Select Committee on Treasury Minutes of Evidence


Examination of witnesses (Questions 240-259)

MONDAY 26 FEBRUARY 2001

MR ROGER BOOTLE, MR DAVID MILES, MRS BRIDGET ROSEWELL AND PROFESSOR ANDREW SCOTT

Chairman

  240. And you say in your paper that "one is left with the suspicion that the central forecast is being driven by hard-line members of the Committee and that it does not fairly reflect the balance of views on the Committee as a whole". This is tough stuff.
  (Mr Bootle) That is right. I am saying that because the report does not reveal that there is any camp on the other side of the so-called central view.

Mr Kidney

  241. David, you wanted to add something.
  (Mr Miles) I think an interesting question to ask the MPC is whether they consider the costs of deviating from the central target of 2.5 per cent are entirely symmetric. In other words, do they consider inflation turning out at one per cent to be as bad as inflation turning out to be four per cent. I think that the official remit the MPC is given does not actually answer the question as to whether the costs are symmetric. It does say that if one is above or beneath the central rate by a certain (equal) distance then a letter has to be written justifying this but that does not imply that the costs of being above or beneath by the same amount are equal. I think it would be interesting to hear what MPC members—and they may well disagree—say about how they view the costs of deviating.

  242. You mean the cost to the economy, not to their reputation?
  (Mr Miles) That is a very interesting distinction to draw. It will be interesting to see whether they come up with different answers depending on how they see the costs.

  243. Professor, before I move on to another question, do you want to add anything?
  (Professor Scott) Just to pick up a little bit more on what Roger was saying. You do not want the fan chart to be an average forecast and when you have a close vote 5:4 there are two camps and naturally the fan chart probably reflects the dominant group. The question here about how you deal with these two different camps is crucial to what you are trying to achieve. Do you say "Well let us not worry about the uncertainty around our forecast, let us just go with our central forecast. How do you factor in uncertainty?" The two downside risks, absolutely right, are the US and the other one slips my mind right at the moment. So there is downside risk in inflation which is dominating. There is another camp which can make a case—it is made in the Inflation Report—about strong domestic demands, strong wage market and also strength in Bank lending. What seems to be the case is that there is a very low weight on the downside risks. They know there is this downside risk but there is a low weight on it in that original 5:4 vote. It is a central forecast, it is the dominant one but there are two different camps and you have to work out how to deal with those different ones.
  (Mr Bootle) Chairman, can I follow up on that? I think the word "central" is critical really. To say it is the majority view with dissenters seems to me to be fair, if that indeed is what it is. To say that it is central when in fact it is simply a 5:4 vote with nothing the other side seems to me to be misleading. What is happening here, I think, increasingly, is it is becoming clear how difficult it is to present a single view of the future in this way. This has been an issue which has cropped up, of course, repeatedly over the last few years. There is an awful lot to be said, as this particular Inflation Report is emphasising, for the idea of having a forecast of the future from the Bank staff and it being quite open and clear that this is not necessarily, as it were, the central view of the Committee as a whole.

Chairman

  244. Donald Kohn has just rejected that rather firmly in front of us a few minutes ago. He does not think that would be a good idea.
  (Mr Miles) There is a hint in table 6B on page 67. I do not think we have seen a table like this before. It is a measure of the disagreements within the Committee on what the impact of things like changes in the UK supply side potential are. That is quite a big factor. Somebody on the Committee believes the central forecast is a quarter of a per cent less than the middle of the range due to what they think is happening in the labour market and somebody else thinks it is about the same the other way. Maybe the MPC are moving in the direction of giving more of an indication of the range of opinion and why there is a range of opinion.
  (Mrs Rosewell) It is, however, quite surprising. I thought what was interesting here was that this range was actually quite narrow.
  (Mr Miles) It is narrow.
  (Mrs Rosewell) The impact of supply side and labour market performance would only be a quarter point either way. Whatever the risk is surely it is a lot bigger than that or, indeed, the world slow down and impact on the United Kingdom, the maximum is about a quarter point lower and that is only on inflation and it is only 0.15 on GDP. It is a consensus of what the possible effects are of these risks. I found that surprisingly unilluminating. I agree that is the first time we have seen this sort of table. The real difficulty is that we hear from members outside the Committee process, they make speeches and so on and it is clear that there is this alternative view emerging but it does not emerge in the pages of the Inflation Report. I think that is our real difficulty, that we get potentially one specification, we get this obscure statement Roger referred to about certain Committee members who prefer to make different judgments but we are not actually told what these different judgments are.

Mr Kidney

  245. If I can move on, perhaps to David Miles, David Walter has written to us saying "There seems little reason not to expect another cut in interest rates soon" and that is right, is it not?
  (Mr Miles) I am not sure for two reasons. Firstly, it seems to me that what has been happening with the building society and bank sector on mortgages has eased monetary policy quite significantly. Typical mortgage interest rates might be lower by half a percentage point as a result of what the Halifax has announced and the reactions to that. That is quite a substantial reduction in the cost of mortgage finance and it is an easing in monetary policy in some sense. That may have done some of the job that people were expecting the MPC to do. The other thing comes back to the uncertainty in the US. I think had there not been those dramatic falls in the confidence indicators, I doubt very much whether there would have been such a reaction from the US Fed. Those confidence indicators, I would imagine, are extremely volatile. One might find in a month's time or two months' time that they have shot right back up and we are not hearing talk about the US going into recession at all. I suspect the MPC is going to wait and see what happens on the US economy. It strikes me as far from clear cut that there are more interest rate cuts to come in the UK.

  246. Who is with this David and who is with the other David who is not here today? Will rates stay or will there be further cuts?
  (Professor Scott) I am not expecting an increase in interest rates. I think we will get another one. I do not think there will be a rush.

Chairman

  247. Another cut?
  (Professor Scott) Another cut, that is right. It may be we will get one next meeting, I doubt it, but I think undoubtedly interest rates will fall. I do not think there is any evidence yet for a dramatic downward reduction in interest rates. We have to realise the US boom has been very different from the UK growth experience and on previous evidence the US slow down does not have a disastrous effect on the UK economy. I do not think we should over exaggerate and draw too strong a parallel with US monetary policy in the UK but the economy does seem to be slowing down. It is probably going to nudge below trend growth so one would expect reductions in interest rates but not dramatically and not large unless something materialises which is unexpectedly bad.
  (Mr Bootle) I take a rather different view; I do not know if you would call it optimistic or pessimistic. I suspect that interest rates are on course to hit something like about five per cent by the end of the year. I believe that not because I think the UK is going to suffer massively as a result of the US slow down but rather because of the inflation picture which is after all the objective with which the Bank is primarily charged. I think the status of the Governor's impending letter is worthy of some discussion. I reckon he is going to have to write a letter at some point or another this summer. I sent you some charts, which I hope you have got, which showed that if you took out petrol prices, he would have to have written a letter already. It is not that one needs petrol prices or oil prices to fall off from where they are, it is simply the falling out of an upward distortion from before. My judgment is that it is going to be increasingly difficult for the Bank to argue as we go forward that in two years' time inflation is going to pick up nicely to hit the 2.5 per cent target point as the starting level gets lower and lower.

Mr Kidney

  248. David, you want to argue for wait and see: do you think the Governor is about to send this letter later this year?
  (Mr Miles) I think what triggers the inflation letter is one per cent beneath the central target, so that would be 1.5 per cent. It is clearly something that may well happen. I would guess that it is less than a 50 per cent chance that it will happen. Just looking at the fan chart again, if that is a representation of the MPC's own views on the probabilities then it looks pretty small to me.
  (Professor Scott) There is a table on page 67.
  (Mr Miles) Okay.
  (Professor Scott) Which has also been pointed out to me which gives an exact number, it is 25 per cent.
  (Mr Miles) The MPC's own view is revealed here, there is a 25 per cent chance they are going to have to write a letter. It seems it is far from clear that they are going to have to write a letter.

  249. Do you think they are wrong, Roger, with 25 per cent?
  (Mr Bootle) Yes, I reckon the chances are much greater than that.

  250. Bridget, are you "wait and see" or do you expect more cuts?
  (Mrs Rosewell) I am glad everybody else answered the question first because I am trying to make up my mind what I think they will do as distinct from what they ought to do. I suspect that they will wait and see. They have, after all, been waiting and seeing now for a very considerable time. They have made one very small cut. The relationship between interest rates and inflation, I suspect, is getting stickier and inflation is moving downwards generally, so I would agree with Roger that the probability he would have to write a letter is higher than 25 per cent—I put it more like 50/50, possibly 60/40—and that this downward pressure on inflation which is being generated elsewhere will continue. I think the loosening of policy by the cuts in mortgage rates is not going to be big enough to counteract that. It does not apply to new mortgages which are all on special deals anyway. It will help some people but it is not going to make much difference to people's spending patterns and anyway it is not going to last unless interest rates come down to bring down the rates on savings, because otherwise they go bankrupt at these sorts of rates across the piece. I think combined with that there will through this year be developing a cumulative slowdown in the economy itself which will put further downward pressure on inflation. So all of that adds up to wait and see on the part of the Committee because they do not seem to care about high real rates in any fundamental sense and at the same time inflation is falling, so that raises the odds on having to write the letter. I am more pessimistic than Roger that we will hit five per cent by the end of the year.

  251. Andrew, when you said there might be another quarter per cent cut at the next meeting, the next meeting is the last one before the General Election if it is May 3, as lots of people think it is going to be; does that influence the thing one way or the other? Either, "Let us help the Government be re-elected," or, "Let's show we are absolutely independent by not changing the rates"?
  (Professor Scott) I can only speak for myself. Given the speed they normally move it is unlikely that they will do two cuts. Given they are normally very cautious in change, I do not think there will be another cut. The risk of appearing political in some way would be something that they would wish to avoid but you will have to ask them. Roger is talking about five per cent by the end of the year. We have got a lot of meetings and we can proceed at quite a cautious pace. I do not think we need to do anything dramatic like the Fed has been doing in the last few months, so it really is a question of a number of small cuts, two or three, spaced out over six months or a year. I do not think it is too different from what Roger was suggesting.

Mr Beard

  252. Is there evidence in the data so far of the slowdown in the USA affecting the UK economy?
  (Mr Bootle) The first direct evidence came the other day, namely the CBI Survey, which showed a real weakness on export orders. Before then I think it is fair to say that there was next to no direct evidence. There were some signs of UK slowdown, the figures for Q4 GDP for instance, but you cannot pin those down directly on anything to do with America. So the evidence at the moment is very, very slender and I think I would point to the CBI Survey as the only bit so far.
  (Mr Miles) I do not know if you have got a copy, but Sushil Wadhwani gave a talk in Newcastle last Thursday specifically about the US slowdown and all the rest of it and he has got some information there about new indicators that have come out since it became clear about the slowdown. Some of them show optimism falling off, some of them show consumer confidence looking a little bit stronger. His interpretation of this is that as yet there is not any clear knock-on effect in the United Kingdom. I have got a copy if you want.

  253. How long do you think it will be before there are positive signs, if there are going to be positive signs, reliable signs, of the US slowdown affecting us?
  (Mr Miles) The direct channel is that if the US economy slows down a lot, demand for UK exports to the US falls off. If that is the channel one is looking at, it is probably not a terribly powerful one because so much more of the UK's exports go to Europe than to the US If that is the channel you are looking at it probably takes quite a long time and the size of the impact may not be very dramatic. I think if there is going to be a big knock-on effect it is more likely to come through something like the stock market selling off very dramatically in the US and that having a very big impact on stock prices in the UK, and that really could hit. That is the way it is going to happen, if it is going to happen significantly, rather than via trade.
  (Mrs Rosewell) There are two other things. One is not so much a direct effect through trade but an indirect one through the exchange rate. The collapse in the US economy and the dollar strengthening is a problem across many markets where there is dollar pricing. That is one additional thing. The other is a general confidence effect. People do read the newspapers and if they see stories about difficulties in the world economy or stock market, or whatever, that does have an impact on people's willingness to invest, in particular, and that is one of the areas where you could look for the evidence on the confidence front.
  (Professor Scott) Not much to add there. The biggest threat is a serious US recession which creates a lot of financial sector/banking sector weaknesses. It can spread very quickly and have a big effect here. It would manifest itself in the stock market with a banking sector weakness. I do not think that is going to happen. That would be a quicker and more substantial route. Exchange rate, small effect, six months, nine months, that sort of timescale. On confidence I am less concerned about the confidence measures. What you do see is very much what Bridget is saying, short-term weakness. The Chairman of the Fed talking up recession, confidence levels plummet. You hear that and the UK consumer/producer confidence falls but unless the economy actually weakens and unless unemployment rises or wages fall a lot, it does not have a long-running effect on confidence and so does not affect it.

  254. Do you all agree with the MPC central projections based on the assumption that the US should see a return to moderate growth in the latter part of this year, or are you more pessimistic than that?
  (Mrs Rosewell) I think the difficulty is what happens between now and the end part of this year. It is clear if there are signs of further weakness that there will be further strong policy reactions, judging by what we have seen already, so I suspect that by the time we get to the end of this year then there would be a return to some low/moderate growth. I think, however, there is a possibility of quite severe weakness in between those two points and quite a lot of turbulence in the markets as a result of that. It is the bit in the middle that I am most worried about particularly over the summer. By the time we are sitting here in a year's time it will all look a bit more comfortable.

  255. You expect it to be that quick?
  (Mrs Rosewell) It is a very flexible economy. It grew very fast but it can also go back down very fast too. It is the downside of the upside.
  (Professor Scott) Most economies react with a year/18 month lag with interest rates. Given the big reductions at the end of last year that should be feeding through. The concern is what is happening in between whiles. I would have thought low positive and rising growth is the most likely scenario in the US. I am not sure about moderate, I am not sure what that means.
  (Mr Bootle) I take a different view on that. No-one knows the answer on this. In my view we are dealing with a mass psychological phenomenon so it is extremely difficult to be remotely confident about it, but my view is that the outturn of the US is likely to be rather worse than the one the Bank is assuming. I think that partly because of the underlying conditions in the American economy. It is not as though weakness in the demand indicators you have seen over the last month or two months come out of clear blue sky. On the contrary, the Bank itself has been warning about the underlying imbalances in the United States' economy for some years and worrying about the risks that they pose to the world. It may well be that the whole shemozzle can continue for even a matter of years yet and that therefore there will be this bounce back later on, but my suspicion is that this is the long-awaited adjustment which will eventually deal with the imbalances referred to so often and the danger for the rest of the world, of course, is that although that adjustment is necessary it is not very helpful with regard to the adjustment in the world demand.

  256. Mr Miles, do you have a different view?
  (Mr Miles) I think it is enormously uncertain what is happening in the US. As I said before, I think the confidence indicators have had a big impact on the Fed but I suspect those confidence indicators are extremely volatile. It would not surprise me if they shot right back up within the next few months; we might not be talking about recessions by the summer.

  257. Looking at the US on its own, would you say the MPC was right to lower interest rates pre-emptively last month?
  (Mrs Rosewell) They have described it as pre-emptive. It is not quite clear to me what it is supposed to be pre-emptive of, given that there is already in progress a slow down in the UK economy and this just seems to me to be making an excuse for something which is actually justified on other grounds, if that is what they really think is happening. As I said before, I think that interest rates in the UK are getting increasingly out of line with both what is happening in other countries and also the state of the economy. We could easily be at five per cent now and it would be an appropriate rate for the state of the economy that we are at and the underlying inflation that we have.
  (Mr Bootle) I think you have to consider it in terms of risks. If you ask yourself the question what risk the Bank was running by cutting rates by a quarter when it did, I think it is difficult to come up with a convincing answer. Now that would not have been the case—to get back to my hobby horse—if inflation had been running well above the target and if there had been clear dangers in the near term that it could go a lot higher. It seems to me that there was not any risk of that nature. There was however a risk, there is a risk, that the US slow down will be serious and the knock on effects on Britain will be serious and therefore I think it is right to think of it as a sort of insurance premium really. The direct effect of the quarter per cent I do not think will be very great, I have to say, in staving off a recession. It is not so much that, I think it is more akin to what the Bank did in 1998, which it did very successfully I think, which was to say to people "Look, you may be worried about the state of the world, and you are right to be, but be confident that we are going to make adjustments quickly and firmly". It is only a quarter of a per cent but I think it has demonstrated that, again, it has said they are prepared to cut, I think in principle, as far as is necessary.

  258. Would it be fair to say your unanimous opinion is that interest rates should fall and will fall almost irrespective of what happens in the United States?
  (Mrs Rosewell) Yes, that would be my view.

Chairman

  259. David Miles takes a different view.
  (Mr Miles) Yes, I do slightly take a different view. It is partly because of looking at the structure of the real economy where unemployment is the lowest level it has been for probably 25 years and various indicators of skill shortages suggest great tightness in parts of the labour market. Inflation clearly is underneath the 2.5 per cent limit but it is not enough simply to say, "well inflation is beneath the target, it probably will not go back to the target or above it over the next year or so and therefore we should cut rates". I think you have to ask what is the wider economic environment we are in, and we are in an environment where GDP growth has been pretty strong. Over the next year or so it may be running at around, or very marginally beneath, the trend rate. Unemployment is extremely low. It does not seem to me an environment where you would say well clearly monetary policy should be significantly looser so I think I do take a slightly different view from some of my colleagues here.
  (Professor Scott) I think to understand what is happening here you have to draw a distinction between a forward looking inflation target where all the time the Bank is saying what is going to happen to inflation 18 months, two years down the road, and then what the level of inflation is today. Inflation is really quite a sluggish variable, it does not suddenly roar up in a month or two. That I think is causing a bit of a problem here because, as Bridget says, we could have five per cent interest rates without probably breaching the inflation target in 2003. I think that is right but I think you then breach it beyond that. I think what the Bank is wrestling with is saying "Why is inflation currently low, why is it below target? Is there a mistake that we have made over the last couple of years which will make us review or change the models we are using to think `Oh, what is going to happen over the next two years'". If you do not want to change your models then all the factors David is talking about—low unemployment, high consumption growth—will lead you to worry about reducing interest rates very sharply. If you think there is a reason why you have inflation low at the moment, because the world has changed and there is a structural change in the economy, you would probably want to be more aggressive about changing interest rates. That is the tension you have. What weight do you put on the current inflation models? I think the Bank always says, "Today's inflation reflects what happened a year, a year and a half ago", and that is the key forecast issue.
  (Mr Bootle) I agree with my colleagues in principle but I am afraid I disagree, as it were, in fact about where the argument leads, in the sense I think the current and immediately prospective inflation rate is worth more than some of my colleagues suggest. It is true to say it does not matter or mean a great deal if you know the correct model for the way the economy works and all the parameters and so on but, of course, we do not. One of the things in particular we do not know is the sustainable rate of growth of this economy, and the sustainable rate of productivity growth is a part of that. It is possible that the sustainable rate of growth is higher than it has been in the past and higher than we are giving it credit for. One of the ways in which that would be revealed I think is to see this downward pressure on inflation for no apparent good reason. Given that we do not know—and this is the great imponderable—this sustainable rate of growth, I think there is a lot to be said for looking at the thing which you are actually measuring there in front of you month by month, a price, a little imperfect but a price of sorts. I think that is telling you something. If this were just to occur on the odd month, it would not mean very much, but I go back to my point that it has been happening for getting on for two years. If the Bank could explain that by virtue of all sorts of favourable shocks which are responsible for that development, that might be one thing, but I do not think it can. It has got the exchange rate up to a point but there have been an awful lot of unfavourable shocks as well, in particular oil prices and petrol taxes. So the fact inflation is so low and looks likely to be so low for the foreseeable future I do not think can just be dismissed.
  (Mrs Rosewell) I think there is another way of putting what Roger just said, which is that it may not be so much that the sustainable rate of output growth has increased, or has only increased a little in terms of capacity increases and so on, but if you like the sustainable rate of inflation which goes alongside that has fallen as a result of changing expectations, the way that wages are set, the inflation expectations which are embedded in the system. I think the extraordinary thing is that we have got low unemployment and we have got strong demand and yet we have got wage increases of only 4 to 4.5 per cent and we have inflation at around 2 per cent. That is why I think you have to put a strong weight on the current numbers because they seem to me to tell us something about where the trend is in these numbers going forward, and why I find this rise to 2.5 per cent at the end of the forecast period so completely incredible, frankly. I just do not think that is really what is happening in the economic system that we currently have, and that is why I think you could reduce interest rates and it will not make a tremendous difference to anything, and it will give you a lower base to start from if the economy, after going through the current downturn, is then in its upturn period by the time you get to 2003. If you started from a base of 4.5 now, it would be easier because when you are going to increase them you would not have to go quite so high and it would not make a tremendous amount of difference to the situation now. That is the real situation. Of course it is entirely possible, I guess, that the Chancellor may get Eddie George out of the need to write a letter in a month or two's time by changing the target level in the Budget and bringing it down to 2 per cent, and that would get everybody off the hook.


 
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