House of Commons - Treasury

Select Committee on Treasury Second Report

2 THE ECONOMY

The United Kingdom Presidency of the G7/8

4. The United Kingdom Government set out the priorities for its Presidency of the G7/8 in December 2004. These were international poverty reduction, structural economic reform, trade and climate change. Regarding international poverty reduction, the Gleneagles G8 Summit made progress in the following areas:

Aid: A doubling of aid for Africa by $25 billion a year by 2010, as part of an overall increase of $50 billion a year for all developing countries;

Debt relief: 100 per cent multilateral debt relief for 38 Highly Indebted Poor Countries; and

Trade: The G8 leaders stated their commitment to eliminate all forms of export subsidy by a credible end-date and to reduce substantially trade-distorting domestic support.

5. Bob Geldof characterised the Gleneagles Summit as "a qualified triumph" and "without equivocation the greatest G8 summit there has ever been for Africa."[6] OXFAM, while welcoming the fact that "no previous G8 summit has done as much for development, particularly in Africa", noted that the increased aid will still come too late and fall far short of UN and World Bank estimates of what is needed to meet the Millennium Development Goals.[7] While listing the additional commitments made during the United Kingdom Presidency of the G8, the Pre-Budget Report concludes that "more needs to be done both to deliver and bring forward these commitments".[8] To this end, the Government has supported the development of an International Finance Facility, which would front-load donors' existing long-term aid commitments through bond issuances on the international capital markets. The Chancellor of the Exchequer told us in July that, "if we cannot front-load money between now and 2015, our major objective of meeting the Millennium Development Goals will not be met".[9] In September, the British Government launched the pilot International Finance Facility for Immunisation (IFFIm), in partnership with France, Italy, Spain and Sweden, and alongside contributions from the Bill & Melinda Gates Foundation. The IFFIm will generate an additional $4 billion over the next ten years to provide vaccines to tackle some of the deadliest diseases in the world's poorest countries.[10]

6. The G8 research centre at the University of Toronto has calculated that the documents issued at the Gleneagles summit contained 212 separate commitments.[11] In the light of the fact that the G8 does not have an independent secretariat and that the Russian G8 Presidency will focus on energy, we asked the Chancellor of the Exchequer what mechanisms were in place to monitor the delivery of the G8's commitments. He told us that "the G8 has got to continue to monitor what it has decided, because if it does not secure the implementation of its agreement then the credibility of the G8 is in issue".[12]

7. Following the Pre-Budget Report, the World Trade Organisation (WTO) Ministerial Conference took place in Hong Kong from 13 to 18 December 2005. The Chancellor of the Exchequer told us that a successful trade deal could be worth around $300 billion of economic growth and that developing countries could benefit from a reduction in agricultural protectionism. He considered that "it is very important that we send a signal that we are all determined to get the trade talks moving".[13] In a statement to the House on 20 December 2005, the Secretary of State for Trade and Industry, the Rt Hon Alan Johnson MP, while welcoming progress on the elimination of agricultural export subsidies and access to markets for least developed countries, described the overall outcome of the WTO Ministerial Conference as "disappointing".[14] We welcome action taken during the United Kingdom's G8 Presidency to tackle global poverty, including the increases in aid and the provision of debt relief. It is important that there is clarity about the level of aid and debt relief commitments and clear monitoring to ensure that the G8 delivers on commitments at Gleneagles. We recommend accordingly that the Treasury include reports on G8 progress on the Gleneagles commitments in each Budget and Pre-Budget Report, as well as seeking to strengthen international mechanisms for tracking and delivery such as the Africa Partnership Forum. We also welcome the launch of the International Finance Facility for Immunisation and encourage the Government to continue to explore how innovative financing mechanisms such as the broader International Finance Facility can be used to provide the additional aid necessary to meet the Millennium Development Goals. It is disappointing that the Hong Kong trade talks failed to deliver the hoped-for trade deal; progress in 2006 will be important if world economic growth is to be supported and market access for developing countries is to be increased.

The recent past

8. While remaining positive in every quarter, output growth has moderated since mid-2004. The revisions to the national accounts published in June 2005 indicated that growth was higher than previously estimated in 2001, 2002, 2003 and 2004, but that there had been a sharper slowing of growth in the second half of 2004 than had previously been thought. This meant that the economy had less momentum going into the early part of 2005. Excluding volatile energy output, it is clear that the quarterly growth rate of economic activity reached a trough in the first quarter of 2005, before recovering gradually through the year. Some information from the labour market and business surveys points to a less sharp slowing of growth in 2005 than indicated by official data. The Bank of England has described employment growth during the first three quarters of 2005 as "reasonably robust" and, despite an increase in the claimant count for unemployment, the employment rate remains close to a 15-year high.[15] The Bank of England has also noted discrepancies between business surveys and official measurements of growth in the service sector: the Governor of the Bank of England, Professor Mervyn King, told us in late November 2005 that he thought that the Office of National Statistics (ONS) might be underestimating the extent of growth in the economy and that the Monetary Policy Committee (MPC) had made a judgment that, "on average, we would expect some upward revision to growth, not a lot but a little".[16] Mr Ben Broadbent of Goldman Sachs told us that he expected that growth would prove to have been "a little over 2 per cent" in 2005.[17] Mr Cunliffe told us that "it is very unusual to have a period in which the economy puts on 330,000 new jobs in a year, which is the strongest employment growth we have had for a couple of years, at the same time that the rate of output [growth] is dropping".[18]

9. At the time of the 2005 Budget, the Treasury was forecasting growth of 3 to 3½ per cent in 2005; in the 2005 Pre-Budget Report, the Treasury forecasts that the economy will have grown by 1¾ per cent in 2005. As can be seen from the table below, all components of demand have grown slower than the Treasury expected.

Table 1: Summary of economic forecast

	Percentage changes on a year earlier
	2005
	Budget	PBR
GDP	3 to 3½	1¾
Manufacturing output	1½ to 2	-½
Domestic demand	3¼ to 3½	1¾
Household consumption	2¼ to 2¾	1¾
General Government consumption	3¼	1½
Fixed investment	6 to 6¼	2¾
Change in inventories	¼	0
Exports of goods and services	6 to 6½	4¾
Imports of goods and services	6 to 6½	4¾

Data source: HM Treasury: Budget 2005 p 237, Pre-Budget Report 2005, p 204

Table 2: Forecast contributions to GDP growth

	Percentage points
	2005
	Budget	PBR
Private consumption	1¾	1¼
Business investment	½	¼
Government	1	½
Change in inventories	¼	0
Net trade	-¼	-¼
GDP growth, per cent	3¼	1¾

Data source: HM Treasury: Budget 2005 p 229, Pre-Budget Report 2005, p 192

Mr Cunliffe told us that, in explaining the slower than forecast growth, 0.5 percentage points could be accounted for by the national accounts revisions and 0.5 percentage points by higher oil prices and lower growth of exports to the eurozone; the effect on household disposable income growth through lower earnings growth accounted for most of the remainder, including the possibility that highly-geared households slowed down their consumption more than was forecast in the face of higher interest rates and easing house price inflation.[19] Asked to comment on why the Treasury's forecast was wrong, the Chancellor of the Exchequer said:

10. The Chancellor of the Exchequer went on to say that "in any other decade when we either had an oil shock or we have had a hit to the housing market in this way … in each of these situations we have usually had to deal with this with a recession … People will look back on this year and say the economy was challenged … but that challenge was met by us being able to deal with the inflationary problem, both domestic and international, and as we move into next year people can be more confident about growth."[21] Mr Broadbent, while noting that the downgrade was abnormally large (1½ per cent compared with an average error of ½ per cent), told us that "forecast errors are inevitable and, over the years, the Treasury has a good track record".[22] After above trend growth in 2004, growth has moderated during 2005. A number of reasons for lower growth were put forward by witnesses, including high and volatile oil prices, rising interest rates, weak eurozone growth, slower growth in real government consumption, increasing tax revenues and weak earnings growth, as well as national accounts revisions. Overall GDP growth for 2005 is now estimated by the Treasury at 1.75 per cent, significantly below the Treasury's forecast of 3 to 3.5 per cent at the time of the Budget. We note evidence from the labour market and business surveys suggesting growth might be revised upwards and that non-oil output growth has strengthened from the trough at the start of 2005. We also note that, despite its relatively large forecast error in 2005, overall the Treasury has had a good forecasting record for GDP growth in previous years.

Macroeconomic stability

11. In its economic survey of the United Kingdom in October 2005 the Organisation for Economic Co-operation and Development (OECD) concluded that, over the last decade, "macroeconomic performance has been impressive; GDP growth has been robust and cyclical fluctuations in output have proved smaller than for almost any other OECD country, while inflation has remained close to target". The OECD believed that this was "a testament to the strength of the institutional arrangements for setting monetary and fiscal policy as well as to the flexibility of labour and product markets".[23] Our expert witnesses agreed with this assessment. Mr Martin Weale of the National Institute of Economic and Social Research (NIESR) told us that "the policy framework has been very helpful in delivering stability, in particular the monetary [policy] arrangements that we have had have meant that the Bank of England has been able to react in a way that other countries have found difficult". He also believed that the surge in tax revenue in the late 1990s had given the Government considerable room for manoeuvre in terms of producing what has subsequently been an expansion of fiscal policy.[24] The IMF recently described macroeconomic stability in the United Kingdom as "remarkable"[25] and concluded that this impressive record owed much to good macroeconomic, financial and structural policies, underpinned by sound policy frameworks and supported by a generally favourable external environment. We note the confirmation that over the past six years the United Kingdom has been the most stable economy in the OECD and G7, a record that international institutions have described as "impressive". We note evidence that the institutional arrangements for monetary and fiscal policy have played an important role in delivering this stability.

12. On 11 January 2006, the European Commission recommended "that the United Kingdom deficit be declared excessive and the United Kingdom be asked to correct the situation".[26] This recommendation was under the Excessive Deficit Procedure of the Stability and Growth Pact, which allows the fiscal deficit to exceed 3 per cent of GDP only temporarily or for exceptional reasons. This is an issue to which we will return in our inquiry into the 2006 Budget.

Growth in 2006 and beyond

13. In addition to downgrading their forecast for 2005, the Pre-Budget Report indicates that the Treasury now expects growth in 2006 to remain at below trend rates of 2 to 2½ per cent. The Treasury said that this reflects "the continued drag on real household disposable incomes arising from high oil prices, together with the ongoing effects of subdued earnings growth, acting to keep growth of private consumption at relatively modest rates. The effects of oil prices on business confidence, together with subdued demand growth, are also expected to encourage the corporate sector to remain cautious about stepping up business investment growth in the short term."[27] The Treasury's forecast for 2006 is now close to the consensus of 2.2 per cent and the MPC's central forecast of 2.5 per cent. Professor David Miles of Morgan Stanley told us that, while "the short-term Treasury forecast looks fairly plausible, of relatively weak growth next year, the forecast they have for 2007 [and] 2008, which is for above trend growth, looks on the optimistic side".[28]

Monetary policy

14. The MPC raised interest rates by 25 basis points five times between November 2003 and August 2004. The MPC then kept interest rates steady at 4.75 per cent until August 2005, when it decided by five votes to four to reduce interest rates by 25 basis points. Following a long period when inflation was below target, CPI (Consumer Price Index) inflation rose above the Bank of England's central target of 2 per cent in mid-2005, peaking at 2.5 per cent in September, before easing back to 2.1 per cent in November as oil prices passed their peak. MPC members have told the Committee that the rise in oil prices accounts for around one half of the rise in CPI inflation, with the remainder resulting from increased food prices and the pressure of demand on supply from the strong growth during 2004.[29] Core inflation, excluding volatile energy and food prices, has remained subdued, peaking at 1.8 per cent.[30]

15. In the Bank of England's November Inflation Report the MPC assessed the risks to its growth and inflation forecasts as broadly balanced. The Governor told us in late November 2005 that, over the past year, the economy had seen a traditional supply side shock with the economy slowing and inflation picking up. He told us that the MPC would be focusing on three areas in the coming months:

the impact of the rise in oil and other energy prices on demand; despite the fact that the United Kingdom is an oil producer, the increase will reduce overall purchasing power in the British economy;
the supply-side impact of increases in energy prices, which was difficult to assess, but where it is conceivable that the rise in energy prices will reduce temporarily the supply capacity of the economy; and
the direct effect of energy price increases on inflation, including the risk that the short-term rise in inflation might dislodge inflation expectations and lead to attempts to push up earnings growth to compensate for the loss of purchasing power.[31]

In a period of high and volatile oil prices, the Monetary Policy Committee of the Bank of England has so far managed to keep inflation close to the target. So far there is little indication that inflation expectations have become dislodged or that there are significant second round effects stemming from the rise in CPI inflation. However, this is a risk that will require close examination by the MPC in coming months, particularly as the results of pay rounds filter through in the early months of 2006.

Measuring service sector output

16. The service sector accounts for 70 per cent of United Kingdom output and GDP growth. We have received evidence that the reliability of the statistics in the service sector could be improved. Mr Broadbent told us that "some of the business surveys are in the end a better indication of what the ONS will eventually say growth has been than its own preliminary numbers, particularly in services".[32] The Governor told us in November 2005 that the Bank of England would "certainly like to see more resources devoted to trying to understand what is happening in the services sector because this is now many times larger than the manufacturing sector", adding that the MPC felt that "the official data for manufacturing output are very reliable and we do not feel that the other sources of information to which we have access really add very much to the official data; I do not think we feel quite the same about the services sector. This is a problem facing statistical agencies around the world and it is a problem which results from the changing structure of our economy."[33] Mr Cunliffe acknowledged the problem, telling us that the service sector is "now nearly four times as large as the manufacturing sector but we have much better statistics for manufacturing".[34] Measuring output in the service sector is inherently more complex than in the manufacturing sector. We recommend that the ONS make it a priority to review the measurement of service sector output, and devote more resources to improving measures of service sector output. Any such change should be accomplished as far as practicable within existing budgets and without increasing overall compliance costs on business, by rebalancing coverage away from sectors of the economy of declining importance.

Consumer spending and the housing market

17. Consumer spending growth has slowed sharply since the first half of 2004, a slow down mainly attributable to slower spending growth on durable and non-durable goods; spending growth on services has levelled out. Growth of 1.3 per cent in the year to the end of the third quarter of 2005 was the weakest growth over a period of four successive quarters for ten years. However, the Bank of England has described the slowdown in consumption growth as "moderate compared with many slowdowns since 1960"[35] and the current vintage of national accounts indicates that the quarterly growth rate of consumer spending has picked up modestly during the course of 2005. The 2005 Pre-Budget Report attributes the slowing in consumption growth to households adjusting to higher levels of personal debt and the lagged effects of the increases in interest rates between late 2003 and summer 2004 alongside a slowing in house price inflation and increasing oil and energy prices leading to a reduction in real income growth.[36]

18. At the November 2005 Inflation Report press conference, the Governor of the Bank of England said that two factors were worth emphasising in accounting for the slowing of consumption growth. The first was the "quite sharp rise in the ratio of taxes to household disposable incomes", a ratio that "has gone up by almost 2 percentage points over the last couple of years and contributed to a sharp slowing in real disposable incomes in the second half of 2004". The second factor "has been a change in relative prices in which the prices of boring items of consumer spending such as rent, payment for housing, utilities, energy and insurance … have risen quite sharply relative to the prices of the more 'fun' items of consumer spending which involve going to shops".[37] Later in November the Governor told us that the increase in the ratio of taxes to household disposable incomes was "more than one would expect from normal fiscal drag because it reflects in part the rise in national insurance contributions which took place".[38] Asked whether he accepted the Governor's analysis, the Chancellor of the Exchequer told us that "I do not think anybody should be in any doubt that four rises in interest rates … [were] bound to be the major factor in affecting consumer demand in the economy".[39] In addition to this "actual pre-tax wage rises have been lower than expected".[40]

19. Mr Broadbent told us that the increase in household income taxes had certainly outweighed, for example, the effect of higher energy prices on real take-home pay of households; he thought that it "has probably been quite an important factor in explaining slower consumption growth", but that the increase in taxes relative to income was "unlikely to carry on rising at that rate".[41] The NIESR has indicated that, while the increase in the effective tax rate reduced disposable income growth by 0.9 percentage points in 2004 and 0.7 percentage points in 2005, the effect will reduce to just 0.1 per cent in both 2006 and 2007. Mr Cunliffe told us that the "increase in the tax to GDP ratio was as forecast by the Treasury … A lot of the increase is fiscal drag and also compositional effects where you get particularly strong growth in the financial sector that increases the tax take from people at the very top paying income tax."[42] He also told us that "the rise is not due to any tax policy decisions; it is not as if taxes have been increased; the rise is due to fiscal drag. The rise is also due, as to some extent we forecast, to a higher proportion of higher rate taxpayers getting a higher proportion of the pay increases … to a large extent this is people at the top end paying a higher effective rate of tax because they are earning more."[43] Consumer spending growth slowed sharply during late 2004 and early 2005. The evidence we have received indicates that this was due to rising interest payments, lower than expected wage growth, higher petrol and energy prices slowing disposable income growth, and an increase in the ratio of tax to household disposable income. The MPC cut short-term interest rates by 25 basis points in August 2005 and the tax ratio is not expected to continue to increase at recent rates. This may lead to a moderate recovery in consumption growth, but to a rate that is still below its long-term average.

20. The 2005 Pre-Budget Report states that, "despite household consumption slightly outpacing disposable income, the saving ratio is expected to be broadly stable over the forecast horizon at just above its average over the recent past, reflecting the assumption that households net equity in pension funds continues to increase at recent rates".[44] Professor Miles noted that the Treasury forecasts were "based on an assumption that the household savings ratio, which is at an unusually low level, does not increase … and stays at around 4.5 per cent or so, which is historically an extremely low level".[45] We note that the Treasury's forecasts for consumption growth are based on an assumption that the savings ratio will stabilise at 4¾ per cent, which is around its current level.

21. Growth in household lending has slowed through 2005, as has consumer credit. In line with the rise in interest rates, mortgage arrears have risen slightly, although they remain low by historic standards. Research conducted by the Bank of England found that, while there has been a small increase in financial pressure on households, the bulk of household debt is owed by homeowners, the majority of whom appear to have little difficulty in servicing it.[46] The main problems are associated with unsecured as opposed to secured debt. The Governor of the Bank of England told us in late November 2005 that there were a minority of households which had borrowed extraordinarily large sums relative to their income and expenditure in the area of credit cards and store cards: he said that "they may have multiple credit cards and they do face very serious problems now in trying to work out how to consolidate that debt and meet their obligations". The Governor thought that "it was very serious for those individuals involved", but that this group was not large enough to have a "significant impact on the economy as a whole".[47]

22. House prices grew at around 3-4 per cent during 2005, the first time in ten years that they have grown more slowly than average earnings. The Pre-Budget Report sounded notably confident about housing market prospects, citing "increasing evidence that the housing market is undergoing an orderly adjustment, with little prospect of a sustained fall in house prices. Indeed prices have firmed a little of late."[48] In late November, the Governor of the Bank of England, while noting that house prices had not fallen in the way that many people had anticipated that they would and while stressing that no possibility could be ruled out, told us that the "way I should want to describe the housing market is one of broad stability".[49] With regard to secured debt, he told us that, "given that we start from a position when arrears are at a remarkably low level compared with historical experience, it would not be surprising if there were some pickup in that figure, but I do not think it has been really significant, certainly not on a macroeconomic scale".[50] Treasury officials told us that, while there was still a risk from the housing market, "the risk is less than it was a year ago, a year and a half ago" noting that "the house price to earnings ratio has come down, but it has come down not by house prices going down but simply by house prices growing [slower than earnings]".[51] The recent signs that the housing market is cooling, with house price growth slower than earnings, are welcome and this, so far, has come without the abrupt adjustment predicted by some forecasters. In the longer term, the implementation of the recommendations from the Barker and Miles reviews should improve the stability of the United Kingdom housing market. We note evidence that, while the majority of households can manage their debt repayments, there is a small, but significant, minority of households with problems with increased mortgage arrears and unsecured debt on credit and store cards.

Business investment and pension fund deficits

23. In the 2005 Pre-Budget Report the Treasury forecasts business investment growth in 2005 at 3 per cent, compared with a forecast at the time of the 2005 Budget of 4¼ to 4¾ per cent. [52] This fall is in spite of strong profit growth, the low cost of capital and falling capital gearing. Mr Cunliffe told us that weaker levels of business investment than expected were an "international phenomenon", partly attributable to the increase in the oil price and the over-investment that took place in the IT sector and more widely in the years leading up to 2000 and 2001.[53] He did not think that "the Pre-Budget Report and the measures in it will have an impact, or should have any impact on investment".[54] The Chancellor of the Exchequer told us that, "after this huge spurt of business investment in the late 1990s, particularly investment in IT, when there was an IT bubble as people now define it, there was a huge amount of additional business investment taking place and there has been a slower rate of growth of business investment in recent years, partly because a lot of these technological investments were made earlier on. I just say that business investment continues to rise."[55]

24. There has been concern that deficits in defined benefit pension funds could have led to increased financial pressure on companies and contributed to the weaker than expected growth of business investment. The latest data indicate that, over the past year, increases in equity prices have been balanced by increasing liabilities, leaving the overall pension fund deficit for FTSE 350 companies broadly constant at £72.9 billion in November 2005. Long-term interest rates have continued to fall, with the largest declines occurring at very long horizons. In December 2005, long real forward rates reached their lowest level since the British Government began to issue index-linked gilts in 1981. Lower long-term interest rates could provide increased incentives for companies to invest. However, they can also have a negative effect, to the extent that falling rates have a downward effect upon the discount rates that pension funds employ to measure their liabilities which could result in an off-setting effect as the total size of the liability increases. The Chancellor of the Exchequer told us that, "despite evidence that companies have continued to devote resources to pension fund deficits, there are no clear grounds for supposing that this has exercised much material constraint on investment".[56] This was supported by Bank of England research which found that up to 2002, dividends were reduced in response to higher pension contributions, with only weak evidence of any impact on investment.[57] However, since then employer contributions to funded occupational schemes have continued to increase, reaching almost £30 billion a year in 2004.[58] The Pensions Regulator is currently consulting on how it plans to regulate scheme funding under new requirements introduced under the Pension Act 2004. Research conducted for The Pensions Regulator by PricewaterhouseCoopers found that, if companies paid off their FRS 17 shortfall over ten years, around 65 to 80 per cent of companies would be required to make contributions less than 25 per cent of their free cash flow, but around 10 to 20 per cent of companies would face a cash call greater than their net cash flow.[59] In addition, financial year 2006-07 will be the first year in which companies will have to pay a levy to the Pensions Protection Fund. The total charge for this levy is estimated to be £575 million in 2006-07.[60] The growth of business investment has been modest in recent times compared with previous periods of economic recovery. The need for companies to devote additional resources to pension funds may have been a factor in this. Initial evidence from the Bank of England indicates that, in the years leading up to 2002, companies mainly adjusted to these financial pressures by reducing dividends rather than cutting investment. The Pensions Regulator and the Treasury need to assess carefully the impact of the new regulations on pension funding and of other requirements arising from the Pensions Act 2004 and the effect they could have on investment by and the solvency of companies affected and place a copy of their assessments in the Libraries of both Houses.

Oil and gas prices

25. Oil and gas prices have continued their rapid appreciation that began during 2004. As Professor Anton Muscatelli of the University of Glasgow observed, "the world economy is experiencing the first substantial and sustained major increase in energy and other imported materials and metals since the 1980s".[61] Markets in oil futures indicate that, unlike at the time of the 2005 Budget, markets expect higher oil prices to be sustained into the medium term. The Pre-Budget Report cites "rapid growth in the demand for oil, particularly from China," as "the primary driver underpinning rising oil prices since 2004", which, together with "supply uncertainties" associated with hurricanes in the Gulf of Mexico, has led to "prices significantly exceeding market expectations at Budget time".[62] Some witnesses were sceptical as to whether higher oil prices could be seen as the main cause of the slow-down in growth in the British economy. Mr Broadbent noted that, "excluding the United Kingdom, the Treasury predicted in the Budget that the other countries in the G7 would grow by just under 2½ per cent this year; the out-turn is likely to be around 2.7 per cent. This suggests weak growth in the United Kingdom has more to do with United Kingdom-specific factors than with higher oil prices".[63] Mr Broadbent told us that globally higher oil prices have probably had less of an effect than people feared earlier this year and late last year.[64] Mr Cunliffe told us that, despite the United Kingdom being a slight net oil exporter, the oil sector was a separate part of the economy, and the fact that there was oil in the North Sea did not in the short run affect the impact that the oil price had on household disposable incomes, "but that over a number of years I would expect the United Kingdom to be able to weather an oil price increase better than non-oil producers because having the benefit of an oil sector will feed back into the economy".[65] We recommend that the Treasury investigate the extent to which the negative effects on growth of higher oil prices were greater in the United Kingdom than in the other major G7 economies and report on the outcome of those investigations at the time of the 2006 Budget.

26. Mr Broadbent believed that the Treasury's forecasts for economic growth in 2007 and 2008 might be on the high side because the Treasury had "not allowed for the effect of higher energy prices on potential output".[66] Mr Weale told us that the NIESR estimate was that the increase in the price of oil over the last year or year and a half had taken something like one to one and half percentage points off Britain's trend level of output.[67] The Treasury seemed more relaxed about the effect of oil prices, describing as "conventional wisdom" the idea that they might impact adversely on the productive potential of the economy and pointing to evidence of "unexpectedly positive labour market outcomes" which might reduce the extent "to which high oil prices may threaten output growth and the anchoring of inflation expectations".[68] In the past, rises in oil prices have led to demands for higher wages and dislodged inflation expectations. MPC members have indicated that any factors which increase inflation expectations would have substantial costs for the United Kingdom economy. The Governor of the Bank of England told us in late November that "it is too early to be sure that the recent pick-up in inflation will not lead to further second-round increases in pay and prices although the [MPC] draws comfort from the observation that so far neither inflation expectations nor earnings growth have risen".[69] Despite the rise in CPI inflation over the last twelve months, RPI (Retail Price Index) inflation has fallen. This might reduce the probability of second round effects in the near term as RPI is used more frequently for pay negotiations than CPI inflation.

27. In recent months, there has been increasing focus on gas prices in the United Kingdom, with reports of highly volatile prices in the spot market. The Chancellor of the Exchequer told the House that, in order to ensure that all import capacity is put to use, "OFGEM have announced today they will use their powers to intervene where necessary to ensure that importers either 'use or lose' their capacity to import. And the Trade Secretary and I have today written to the European Commission supporting OFGEM's call for an urgent investigation to make sure that this winter there are no blockages to the full use of the interconnector with Europe and thus no restriction on imports of gas from Europe."[70] The CBI welcomed the "inquiry into the behaviour of European energy markets to find out why gas supplies have been diverting away from the United Kingdom". They regarded this as an "urgent matter, as this diversion is damaging United Kingdom business by the day".[71] The Chairman of OFGEM has acknowledged that the United Kingdom's "consumers and businesses are paying a high price for the lack of competition in most continental energy markets."[72] Ensuring adequate energy supplies, without unnecessary volatility in prices, is essential to the health and strength of the United Kingdom economy. We look forward to learning of the outcome of OFGEM's call for an investigation into the use of import capacity for gas and consider that the Government should accelerate its work with the European Commission and other Member States to encourage liberalisation of continental energy markets.

The labour market

28. The 2005 Pre-Budget Report concludes that "the labour market is performing strongly, with employment growing robustly and more people in work than ever before". Despite the strong increase in job creation, low rates of unemployment and the rise in CPI inflation, average earnings growth (excluding bonuses) has remained moderate throughout 2005, rising by 3.9 per cent in the year to October.[73] It has been suggested that high levels of migration have played an important role in moderating wage claims. Mr Paul Tucker, a member of the Bank of England's Monetary Policy Committee, told us in October 2005 that he had little doubt that international migration "has helped to dampen the effect of demand pressures [on] inflation over the past 12 months, partly, of course, because the United Kingdom was open to the new Member States … before some of the other countries in the European Union", but that "when one is relying on anecdotal data it is tough".[74] In November the Governor of the Bank of England told us that he thought that the use of migrant labour to fill particular skills gaps had "helped the economy to continue growing without upward pressure on wages, which would otherwise have forced us to raise interest rates further than they actually went".[75] The 2005 Pre-Budget Report noted that population projections from the Government Actuary's Department incorporate the assumption of an extra 150,000 migrants from the eight accession countries in the first three years following accession in May 2004.[76]

29. Mr Weale thought that, in addition to international migration, another factor contributing to the moderate wage growth was "the Government's continuing policies to get more people of working age out to work", referring particularly to increases in the proportion of lone parents and people aged 55 and above participating in the labour market.[77] The 2005 Pre-Budget Report indicated that the lone parent employment rate now stands at 56.6 per cent—the highest rate on record and an increase of over 11 percentage points since 1997.[78] The employment of people aged between 50 and the State Pension age has increased from less than 65 per cent in 1997 to over 70 per cent.[79] Despite these welcome improvements, the United Kingdom still has a higher proportion of its children living in workless households than any other major EU country, mainly due to the high number of lone parent households without work. This indicates that there is still substantial room for further progress in this area and the Government has set a challenging target of a 70 per cent lone parent employment rate by 2010. In addition to these two areas, the Government's Pathways to Work pilots are aimed at providing additional support to help incapacity benefit claimants return to work. The OECD described these as a "considerable success"[80] and the Pre-Budget Report referred to evidence which "shows that the pilots are resulting in significant improvements in the employment prospects of incapacity benefits claimants".[81] The Government is also seeking to reform the structure of incapacity benefit to tackle further barriers to work. Specific proposals will be set out in the Green Paper on welfare reform due in early 2006.[82]

30. The Leitch report, which was published at the time of the 2005 Pre-Budget Report and which arose from a review of skills conducted by Lord Leitch, found that "over the last decade the skills profile of the United Kingdom has improved. For example, the proportion of adults with a degree has increased from one fifth to over one quarter of the population," but the report concludes that "despite these improvements, the United Kingdom still does not have a world class skills base".[83] The OECD identified the "lack of skills in large parts of the workforce" as "a key factor holding back the capacity to absorb innovations and adapt work processes to take advantage of new technologies". They found that, "while the supply of university graduates compares well internationally, there is a lack of intermediate and vocational qualifications even for the current youth cohorts".[84] Our experts agreed with this assessment, Mr Weale telling us that Britain's poor productivity performance is mainly associated with "what I believe to be the poor quality of education, a long tail of children who have difficulty with literacy and numeracy" and he thought that, "although the Government is addressing basic skills at an adult level, it will be a long process of putting [it] right.".[85] Professor Miles told us that "skills are arguably far more important now in terms of people's productivity than they were 20 or 30 years ago. They are likely to become even more important."[86] The CBI welcomed the roll-out of the National Employer Training Programme, stating that "a voluntary national programme for low skilled employees that provides free, flexible training is a positive step … The training has to be applied flexibly and must take into account the day-to-day needs of business, particularly smaller firms."[87]

31. The United Kingdom labour market continues to perform strongly, with employment growing despite the slowing in output growth. We note the anecdotal evidence we have received suggesting that migration into the United Kingdom has played a role in relieving skills shortages and moderating wage pressure. We recommend that the Government consider commissioning research into the economic effects of migration and the extent to which it has relieved skills shortages and moderated wage pressures in individual sectors. We further recommend that the Government report on the initial outcome of such research no later than the 2006 Pre-Budget Report.

32. The United Kingdom has slipped two places from eleventh to thirteenth between 2004 and 2005 in the World Economic Forum's Global Competitiveness Report, which measures the competitive business and economic climate in economies worldwide. Raising skills levels in the United Kingdom is vital to meeting the competitive challenges of the global economy and has an important role to play in improving the productivity of the United Kingdom economy, where there is still room for improvement. We note the conclusions of the Leitch report that, despite improvements in recent years, the "United Kingdom does not have a world class skills base". Evidence suggests that there is particularly room for improvement in the areas of intermediate and vocational skills and we welcome the roll out of the National Employer Training Programme. This is likely to require long-term solutions and we welcome the opportunity offered by the Leitch report and the Comprehensive Spending Review to examine and take forward those solutions.

The degree of spare capacity (the output gap)

33. The Treasury uses a "growth cycle" approach to define the business cycle, a method which provides a measure of the output gap—the difference between actual output in an economy and output at full capacity. Mr Cunliffe confirmed that for the 2005 Pre-Budget Report the Treasury had left unchanged its estimate of trend growth and still assumed that the economy was last on-trend in the second half of 2001.[88] This meant that the slow economic growth during late 2004 and early 2005 had led to the emergence of a degree of spare capacity in the economy, and the Treasury concludes that there is now a "sizeable negative output gap".[89] Our expert witnesses, while noting the uncertainties, generally believed that the output gap and the amount of spare capacity in the economy were lower than estimated by the Treasury. Mr Broadbent believed that there was a risk that "the output gap has not widened by as much as the Treasury claims and, therefore, that the medium-term prospects for growth are not as favourable".[90] Mr Weale told us that the Treasury's approach did not take account of "the fact that in the last year we have had substantial shocks to the trend, most notably associated with oil".[91] Treasury officials acknowledged the uncertainty of output gap estimates, Mr Cunliffe telling us that "forecasting the output gap is an art, not a science" and adding that "the Treasury estimated the output gap to be around 1.4 per cent and other forecasters have it in that area. The Bank of England has it somewhere around 1 per cent, on the short side of 1 per cent. The IMF, the EU and the OECD are around 0.5 per cent."[92]

34. Several recent developments in three areas could affect the Treasury's estimate of trend growth and the output gap. These are:

Oil prices: Higher oil and other energy prices could reduce trend growth; the smaller share of oil and gas input costs as a percentage of GDP should mean that such effects are lower than in the 1970s and 1980s;
Labour market: Increased migration could have increased trend growth in the recent past, but there are substantial uncertainties about the overall effects of migration and whether it will continue at recent rates. The Governor of the Bank of England has indicated that the ability of a faster growing United Kingdom economy to attract additional workers "means that some of the traditional jargon which economists used to use like the output gap is somewhat less firmly based that it used to be";[93] and
Rising public sector employment: The Pre-Budget Report notes that "the stronger growth of public relative to private employment may have slowed the growth in labour supply to the private sector enough to have kept the economy somewhat closer to trend than implied by the output data and the trend growth assumption". The Treasury believes that "estimating the output gap in terms of market sector non-oil GVA (Gross Value Added) tends to suggest a somewhat narrower gap than when estimated on a whole economy basis"[94], but that the measure is still experimental.

35. The Treasury's central estimate of the economy's trend output growth is 2¾ per cent a year to the end of 2006, slowing to 2½ per cent thereafter due to demographic effects. For the fiscal projections, the Treasury uses an assumption of trend growth at a ¼ percentage point lower than the Government's neutral view. The key assumptions underlying the fiscal projections are audited by the National Audit Office under a three year rolling review process. The Comptroller and Auditor General's last audit of the trend growth assumption was completed in Budget 2002. Under the three-year rolling review process, a further audit of the assumption would have been due at the time of Budget 2005. However, the audit was delayed by the Treasury until the current cycle had ended, then projected to be around the end of 2005. In the 2005 Pre-Budget Report, the Treasury indicates its intention to invite the NAO to complete its next rolling review of the trend growth assumption at the time of Budget 2006.

36. There is considerable uncertainty about the amount of spare capacity in the United Kingdom economy. This is due to recent developments in a number of areas including international migration, oil prices and the measurement of government output. The Treasury believes that the slow growth during late 2004 and early 2005 has led to the emergence of a sizeable negative output gap. Other forecasters including the IMF and OECD believe that the output gap is smaller. The Treasury should continue to take a cautious view of trend growth. We note that the Treasury has departed from its previous practice of a three year rolling review by delaying the NAO audit of the trend growth assumption until Budget 2006. It is important that, regardless of any future changes to the Treasury's assessment of the timing of the economic cycle, the NAO is invited to audit the trend growth assumption at the time of Budget 2006. This audit should assess whether developments between the fourth quarter of 2001 and 2006 support the Treasury's assessment of trend growth of 2¾ per cent over that period.

6 Bono, Geldof reaction to G8 Africa Communique, www.data.org Back

7 OXFAM, Gleneagles: what really happened at the G8 Summit: www.oxfam.org.uk/what_we_do/issues/debt-aid/bn-gleneagles.htm Back

8 Pre-Budget Report 2005, p 119, para 5.134 Back

9 HC (2005-06) 399-i, Q 15 Back

10 HM Treasury, press release on 9 September 2005, New International Finance Facility for Immunisation could save 10 million lives Back

11 http://www.g8.utoronto.ca/evaluations/2005gleneagles/2005commitments.html Back

12 Q 277 Back

13 Q 276 Back

14 HC Debates, 20 December 2005, col 1710 Back

15 Bank of England November Inflation Report 2005, p iii Back

16 Treasury Committee, Minutes of Evidence, Bank of England November 2005 Inflation Report; HC (2005-06) 718-i, Q 18 Back

17 Q 7 Back