Examination of Witnesses (Questions 20-35)
BARR, MR ROGER
BOOTLE, MR CHRIS
PISSARIDES, MR ANDREW
SCOTT AND MS
TUESDAY 26 FEBRUARY 2002
20. If you follow the answer you have just given, we have just gone through a period where consumer demand has been quite high and yet at the same time business investment has been going down, so why should we think it will be different in the future?
(Mr Scott) I do not think that the banks are lending to consumers rather than business. The corporates are just willing to borrow because they have done quite a lot of investment, so I do not think it is really going to affect productivity in that way. I think we have to be careful here how we emphasise this problem. Roger said that the imbalances were not a massive problem and I think we would all agree with that. I think what the Bank is saying is not that it is a problem at the moment, but if the consumer carries on spending even though the economy has slowed down, even though corporates have had to slow down, then it becomes a problem. That is why they are not raising rates at the moment. That is why the forecast is for quite weak GDP growth. It is only if the consumer carries on spending, even when productivity and wages and income growth are not growing fast, it is at that point that you get sharp correction and that could lead to problems.
(Mr Barr) Particularly if it is business financed by borrowing.
(Mr Scott) Exactly.
(Ms Rosewell) Coming back on the business investment point, that point is important, but I think that what has been happening over the last year or so is (a) the unwinding of investment decisions which were shown to be inappropriate, the dotcom stuff, and (b) also the exploitation of quite a bit of very high levels of investment and what tends to happen is that there is then a period of consolidation of exploitation of those investments before the thing begins to pick up again. Nonetheless, when planning new investments, when appraising new investments, one of the most important things is what is the demand going to be for the product in which you are investing and that remains very important.
(Mr Pissarides) I want to come back on the imbalances because my remarks were for the worst-case scenario in terms of what was going to happen, but in fact the case I outlined is the one that Andrew pointed out as well. The worrying thing about imbalances is that consumer debt might continue to build up and the reason it does not look so bad on chart 1.5 is that house prices have been going up as well, but if house prices stop going up and consumer debt continues going up, then it is going to create problems. A kind of wishful thinking of the MPC is that although the build-up of imbalances is inevitable when the economy is slowing down because investment is more volatile than consumer spending, if consumer spending was not as confident or as resilient as it is now, the Bank could reduce interest rates further to encourage business investment and to encourage also the depreciation of sterling, which they see coming anyway, so the sooner it comes, the better from their point of view. Altogether monetary policy would be looser and the economy would be getting into a situation where it would be better prepared for a recovery coming through the corporate sector. Because consumer spending and consumer debt do not show any signs of decline, they do have to keep monetary policy tighter. Now, I also agree entirely with CiaĞran in that if the Treasury were now to impose some fiscal restraint, either cutting spending or increasing taxes, then the Bank would be in a position to reduce interest rates further to help the corporate sector. The solution to the build-up of debt is not in tighter monetary policy, but it is in fiscal measures and the problem that the MPC will be facing in keeping monetary policy tighter than they might want to in the circumstances is precisely because they do not see any fiscal tightening coming from the Treasury.
21. Will fiscal policy bite quickly?
(Mr Scott) Fiscal policy operates on the lag and if we are projecting a slow-down with the consumer, it is quite dangerous to morale. What I would say though, it is quite a useful thing when you think about fiscal policy and consumer mix, the nightmare scenario, the upside risk of inflation that the Bank is worrying about is consumers suddenly building up their savings and sterling falling, but I would imagine that offsetting that risk would actually be a fiscal deficit rather, which would partly offset the increase in consumer savings. I am not sure that you can use a slow-down of consumption in a way that is advisable now, given that you think consumption is going to slow down, but if there is to be a larger fiscal deficit, I think it actually mitigates this risk of higher inflation because it will offset the consumers' assets.
22. At the prospect of politicians being encouraged to twiddle dials every time they see an imbalance, or even worse, the prospect of the use of fiscal policy beyond automatic stabilisers, would fill me with dread. It would open up a return to the disasters that we had in the first part of the post-war period, but I will let that pass. There is something I do agree with CiaĞran on which is on the subject which Roger threw into the hat before he left which was a very interesting point. That is that if there is systematic bias below the 2Ö per cent target, then by implication the MPC are saying, "We think the target is too high". If they are not doing that, the only other explanation is that they are so desperate to accumulate as anti-inflationary credibility, that they would rather err at the risk of writing a letter to explain inflation being too low than too high. Could I ask anybody who wants to answer this question whether they do think the 2Ö per cent target is the right target, what level of inflation there really is within the target of 2Ö per cent if you strip away the substitution effects which take place which mean really that inflation is lower than the figures which are published every year, and if it is not the right target, what the target should be? This will be very relevant in the context of the discussion we had on EMU because they had a completely different targeting framework.
(Ms Rosewell) I think that all of the targets offer something which is measured in a particular way. For example, if you look at what happens to HICP, the Harmonised Index of Consumer Prices, or whatever it is, it is much lower than what comes out of RPI-x and indeed is relatively low compared to other European countries, so if you say, "Is this target focused on anything called RPI-x, that 2Ö per cent, generating inflation which is comparable with what is going on with other major European countries?", then the answer is yes, in which case maybe if you choose a different variable and focus on that, but given that we have got this and we have got some sort of experience of it, why not stick with it. If you think about how they are targeting it, on the other hand, one of the interesting things, and I was trying to think about every Inflation Report that I have seen, I think, if I recall correctly, you always see that the risks on the upside are bigger than the risks on the downside and you see that right through the experience of the Monetary Policy Committee, unless somebody can find an issue where that is not the case. My suspicion is that they are under-shooting because they are always thinking that the risks are on the upside compared to the downside and on the whole that has not actually been the case and the risks are, therefore, in practice rather more evenly balanced than that with the result that there is this continual slight under-shooting. Does it matter? Well, if you move the target down to 2 per cent and we then get 1Ö per cent instead, well, probably since I suspect there is always a tendency to think that the risks are bigger on the upside than the downside given historical experience and memory and so on and it will take some time before that ceases to be the case. Are periods of under-performance long enough? Well, perhaps we ought to leave it another year or two.
23. That means we have to shake them out of that
(Ms Rosewell) I do not think you can.
24.in view of the fact there are genuine global risks in the global economy and Japan stands as an example of a country that got that wrong .
(Ms Rosewell) I think one could continue to point out to them and indeed ask, "Why are your risks always bigger on the upside than on the downside and does this not lead to under-shooting of the target?" Does it matter if the target is 2 per cent or 2Ö per cent? It is so within margins of error that I am not sure that makes any difference. Does it matter whether it is RPI-x rather than HICP? I do not think it does. This is one we have got used to and we might as well stick to it at least while we have a thing called the Monetary Policy Committee, and there are the results of the other considerations which we have already discussed.
(Mr Barr) The RPI target of 2Ö per cent actually equates to the HICP target of 2 per cent with no change in the basket because ours is a domestic average and HICP is a geometric average and that at the moment counts for Ö per cent of the difference, so actually we do have a harmonised target of 2 per cent. Now, the ECB's is 2 per cent or less, so we are half way there, you could argue. I do not think the Bank of England thinks about those issues. I think if it has this bias, it has probably come about because of what Andrew was saying about deliberate slack, credibility issues and so on. The other big difference of course is the treatment of housing and the harmonised ICP is so low because housing is not in it. Now, you could argue that that is a problem because housing is so important in the UK. I personally think RPI-x is bad when it comes to housing because this depreciation element is ridiculous, so it is a bit of a mix, but I do think it is interesting to note that our target, if you were to compare it with European or EMU standards, we actually have had a very good performance in recent years which is quite interesting. If you want to go into the political realms of EMU, we have actually been fairly successful in operating under their constraints.
25. And 2Ö per cent would equate to how stable prices given the substitution effect?
(Mr Barr) The UK is very good at adjusting our basket. The Boston Commission in the US said that the CPI was overstated by 1 per cent. We do not have that problem because our basket is redone every year and in fact if you ask me what are our best figures published by the ONS, I would say our inflation figures. They are never revised, apart from once when they got it wrong. I think they are pretty good, I think they are pretty accurate given the baskets they cover. We can see that in the correlation between things like the BRC, the shop price index, and some elements of the ONS's RPI, they work together very well, which tends to make me believe that it is a successful basket. Stable prices, I would not think you would want to go much below 1Ö to 2 per cent really given the uncertainties in all of this because if you go into deflation, you have got as many problems as you have with inflation. The prospect of being too aggressive resulting in deflation in the UK is not nice given these debt levels which are out there. If you tell me that the real value of debts is about to go up then we have got a recession, but that is not going to happen.
(Ms Rosewell) I would agree with you about the RPI and how it is measured. Of course even if there is what we do not know, what changes in quality are happening to the whole pattern of goods and services, and I do not think there is really any way we could properly measure that, but, nonetheless, quality improvements are happening, so the real price is some way below whatever the retail price is, however accurate that is.
26. Could I go back to the investment measurement. I think your answer essentially was to say, "Well, don't worry because once the dotcom fiasco is over and things have shaken out, it will come back again", so you get a resurgence in investment. Mr Pissarides says in his note that the projections are disappointingly downwards. He is not expecting a return. I am just a bit surprised that the general drift of the evidence seems to be fairly tranquil about all this and that it is the long-term indication which has certain downside connotations to it, does it not?
(Ms Rosewell) I think that is one of the reasons why the Bank has got all these sort of upside risks because they are somehow expecting everything else in the economy to stay very weak and then there is the sort of consumer stuff going on which is going to generate an upside risk of inflation. Also it comes back to this decline in the exchange rate argument because the corporate side of the economy seems to be so weak in their view that you get presumably somewhere in there an exchange rate decline which then pushes up inflation, or that is the risk, and that is why you have got this move up on the top end of the risk distribution. Business investment does follow fairly strong cycles and then once it begins to pick up, it picks up quite rapidly.
27. They are pointing downwards.
(Ms Rosewell) And they are still pointing downwards. I am not as pessimistic about it as that.
(Mr Scott) I think with 4 per cent interest rate and inflation what it is, you cannot really blame the Bank if firms are not investing. I think it is obviously a commercial decision not to invest. I think it is a rather curious combination sort of to back a quick US recovery, which must say something about IT and productivity growth if that is what is happening, and then at the same time to say that UK investments are going to remain low for a long period of time. That does seem a somewhat strange combination. I do not think that is something the Bank can do much about if real rates are 1Ö per cent and people are not borrowing.
(Mr Pissarides) The investment forecast is more pessimistic than what we think given current consumer spending and the reason that it is like that is that it is probably a consequence of consumer spending staying at high levels, when the risk is more about what happens with the build-up of debt. If there is a revival, when it comes, in the economy, a recovery in the economy will come more from foreign demand and possibly from depreciation of sterling, more from a recovery in the world economy and not from domestic consumer demand and that is what they have not factored in, I think, yet. If I can make a comment on the inflation target, you may see a distinction between being cautious not to exceed their target and, therefore, not doing anything about it, which is what Andrew was hinting at before, or actually thinking that inflation risk is on the upside and, therefore, not doing anything about it because of the lag of the effect of monetary policy. If we had a lag of about six months between the time of when interest rates change and the time when we see any effect on the inflation rate, then if they are thinking that the inflation rate is coming up anyway towards the end of the year, they might as well not do anything now, and I think that is what is driving them rather than any attempt to think, "2Ö per cent is too high. Let's aim for 2 per cent instead".
28. Moving a bit from inflation projections to interest rate projections, there have been a couple of suggestions in recent speeches by Eddie George that he at least considers that the market is over-estimating the certainty that the next interest rate move will be up. Do you think that is the case or do you think that he is expressing a genuine uncertainty, open mind and so on, or do you think that the markets are correct in judging that if we are not at the bottom, we are extremely close to the bottom?
(Mr Barr) That was actually something which, if it did not come up, I was going to mention towards the end. I think it is interesting. If he can be pinned down on that when he is giving his testimony to yourselves, the markets are quite aggressive on an increase in interest rates going forward, not just this year, but next year, going up towards 6 per cent again, so taking back all of the stimulus that we have had in the recent period, that will obviously have implications for corporate borrowing and so on. Consumers do not seem too bothered by it and that probably reflects the very competitive landscape out there in consumer borrowing land, but certainly for corporates, they are not borrowing as much and there is certainly evidence that the back-up in yields is causing some companies not to want to borrow, the investment point as well. Normally when that happens in the US, we do see that if the authorities do not like it, they talk the curve down. It is unclear whether the Governor is trying to do that and I can tell you from a City respect that that sentence, that comment has caused so much head-scratching. What is he trying to say to us? In one instance you can just look at it and basically he said that the term premium is high, reflecting various technicalities, and what the curve is saying on interest rates may not be an accurate reflection of future official interest rates. Now, that seems to be a very dry and technical observation that if you look at it forwards and say that the interest rate has gone up to 6 per cent, on various technical issues you might be wrong and they might just technically be saying 5Ö, or was he trying to give a steer that he is a bit worried that the market is backed up so much and this could be interfering with monetary policy? It is very unclear.
(Mr Scott) I think the markets probably are expecting too much. The way I read things, I think we are over-reading things and that is the trouble. If you read what the forecast says here, it says, "We think the consumer is slowing down, but we are bit worried that he might not be, in which case we don't change rates, but we signal that we are going to raise them". Everyone believes that not for long and then Eddie George comes along and says, "Well, actually, hold on a minute, we have got this dual economy, and the investment sector is weak, so perhaps we are not going to have to raise them by as much as we want", so I think there is an awful lot of that going on.
29. Is not the problem in some ways that the Governor was perceived in the past year to have certain expectations of higher rates and he may now be worried, both in terms of his expectations and in terms of the Committee as a whole, which includes far more dovish members, that the profile of great increases is simply too sharp?
(Ms Rosewell) I could take a fairly simple view of this which is to say that the forecasts that we have in this Inflation Report with constant interest rates of 4 per cent, they tell us, as the background to that suggest that inflation merely drifts back up to the 2Ö per cent target over the coming two years with 4 per cent, in which case why would we expect any increase in interest rates over the coming two years.
(Mr Barr) There is a lot of head-scratching going on in the financial markets as to what signal, if any, the Bank is meant to be giving us. This is a reasonably dovishthey hate that wordInflation Report, I would argue, and the markets are not sure what to make of it. I think it is interesting, and I know it is difficult sometimes extrapolating these things, but if there is a general signal they are trying to convey, then perhaps they could give a rather better one.
30. We will ask the Deutsche Bank.
(Mr Barr) If you get the answer, then phone us beforehand!
(Mr Pissarides) My reply is exactly the same as CiaĞran said. There seem to be so many conferences gong on that interest rates are staying where they are for a while and we will not see them rising to the extent that is reflected in the curve. I think the Governor's remarks were directed to the fact that now coming through the Report maybe interest rates have bottomed out and suddenly markets clean up and, therefore, there would be a change up rather than down. They seem to have discounted the possibility of stability, whereas I do see stability of interest rates where they are for a few months at least to the end of the year.
(Ms Rosewell) Markets like a movement in interest rates. It is much easier to make a turn if there are movements, so maybe it is just a sort of wish fulfilment.
(Mr Barr) And a lot of it is the US as well. A lot of this was the US because we are in a position now where some of our interest rate futures react more to US data than to UK data which economically does not make sense and again comes back to this point that maybe it is a mechanistic assumption that they are making and, if so, does the Bank have any worries about that because you can argue that it is interfering with the operation of monetary policy, particularly for the corporate sector who just are not borrowing right now.
31. Can I just ask you three very brief questions with really just yes or no answers. One is are you all agreed that the rate profile is too sharp in terms of the implied increase in short-term rates? Two, do you think that we have bottomed in terms of the level of short-term rates? Three, do you think we will have a euro referendum next year?
(Ms Rosewell) Yes, yes and do not know.
(Mr Pissarides) I second that.
(Mr Scott) Yes, probably and do not know.
(Mr Barr) Yes, yes and yes. My forecast is that we will join during this Parliament as well, as a subsequent issue.
32. Could I ask back to what we discussed at the beginning, the projections of inflation and growth. The minutes of the February meeting, paragraph 33, say, "Various arguments . . . were also identified for cutting the repo rate. First, the central projection for inflation was below the 2Ö per cent target throughout the two-year forecast period. That created a prima facie case for a rate cut, especially given the need for symmetry in policy reactions." Should the MPC members give the same weight to the central projection of inflation and the balance of risks?
(Ms Rosewell) Yes, they should.
(Mr Barr) I think the arguments for it are difficult right now given the uncertainty and I think that in a period of such uncertainty, with the economy in this phase, it does make sense to wait and see, but certainly you can argue that the central projection sometimes does not get enough attention. There is an asymmetry here. The central projection is the one that we spend a lot of time looking at and arguing over and when you see the Bank in its press conferences, they actually spend very little time looking at the central projection because they say it is only a 10 per cent probability band. Fair enough, but it is their central probability band to me. They much prefer to emphasise the balance of risks and I think this brings us back to the argument we have already had, about whether there is a bias and so on, but certainly a lot of us and I spend a lot of time looking at the central projection as well as the risks.
(Mr Scott) I do not think it should be the same weight, but obviously they should give the central forecast a greater weight than the risks, but they should look at both of them honestly. I would give it a different gloss. To me, I think the problem here is that we are discussing a report which has been produced by lots of very good economists and everything is well reasoned, so we are either going to talk about detailed nuances or very big picture things, so we focus I think a great deal on the distribution of risk for that very reason. I am slightly cynical about what the "rivers of blood" diagram is actually showing us because I always had a feeling that certain members use it as much as a communication device as opposed to actually showing what the forecasts are. It is worth pointing out some of the nuances of debate. I know there is a problem where they can point to us how they calculate these things, but I do get the feeling it is communicating some of the nuances of particular members of the MPC and deviations from some average feeling. It is that lack of consensus in the MPC which I think comes out of that "rivers of blood".
(Ms Rosewell) If you ask each member of the MPC what their personal risk spread was, that might be quite informative, but would certainly give you different answers. Presumably, as you say, the maximum spread almost reflects the degree of disagreement which is going on here. The narrower it is, the closer the consensus is. My understanding of the way the river of blood is developed is that it is not entirely a sort of mechanical process and does in fact reflect the range of assumptions and views about the economy which different members of the MPC have.
(Mr Pissarides) That is entirely my view, although I think they should be giving more emphasis to their central projection. I think the comments here probably reflect different views about the range that the Bank gives and probabilities. You can choose your own probabilities and different members choose different probabilities and risks, up or down.
(Mr Barr) There is just one final point I want to make and this takes us a bit away from this, but as to the balance of people on the Committee, I did a very, very short, one-page note recently which I can send to the Committee if they would like, looking at the members and this hawkishness versus dovishness, which I know they do not like, but it is there. Actually the Committee is very symmetrical. Mervyn King is, whether he likes it or not, hawkish in his views and you just need to look at his voting record to see the amount to which he has disagreed. He has never voted for easier policy than the central decision ever. Sushil Wadhwani has never voted for a tighter policy than the central decision and there is a track record of 38 for Sushil and 55 for Mervyn King, so the facts speak for themselves, but it is very symmetrical. In fact if you look at the average divergence, it is close to zero, and there is a lot of balance there. If Sushil Wadhwani does not stay, and I have no idea whether he wants to or whether he will be reappointed, but it is something which I know that yourselves take a big interest in, looking at the candidates, if he is removed and not replaced with another dove, it will increase this hawkishness. As I say, I will be more than happy to send this note to you, and if you look at the chart I have done and you pluck away the dovish member, you automatically tilt the bias upwards, which may have some implications for policy going forward which perhaps are not as obvious. As I say, I have no idea whether he is going to stay on, but if he does leave, he should be replaced by someone similar.
33. But Wadhwani has been in the minority and the majority appear to have won on all occasions.
(Mr Barr) I think if you look at some of his voting records over the recent downturn, where it went from 6 to 4 per cent, we actually got very much to where he was probably voting for in the first place. The point is not whether he is correct or not, and you could argue that Mervyn King has also been incorrect in that sense because he has consistently voted for tighter policy which has not come through, the point to me is all about symmetry. The people on the Committee should form a symmetry around the Governor who is always going to be in the consensus and will never be the wrong side of the vote and I think that when people are selected for that, they should take into account that kind of automatic nice, neutral bias with a balance.
(Ms Rosewell) We need an ex ante forecast of potential MPC members. It would be an interesting thing to do.
(Mr Barr) It does come back to this point about whether there is an upside to inflation.
(Mr Scott) I think we should just go for good economists and not worry too much about whether they are hawkish or dovish.
34. We will suggest you, Andrew!
(Mr Scott) But I do think it is the quality of the economists.
35. Are you generally happy with their assumptions on the labour market and the average earnings?
(Mr Scott) I thought the labour market note was very interesting and I thought that one very interesting topic they were raising was how the labour supply was growing faster than in the past because of immigration, which showed other reasons for how inflation might be lower than you imagine, and Chris is more expert on the labour market than I am, but from my reading of this, it seemed that apart from public sector earnings, which I think has been rising very fast, I thought it was a fairly fair analysis.
(Mr Pissarides) I do get the impression from reading it that they do attach a lot of importance to the rise in labour supply until recently coming from increased participation now we have reached very high levels of participation of labour in the economy and now it is coming from migration into the country. That must be what is keeping the rate of growth of earnings in the private sector down and at the same time that is helping to finance the faster rate of growth of earnings in the public sector which is a catch-up on what is happening over the last four or five years, but you still have inflationary implications for the increased labour supply. Provided there is no big change in immigration policy or education policy which might keep more young people in schools and universities, then the assumptions they are making are correct assumptions. Altogether the labour market is looking a lot better in this recession or slow-down than it ever did before in fact. It is surprising how well private sector earnings have adjusted to this slow-down and it is also surprising how good the settlements are beginning to look in this first quarter. The settlements coming through are encouraging.
(Mr Barr) The only thing I do not like about the labour market discussion is I do not think it is quite right there is no full discussion of why employment has not yet risen. Virtually every independent commentator has expected unemployment to rise in this cycle, but basically because all the leading indicators that we look at, such as surveys, advertising and so on, have suggested quite a significant deterioration in labour conditions which has not happened. I think the Bank of England continue to expect unemployment to rise, going forward, and that in turn will push the consumer to slow, which we have already discussed at length, but as why do they believe unemployment has yet to rise, is it just lags or is it something more fundamental? I have various ideas in my note of where we are now, but it is definitely an area where most people have got it wrong. They look at the total hours worked series and the total hours worked is actually falling, which they suggest is a precursor to rising unemployment. It is not a very good series; it is very erratic, it is very volatile and I do not attach much credence to it personally, so I think that is an area where definitely there is not enough explanation as to why they think unemployment is going to increase when it has failed to do so so far.
(Mr Pissarides) Because earnings growth has reacted so well to the recession, so job creation has continued and there is a lot more flexibility in the economy now in the creation of part-time jobs and more flexible working time.
(Mr Barr) I agree with that, Chris, but what I am saying is why does it not rise now. I have no problems with why it has not yet risen, and I have got reasons why I forecast that it would, but why will it suddenly start to do so? Because it is a key part of this Inflation Report.
Chairman: I am glad to say that you parted quite markedly from the unanimity in answer to question one and you provided a very good discussion for us. Thank you very much for your time; it is very valuable to us in the run-up to Thursday's evidence session. The MPC and the Governor of the Bank of England HC 664-ii.