Select Committee on Treasury Minutes of Evidence


Memorandum submitted by Mr Roger Bootle

  1.  As usual, the November Inflation Report predicted that RPIX inflation would be very close to its 2.5 per cent inflation forecast in two years' time, implying that the current stance of monetary policy is broadly correct. Despite this, financial markets scaled back their existing expectations of further reductions in interest rates in response to the Report, and in particular to the line that "the overall risks to inflation are on the upside".

  2.  I believe that this judgement will prove to be wrong, however, and that further interest rate cuts will be required. Aside from the MPC's usual tendency to be too pessimistic on inflation, there are several specific areas of the forecast which are likely to overestimate the upward pressure on prices.

  3.  First, although the Inflation Report contains downward revisions to growth, the central RPIX forecast is still based on a very moderate slowdown in activity, with annual GDP growth staying at or above 2 per cent right through the forecast period. Yet forward-looking indicators currently warn of a significantly sharper slowdown. Although it is true that domestic demand has been stronger than international, it looks as though international demand may weaken still further. Manufacturers have not yet felt the full impact of the international slowdown on their exports. Meanwhile, there are serious risks to domestic demand too. Consumers have not yet felt the blow to confidence from a sharply slowing housing market or a significant increase in unemployment. Yet all these things seem to be in train.

  4.  Second, and in connection with the above, the RPIX forecasts are based on the assumption that commodity prices do not fall significantly. In particular, oil prices are assumed to hold steady at around $20 per barrel. They have already fallen by another 15 per cent (to around $17 per barrel) since the Report was prepared, however, and further falls look likely. (Kuwait has warned that the price may reach $10.)

  5.  Third, I suspect that the central RPIX forecast underestimates the extent to which the falls in factory gate inflation over the last year and any future falls are likely to feed through to retail goods prices.

  6.  Taken together, I expect these factors to result in a rather lower path for RPIX than that predicted in the November Report. Indeed, depending on the behaviour of some of the erratic items such as seasonal food prices, I believe that RPIX could even breach the bottom of the 1.5 per cent to 3.5 per cent target range next Spring, triggering a letter of explanation from the Governor to the Chancellor.

  7.  Both the MPC and the public need to guard against the danger of being misled by the already apparently low rate of interest. Rates in the UK are higher than in any other G7 country and in real terms they are pretty high absolutely—almost 3 per cent, when measured against the HICP, compared with 0.75 per cent in the euro-zone and minus 0.6 per cent in the US. This leaves plenty of scope for further rate cuts if they are needed. But if the public believes that rates are already so very low that they must soon rise then the effectiveness of rate reductions will be lessened.

  8.  The MPC takes the view that the risks to growth are balanced while the risks to inflation are on the upside (the latter arising from a fall in sterling or private spending remaining stronger for longer than expected). By contrast, I believe that the risks to both growth and inflation are firmly on the downside.

  9.  The risk from a big sterling fall persists, even though the record of the Bank's method of projecting the exchange rate has continued to be poor. (See Chart.) (Incidentally, under the current formula, if UK interest rates reached parity with other countries, then the Bank would be obliged to assume that the exchange rate remained unchanged over the forecast horizon—even though it, or at least a significant body of opinion on the MPC, clearly believes that the risks are strongly on the downside.)

  10.  The Report also confirms an apparent departure in monetary policy strategy hinted at in speeches by various Committee members over the past month or two. The November rate cut was explicitly cited as intended to help keep private domestic spending firm. In other words, fears about the need for private spending to ease back in order to make way for faster growth in public spending have been relegated to the back burner—rightly.

  11.  It is worth noting that some of my worries about risks are incorporated in the alternative assumptions preferred by some Committee members, the combined effect of which would be to reduce the central RPIX forecast by 0.5 per cent at the two year horizon (and hence imply the need for lower interest rates). I continue to be puzzled as to why the views of some members are apparently excluded from the central forecast upon which policy decisions are made in this way, especially when they are not counterbalanced by other alternative assumptions which might add to inflation.

16 November 2001





 
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