Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor Danny Quah, London School of Economics


  The Bank of England's February 2006 Inflation Report makes the case that, should fundamentals remain unchanged, over the next two years the (greatest probability) modal outcome shows:

    1.  inflation remaining on track at 2% and

    2.  output growth rising to a high of 3% in late 2006 before easing to 2½% in 2007.

  The 90% confidence region is symmetrically distributed around this mode, increasing gradually to around 2 percentage points in either direction by two years out. Given this, it is unsurprising and well-justified how the Bank has kept interest rates constant at 4.5% for December through February.

  This nice outcome has emerged from a conjunction of two sets of opposing forces. On the one hand, somewhat unexpectedly, relatively weak business investment (not just in the UK but in most of the West) and significant increases in global oil and energy prices have not perturbed a stable UK growth and inflationary equilibrium. On the other hand instead, positive factors-strong domestic consumption demand, robust service sector output, a somewhat resurgent housing market, subdued pay pressures-have dominated.

  Such a delicate balance of forces guides our attention to possible future risks. Any change, either strengthening or weakening, on one side of this mix can disturb the current outcome. The Inflation Report discusses some obvious risks, with great depth and clarity. Here, I seek clarification on three others, that I feel might be usefully expanded on from what's already in the Report.


  The US term structure of interest rates has threatened to invert for several months now, to some journalistic fanfare on its economic significance. Popular view and weak statistical evidence has it that an inverted yield curve presages economic downturns. On the other hand, the UK term structure has already, quietly, gone ahead and inverted (and, indeed, has been inverted for years now) [p 6 of the Inflation Report, and that today below].

  One reason observers find this inversion interesting is that some evidence (not absolutely ironclad but then not casually dismissed either) suggests its predictive power for economic downturns. The relation in the US is illustrated in the following graph:

  (In regressions, other variables outperform the yield curve spread for predicting output growth [Ang, Piazzesi, and Wei, 2006]. The Chart is meant only to be suggestive.) Practically every time the term structure rotates sharply clockwise, recessions-the shaded vertical bars-follow.

  I cannot tell from the February Inflation Report if this enters the MPC's current thinking or how this relation has been dealt with. Perhaps it needn't be considered now, but some (ongoing) clarification might be helpful. On the other hand, the Bank's analysis [pp 4-7] of why, internationally, long-term interest rates are so low is certainly insightful and, to my mind, correct. But then put these two ideas together. Let long yields indeed be determined by some combination of global savings (from East Asia and the oil-exporting economies), a reduction in long-term risk and risk premia, and global pension funds' demand. Let short yields, subject to very small adjustment, be fixed by monetary policy. This then explains the inverted yield curve. It does not, however, say that that curve's predictive relation for future output growth has changed, that "things are different this time." Indeed, the Inflation Report's own analysis of the possible unwinding of long rates provides a description of how a recession and deflation might indeed occur as a result.

  I suppose the question then is, is the MPC's analysis of low long-term interest rates already sufficient for evaluating the MPC's prediction of inflation and growth prospects? Or does the inverted yield curve contain further information that might be usefully exploited? Has the MPC done so explicitly?

  To repeat, the MPC's concern is inflation, not output growth and not recessions. But in the short run these macroeconomic variables are usually statistically related, and output stability does enter the ancillary part of the Bank's remit.


  Longer term and more generally observers have noted for a while now the large global anomaly of poorer economies saving to send capital to the richer economies. Typically, this is the concern of real-side analysis of longer-term economic growth, not of shorter-run monetary policy. And, of course, plausible explanations of these global capital flows abound.

  The link from those flows to more immediate inflation and growth outcomes, in most of the Western economies not just the UK, turns on what might happen to the US dollar and its current account deficit, should the current global situation reverse or, put bluntly, should global savers stop investing in US securities?

  Such concerns are implicit in the MPC's analysis of the impact of external trade, long-term interest rates [as described in 1. above], and so on. All that analysis is rigorous and compelling, taken on its own. I wonder, however, if thinking about global imbalances and their possible unwinding have been factored in sufficiently. I'm not sure how I would formalize this. Since nothing has happened yet, any econometric or statistical reasoning runs into a version of the so-called "peso problem". But I would like to know how the MPC and the Bank have thought about this.


  International observers have remarked how the global economy's successful recent growth performance is akin to an airliner, flying on just one engine, namely the US economy and its consumers. The situation, in the minds of these observers, is unsustainable.

  In this regard, Chart A. on p 5 is striking. It is the Euro area's broad money contribution to global liquidity that is by the largest. The US, by contrast, barely shows, while Japan despite remaining the world's second largest economy and trying its hardest to pump liquidity into the system provides a contribution less than half that of the Euro area's.

  Perhaps that global economy airliner is using more than just one engine. Or, alternatively, perhaps the risk of global imbalances unwinding is more profound and pervasive than everyone had previously thought.

March 2006

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