Examination of Witnesses (Questions 40-47)
PROFESSOR ANTON
MUSCATELLI, PROFESSOR
DANNY QUAH,
MR JOHN
BUTLER AND
MR MICHAEL
SAUNDERS
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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