Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Professor Christopher Pissarides, London School of Economics

  Short-term interest rates and their expectation over the near future have fallen. But uncertainty about the future path of interest rates is now higher than in the summer and asset prices are falling. This indicates that financial markets are unsettled and further reductions in interest rates may be factored into prices, so a quick recovery of stock prices through reductions in interest rates is unlikely. The extent of the fall in asset prices since its last Inflation Report surprised the MPC.

  Household liquidity remains high. This may be partly explained by the uncertainty surrounding asset markets, with households remaining liquid to protect their capital. Overall household financial wealth is weaker than in August because of the fall in asset prices and because of signs that both income from employment and house prices are weakening. Business confidence is down and domestic investment is expected to be weak. The MPC expects domestic demand to slow down across the board, but mainly in business spending.

  World economic growth was showing clear signs of slowdown even before 11 September. Expectations worsened since then because of the negative impact that the attacks and the war are likely to have on trade (especially in services, such as tourism). This development seems to be the determining influence behind the MPC's recent actions.

  The LFS definition of employment fell by 19,000 in the third quarter of 2001. The number of unemployed looking for work has increased although the claimant count of unemployment has been more stable. Employment fell for prime-age groups and increased for the over 60s. Inactivity has risen too, especially among younger workers. These changes show that inflationary pressures in the labour market are easing.

  During the expansion of the late 1990s wage pressure did not build up because the expansion reduced mainly long-term unemployment, which is not a strong inflation deterrent. Basic wage growth remains largely unaffected by recent rises in unemployment but bonus pay is falling. Public sector pay has been higher than private sector pay, with public sector pay at an annualised rate of growth of 5.7 per cent and private sector pay at 4.2 per cent. With productivity growth expected to fall, wage growth has to slow down if the inflation target is to be met. In the near term this slowdown should come from falling bonus payments.

  The cost pressures on manufacturing due to the resilience of unit labour costs are likely to be offset by falling oil prices (with the price of oil expected to be about $20 a barrel or less), weaker raw material prices and weaker import prices. Unit labour costs are showing more signs of weakness in services than in manufacturing, a development that the MPC considers encouraging because labour costs are a bigger fraction of overall costs in services than in manufacturing. In view of these developments the committee think that inflation will be in the range of two to two and a half over the next three months.

  The MPC cut interest rates by a cumulative 2 per cent since the beginning of the year, with cuts concentrated in more recent months. The need for this came from the deteriorating world economic situation and the absence of inflationary pressures within the domestic economy. The Committee therefore thought that it could partly offset the negative impact of the world slowdown on the domestic economy without putting at risk its domestic inflation target. Inflation is expected to be a little below target over the next three months and output growth to be below trend. Exchange rates are not showing signs of change and although some members of the MPC are concerned that a depreciation in sterling may push prices up, there would appear to be even further scope for interest rate cuts.

November 2001

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