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.
1. SERVICE SECTOR
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
uncertaintyfor instance that on what people in the economy
expectmight 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 inflationalthough the Inflation Report
does not make explicit this connection) I think greater transparency
and detail here would be helpful.
2. EURO AREA
AND US MONETARY
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
Will financial developmentssay the changing
relations between the US dollar and other currenciesmatter
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.
3. OTHER MATTERS
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 pricescheap 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