Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 121-139)


12 DECEMBER 2006

  Q121 Chairman: Mr Cunliffe, good morning to you and your colleagues, and perhaps you could introduce them.

  Mr Cunliffe: Yes, on my left is John Kingman, who is the Managing Director of Public Services and the new Public Services and Growth Directorate. I am Jon Cunliffe, the Managing Director of the International Finance Directorate of the Treasury. On my right is Dave Ramsden, who is our Director of Macroeconomics. Next to him is Mark Neale, the Managing Director for the Budget, Tax and Welfare Directorate and next to him is Mridul Brivati, who is the Director for Public Spending.

  Q122  Chairman: Welcome. On the issue of uncertainty around the economic outlook, in the Inflation Report in November this year, the Governor in his opening statement spoke about uncertainty and in his evidence to our Committee on the Inflation Report on Thursday 30 November he said, "I think we are genuinely uncertain as to how price-setting in the economy will respond to large movements in certain costs, such as energy prices". What are the main risks both from the upside and the downside?

  Mr Cunliffe: To the global economy and the UK?

  Q123  Chairman: Just uncertainty around the economic outlook.

  Mr Cunliffe: The main global risks for us are around inflation which, I think, is the one the Governor has mentioned, around the US economy and whether the housing market downturn will broaden into a more widespread slowdown of the US economy, around protectionism and the Doha Round and the impact that will have, around oil and energy prices, which are still a risk, but perhaps less so than at Budget time, and around global imbalances because that risk is always there. I think, as far as the UK side is concerned, there is a risk that the effective labour force is larger than we think and, therefore, there is more slack in the economy and more room for growth, and on the demand side I think there are risk around the housing market, the extent to which the recent increase in the housing market will lead to an increase in consumption and the extent to which there is a link between the housing market and household consumption. There is a risk around savings and whether households will want to save more. There is an upside risk around business investment, with profits strong and corporate financing relatively cheap, whether we could see more business investment than we forecast. Then I think there is a risk to exports both ways, the US risk would be a downturn in global growth and world markets, but, on the other hand, for the eurozone, where most of our exports go, it has grown more strongly and I think there is an upside risk there.

  Q124  Chairman: In relation to migration, the figures are cloudy, at best, are they not? The Governor of the Bank of England, when he was talking about the migration from Poland to here, mentioned that in 2003 there were 516,000 flights between the UK and Poland, but over the next two years it went to 1.8 million, but International Passenger Survey forms were handed out at Heathrow, Gatwick and Manchester, so that missed most of the people who were coming into the country because it was elsewhere. Is there anything that you are going to do to get a better handle on it?

  Mr Cunliffe: Yes, the Governor made a number of points about migration statistics, first, that the International Passenger Survey, as he said, was originally designed to look at tourism and is now having to pick up answers on migration. There are also points about how you bring together the information we have from the Workers Registration Scheme, and for the issue of National Insurance numbers with the information that is in the International Survey. The ONS have a programme of work to try and improve migration statistics. They have set up an inter-departmental workforce working group to try and bring this together and I think they plan to issue their report before Christmas, and there is also, within the ONS itself, a number of projects trying to improve the quality of migration data.

  Q125  Chairman: In answer to a question in a session on the Inflation Report, Charlie Bean of the Bank of England suggested that labour may be pricing itself out of jobs. Have you any evidence that that is the case and can this explain some of the recent rise in unemployment?

  Mr Cunliffe: I do not think we have any evidence for that. As far as migration is concerned, we have no evidence that migration has affected directly pay rates. Certainly average earnings have been low for this stage in the cycle, growth in average earnings has been low, and that might be an effect from migration, but it might also be an effect from globalisation because, I think, right across the economy workers can see that there is much greater global competition than there used to be. I think we have certainly not picked up anything definite to suggest that workers are pricing themselves out of business. I know that one of the points that Charlie Bean has made in the past is that the increase in energy prices will in the end have to be absorbed through pay and maybe not all of that has happened yet and, therefore, there will have to be slower real growth in earnings going forward than there has been to make that happen, so that may have been his point, but certainly we have picked up no direct effects.

  Q126  Mr Fallon: This cannot quite be right, can it, Mr Cunliffe, because in your own report, page 242, you say you are having to spend £½ billion more on tax credits because of lower earnings growth amongst low income households. Dr Weale yesterday attributed that almost directly to immigration from Eastern and Central Europe.

  Mr Cunliffe: Well, it is certainly right that we are having to spend more on tax credits on low income families than we forecast and it is also true that for this stage in the cycle average earnings seems low. Whether that is directly related to migration or not is another point.

  Q127  Angela Eagle: Sticking with the labour market, we have seen an upturn in unemployment, but we have also seen continuing growth in the number of jobs. What do you think is happening in the labour market? You did just mention that perhaps the effective labour market is larger than might have been thought, so how is this playing through in your policy recommendations and thoughts?

  Mr Cunliffe: On the first question, we think what has happened in the labour market in the last year has been a very big increase in the labour supply of about 450,000. We think half of that has come from an increase in the population above 16 and some of that is migration, but some of that is actually natural population growth, but half of that has come from a reduction in inactivity. These are people of working age who are—

  Q128  Angela Eagle: Is this the Pathways to Work issues on the supply side?

  Mr Cunliffe: It is partly that. It is three things. It is Pathways to Work and people who have been on long-term sickness and incapacity coming back into the workforce and it is a continuation of a trend that is bringing more women into the workforce who were staying at home. The other effect, and this comes back to how we interpret the labour market, has been from students. The number of students, which who are people going out of the workforce while they study, has been rising quite strongly for the last few years. We saw a very large increase in students, larger than trend, in 2005 and a smaller increase in 2006 and what may well have happened, with tuition fees coming in, is a number of people have brought forward the start of their studies. Averaged over those two years, the increase is about in line with trend. If that is the case and next year it goes back to the trend, then we will find that there will be more students and, if you like, the level of inactivity, because there will be more people studying, will go up. Our forecast is that claimant unemployment has already flattened off, I think, by at least 15-16,000 over the last six months and we expect that to continue and probably reverse and unemployment on the other, side, the labour force survey measure, we expect to turn around as the demand in the economy picks up.

  Q129  Angela Eagle: Those structural changes you have described would probably have positive effects on the economy, would they not, because actually it is people coming off inactivity where the Government are paying them for being active, going into work and paying and, like with migrants, they are working and contributing?

  Mr Cunliffe: The reduction in inactivity, the increase in the participation rate increases the productive capacity of the economy. The same happens with migration because it adds to the labour force and of course the increase in students is an investment for the future which should also result in a more productive workforce.

  Q130  Angela Eagle: In terms of the regional effects, have you analysed with the rises in employment whether they are disproportionately impacting in particular areas and what is your insight into that?

  Mr Cunliffe: I do not know of any particularly pronounced regional spread.

  Mr Ramsden: We have not done a regional forecasting exercise for this PBR and that is consistent, that we stick to forecasting at the macro level. However, for the latest data that we have, that has shown that over the last year employment has increased in most regions.

  Q131  Angela Eagle: Might it be possible that the next structural change will be older people staying on in the workforce rather than retiring and have you thought about what effect that might have on structural change?

  Mr Cunliffe: We have seen over the last four or five years quite a strong trend of people who have retired coming back into the workforce or staying on after retirement age and that was quite a big factor last year in the increase in the labour supply. You would expect, particularly as life expectancy increases and healthy life expectancy increases, to see more people coming into the working population and indeed that is what we are seeing.

  Q132  Angela Eagle: In terms of the impact that the structural changes in the labour market are having in other areas, what is your analysis of what effect this is having on productivity, for example?

  Mr Cunliffe: The expectation from migration, I think, is that they would add to productivity because, on the information we have got, migrants tend to be better qualified, there are higher proportions, in the sectors they are going to with university degrees and qualifications, so over time you would expect that to increase productivity. The productivity numbers we have at present show that productivity has come back now quite strongly since the last on-trend performance in the cycle to, I think, about 2.4%, but we have not tried to analyse recent productivity performance against the changing structure of the labour market. Overall, you would expect a more educated labour force to be more productive.

  Q133  Angela Eagle: Finally, on the minimum wage, there is a rise in the enforcement spending on that and also an increase in the minimum wage itself. Is that impacting in any way on your analysis in terms of costs?

  Mr Cunliffe: Well, in the macroeconomic forecast we do not try and incorporate the effect of announced policies, so the greater enforcement of the minimum wage which has now been announced has not been put into the numbers. You would expect again over time that, if that happens, it could increase the attractiveness of going back to work for a number of people who are outside the labour market and that would have an impact, but we have not put a number in the forecast for that.

  Q134  Mr Breed: Could we turn now to consumer spending which of course has been rather volatile. What, therefore, are the main risks to your forecasts for household consumption, do you think?

  Mr Cunliffe: I start with the forecast which is pretty much unchanged from Budget to now which is that it grows at about 2% this year and about 2.25-2.75% going forward which is slower than the growth rate of the economy and it has recovered from the low in 2005. The view on the past is that the low in 2005 was caused by two things: one, a reduction in disposable income growth really going back to 2003-04, the partly due to higher interest rates when we had the five interest rate increases in those years; and then in around about the middle of 2005 households began to feel the impact on disposable income of higher energy prices. Going forward, we think those increases have come out of the system and actually—

  Q135  Mr Breed: What, energy is going to come down?

  Mr Cunliffe: Well, in inflationary terms, energy prices will drop, the rate of inflation will drop. Energy prices have come down, but, even if they stay stable, the rate of inflation drops if energy prices stay stable, and we do not think energy prices are going to continue to increase, although, as I said at the beginning, that is one of the risks to the global forecasts, so we see consumption growing just below the rate of the economy. As to the risks to of consumption, there are a number. As I said, there is an upside risk that consumption could take off or grow a bit more strongly because the housing market has been stronger in 2006 certainly than we forecast and, I think, anybody else forecast. There, you have to make some assumptions about whether household consumption in the UK is linked to the housing market and to what extent there is a link. In the past, there has been a link, but there have also been periods like the recent increase in house prices earlier this century where the link did not seem to be very strong at all. So there is quite a lot of uncertainty as to whether these two things are directly linked or whether they are linked to some other factors and it is only if those other factors grow that consumption will grow. There is a potential downside risk to consumption on savings. The savings ratio has gone up over the last year. As we explained in the PBR, that is partly because employers' contributions to employees' pension schemes have gone up and that is counted as saving. In surveys, households seem to be saying that their saving intentions are greater than their actual saving is.

  Q136  Mr Breed: If it works.

  Mr Cunliffe: That may just be human nature, but it may be that they have not taken into account the higher saving that is being made on their behalf by their employers and, if they did decide to increase their savings, clearly that would reduce their consumption going forward. So those are really the main risks around the consumption forecast.

  Q137  Mr Breed: So house prices generally, do they have an effect, do you believe, after all the sort of experience you have had of volatility there? Are they actually having an effect on consumption then?

  Mr Cunliffe: I do not think anybody knows the answer to that. My personal view is that they have had effects in the past and the effects came through the so-called "wealth channel", that, as people's wealth grew, they felt they were more able to spend, and maybe some came through the liquidity channel, that they had more collateral to put down and to borrow. However, I think that relationship is not as strong as it used to be and I think as well that house prices are driven by individuals' expectations about employment and expectations of future income, so more fundamental reasons. I think it is also driven by the costs of purchasing a house and it is not just the purchase price of the house, but it is the interest—

  Q138  Mr Breed: The stamp duty.

  Mr Cunliffe: Well, there is the stamp duty, but it is mainly the interest cost on the mortgage and there is some evidence that, although the Bank of England has not reduced the bank rate, because more mortgages are now being financed on two- or three-year fixed terms and because over the last year the two-year part of the yield curve for international reasons was very low, the financing of house purchases became low and that is what stimulated the market. I would not want to make the prediction as to how strong the link with consumption is going forward. It is difficult. As I say, my personal view is that it is not as strong as it was and certainly, although house prices have come back, we have not seen consumption come back.

  Q139  Mr Breed: Not yet.

  Mr Cunliffe: Not yet, no.

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