Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 140 - 159)



  140. But there is not a single reference to it anywhere in this document?
  (Mr O'Donnell) Like I say, we keep saying that our framework is based around stable inflation and good, sound fiscal policy, so the exchange rate emerges from that.

  141. So you kind of missed it out?
  (Mr O'Donnell) No. The exchange rate is a consequence of our policies: not a policy objective. We do not have an exchange rate target.

  142. I am aware of that. Now, the balance of payments current account is estimated to deteriorate quite significantly this year and next. Have you estimated the likely effect of that on the stability of market value of sterling?
  (Mr O'Donnell) I was replying to a question earlier on the issue of the world slowdown and the impact that would have on the UK and you are absolutely right—growth in our export markets is due to reduce quite substantially, and that will have the effect of producing a somewhat bigger trade deficit. As to what that will do to exchange rates, when we do our forecasts we use, as we have for many years, the illustrative assumption of what we call uncovered interest rate parity—essentially that sterling will change relative to other currencies in line with the interest rate differential between those currencies. For example, in sterling versus another currency, if sterling's interest rate was, say, 5 per cent higher than the other currency's, we would be predicting a 5 per cent decline in the exchange rate over that period. That is just using the illustrative assumption because if we could predict exchange rates then we would make vast amounts of money, and we cannot.

  143. But the illustrative assumption is not in here?
  (Mr O'Donnell) It has been the same illustrative assumption for as long as I can remember.

Mr Beard

  144. What was the American growth rate over this year and next year that is behind your assumptions in this forecast?
  (Mr O'Donnell) Next year we are assuming US growth of 1.75 per cent.

  145. What balance of probability are you putting in for a prolonged downturn as opposed to a quick recovery?
  (Mr O'Donnell) I think there are certainly downside risks to that. Most people use the alphabet to describe what is going to happen to America and you have these V-shaped or U-shaped or L-shaped outcomes. I guess you would say we are in the kind of "U" camp on that rather than the "V" camp.

  146. Over the next two years?
  (Mr O'Donnell) Yes.

  147. To what extent do you think the UK economy will be affected by the same factors that have caused the United States drop in growth rate?
  (Mr O'Donnell) What is hitting the US I think is partly an equity market response which has had an effect on consumers. That kind of response is not as big in the UK because simply household direct holdings of equities are much lower so you do not get as much of that. Also, they have had a period of substantially above-trend growth so there is a necessary slowing for them. We are not in that position; our estimate is that our output gap, the difference being actual GDP and trend GDP, is relatively small—small and positive but small. So I think that in the US you can understand why there may well be a slowdown and, indeed, the Chairman of the Federal Reserve thinks that some of the new economy gains that push them up will also mean that that slowdown may be quite rapid because companies can adjust their inventories very quickly, and lots of the response mechanisms in the economy have been accelerated so there will be quite a fast fall down, and also he thinks that when it does turn up it could be a fast turn-up, but he is still very optimistic about medium term prospects. They think the new economy productivity gains have not worked their way through the economy by any means yet and there is quite a lot more to come, and you can see some signs of productivity gains in the UK. So essentially I do not think a US fall translates one-for-one into a fall in the UK because, for example, over half our trade is with the EU, so we are not as dependent on trade there, but there are other mechanisms like investment flows, equities, where there are reasons just to be cautious, and I think the world certainly presents downside risks for our forecast whereas on the domestic side one can observe some up-side risks.

  148. Your forecasts for the growth in the economy assume it will grow at trend rate over the next three years. Is the trade cycle not likely to intrude on this?
  (Mr O'Donnell) One of the ways in which we get trend growth right is we expect private consumption—which is strong at the moment—to start tapering off, so consumption growth comes down. As that happens, growth in demand for import should come down and we should find the trade deficit—which widens for a while—starting to come back. On our forecast, anyway, the trade deficit certainly does peak, as I said, for the current account at 2.5 per cent of GDP but then starts to come back.

  149. But in the sense of the trade cycle in economic activity, is your assumption that the different fiscal and monetary measures put in place have virtually cancelled it out?
  (Mr O'Donnell) Certainly we would expect, if we were observing the economy going below trend growth and there were forecasts for that, we would expect policy to respond, yes, and that is where the MPC will be looking at interest rate policy to ensure that and on fiscal policy the automatic stabilisers kick in to produce that effect. As I said, both policies have room for manoeuvre so we can respond using both to ensure we stay close to trend.

  150. So the assumption behind the Treasury forecasting is that effectively the trade cycle can be abolished and the reaction from fiscal and monetary policy can cancel it out more or less permanently?
  (Mr O'Donnell) Not that it can be abolished but that we can reduce the amplitude. As it happens, going forward, we expect to stay reasonably close to trend but we certainly do not think that we will every year be on trend. There will still be forecasting errors, let's be clear about that, but if the path of the economy is more stable so the fluctuations around trend are smaller, then that does make it slightly easier to forecast.

Mr Davey

  151. If we come back to the forecast and how it is disaggregated, in table B3 you predict that real or household disposable income in 2001 will grow between 4.25 to 4.5 per cent. If that transpires, we are told it will be the biggest increase in household spending since the boom of 1988. Is that worrying you at all? I know it is election year but in economic terms is it worrying you?
  (Mr O'Donnell) No, because the statistics that would reveal whether that is true or not will come out in the second half of the year, if it is emerging. It does not worry me in the sense that what we have here, as I said before, is a slowdown happening from the net trade side. That is, as I say, taking out about 1 per cent of GDP from our growth on the net trade side so in order that GDP grows at trend we need there to be reasonably strong domestic consumption. That is what we would expect to happen this year, but it does need to slow down because households do need to rebuild their savings ratio.

  152. But is that not the concern though? You are predicting that the savings ratio will actually increase a little bit over the next two years but if that does not transpire, given the trend at the moment is going the other way so you are forecasting a complete change in the direction of where the saving ratio is going, consumption will be growing even more—possibly faster—than in the 1988 boom, and we are told that boom and bust is a thing of the past?
  (Mr O'Donnell) And indeed, in terms of overall GDP growth, what is important is to keep that close to trend. As I have said, what we are observing here is a compositional change and this is brought out very much by the difference between our pre Budget report forecast and the current forecast. The world has slowed down a lot more so our net trade composition will be a lot worse so we need consumption to stay stronger for a while. If domestic consumption is growing too rapidly—and, as I said, there are downside risks on the world side—you are absolutely right, there is a upside risk there, and that is what the MPC will watch—I was going to say like hawks but I hope like the appropriate combination of hawks and doves! They will watch very closely and make interest rate decisions to ensure that the path of overall economy and inflationary pressures are kept under control, and I have every faith that they will do that.

  153. But it is that composition of aggregate demand that worries some of us. You are forecasting and enabling there to be this large increase in personal consumption and then we get figures this month on 9 March showing that production industries, which is another possibly even more important part of aggregate demand, are going down. Production industry output fell in the last three months by 0.6 per cent; between December and January manufacturing output decreased by 0.9 per cent and, if you look at key industries, electrical and optical and equivalent industries, there is a fall of 4.8 per cent. So in that key area of manufacturing we are seeing output really coming not to a halt but going into decline, and consumption go through the roof, and that is not a really very healthy sustainable mixture of aggregate demand, is it?
  (Mr O'Donnell) I would not read too much into that set of figures because, as you rightly pointed out, they are very sector specific and if you look at them in more detail, you look at the mobile phones effect there, the pre-Christmas and post-Christmas effect is quite big and ONS were pointing out that these are rather distorted numbers. Our prediction is that manufacturing growth next year will be fairly robust and somewhat higher than it has been in the past.

  154. Would you describe 1.75 and 2 per cent as "robust"?
  (Mr O'Donnell) Yes, for manufacturing output. This is combined with strong productivity gains. Remember, compared to its recent history, this is reasonably robust, I would say, yes, and the services sector is growing quite strongly.

  155. So if 2 per cent is robust for manufacturing, how would you describe 4.5 per cent for consumption? Extremely robust?
  (Mr O'Donnell) That is spending versus output and in the end these measures all have to come into line because GDP measures through spending and output have to come into line. I would not read too much into those monthly figures.

  156. But I am concerned about this mixture of aggregate demand. You give this picture, "All is rosy; do not worry; we have it all under control", and we are seeing consumption go through the roof and production falling, and those of us who want to see a long-term sustainable development economy are worried about the output of production industries.
  (Mr O'Donnell) Like I say, we are forecasting that output production industries will recover from those numbers and that they will be seen to be rather distorted, and certainly that is in line with what independent forecasters view as well. It is not that we are coming up with an unusually optimistic or rosy forecast; we are pretty much in the middle of the pack.

  157. Is not this decline in the manufacturing output now and the not quite so robust growth in manufacturing output, which is the way I would describe it generously, behind the fact that imports are increasing much faster than exports? That was the case this year; you are forecasting it for next year; you are forecasting it for the year after that. Is that not the reason why we are seeing a huge decline in the balance of payments position, because you have an imbalance in the economy?
  (Mr O'Donnell) Like I say, the change in the forecast since the pre Budget report time is that the world has slowed down much more than the UK. It is difficult to be pressured because the UK economy is doing rather better than, say, the US and Japan and all these other areas. It is certainly true—world growth has been revised down quite substantially. There are problems out there. The rest of the world is responding to this. They are cutting interest rates in Canada, United States, Mexico, Brazil, Japan, Hong Kong, Australia, New Zealand, the UK—we are going through a period where we need some policy responses to ensure that world growth stays at a reasonable level and during that period, when the world slows down more than we do, we will go through a period where we run a trade deficit for a while. That is inevitable.

  158. My question is not so much about the overall level of aggregate demand for the UK and how that is relevant to the other countries but the composition of that demand and the fact that you, in the policies you seem to be pursuing, are trying to make sure it is the consumer and not manufacturing industry.
  (Mr O'Donnell) We have put in place policies to ensure, like I say, a macroframework that is delivering macro-economic stability and low interest rates, and you are seeing employment carrying on rising and that shows—

  159. Not in manufacturing or agriculture?
  (Mr O'Donnell)—Overall employment carries on rising, certainly within that total. There will always be sectors that are falling and some that are rising. Manufacturing employment has been falling ever since the 1950s.

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