Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 40-47)


6 JUNE 2006

  Q40  John Thurso: I wanted to ask you, Mr Saunders, about core inflation. In your submission you noted that core inflation remains well below the 2% target for CPI inflation, and, indeed, you are quite dismissive of the analysis that the MPC have done. How likely do you think it is that core inflation will rise to the 2% which you suggest was needed to meet the Bank's inflation target once the energy effects have fallen away?

  Mr Saunders: We do not know for certain what the MPC have as their core inflation forecast. It would be nice if they told us, but, if they do not, we sort of have to guess. I think their forecast requires core inflation to accelerate significantly to above any pace that we have seen since the Bank became independent. I think it is pretty unlikely that is going to happen. We have been talking about the background of rising pay, inflows of low-cost labour, and fairly tough competition in the retail sector. You have got plenty of head-winds there which are likely to keep core inflation low. If you look at the recent evidence, the last six months has seen core inflation slowing, not accelerating. Again, to me this is an area where the MPC could afford to wait. I think they need to see core inflation head higher significantly before they need to think about raising rates on the basis of a forecast that it might do.

  Q41  John Thurso: Is that a generalised view?

  Mr Butler: I share the view. I am pretty relaxed, as you may have gathered, on the inflation outlook. Once the energy price drops out, I do not think there will be second-round effects coming through. I think the big risk for me is if you saw a more substantial pick up in import prices, which is something that the UK has not seen for some time and has been one of reasons why UK inflation was persistently below the target; but at the moment, in the environment we going forward in, I think global growth is probably going to slow and you will eventually see sterling pick up and potentially it could rise further if the dollar adjusts, then I do not see that as much a risk at the moment.

  Professor Muscatelli: I am a bit more cautious. As I said earlier, I still think that increasing expectations is an amber light and, although I do not think they will act immediately, it might be difficult for them to do anything dramatic to interest rates in terms of a downward direction as long as we are seeing inflation above the target. Let us remember that the Bank has to target actual inflation, not core inflation. That is their target and that is what they are trying to meet, and so I am a bit more cautious on this in the longer term.

  Q42  John Thurso: How important, therefore, is core inflation to what we are looking at? From what you were saying there, it is almost something one should perhaps play down.

  Professor Muscatelli: Core inflation is a concept which is essentially—one it is a sort of medium-term built in sort of level of inflation. I think it comes back to the discussion we were having earlier. To what extent are there going to be second-round effects? To what extent might some of these expectations feed through to some earnings? It may not be in all sectors. As I said earlier, I am a bit concerned about the public sector. I think there might be less slack there. We will need to see, but I do not think it is that easy a concept to pin down, especially when we are unsure about how all these effects on non-labour costs will eventually feed through. That is why I think it is more of an amber light at the moment.

  Mr Butler: I think the issue, again, goes back to energy price issues. If you think one of the reasons why energy prices are so strong is because of China coming on stream and there being a demand for these products, there are implications of China coming on stream, they are producing a lot of cheap goods that end up on the high street, and so there is an issue of why should you exclude one, i.e. energy costs, and not exclude high street inflation. Therefore, core inflation, I think, is a concept that is useful but I do not think it is something that banks ever will target or should target or gives you an accurate guide of maybe some of the trends that are going on.

  Q43  John Thurso: Can I turn to some of the uncertainty around the projections. We had some written evidence from Professor Dow. In her submission she noted that the width of the `fan' is derived from past forecast errors and so cannot reflect new structural change. To what extent do you believe that the use of derivatives and the speed of international markets being used for information, and so forth, such as the inflation expectation data, mean that there has been a structural change and past forecast errors may not, therefore, be a good guide to the future?

  Mr Saunders: I think this is a very hard one. To me the question of converting into numbers the uncertainty in your forecast, I think the MPC deserve congratulations for having a go at it. It is not one which I would want to—. I cannot think of a better way to do it.

  Mr Butler: If anything, I think you can argue that the franchise should be widened. If you look at, say, the probability they give of a negative GDP on a year-on-year basis is next to zero, in my view I would argue I think it would probably be greater than that. I think what they do is probably the best way of trying to handle a probability distribution. Basing it on past experience and also basing it on a view about the risks going forward makes sense.

  Professor Quah: I think structural change is an easy and over-used accusation against many things that one disagrees with. It is one of these unverifiable things. I think that the MPC and the Bank of England is technically superb in how they have done the fan charts. Statistically, economically, the reading of the evidence and then the conveying of that information through the franchise is exactly what I think an erudite member of the public would want to see. I think anyone who wants to bring a charge of structural change should bring more evidence to bear. It is something that is debated in the academic literature as well as more generally, and my impression from the history of these things is that we way over-use that term.

  Professor Muscatelli: I would agree with that. I think we need to ask the question: what structural change was Professor Dow envisaging? I think what is done is the best that can be done, and it is also a very useful device in addition before anchoring expectations, so it actually communicates very well what the Bank is trying to do.

  Q44  Chairman: I have got a couple of questions to end with on personal insolvencies. In the main Inflation Report the Governor said that the quite large social problem of insolvencies and a problem with debt is materialising, but he also down-played the macro economic effects of this problem. Do you agree with him? If you have got something to say, John, I have got a specific question for you later. Are there any comments from the rest of you?

  Mr Saunders: I think it is right to say it is a bigger micro social issue than a macro issue. I am not sure that means that you should dismiss it as a macro issue. What you have seen, after all, for the last couple of years is persistent weakness in consumer spending, a slight upward tilt to the savings rate and in surveys, like the GFK Survey, you see a marked bias to higher savings among consumers. I think that reflects in part the high level of household debt. The debt to income ratio in the UK is at a record high, it is the highest in the G7, and, although there is a legislative effect on the rise in insolvencies, it is also in part a reflection of that high debt story, and I think that probably is having a macro effect. Whether you pin that macro effect to insolvencies or to debt in a sense is a secondary question, but I think there is something there, which is a genuine headwind.

  Q45  Chairman: In support of his argument he refers to the USA and says that personal insolvencies are three times higher there but nobody talks about it having an effect on the macro economic field.

  Professor Muscatelli: I would agree with Michael. In itself it can have a large macro effect, but it may be symptomatic of attitudes towards saving and debt, changing attitudes, which are important because they generalise beyond insolvencies to the rest of the consumer population. In itself, I think it is a big social problem. It was very striking how the numbers increased, even in Northern Ireland and Scotland where there was no change in regime. It is very striking as a behavioural change.

  Professor Quah: The change in regime issue, which might not by itself explain the behaviour or the reaction in those parts of the country where it has not taken hold, does show that there are two sides to this question. One is that, yes, more people are going into personal insolvency, but, on the other hand, they are coming out of it faster, they are coming out within a year rather than three years, and that cuts two ways. That restores their spending patterns, it restores the action they want to undertake. At the same time that we see an increase in recorded insolvencies, then we see an increase in restrictions on their behaviour for a year. I would tend to agree that this is not going to be a big issue macro-economically for inflation.

  Q46  Chairman: John, you made the point in your submission that typically mortgage arrears and personal insolvencies like the pick-up in unemployment, but this time the relationship has appeared to be coincident. Insolvencies have risen despite the low levels of unemployment. How serious a problem do you see that and what indication do you think this provides as to the interest rate sensitivity of households?

  Mr Butler: I would be more concerned about it than, say, the Bank alluded to. I think it has been interesting that the pick-up has been very sharp despite unemployment still being incredibly low. One explanation for that, I think, relates to an issue we have already discussed, that UK employment has been pretty flat but we have seen an influx of people coming into the workforce over the retirement age. It has meant that the unemployment rate, or the employment rate of people of 18 to 35 years old, has been falling quite sharply, and, typically, they are the people that take on much of the debt in the UK over the last couple of years, particularly the unsecured debt. I think that the employment prospects have particularly proved probably the most vulnerable in terms of the debt picture and have deteriorated sharply. I also think it is an issue about the level of debt and that that has made consumers much more sensitive to a smaller change in interest rates or a smaller change in job uncertainty than in the past. I think it is an issue. I think it means that we are going forward moving in the dark—you do not know the power of interest rates until they are adjusted—and, even though it is a lower level, I think the rapid change goes way beyond the changes in the law of bankruptcy and I think it shows a greater sensitivity on the household sector.

  Q47  Chairman: A question, each of you, for the Governor. What should we press him on?

  Professor Muscatelli: I think I would press him hard on this issue of financial imbalances in the world. I think that is the biggest risk. What sort of contingency plans might they have if the whole thing unwinds rather more unstably than currently predicted?

  Professor Quah: He has already taken my favourite hobby horse, which is global imbalances, so I will have to settle for something else, and that is why business investment remains weak.

  Mr Butler: I would ask him what has changed. I think in November they had, I would say, a loosening bias. They have now got a tightening bias, but their GDP forecasts were almost identical to back then, and there seems to be a deteriorating trade-off between growth and inflation, and I am not sure what the source of that is and whether they fully incorporate the labour market issues.

  Mr Saunders: I would ask him how the news since the MPC meeting of May and the Inflation Report would affect their judgment. The pound is up, equities are down, we have had various bits of data. We know what they thought then. Let us try and get an update.

  Chairman: Okay, that is good. There is just one draw back: the Governor will know what we are going to ask him! Thank you very much.

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