Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor Danny Quah, London School of Economics

  The November 2005 Inflation Report constitutes, as do all the previous Inflation Reports, an excellent and persuasive piece of professional analysis. Sharp, balanced, and transparent is the argument leading up to the MPC decision to leave the interest rate unchanged at 4.5%. More, the reasoning makes explicit what the Bank and the MPC identify to be the large, immediate risks and uncertainties in the UK macroeconomy. The Inflation Report is a model to which central banks everywhere should aspire in their accounting of macroeconomic facts and policy thinking to the economy at large.

  One of the most remarkable features in this Report, although not surprising from accounts elsewhere in other [US and European] official publications, is how little macroeconomies worldwide have been affected by the two US hurricanes and associated oil supply disruptions. Part of this resilience stems of course from how fuel consumption (Chart 2.4, p 10) has become a much smaller part of total spending than before. From a peak of almost 10% in the early 1980s fuel spending in the UK has fallen to only 5% as a fraction of total consumption. Similar declines have been noted elsewhere, notably for US data despite popular impression on SUV proliferation in that country. Another part of the explanation for this macroeconomic robustness must be how more adept economies in general and central banks in particular have become at dealing with such disturbances.

  My own report here raises two principal points I find not completely satisfactorily dealt with in the Bank of England's November publication. These two are, first, the uncertainty and ambiguity surrounding service sector performance in the UK economy; and, second, the impact on the UK and the likelihood of incipient monetary tightening in the Euro and US economies. On the first, the Report is unclear on how widely divergent estimates (in my view) have been merged and reconciled into the MPC's final judgment on the most likely paths for output and inflation. That this matters and is not just statistical quibbling comes out of numbers presented in the Inflation Report itself.

  On the second, I would welcome greater volume and more detail in forward-looking assessments on international developments more generally. Although the Chairman-elect of the Federal Reserve Board of Governors has announced a wish to continue the policies of Alan Greenspan, emerging US economic developments will imply higher interest rates there soon. Similarly, although the Euro area economy remains subdued, indications are that there too higher interest rates have become more likely than at any time in the last five years. These represent, it seems to me, significant changes in the international macroeconomic environment relevant for UK monetary policy. Discussion on these matters appears sparse in the current Inflation Report.

  I now take in greater detail these two points in turn. The last section then makes further observations, related to these first two.


  Chart 3.3 on p 16 shows estimates of service sector output growth derived from two sources, one an official ONS estimate and the other, a survey-based estimate, obtained from correlation with historical official data. The official ONS estimate shows current (2005) percentage growth from a year ago equal to 2%; the latter survey-based historically-correlated estimate, 3.5%. The difference is striking: One estimate for the growth rate is almost double the other.

  This is not just minor quibbling on data accuracy. Chart 3.4 on p 17 makes clear that for a while now the services sector has regularly made up over 70% of overall GDP growth. Uncertainty on such a large, important component must necessarily render imprecise the final aggregate estimate.

  I was unable to find in the Bank's Inflation Report clear discussion on how this uncertainty in the services sector feeds through to the likelihoods on alternative outturns for GDP growth and CPI inflation. Does the MPC simply take the final ONS numbers on measured GDP and inflation? Given how the latest revisions in GDP back data have confirmed the ONS's lower growth estimates for services, should the smaller numbers be taken for now to be the more reliable?

  It is not routine econometric modeling (neither with vector autoregressions nor with more structured models) how a researcher combines alternative numbers for the same concept, in this case growth in the services sector, to obtain a final estimate for aggregate GDP. The Inflation Report does not indicate clearly how the MPC has done this beyond statements on how the MPC [p ii, p 16] "continues to place some weight on" the survey-based results. The discussion on p 16 refers to how previous Inflation Reports have already pointed to this uncertainty. The current Inflation Report [still on p 16] goes on to describe some strengths and weaknesses of the different estimates on growth in the services sector.

  I don't know how other readers of the Inflation Report interpret this discussion. But I for one am left unclear how exactly the MPC digested and used this information. Do the fan charts incorporate this uncertainty in a statistical or econometric model? Or are the 90%, 99% ranges drawn to MPC consensus, judgmentally including this uncertainty in the services sector?

  (I don't make similar observations about the other constituents making up the GDP and inflation fan charts because no other component appears to have such diversity and disagreement in the underlying measurements. I might not have the exact details but I can imagine how the other variables could be readily used in informing consensus scenarios. Also, other uncertainty—for instance that on what people in the economy expect—might matter for behavioural relations; this one, on the other hand, matters directly for what GDP actually is.)

  All statistics are, of course, imprecise. But a reader naturally supposes that fan charts of the kind shown in Chart 1 (p ii) have their alternate possibilities driven by unexpected, future disturbances to the aggregate economy, not current uncertainty in underlying measurements. Given how large the services sector component is for GDP growth overall (and, I assume, for CPI inflation—although the Inflation Report does not make explicit this connection) I think greater transparency and detail here would be helpful.


  Turn next to Euro area and US monetary developments. These matter: the UK ships two-thirds of its total exports to Europe and North America. And, in general, what happens to US economic growth matters for world economic growth.

  All indications are that interest rates will be raised soon by Euro area and US policy-makers. The US continues to run a current account deficit one-sixth that of its GDP. The stock of US debt held abroad is large by historical standards, and uncertainty remains considerable on the medium-term sustainability of this pattern of global financial flows.

  Higher interest rates in the Euro area and North America could perturb the recent stability of sterling's effective Exchange Rate Index (ERI), driving up CPI inflation directly through pass-through of sterling's depreciation. Conversely, real macroeconomic slowdown in the Euro area and North America could lower UK exports, reducing demand and thereby GDP growth. Different possibilities and risks suggest themselves. For now, however, the November Inflation Report contains little assessment of these possibilities. It confines its analysis of external developments mostly to narrow discussion of the statistical behaviour of exports and effective exchange rates.

  Will financial developments—say the changing relations between the US dollar and other currencies—matter directly for UK inflation, deviating from historical correlations because the driving forces might now be so different? Is there an MPC evaluation of sustainability of global financial imbalance?

  I don't know that there is any kind of a consensus on this either in the profession at large, but my suspicion is that more extended and detailed discussions of such questions will be important and informative for UK monetary policy.


  A further dimension related to this discussion of international developments lies in labour market performance. The November 2005 Inflation Report documents total net migrant flows amounting to 250,000 in the year to mid-2005. This number of course has significant implications for UK wage and price dynamics, and thus CPI inflation and GDP growth.

  But India's and China's entering the global labour marketplace and doubling the effective number of workers has impact that, according to economic theory, does not need to occur through actual migration of workers. All that needs to happen is merchandise trade to occur for effective factor inputs to influence wages and prices—cheap labour itself does not need to move. The actual number of migrants will reveal only part of the dampening effects on wages and prices.


  As I said at the beginning of this written evidence I am very impressed with how excellent a piece of research and balanced communication the November 2005 Inflation Report is. It maintains the high standards consistently set by all the earlier Inflation Reports. My comments above are not so much criticisms but questions and perhaps suggestions for what might be useful to expand further, either in discussion surrounding the November Report or, longer-term, in subsequent Reports.

21 November 2005

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