Select Committee on Treasury Minutes of Evidence


Examination of witnesses (Questions 260-279)

MONDAY 26 FEBRUARY 2001

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

Mr Ruffley

  260. Do you know something we do not?
  (Mrs Rosewell) I know absolutely nothing.

  261. Is that something which is going around, that there is an expectation the Chancellor may change the target quite soon?
  (Mrs Rosewell) I have not heard that, except some journalists have been mentioning it. I have no knowledge whatsoever. I merely offer it as a possibility.

  262. It was an interesting speculation. Can I ask some questions about data and what the January minutes said about data? In paragraph 11 of the January minutes it refers to, "Part of the puzzle presented by the consumption and investment data might relate to mismeasurement ... it was ... possible that the growth rate of real consumption was being overstated. It was plausible too that investment was being understated." Then it goes on in paragraph 21 to say, "It was possible that the GDP deflator might have been mismeasured." Two quick questions for each of you. One, in relative terms are the problems over that kind of data mismeasurement better or worse now than they have been historically? Secondly, how much of a difference do those mismeasurements referred to in the January minutes make to the present conduct of policy formation? Or are these references to mismeasurement not desperately important things?
  (Mr Bootle) I am not aware of any evidence to suggest that the problems of mismeasurement are any worse than they were. I think that the points you rightly pick up can be emphasised rather because of the low levels of inflation we have got down to and the fact these small differences actually are now quite significant with regard to inflation performance, and also we have got in the inflation report and the minutes someone picking over them in great detail. After all, we have had plenty of occasions in the past when GDP numbers themselves have been well out. In 1988 the first estimate of GDP growth for that year is now shown to be 1 per cent off from the latest revised figure. That is one of the reasons, after all, why the boom in the late 1980s got as bad as it did.
  (Mr Miles) I think that is absolutely right. Revisions to data happen all the time and historically there have been lots of huge revisions to GDP and to trade flows particularly. I have not seen any evidence that the scale of revision is larger now than in the past.
  (Mrs Rosewell) I think it is right that the scale of revision has always been a serious problem. It is very important to remember that the revisions have now become relatively more important because instead of dealing with the 15 per cents we are down to the 2 or 3 per cents. But it could also be argued that the difficulty of measuring the economy has increased over the last few decades. In the old days you counted "things" and most of the effort in statistics was put into the manufacturing sector where it was also much more productive to put it. Now you are trying to measure things which are in principle more difficult to measure, and it is only in the last five or ten years that we have had quarterly measures in the service sector at all, and statisticians are still struggling with where the margins of error are in those and therefore the adjustments they make to first estimates. Secondly, the advent of computer systems and investment in computer systems has also substantially confused where you put consumption and investment as far as corporates are concerned. Investment in software has traditionally been dealt with not as investment but as consumption of services—is that right, is it not right, what do you with the sharply falling price of computer supplies and how do you adjust for those within the construction of different indices? So the scope for error in some of these series has probably substantially increased over the last decade or so, and it is not yet clear how you escape from that either.
  (Professor Scott) Forgive me, I cannot remember the discussion—I normally avoid detailed discussions of deflators—but I think this question is absolutely about IT. The US has changed its way of measuring IT, software is now included as an investment. You have difficulty dealing with commodities which have substantial increases in quality and big falls in prices, and that is going to cause all sorts of problems for consumption, investment and GDP deflators. It is less of a problem for the UK because we do not make so many computers but it does raise the issue of what the trend rate of growth is in the economy. Sushil Wadhwani is on record as saying he thinks we do not measure the economy very well, PRS has said that if it adopted the methodology the US has just adopted which boosted its growth rate, UK growth would be much faster than it is now. It is a slightly two-edged sword because if you are mismeasuring the economy then growth is actually faster than we see, so if you are a supply-side structural change person it is likely you are not actually observing properly the rate of growth.

  263. Do any of those issues impact on Monetary Policy Committee decision-making? Do they say, "It is a zero gain" and just get on with it, or is any change likely to take place as a result of Sushil Wadhwani's arguments? Is there going to be a sea-change in the way we account for these mismeasurements which, as you say, have historically always been there?
  (Mrs Rosewell) I am not sure it does make any difference to the way you view the economy. If you are used to saying, "The economy as we measure it has grown by a 2.25, 2.5 per cent trend, and that is how we expect it to go on in the future", then the fact it actually grew by 3.25 per cent or whatever instead is just an adjustment factor. The difficulty comes if you think that factor is changing. If we have been mismeasuring it, we can go on mismeasuring it. It is a bit like the CBI survey which asks, "Are you more or less optimistic than you were four months ago?" This is not actually the question which anybody answers. Most answer the question, "Am I optimistic or not at the moment?", but the question has been asked in the same way for so long that you can adjust for that and the thing is not to mess up the series by changing the question. That is actually better than trying to correctly measure what it is you think you want to measure. But if people are changing the way in which they count output and that is getting more intense going forward, then that would make a difficulty. The problem is of course we do not know whether that is the case or not, but if you think the world is getting more virtual, if you like, and more computer intensive, harder to measure, then it will get worse going forward and that does make a difference.

  264. But not an immediate cause for concern?
  (Mrs Rosewell) No more an immediate cause for concern than it was five years ago. It is something you can continually adjust your way out of.
  (Professor Scott) Having sat in on a lot of macro-monetary forecast meetings—sign of a misspent youth—one of the key questions you have to look at is, is the data sensible and is it being badly measured? If the data is wrong, then you are not going to have the same relationship you have seen in the past, so that question is important. Is it a reason to say, "I do not believe the central forecast that comes out of the macro-monetary model", and I think there are grounds to be more suspicious than in the past. That is very germane to why inflation has been under-shooting for so long. That is the key question.
  (Mr Bootle) There is one issue of disagreement in the stats which I think the Bank ought to be concerned about, and it is one they do refer to and I mentioned it in the last point of my note, namely the different picture given by different measures of inflation. We are well-used to the HICP figure coming out differently and the discrepancy has not altered a great deal over the time we have been discussing it, but it is right to note that the consumer expenditure deflator in the third quarter of last year was only 0.6 per cent, the lowest for 40 years, and the GDP deflator covering the economy as a whole was only 1.6. This, again, relates to my earlier point about looking at the evidence before you, imperfect though it is, and being guided by the numbers. The fact those figures are as low as they are, a good deal lower than the RPI, I should have thought would raise a few questions, in my mind anyway, about the extent of inflationary pressures in the economy at the moment.

Mr Beard

  265. Table B6 in the inflation report, which has been referred to already, shows quite a wide range of views as to where inflation will be in two years' time, and yet the vote to lower interest rates was unanimous. How do you explain that?
  (Mrs Rosewell) I explain it by you having two different views as part of the same process. So there is probably a group who would have wanted a bigger cut, could not get it, so converged on the smaller cut and that became unanimous as you had the series of votes going through the process.

  266. But the implication of seeing inflation higher would have been that the cut was not required.
  (Professor Scott) This was pre-dating the recent vote. I was not suggesting you should ignore current inflation. The inflation report says there are three things you should worry about: one is the current low level of inflation, one is strong consumer bank lending, and the third is the labour market. We have seen in the most recent months no sign that wage inflation is rising, if anything it is calming or easing off, and for me that is what has accounted for it. If you think there is supply side growth which is very robust, you can still think the economy will grow too fast and you can have an overheating of the labour market. I think it was this very slight easing of the labour market which converted that 5-4 vote, combined with the current low level of inflation.

  267. Any other views?
  (Mr Miles) I think Bridget is right. If we had been told what the result of a vote was—if indeed such a vote took place—where the proposal was to cut by 50 basis points, I suspect very strongly you would not have seen 9-0.
  (Mrs Rosewell) It was probably 5-4.
  (Mr Miles) Quite possibly.

  268. The earlier discussion has been questioning the fan charts and there is the possibility that the central projection in these fan charts for inflation can represent a minority position on the MPC. Is there a form of presentation of these inflation forecasts which would be rather more meaningful and transparent than the present arrangement?
  (Mrs Rosewell) I cannot think of one. That was my answer to an earlier question to Mr Kidney. By disentangling the fan charts, which is something to do with the general uncertainty around a particular set of assumptions and what might be the uncertainty around some alternative set of assumptions, we could end up with nine different fan charts, one for each member of the Committee. You could then superimpose those. There was a paper in the quarterly bulletin 18 or so months ago talking about having different fan charts, which did suggest there was something along those lines going on. What they have seemed to try to do here is disentangle it to some extent by having this Table B6 about the alternative assumptions along with a fan chart and there is a fan chart to go with those assumptions which might be a completely different fan chart, so unless we want to go down the road of having nine different fan charts or some group of fan charts I think we are probably stuck with this as the best way of doing it. It is an advance on having simply one line and nothing else.
  (Mr Miles) There is another table which you could in principle have, which is, without revealing who they are, simply nine different estimates of the most likely rate of inflation, say, two years ahead. You cannot infer anything like that from this. What we do not know from the fan chart is whether the spread of possible outcomes and skewness is a view everybody has or whether there are some people who think inflation would be a bit above 2.5 and then another group who think it will be a long way beneath. You cannot work anything like that out from this stuff, but we could have nine different numbers.
  (Mrs Rosewell) On unchanged interest rates.
  (Mr Miles) Yes.
  (Mr Bootle) Do we know enough about the process by which the fan chart is generated? I do not mean the technical stuff on computer models, I mean the to-ing and fro-ing, or rather lack of it, between the Bank staff and the MPC members? Presumably what happens is that at some stage or another a draft fan chart of the likely future appears, but what actually happens thereafter? This is a genuine question. I do not know what happens, I do not know whether anyone in the public domain does know what happens, but this seems to me the critical question. One could imagine either extensive scope for to-ing and fro-ing and discussion about what the central view of the fan chart is, and in another state of the world it might be a rather cursory procedure under which Committee members think, "What is the point of engaging in a great argy-bargy about the central forecast because the real issue is, having got a central forecast, what do we say about what we think the risks are and which way we are going to vote?" It is not clear to me that we know enough about how this central view is made.

Chairman

  269. That is clearly a question we can ask the MPC tomorrow morning.
  (Professor Scott) Given the divergences amongst the MPC members, the current fan chart does not seem to reflect the spread of views of MPC members. The chart David is talking about is a great chart and hopefully it should be incorporated into this chart. This is a great way of translating a multi-personal, multi-national conversation into one chart, but if there is very strong editorial control it may not reflect the nine views.

  270. Don Kohn suggested to us earlier that in fact they had started by spending all their time on the building blocks of the chart, the technical bit, but now they spend more time on the chart at the end than they do on the building blocks. That is what he said to us.
  (Mrs Rosewell) It might be worth revisiting the description of how the fan chart which was published was put together, and then discovering how far it is now different. I think there is some thought that as new members of the Committee have come on it has, as you say, become less of a technical process and more of a risk assessment process, and in that case what is the relationship between the fan chart and table B6? Perhaps that is the key question to ask.

Mr Cousins

  271. In Mr Bootle's note to us, it says, "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." I wonder how that grabs the other three of you as a thought.
  (Professor Scott) It is clear there are two forecasts and the absolutely critical point is how you build uncertainty around the forecasts. I think one part of the Committee is saying, "Either the world has not changed, in which case we are right in doing what we are doing, or the world has changed, in which case inflation will be lower than the target, and that is a bias we have to put up with." I think that camp is a strong one. I do not think they are necessarily saying there is only one view of the world, but saying, "This is how we are going to deal with the uncertainty around the forecast." The other group who feel the world has changed feel you can be much more relaxed about financial controls. I think I would put it in a slightly different way. You may want to use the same terminology but I think we can put it in a slightly less oppositional way and more rational decision-making way, how do you deal with risks around the central forecast. If there are two different camps, it is clear which side one of those camps is, and that may well be connected with the idea that an under-shoot of inflation is better than an over-shoot of inflation in the early years of forming credibility. That is hard line but it may be a justifiable hard line. It is not a pure inflation matter, there is a reason for it.

  272. The other two of you?
  (Mrs Rosewell) I think that there is a group of hard liners who are characterised by a combination of thinking that the world is the same sort of place as it used to be and as an implication of that that inflation is around the corner all the time, the historically determinist group perhaps, and that is probably the one that is represented most strongly both on the Committee and in life for that matter, and that you could argue is behind the sort of fan chart we have here. The minority view is then the view that you cannot rely on history to describe what is going on at the moment, there is a change in behaviour—of which indeed the existence of the MPC is one instance—and that inflation is not ready to re-ignite around every corner, and that view is not fully represented in these fan charts. If you want to convey that in terms of probabilities and risks you can do so, but I doubt the individual members of the Committee would do that as it happens. They have a coherent picture of the way the economy works, and that is one coherent picture, and there is an alternative coherent picture to the way the economy works and they are alternatives. If that is a correct representation of the schools of thought if you like within the Committee, but that is perhaps something we do not actually know. If that is the case, they are alternatives, and it is not a question of the balance of probabilities. The balance of probabilities might be used by some third group standing outside these two, to judge between them on probabilistic grounds, but I do not think you can use that as a sort of get-out within the Committee itself, if it is the case that my characterisation of these two views is the correct one.
  (Mr Miles) I think it is possible to over-estimate the degree of disagreement on the Monetary Policy Committee. I suspect there is wide agreement that—and indeed the charts show it—inflation is very likely to be below 2.5 per cent for most of the next two years. Nobody is dissenting from the proposition that there is more chance that it will be under 2.5 per cent than above it two years from now. If there is a disagreement, I tend to agree with what Andrew Scott said, which is, that it is about attitudes to the risks and do you seem them as symmetric? Do you consider inflation being at, say, 4 per cent as being as bad as inflation being at 1.5 per cent? How bad you think inflation being at 1.5 per cent is depends very much on the wider economic environment. Inflation being at 2 or 1.5 per cent and staying there in an environment with unemployment very low and growth continuing, is completely different from under-shooting the inflation target in an environment of stagnant output and rising unemployment. I suspect, and I have no strong evidence for this, there are several members of the Committee who take the view that keeping interest rates where they are is more likely to lead to an under-shoot even two years ahead than it is to an over-shoot, but given this is the first cycle we have gone through with an independent central bank it would be a bad outcome to end up at the end of the cycle, a couple of years from now, with inflation above 2.5 per cent. They would rather have it a bit beneath it especially if you were not paying a high price in terms of unemployment or stagnation to have inflation there.

  273. Who are the hard line members of the Committee? Can we just infer it from the voting records or is it some rather more special status in terms of driving the process forward?
  (Mr Bootle) I think the voting records will tell you quite a lot but what I am suggesting has to be seen in the context of the comments I have just made about what I think is a considerable degree of opacity about the fan charts. This is really precision disguising opacity. Putting those two things together, the person I think who needs to be questioned most intensely on this whole process is none other than the Deputy Governor, Mervyn King, and I am suggesting he is the person to whom some of the questions that David Miles has been raising should be addressed—like how much value you place upon under-shoot versus over-shoot. I do think this is a fantastically important question that David has raised, and it is not obvious to me that his description of what is permissible within the existing regime is permissible. I thought there were clear statements both by the Chancellor and by the Governor and other Committee members to the effect that the target was perfectly symmetrical. There is an issue as to what costs are incurred by under and over-shoots but I think it is quite clear in the remit that 1.5 per cent is to be regarded as bad as 3.5 per cent. I very much agree with the thrust of what David is saying, that given the youth of the whole regime if one were, as it were, at all politically-minded, with a small "p", sitting on this Committee and thinking about the health of the economy and the sustainability of the regime going forward, one might well interpret things somewhat differently. One might be secretly rather pleased about the idea of under-shoot, but my understanding of the remit is that it is not within the remit of the MPC.
  (Mrs Rosewell) I think that is absolutely right.

  274. If we got to a situation in which the famous letter had to be written because of an undershoot, what would that do for market sentiment? What would the reaction of the markets be to that?
  (Mr Bootle) I do not think myself the markets' reaction would be that significant. After all, writing a letter as opposed to not writing a letter is a difference of 0.1 per cent. I think technically it has to be 1.4 or otherwise it would be more than 0.1 per cent outside the target. I think its significance, dare I say it, is rather more in this domain and with regard to this whole question of the symmetry of the target and the suspicion that perhaps, in fact, the operators on the Committee are not regarding it symmetrically. It is really rather in that context that I think it is going to be significant. I do not think the markets are going to be much bothered by the fact that it is 1.4 or 1.5.
  (Professor Scott) I suspect they feel that it would give more weight to the soft liners rather than the hard liners. It would not have a big effect. The news would be in the inflation numbers which they would know already, but they would probably feel it would constrain the enthusiasm of the hard liners, so it may alter their expectations.
  (Mr Miles) I think it depends what is in the letter. I believe it is an open letter that we all get to see.

  Chairman: You will be able to have hearings on it.

Mr Cousins

  275. It would be rather exciting, a constitutional innovation.
  (Mrs Rosewell) Excellent.
  (Professor Scott) Yes.

Chairman

  276. Hearings on a letter.
  (Mr Miles) It could be very short.
  (Mr Bootle) In a sense I think how significant the letter proves to be is partly, as it were, up to you as to how you interpret it. It seems to me quite important that the Governor has on numerous occasions said he does not think it is significant at all, that he is surprised he has not had to write umpteen letters already, he has got them stacked up ready to go, it does not really much matter. I think that it might matter depending on the context of inflation. The fact that we have been undershooting for the best part of two years and then he would have to write a letter is, I think, altogether different from writing a letter out of the blue because you have suddenly had some oil shock which has come along and upset you.

Mr Cousins

  277. Professor Scott in his thoughts to the Committee in italics is reassuring us that the undershoot has been modest, well within the standard error bands and has not been accompanied by weak growth. Then he reverts to ordinary type in which a rather different thought emerges which is, "I suspect," that is him, "that the economic climate of the next 12-18 months will not be so forgiving—an inflation undershoot during this time period may well be accompanied by below trend growth." I wonder if I could ask the other three of you how that grabs you. Do you see that as being a sensible thought, that if the economic climate is not so forgiving in the next 12-18 months then the consequences of an undershoot may be rather greater future in the future than it has been in the past?
  (Mr Miles) I think that the implications of undershooting the target by a certain amount, be it by 2 per cent or 0.5 per cent, critically depend on what is happening in the rest of the economy. It is one thing to undershoot by that amount consistently when unemployment is relatively low, has been falling and growth is okay. It is very different from an environment where unemployment is really beginning to rise and output is very sluggish. I think whether or not over the next year the real economy will be substantially weaker than it has been over the last few years or not is still a very open question. We could go through the list of indicators that are still quite strong—the housing market still appears to be quite strong and unemployment is low and all that—and then there is a bunch of other indicators that are slightly more worrying. It seems to me that looking at the thing in the round it is still pretty evenly balanced and I would not say that there is a strong weight of evidence that the economy is going to be a lot slower over the next year than it has over the last couple of years.
  (Mrs Rosewell) I would say that the economy will be slower over the next year than it has been over the last couple of years, particularly over the last year, and we are already seeing signs of that. We have certainly seen that unemployment has stopped falling, or pretty much stopped falling, and in some places, in quite a lot of places now, it has started to rise depending on which measures you take and so on. I think that is going to work through. Manufacturing is doing a bit better because the exchange rate has fallen off the top. The general pattern of the economy is down, so therefore that will intensify the undershooting that we have already got, and indeed that is what we can see in the fan charts that we have got. Inflation continues to move down in the forecast, as does GDP growth. Then it all starts to accelerate when we get through this year and into 2002. That is the reason why we all think that there will be some continued cuts in interest rates over the coming year. Quite when and quite how much there is rather less agreement on, but the general path is you could stick us into the MPC meetings and the outcome might well be the same.

  278. Do you have any thoughts, Mr Bootle?
  (Mr Bootle) No.

  Mr Cousins: My last question really is about this. It is described as a speech, so let us call it that. It is the speech of Dr Wadhwani—

  Chairman: The Newcastle speech.

Mr Cousins

  279. The Newcastle speech, yes. He was at a more interesting meeting last Thursday in Newcastle than the one I was at, but that is another story. In the course of his remarks he says this: "Our econometric models tend to let us down when there are large changes in confidence." He finishes by saying: "It is going to be more important than ever to have our ear close to the ground." Now, apart from the fact that obviously going around with your ear close to the ground is an inherently undignified posture, particularly if the ground does not say anything to you, are we really in that kind of situation in which we should place more reliance on the sort of touchy-feely ear close to the ground kind of stuff than on the econometric models?
  (Mrs Rosewell) I think we are always in that position. That is why I do not run an econometric model any more.


 
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