Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 104 - 119)




  104. Good morning, Mr O'Donnell. Welcome to you and your team this morning. Can I start by looking at the economic outlet and the Pre-Budget Report minutes of evidence which indicated that, "The projections for GDP growth. . . are presented as opportunity ranges [which] represent alternative views about the supply side performance of the UK. . . Projections for GDP growth at the low end of the opportunity ranges are intended to be deliberately cautious, and make no allowance for any improvement in the supply side performance of the UK economy over recent years." So your GDP forecast "opportunity range" shows potential supply side improvements. 2001 GDP growth was at the bottom of the Budget 2001 opportunity range, so to what extent was this due to a poor supply side performance, and how is it possible to examine, after the event, the accuracy of your GDP forecasts, given that they are based on opportunity ranges?

  (Mr O'Donnell) You can obviously analyse the accuracy of our forecasts by comparing what is our central estimate against the outturn. Clearly, as you rightly say, and I am glad you put it that way, they are opportunity ranges and not ranges to handle uncertainty. In our forecast they are conditional on our assumptions about what is happening in the rest of the world. When you think about what happened in last year, the surprise to us and to most forecasters was the slowdown in the world economy. That was happening throughout the year but obviously was exacerbated by the effects of September 11, so in that sense I think virtually all forecasts turned out to be somewhat on the optimistic side. Our forecast was for 2.25-2.75 so we ended up in the bottom end of that range but that is the number we used for the public finances so in fact we were spot on in that sense, so I regard it as a pretty credible forecasting performance for last year. Indeed, our record over the last three years has been quite good so we are quite pleased about that. In terms of what has happened to the supply side performance, we analysed that in some detail in our paper on trend growth and our conclusion was that, while there are possibilities that productivity may be starting to rise, and we have gone through a period where we think there has been some labour hoarding as people have seen through this downturn and expected quite a quick recovery, so they have not laid off workers but have stayed with them, that would give you a slight downturn in productivity while output falls but they do not shed labour and then we expect productivity to pick up a bit. Basically, however, on the grounds of caution we have stuck with assuming no change in productivity growth going forward on the grounds of that being the cautious thing to do. Certainly I hope a number of the measures put in place over the last few years will in time lead to increases in productivity, but so far, on the basis of a cautious approach, we are not assuming any.

  105. We will come to productivity at a later stage but is the 2002 GDP growth forecast now on a stronger footing than your PBR position of cautious optimism, and what factors are behind that forecast?
  (Mr O'Donnell) Yes, it is. When we did the PBR forecast it was a particularly difficult forecast to make, because we were just in the aftermath of September 11 and really none of us were that confident that we knew exactly what the impacts of September 11 would be. We started looking at very high frequency data—for example, from the States we had daily data on sales—and those showed some pretty dramatic falls so some people, if you take some of the city forecasters like Goldman Sachs, moved to predicting a big recession in the US. We took the view in our forecast in November, the PBR forecast, that that would not happen but there were obviously very big downside risks to that forecast. What has happened since has been that those downside risks are not as great as we had thought. In fact, Q4 in the US was quite strong: there was a very large reduction in stocks in the United States in Q4. We would expect that to show a recovery in Q1 but what that will mean for the States, and I think it is important that we realise this, is that we will get quite a strong Q1 growth figure for the United States which will then not be followed by as strong a figure by any means in Q2, and that is because of this inventory fall. There will be some correction there and then it will smooth off. Fortunately we do not have to forecast the US quarter by quarter. That is my guess but overall the optimism measures for the US are strong; the IMF at the weekend was putting out a message of cautious optimism; they have revised up their US growth forecasts and, indeed, Paul O'Neill was making something of the fact that his bet with Horst Koehler had come out in Paul O'Neill's favour—that the US did come through this rather better than had been expected by the IMF. So in that sense I feel more confident about our world forecast than I did at the time of September. If anything, the degree of uncertainty is slightly less now.

  106. On the growth forecast, you have a growth forecast of 3-3.5 per cent in 2003. That is more than the average of the other forecasters, which is about 2.5 per cent and a number of commentators' eyes have been raised by that. In evidence yesterday from expert witnesses this point was made by them: that it is rather surprising, given the trend over years where you have underestimated, you now come out with this growth and the Chancellor is saying we will get extra tax receipts and things will be better. Some would suggest that is maybe skating a bit on thin ice. Why do you expect such strong growth?
  (Mr O'Donnell) In terms of the forecasting record I would say that over the last three years we have been either more optimistic or more pessimistic than the consensus when you look back at our forecasts, and every time the degree of correction has been correct, so when we have been more optimistic than the consensus has turned out to be that was right, and when we have been more pessimistic, that was right. But forecasting is very difficult and the past is not necessarily a guide to the future here, so you should not assume we will always do that. Going forward, we do expect quite strong growth there, driven by the growth through the year. Remember, Q4 GDP in the UK was unchanged, so you are starting the year with a relative low. We expect growth to be picking up through the year so you end 2002 with growth quite strong and a high level of GDP, so arithmetically 2003 on 2002 will appear very strong. In fact, what you have there is growth growing quite rapidly in the second half of this year/the first half of next year and then slowing down, so when you look at the half yearly profile it is not as dramatic as you would think. One of the other reasons why we have raised our forecasts somewhat is that, as I said, the revisions to the past that the ONS have given us particularly for 2001 mean that we start the year with a somewhat larger negative output gap, so we are a little bit more below trend than we thought. As we go forward we close that gap and, in fact, we overshoot slightly and then come back to trend level, so we are slightly above the consensus but the consensus has been moving up. In that figure you quoted I think there is one particular outlier that of itself brings down the consensus number by 0.2 per cent in terms of the growth rate, so I would expect the consensus to move up towards the Treasury forecast over the next two or three months and, indeed, the forward-looking surveys that we are getting from people like the CBI, the Engineering Employer's Federation and the fact we had positive output growth in February in manufacturing even suggests that the way in which forecasts are going to be revised now is upwards rather than downwards.

  107. I refer to page 194, paragraph B42, where you say, "The downside risks associated with the events of 11 September have clearly diminished since the time of the key budget report". Do you think that is a comment that is shared by quite a number of organisations?
  (Mr O'Donnell) Yes, most certainly. Having come back from the G7 and the IMF World Bank meetings over the weekend, it is quite clear it is shared by the US authorities, Alan Greenspan and Paul O'Neill, and by the IMF who have come up with the same. Basically when September 11 happened, this is the kind of thing we are very bad at forecasting; we had no real notion of precisely how big an impact that would have. Certainly we had expected just the sheer increase in uncertainty to mean people would hold off on investment and try and see whether, going forward, things looked as bleak as some were predicting. What that does is there is some overhang so, if events turn out not to be as bad and we do not get a repeat of a similar terrorist event, for example, then people can feel more reassured and they will start returning to invest. Also, when you have a big shock like that and economies respond flexibly and it turns out not to be as bad as people expected, that increases the degree of certainty people have. I would not want to say downside risks have gone away. There are important downside risks out there—the situation in the Middle East, oil prices, global imbalances—so there are still downside risks; I just think the degree has diminished.

Mr Beard

  108. The Bank of England inflation report for February of this year says that, "Imbalances within the economy remain pronounced. . . The divergence between output growth in services and manufacturing over the past year is the widest since 1981." What contribution has the Budget made to remedying these imbalances?
  (Mr O'Donnell) I think the Budget will help remedy these imbalances, and I think one way of seeing that they are helping to reduce things is that before we were looking at current account deficits going out of somewhere around 2.5 per cent of GDP; now we are actually expecting them to come out lower, at 2.25 per cent of GDP. The reason is that we have stronger Government consumption through greater expenditure on health, for example, and as this goes forward and we expect private consumption to start falling back, because it has been growing at an excessive rate for a while, we would expect consumers to think about reining back their debts to more sustainable medium term levels so, as private consumption goes down, you get a different mix between private and public consumption, and Public consumption is less import intensive so that helps you on the trade front which is good. Also, the imbalances were hit by very big ICT shock which resulted in big falls in the US but also in the UK. The ICT shock in the UK showed up in manufacturing and in particular in telecoms. There was a big fall in telecoms and, as that shock dissipates, we would expect that to help the manufacturing recovery. We were, surprisingly, hit even harder than the US in some of these areas. I looked into why and it comes down to things like our mobile telephones, for example, where I had expected the take-up of mobile telephones to be the same in the UK and the US but it is much higher in the UK and, if you look at the cause of the downturn in manufacturing, 60 per cent of the fall in finished manufacturing exports is down to ICT reasons. So it is that global ICT shock that actually hit the UK very hard. That has hit manufacturing very hard and, as that comes off, then I would expect manufacturing to recover. Like I say, in February we did see the first growth. I would not place too much weight on one month's figures obviously, but in February and March the CIPS survey for manufacturing shows orders going up, and the CBI and Engineering Employers' Federation's forward-looking survey shows improvements. So that should help rebalance as we move away from private consumption to more manufacturing output, and that helps keep the trade deficit within reasonable bounds.

  109. To what extent were the Budget tax raising measures designed to manage the economy?
  (Mr O'Donnell) We try very hard to make sure that fiscal policy supports monetary policy but we do not go in for fine-tuning with fiscal policy. What is driving our fiscal policy is making sure that we meet our two fiscal rules and, within that, trying to make sure that fiscal policy supports monetary policy. So fiscal policy did support monetary policy through 2001 which was a very difficult year with the automatic stabilisers kicking in; that had an impact and, going forward, the fact that we will be moving towards greater Government consumption with a lower import intensity will help rebalance on the trade side.

  110. So was the purpose of the Budget to tackle growing consumer demand?
  (Mr O'Donnell) The purpose of the Budget was to help, subject to the fact that we do not think fiscal policy can be used for fine-tuning these sorts of things. One of our problems obviously and one of the causes of the imbalance is the euro/dollar exchange rate. That is quite difficult.

  111. In the 1998 Budget the Treasury said that the impact of sterling's appreciation had become evident in a "growing divergence" between industry and services. Do you think that is still in place and apparent, and that there is this growing divergence between the two?
  (Mr O'Donnell) I am not sure I would say "growing divergence" because I would expect manufacturing will start to come back now after a very difficult year in 2001. The exchange rate clearly is an issue, and I would not hide that, and I think if you look at IMF estimates, for example, of the sort of equilibrium exchange rates, they say that a change in the dollar/euro rate towards a weaker dollar and a stronger euro would make sense and would help global imbalances, but the exchange rate has been stubbornly high for some time.

  112. The Red Book says that weak demand has caused a market contraction in UK exports, but the export markets will strengthen in the years 2002 and 2003. What was the effect of sterling on the UK's export growth? Have you analysed this?
  (Mr O'Donnell) We have. As it turns out, when you look at 2001, one of the surprises is that exports stayed up rather more than you might have thought, given the world demand effect. Because the rest of the world was falling away so much, our models were telling us that we should have had somewhat lower exports than we thought and, indeed, if I remember rightly, we revised our net trade impact on the economy to be not as negative as we had thought. So exports have done badly but you can explain the vast proportion of that by world demand. World trade growth grew in 2000—a wonderful year—12 per cent. In 2001 it was zero virtually, so in those circumstances that is going to hit our exports very dramatically. So that is the dominant factor but the exchange rate certainly has not helped.

  113. You say that that is the fact that causes the discrepancy between your model and what has happened?
  (Mr O'Donnell) When we were forecasting forward we were forecasting forward with higher world growth in it than turned out to be the case. We revised down our world growth forecasts principally because of the US, and if you put back in what happened to world growth, then you more than explain things. There is an exchange rate effect but most of that comes through on world trade growth and like I say, given what actually happened to world trade, we would have expected our export performance to be slightly worse than it was.

  114. Is this because the nature of our exports now is changing?
  (Mr O'Donnell) It could be partly that but also this strong exchange rate has required our exporters to perform even better to improve their productivity, and they have clearly done that.

  115. Is the Treasury's policy towards sterling still to achieve a stable and competitive pound in the medium term?
  (Mr O'Donnell) Yes. Exactly right.

  116. How well do you think we are doing?
  (Mr O'Donnell) In some ways it takes two to tango. If there are some other exchange rates that are severely out of line it is quite difficult for to us manage that, but certainly if you look at sterling's rate in effective terms it has been very stable. It has not been fluctuating enormously.

Mr Plaskitt

  117. Can you clarify for us what has happened to the fiscal stance? Has it loosened or tightened relative to the last financial year?
  (Mr O'Donnell) It depends what you mean by "the last financial year" but table 2.8 on page 37 gives you the overall fiscal impact and it gives you the change in the fiscal stance. If you look at the change in the fiscal stance, helpfully in bold you will see the numbers which are changes in cyclically adjusted public sector net borrowing, so they tell you what has happened to net borrowing allowing for the cycle relative to the Pre-Budget Report. Relative to the Pre-Budget Report, therefore, we have tightened fiscal policy over this year and the next, and then there is a very small tightening of 0.1, and then it is slightly looser further out.

  118. But if you refer it back to the financial year 2001-02, what story does that tell about the fiscal stance?
  (Mr O'Donnell) Relative to our Budget forecasts, you mean?

  119. Well, what does this tell us about the fiscal stance of 2002-3 and 2003-04, if we take 2001-02 as the base?
  (Mr O'Donnell) Obviously the Government has been planning for some time to move towards the situation where public sector net investment rose so that is accounted for in the figures which show us moving from a surplus towards a modest deficit going forward. That has always been there but the thing you need to bear in mind is that when, for example, you are thinking about how monetary policy responds to this, what is in the MPC's mind is the fiscal path as they have been told it in our latest forecast. For them, therefore, built into their forecast for the economy and their views about what interest rates should be, they have got in there the Pre-Budget Report numbers. What is the news for the MPC is the difference between our Budget projections and the PBR projections. That is what gives you the fact that we say the fiscal stance in those terms is tighter this year and next.

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