Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 20-39)


7 MARCH 2006

  Q20  Mr Fallon: Why do you think they are forecasting continued steady growth in household consumption? Do they have it wrong?

  Mr Butler: My view would be that is where the disappointment is going to come this year. I would say basing a forecast on a wealth link, at a time when the outlook for disposable income growth I think is deteriorating, is going to suggest a consumer recovery does not come through. So I would be at odds with the Bank of England's latest central projection.

  Q21  Mr Fallon: It is not in the January figures, is it?

  Mr Butler: In terms of retail sales?

  Q22  Mr Fallon: No.

  Mr Butler: My guess is that it will not be in the February or March figures either.

  Q23  Mr Fallon: Do you think it would be helpful if the Bank split its forecast for GDP growth into the component elements, so that we could see more clearly the weight it attached to each?

  Mr Butler: Yes.

  Mr Bootle: Undoubtedly.

  Professor Muscatelli: I think it would be helpful for us interpreting what they are doing. On the other hand it is incredibly much more difficult to do so, especially on some of the components of expenditure. Forecasting some things, such as investment expenditure or net trade, which can be hugely volatile, is extremely difficult.

  Professor Quah: I do not know that the Bank does not already do that in constructing the GDP growth forecasts.

  Q24  Mr Fallon: But it does not publish it.

  Professor Quah: That is right. Those are two different things. Internally the Bank might well have some understanding of what is happening with consumption and investment going forwards that does not manifest in just their forecasts of just GDP growth.

  Mr Butler: In terms of the spirit of what the Bank of England tries to do, they would argue it is very difficult because they would have to provide fan charts for all the different components. I think they can flesh out how they have made a change, in that you look at this forecast in February versus November and you think there is absolutely no change in the Bank of England's optimism, yet the story behind that had fundamentally changed in three months, and I think that is something that could have been brought out much more than it was.

  Q25  Mr Fallon: Your explanation is that the optimism appears to be based on the perception of higher asset prices and the perception of easy access to cheap finance.

  Mr Butler: Yes. I think this is a key part of the story, in that, if wealth is rising, what channel is that feeding through into the consumer? It is either boosting consumer confidence—well, we are not seeing that—or it is working in terms of you liquidating those gains, say from mortgage equity withdrawal, and spending it. That is a link which has already been to some part exhausted over the last couple of years and I think that opens the obvious question: Are you comfortable about housing valuations and is this making you less comfortable, going forward, if people are tapping into that wealth more to support spending?

  Q26  Mr Fallon: You just think the Bank is wrong to rely on a consumer recovery to the extent it is.

  Mr Butler: My forecast is very different. My forecast is one in which the consumer rally you saw at the end of last year will not persist and you will revert back to the similar story you saw from most of last year with the consumers weak. So, yes.

  Q27  Mr Fallon: It was 1.8% last year, the Bank is saying 3%, and you are saying . . .?

  Mr Butler: Their 3% is at the end of the year, but I am 1.8% again for 2006 as a whole.

  Mr Fallon: Thank you.

  Q28  Susan Kramer: I have been very concerned about the whole business investment issue. I am grappling around to try to understand why the numbers have been coming out as they are, particularly with borrowing so cheap, at the long end, and companies cash-rich. Could you help me with this. Am I right in the perception that a lot of companies are now simply using their cash to buy back stock, rather than investing either in expansion or productivity? Is there anything abnormal about the pattern that we are seeing at the moment?

  Mr Butler: I think there is. As you say, a lot of the conditions for investment have been fairly supportive. The oddity is that companies are not feeling confident enough to come out and start investing. I have two explanations for why that might be. I think part of it is that companies do not like to invest in an environment which is becoming more uncertain, and most of the business surveys suggest that they are more pessimistic about the profit outlook than at any time since 2003—which may seem odd, given the equity markets, but I think that is a broader economy element and may be related to the retail sector. The other issue is that I think companies at the moment have other priorities. You have highlighted the buy-backs, the cash-outs, almost rewarding shareholders for some associated risk, but I think there is another issue, which is pensions. There is no way of proving it, but it seems more than a coincidence that companies have added an extra £20 billion a year into their occupational pension schemes where business investment has risen by £1 billion. I think it is showing you that there are other priorities which are using up the cash rather than just investment, and if you are realising a future liability at the expense of investing for future growth, then that could have long-term detrimental effects for the UK economy.

  Q29  Susan Kramer: Do you think that the Bank should be working more closely with the Pension Regulator to try to ensure that contributions towards pension deficits or to offset pension deficits do not harm the growth forecast?

  Mr Butler: I am not sure that is the Bank of England's role.

  Q30  Jim Cousins: Whose role is it?

  Mr Butler: I think it is an issue about regulation, and putting pressure on companies to do something about your pension deficits is much more a government role.

  Professor Muscatelli: I am very concerned about what is happening in business investment. I am not sure exactly what the causal effects are—because, of course, to some extent investment does tend to follow the economic cycle with a lag, so we might still be observing the lag from the recent slow-down—however, I am concerned about what the implications are for that in the upswing, and I have highlighted that in my note. I think it is of concern that productivity has fallen, possibly for cyclical reasons, but now we are observing, on the back of that, a low growth in business investment that might constrain the Bank's actions during 2007.

  Mr Bootle: I agree with what has been said, particularly John Butler's point about pensions, but I think we ought to take account of the international aspect of all this. It is striking that business investment has been pretty low in relation to GDP in most parts of the world. China is obviously a different case, but it has been pretty low almost everywhere, so I think you have to ask yourself what global forces could be behind all that? There are two which particularly attract me as possible explanations, though it is very difficult to measure them. One is that business is suffering from the after effects of the collapse of the boom: business managements feel enfeebled in relation to all that; they feel extremely cautious. The second explanation is to do with the workings of globalisation. Although the economy overall, certainly in this country and a number of others, has been pretty stable at a macro level, at a micro level it has been exactly the opposite. People are all at sea with regard to where business is going to go over the next 10, 15, 20 years: they do not know what the comparative advantage of their country is going to be, never mind a particular sector. It is very difficult against that backdrop to muster the confidence to invest for the future, when you think that the activity might be leeching away to some other place. You just do not know where the land is going to lie. That might go some way to explaining why investment is pretty low in most countries.

  Professor Quah: There is a certain dissonance in the way that all of us are trying to think about the risk environment, what is going on internationally. We give all the reasons we can think of: a lowering in risk premia; people coming up with new financial products; we understand financial markets better; central banks are doing a great job globally, so there is a decline in risk premia worldwide and so long-term interest rates are low, and that is the story we tell. On the other hand, when we turn round and try to think about what is going on with business investment, we have to tell the opposite story: the situation is uncertain; nobody really understands what is going on; everybody is just holding cash; nobody wants to make a first step. There is a dissonance there that I think we need to think through. We cannot leave the story as it is with just the two different parts inconsistent with each other. Initially, I thought that the weak business/weak UK investment had to do with factors specific to the UK—the worrying about the particular state of pension funds in this country, the Turner Report and all the things that are going on there—but, as Roger points out, this is worldwide. It is a global phenomenon, and we do not understand why this is going on. We have risk on the one hand declining; risk on the other hand increasing, Everybody is waiting. The boom ended March 2000, yet by some measures boom Mark II has already taken off and there is a lot of optimism in that sector now. So I think the signals are very contradictory and inconsistent and we really do need to understand what is happening with investment much better. But I do think that, whatever the reason for our consumption-led recovery, it cannot be sustained. No economy for any long stretch of time has ever had just the consumer continuing to propel it to ever greater success. We have to bring investors on board.

  Q31  Susan Kramer: From what I am hearing, you do not think this is just a measurement issue, because sometimes we do hear from the Chancellor or others: "It is just a measurement issue. It will all come right when we get the figures a few months down the line."

  Mr Bootle: It is very difficult to be confident that it is not a measurement issue, but, again, I think the international evidence is quite intriguing in this regard. If we were looking at a circumstance where only British investment were low and everywhere else it were pretty much normal, then I think the argument that there is something wrong with the way we measure it has a certain amount of force. If, however, you are looking at weak investment around the world, where it is measured in all sorts of different ways in different places, I think it has really rather less force.

  Mr Butler: Quite an important element in the Bank of England's forecast is this increased uncertainty about the data and expecting revisions to come through this year. Three months ago, the confidence about that was (1) about historical revisions and (2) that employment was still rising, inflation was picking up, so surely growth was stronger because there must be less spare capacity in the economy. Three months on, employment is now falling and inflation has been coming down. I think the evidence such is that there are always uncertainties about data but I do not think those uncertainties are any greater today than they have been in the past.

  Q32  Peter Viggers: I want to follow the point about pension shortfall and its effect on investment—and I declare an interest as chairman of a pension fund (which is fortunately well invested). The asset and liability management has forced pension fund managers to be more cautious and put more money into bonds. Of course the lower interest rates have caused greater difficulties. Those who say that there is no particular problem arising from pension shortfall, talk about the global amount available where there is £24 billion available to industry to invest, but of course what they fail to identify is the fact that it is an individual, localised problem. There is a significant number of companies, some of them quite large, which have major problems with their pension shortfalls, so it is not good enough to say there is no global problem. It is an individual, localised problem, as Mr Butler has pointed out. There will need to be significant reconstruction of a number of companies and no doubt equity sacrifice. Do you agree that there is a major problem here? How do you see it working its way through?

  Professor Muscatelli: I agree with your analysis: there is a difficulty here. I am hoping that the resolution will be that they will take a slightly more sanguine view about what yields you might get from pension funds over the longer term. It seems to me that we have gone from a situation in which we had a very asymmetric system of valuing assets and liabilities, to one where we are putting a huge amount of strain on companies. Although I cannot claim to be a pension expert, it seems to me as if we have moved too much in that direction. We are forcing everybody to deal here and now with problems that have to do with asset liabilities away in the future and there needs to be some way of valuing these liabilities that do not call on companies to take drastic action in the very short term. But, as I say, I am not a pension expert, so that is just my first view of that.

  Professor Quah: My only response to that is we do have this demographic problem generally, globally. The ageing population is a worldwide problem. I think there is a danger that we are all going to rush in and try to solve the problem too quickly. Businesses are not best placed to be the ones to solve pension fund shortfall problems. Businesses should be making things or providing services or doing things for the rest of the economy. Somebody else should be solving these pension funds problems—financial markets or some other institution. We should not be devolving responsibility onto individual businesses.

  Q33  Chairman: Roger, you mentioned globalisation. We are undertaking an inquiry into globalisation. Are there any particular issues in the macro field we should be looking at?

  Mr Bootle: This is a huge subject. What I have mentioned earlier on would bear some inspection. I have not seen any detailed work on it. It would be interesting to see the extent to which businesses at the micro level felt fearful and uncertain about their own situation and the extent to which that affected their policies with regard to investment and employment. It is a very, very difficult thing to test because you are really trying to get at a state of mind, a sort of attitude. I am not sure you would clearly find it demonstrated in the data, but if you could come up with a convincing answer on that question alone it would be extremely valuable. There are others I could mention, particularly with regard to inflation. Again, the extent to which the fear of market pressures, competition from not only Asia but also Eastern Europe is constraining behaviour now with regard to wages and prices. I think that is also a fascinating question.

  Mr Butler: I think it challenges a lot of the framework in which we think about economies. We tend to start from the building block of: Is there spare capacity in the economy? What does that mean for inflation? But maybe much more emphasis should be on global output gaps rather than domestic output gaps, given the disinflationary effect we have had from import prices for some time. The point Roger made, which I think has been absolutely critical for the UK, is the supply of labour. How do you judge whether a labour market is tight or not, when you can tap into labour markets from around the world?

  Professor Quah: One large factor is that the entrance of China and India into the global marketplace has doubled the world's labour force. That is a massive increase in the number of people out there who can work, willingly work, for relatively low wages. When you ask the question of what you should be studying, looking at something like that makes me think of a whole range of questions. That impacts on inflation; price behaviour; income inequality; labour markets; wages; international trade; outsourcing—a huge range of issues. Maybe your focus is more on monetary developments and inflation, but I think that even with that alone we can try to understand what happens with labour markets, the flow factors, investment and price behaviour.

  Professor Muscatelli: I think the analysis has to be very much divided between short-run impacts and long-run impacts. In the long run, clearly effects of the type Danny has described are bound to be beneficial for the world economy: a huge amount of untapped labour coming onto the market, a more efficient allocation of resources across the globe. The problem in the short run is the adjustment towards this: what it does to balances, how the US whole imbalance situation is going to unwind. It is the fact that it has come on stream very, very quickly, I think, which poses the risks for the world economy. People often make the comparison with Japan. Japan joined the world economy very rapidly during the 50s and 60s, but in terms of size it is nothing like the Chinese and Indian shock. It is a much bigger shock. I think understanding how the inevitable imbalances will unwind is a key area to study in the short run.

  Mr Butler: It is a very difficult question for policy makers, in that, if inflation is low because of big supply changes, with China coming on stream it is not necessarily obvious that you respond to that in the same way that you would respond to, say, weaker domestic demand. I think that has been critical for MPC over the last couple of years, responding perhaps to supply changes as if they were evidence of deficient demand.

  Chairman: We have already visited China, and we are visiting India in June, but I will get the staff to remind you of the terms of reference of our globalisation inquiry, and if you have any further comments we would be pleased to receive a note from you on that.

  Q34  Ms Keeble: I would like to ask a bit more about growth, and it follows on very much from what Michael was asking as well. The first question is for John Butler and Roger Bootle. What are the main reasons for the Bank's optimism on GDP growth for 2006/2007 and indeed 2008 compared with the forecasts from your own organisations?

  Mr Butler: I think the Bank of England have a story, as I highlighted before, which has changed over the last few months but it is one where the imbalances in growth persist for longer than they had previously expected, so consumer a bit stronger, investment picks up a little later than they expected, but eventually you get a rebalancing in the economy and a pretty good growth rate. Where I see the risk is that I think the constraints on corporates may mean the investment recovery is more muted and is more lagged than they are currently expecting. On the export side, we are probably more concerned about the sustainability of the global growth picture. A lot of the issues that are highlighted as risks in the Bank of England's forecasts we would probably incorporate more as a central projection, such as that the US consumer starts to slow, and, with it, UK exports soften.

  Q35  Ms Keeble: They soften further?

  Mr Butler: You do not get the strong recovery in exports that the Bank of England is eventually forecasting. On the consumer side, I think we will come back in three/six months time with the same issues. I think the squeeze on people's disposable income at a time when I think the labour market will be starting to deteriorate will reduce households' willingness to spend.

  Q36  Ms Keeble: You do not think that the slow down of consumer demand which you are predicting would then have an impact on imports, which would obviously help.

  Mr Butler: Yes. My forecast would be one in which net trade does not boost GDP.

  Mr Bootle: I have a very similar view to John. To some extent we covered this earlier on. Of course, quite why the Bank takes the view that it does is shrouded in a certain amount of uncertainty, given that it does not publish the breakdown, so we are fighting in the dark. I would, as John has said, think that the risks are a good deal more serious on the downside than the Bank is allowing for. Our central forecast for consumer spending growth would be 2%—not a disaster, but a good deal weaker than you would think would be consistent with the sort of growth rate for the GDP overall that the Bank has. To be fair to the Bank, there is obviously a very plausible case behind the idea that consumer spending could bounce back this year. In particular, I think a lot depends on how you view what happened last year. The Bank at one point tried to pin responsibility for what happened to consumer spending on a series of one-off rises in energy prices, household bills and so on and so forth. If you believed that that pressure was going to abate, I suppose you could believe that consumer spending was going to bounce back. My argument against that is partly that not all those pressures are in fact going to abate—some of them are still very much there—but also the weakness of the labour market is potentially a very big factor. When you look at last year and you see how weak productivity growth was in this country, I think you have to ask yourself some pretty serious questions. Admittedly, again the numbers may be wrong, but, if they are right, why were businesses behaving in such a way as to allow productivity growth to slump as seriously as that? I think a substantial part of the answer must be that they did not believe in the slowdown, they did not believe it was going to be sustained, and, accordingly, they hung on to labour hoping that the economy would turn up. If that is the case and the economy does not turn up, then they release more labour—and the latest figures, of course, were extremely weak—and as we see the labour market deteriorating, you have to imagine then that, although that was not the original source of consumer weakness last year, it becomes the source of consumer weakness this year.

  Q37  Ms Keeble: Your colleague Jonathan Loynes has been much more critical than that. He is quoted in the Guardian as having said, "It would have been better to have left the growth forecast unchanged, but that would have lowered the inflation forecast to below its target" and "They are having to work hard not to cut interest rates." [3]That, given the sort of critical statements that you are making about their growth projection, comes perilously close to saying they are starting to make the facts fit the decisions and not the other way around. What do you think of what your colleague Jonathan Loynes said? Do you agree with him in his criticisms, which pretty trenchant of the decision?

  Mr Bootle: I would hesitate before disagreeing publicly with what Jonathan said. What he was particularly referring to, as I understand the remark, is something akin to what Stephen Nickell has been arguing; that is to say, this is not only about what the current growth rate is and what that might do to inflation; it is also about your perception of the output gap and where growth has been. The fact of the matter is we had a year, last year, when nearly all forecasters were surprised by how weak the economy was—it was pretty weak—and you therefore expect that ought to have opened up some spare capacity. Given all that, even if you had a growth rate as strong as the Bank is forecasting for this year, I think you might still argue that inflation would be on the downside.

  Q38  Ms Keeble: Do you think there is also an issue about not wanting to cut interest rates because that would start a trend?—which is one of the issues that has been raised as well.

  Mr Bootle: I do not think that would be a good argument for not cutting interest rates; that is to say, that if you cut them the markets would perceive this as the beginning of a trend. I do not recall, for instance, that being an argument in the opposite direction. I do not recall Mervyn King ever saying that we should not increase interest rates once, because if we did that the markets would say: "This is the beginning of a substantial trend." No, surely you have to view each case on its merits. If the situation demands low interest rates, you should cut interest rates.

  Q39  Ms Keeble: Professor, do you think the Bank is being overly bullish in its forecast?

  Professor Muscatelli: I do not think they are being overly bullish but I think it is very delicately poised. As I said in November, I certainly was amongst those who felt at that stage it merited a cut. We have to take these projections at face value. There is a complex timing issue, but if consumption does hold up and if business investment does grow moderately as they are expecting—and I am quoting from page 32 here—then I can see their forecast coming true. [4]There are downside risks. There are downside risks, as we have already discussed, in investment, and there is also a downside risk in trade—in which case I can see a scenario in which they would have to cut interest rates, but I can see the logic of adopting a wait-and-see attitude. I am not saying that we will never cut interest rates. I am saying that at the moment the evidence is, as far as consumer demand is concerned, and looking at what is happening to asset prices, that they are being cautious about cutting interest rates because they want to see how that works out over the next couple of months and look at the next inflation forecast.

  Ms Keeble: Thank you.

3   The Guardian, 16 February. Back

4   Inflation Report February 2006, Bank of England. Back

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