always the case. Indeed, the range that is being
produced for the Bank's forecasts—if you remember we have
had previous discussions with the Bank about how they do that,
and in previous Inflation Reports they have reported on that—that
is as much a matter of judging what the sort of the scenarios
are that you might look at, as saying, "Here is some sort
of confidence interval around that central forecast". There
is an awful lot which goes into producing a forecast which is
beyond what is in the actual model.
Q12 Norman Lamb: Are you
broadly comfortable with the current situation that it is not
published and so it cannot be tested independently?
Ms Rosewell: I
think it would be nice for academic researchers if it were published.
I do not think it would make any difference to our ability to
judge the performance of the Bank of England in its monetary policy.
Q13 Norman Lamb: Would
either of you take a different view?
Professor Pissarides:
I am in favour of more transparency. I should also say in favour
of the Bank that they do so show their model to the outside world—at
least the underlying model. Less than a year ago they had a big
one-day conference on the model they call BEQM, where they invited
academics and other central bankers to comment on the outline
and the detailed equations of the model. What is probably not
a good idea to show outside, for the reasons just outlined, is
the policy forecasting model, so that other people could put in
the policy instruments and forecasts. In fact, reading the November
Inflation Report is a very good example where they should not
do it. There are many things there which they point out, and I
am thinking in terms of the BEQM model which they have. On the
basis of the BEQM I would have guessed that the economy was going
to go in a certain direction, and yet the Inflation Report says,
"We don't think the economy is going to go in that direction
because of such and such a thing that has happened since August".
You cannot put that into the model. There are arguments both for
and against. But on balance I think more transparency is better.
Q14 Norman Lamb: Just
quickly on errors in forecasting. The House of Lords Select Committee
has been quite critical in its recent report on areas both in
inflation forecasting, where it says, "The remarkable finding
is that the MPC consistently over-predicted inflation until 2002,
and after 2002 it consistently under-predicted inflation",
and then it talks about errors in GDP growth rate forecasting.
Its conclusion in that section is that, "Errors in forecasting
remain a live issue"; they say that professional economists
should be showing a greater interest, including why errors in
forecasting persist. Is this a fair criticism or is it just the
international context that is very hard to predict and they are
doing the best they can?
Ms Rosewell: They
are definitely doing the best then can. In fact, they are probably
doing better than most of the rest of us.
Q15 Norman Lamb: So it
is an unfair challenge?
Ms Rosewell: I
think that is an unfair challenge. The difficulty with short or,
indeed, medium-term forecasting is that essentially we do not
have enough data for enough accuracy to be able to do this. When
we have had another couple of hundred years of capitalism maybe
we will know enough about the way that these economies operate
that we will be able to do accurate forecasting—but I would
not bet on it. These are complex situations with lots of interactions
going on in them. With unpredictable events on top of that, and
data which is measured with inaccuracy, and indeed gets revised
all the time, quite often you will find that what looks like an
error in forecasting turns out to be an error because the data
has subsequently been changed. In a world where you never know
where you are but only where you have been (and that with error),
the fact that anybody gets this at all right most of the time
or gets it in the right ballpark is a matter for congratulation.
This is much, much more difficult than people think. Indeed, it
is noticeable and I think the Bank should be congratulated on
the way it has tried to make this clear on every occasion. It
introduced the fan charts in the first place into the public debate;
and tried to get us away from the idea we could know with certainty
which way the economy was going; and indeed that is why they are
making these month-by-month adjustments and attempts to catch-up
with where we are. If it were easy then none of us would be here.
We would not be employed, and neither would the MPC.
Q16 Norman Lamb: On the
voting records in recent times, has it surprised you that it has
been unanimous ever since last April? Is it because the judgments
ultimately have been clear and obvious, or does it perhaps imply
a lack of independence from the outside members? It is an unusual
run they are having.
Professor Pissarides:
The arguments have been a little bit more on one side recently
than in the past. I still find it quite remarkable that so many
economists agree for such a long period of time.
Q17 Norman Lamb: Unique!
Professor Pissarides:
Maybe the arguments for or against were persuasive at the two-day
meetings than before. There is more consensus now.
Professor Scott:
The real test will be if they all change their mind at the same
time. That seems to me the most worrying side of it. Then you
would be able to distinguish between two hypotheses about what
is driving them.
Q18 Norman Lamb: Do you
share the worry expressed by some that the current external members
are failing to challenge Bank orthodoxy in the interest rate decision?
Professor Scott:
I am not at the meetings. I do not know.
Q19 Chairman: I think
Norman's first question to the Governor next Tuesday, Bridget,
will be a congratulatory comment. Is that correct?
Ms Rosewell: Definitely.
Angela Eagle: There will
be nothing to say!
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