Examination of witnesses (Questions 120
THURSDAY 15 MARCH 2001
and MR CLIVE
120. How confident are you that the factors
you have referred to concerning the under-prediction of revenue
will, in fact, continue?
(Mr O'Donnell) The caution that we build in means
that we will, on balance, tend to carry on that way. Going forward,
we have the cautious GDP forecast which is below the consensus
forecast; we assume under the unemployment assumption that whenever
the markets forecast unemployment is going to rise we use that
market forecast, so we have in there a forecast of unemployment
rising. Already that forecast is somewhat out of date with the
figures we received this week so, on that side, things will come
in better than we thought. Consumptionit is too early to
say but what little indications we have from retail sales figures
today shows that the consumption path may come in around where
we think, maybe slightly higher. At the moment, therefore, what
small indications we have suggest that our caution will be maintained
121. Could I just ask you how much you attribute
the differences in the forecasts that I have just mentioned between
last year's Budget, the pre Budget report and this Budget to luck
and how much to judgment? Your previous answer rather claimed
the credit for both luck and judgment, and I am attempting to
distinguish between the two.
(Mr O'Donnell) Essentially we use our econometric
model but, in the end, all economic forecasts require a fair amount
of judgment. The fact that we got it spot on I regard as partly
a consequence of luck, certainly. There are forecast error margins
and, on average, we know how close we will be. We certainly would
not expect to get it exactly right every year so yes, a certain
amount of luck, if you want to call it that. On average we are
hoping that we will be able to improve our forecast performance
as we reduce the volatility of the economy. So I would hope our
forecast errors going forward will be somewhat lower than they
were based on the past.
122. You did say that, whereas others were predicting
a recession as a result of the Asian and Russian financial crises,
you did not and you got it right. If we look at the present situation,
you have already in answer to our Chairman referred to the possibilities
of recessionary effects outside any forecasts that you are making
in the Budget, although they do not form part of the forecast?
(Mr O'Donnell) No, they do. We have revised down our
forecasts of world growth substantially. Between the pre Budget
report time and the Budget we were obviously able to have the
information from the US about the US Q4 GDP numbers, and it was
quite apparent to us then that the US was slowing down quite rapidly,
and our forecast for the US which we have used in the Budget which
was, at the time we made it, below the consensus forecast for
the US. So we revised down our US forecast substantially, and
our forecast for Japan substantially as well. The Euro area we
did not change very much but I would say certainly the evidence
since we made those forecasts has been consistent with there being
a slowdown in the US and a much weaker outlook in Japan, but that
is built in.
123. But continuing growth in Britain at trend
(Mr O'Donnell) Yes. A slight slowdown in the UK, that
is right. Basically what is behind our UK forecast, if you compare
it with, say, even the pre Budget report forecast, is much slower
world growthand the effect of that is that the net trade
position worsensoff-set by domestic demand which has remained
rather stronger than we thought. The overall effect of those two
factors is that our GDP forecast is unchanged but that does hide
a compositional changeyou are right; we are saying that
domestic demand is somewhat stronger and that is because employment
has been stronger and consumption has stayed quite robust and
investment numbers have been revised up substantially by ONS for
the pastwe think that level may be maintained going forwardbut
all this is off-set by net trade which basically takes about one
percentage point off our growth forecasts.
124. So your predictions for future revenues
do depend upon the British consumer continuing to spend large
quantities of money? "IKEA rules, OK"!
(Mr O'Donnell) We have reasonable consumer spending
in there although it does slow down as households in our forecast
start rebuilding their savings ratio which is quite low. Partly
that is because we think some of the wealth effects, particularly
through equities which is a relatively small effect for the UK
but will matter, start to unwind.
125. And, of course, that does have an impact
on the balance of payments?
(Mr O'Donnell) Indeed.
126.Which deteriorates over the forecast
(Mr O'Donnell) It does, that is right, and that is
a consequence of our exchange rate assumptions but also, because
the world is slowing down, our export market growth has slowed
down quite substantially exactly as I said.
127. Is that sustainable? I was asking earlier
about public finances.
(Mr O'Donnell) Indeed. We have highlighted some of
the risks to our forecast in the Red Book and we have put in a
chart showing what has happened to the household financial position,
companies' financial position and the trade deficits. We do think
the trade deficit will worsen and will have a current account
that will move to a peak of around 2.5 per cent of GDP but then
will come back as consumption comes back as households rebuild
their savings. All in all, therefore, we think that is a reasonably
sustainable level. History would suggest this is sustainable but
it does require these changes to take place and it is certainly
an area of risk that we highlight in our forecast.
128. Are your forecasts for public spending
capable of withstanding the British consumer taking his or her
credit cards away?
(Mr O'Donnell) If there were a big reduction in consumption
below what we have here, then I think you would find that the
MPC would be the first people to respond, so the consequence of
that would be cuts in interest rates which would, hopefully, lead
to that fall in consumption being mitigated somewhat and possibly
somewhat higher investment. But that is the response mechanism
there will be.
129. All our four witnesses on Tuesday said
that the fiscal stance had been loosened and fiscal policy was
now quite expansionary. Three were quite worried about this. Mr
Dicks told us that if the Chancellor announced this month in the
Budget all the measures that were coming into effect in April
it would be described as a bonanza; he said that, if you look
at the whole package of measures and their impact on the economy
this year, it is far from prudent; it is risky and expansionary.
What do you say in reply to those comments?
(Mr O'Donnell) I could give you a list of quotes from
other city analysts that said the reverse. Essentially what I
think you have from city analysts is them saying, "This Budget
was very predictable"Goldman Sachs, Barclays Capital,
for examplebecause basically the whole is driven by the
fiscal rules. What is happening is we have observed some changes
during the year but we announced in the Budget 2000 a fiscal path
going forward, we said in the pre Budget report that we would
stick with that, and in Budget 2001 we are sticking with it, we
have locked in that fiscal tightening and it will be at least
as tight going forward as it is now. In that sense, therefore,
what is happening to the fiscal path is completely predictable.
The MPC are very aware of that; they were aware of the measures
introduced in Budget 2000 and of the consultation measures and
the MPC will make up their own minds what they think the impact
is of this on the Budget. They have already made up their minds
because they discussed this extensively at their meeting just
after the Budget. I cannot tell you what was in that meeting because
it will be announced in the minutes shortly, but Professor Nickell
has given an on-the-record statement about that saying that he
thought the Budget was hardly surprising.
130. You use the word "predictable"
but you have not denied that it was expansionary. What addition
to overall aggregate demand do all the measures taken together
in April actually add?
(Mr O'Donnell) My view is that the Budget basically
puts us back on the fiscal path we were on before. What has happened
is we have an unanticipated fiscal tightening this year again.
Things were tighter than we had expected, and what we do is simply
move back to the path, so the fiscal path going forward is exactly
the fiscal path that we predicted at Budget 2000 timewell,
slightly tighter, to be honest.
131. I am slightly worried that we are going
to go back to golf again which I do not really want to revisit.
(Mr O'Donnell) I am quite happy to do a golf analogy,
if you want one!
132. Let's not go that way. You say the fiscal
stance in 2000/2001 was tighter. Moving back to your path, you
are going to have to loosen a little bit to get back to your predicted
path. Given the caution and prudence in your assumptions, is it
possible that when we look at what has happened in six months
or a year's time we have the same argumentthat the fiscal
stimulus will appear to be smaller than it looks today?
(Mr O'Donnell) Quite possibly. If you look back on
what has happened, since the introduction of the Monetary Policy
Committee, cumulative fiscal tightening has been around 4.5 per
cent of GDP, so it is true that, where people are making the mistake
is they are comparing an outturn with a plan based on cautious
assumptions and, if you do that, you will get a big change. The
truth is we, as I said, expect fiscal outcomes to be rather better
than those numbers so yes, you can get dramatic numbers by doing
this but it is not a very sensible way to look at what we are
going to do. We will probably deliver tighter fiscal paths than
are laid out but they give us a band.
133. I understand why you are doing it and we
have had this discussion in this Committee before but does that
not mean that, when we look at your numbers in the Red Book, we
should say, "That is not what is going to happenthey
even think that themselves; it is going to be completely different
from that so let's get the real numbers and change them",
because you have just said to me that you expect it to be different
from what you are predicting?
(Mr O'Donnell) No. What we are saying isand
I will say this againthat we believe fiscal policy is asymmetric;
the costs of trying to tighten policy are much higher than the
costs of loosening it and, therefore, we think we should institute
a bias in the way we do this. What we do, therefore, is use central
economic forecasts but then a set of cautious assumptions to produce
these numbers. The City can then go awaywe are very explicit
about all of the assumptions we useand calculate their
own numbers as they wishand they do. That is why they came
out with rather bigger surplus numbers than we had. I have no
problem with thatthey need to make assumptions. For example,
when we go forward, we do the projections on the assumption that
all departmental money is spent. As you say, outsiders are free
to make other assumptions and we make assumptions on unemployment
based on market forecasts and on interest rates based on market
forecasts, so city analysts can use a different set of assumptions
and come up with different numbers.
134. What you have said really boils down to
this: that you are making these cautious predictions to make sure
you do not have to make difficult decisions on cutbacks to the
planned programme so it makes fiscal policy easier for you, the
Treasury, to operate but outside people looking at what you are
doing should assume that it will not turn out in the way you are
(Mr O'Donnell) Well, we do not want to get into a
situation where we have to have emergency cutbacks on things like
public spending. We want to preserve public spending plans because
we have given people three years' money and we want them to be
able to plan within that horizon.
135. It sounds to me like this is a "rabbit
out of the hat" policy: you are building in an ability for
the Chancellor to have rabbits?
(Mr O'Donnell) We are building in recognition of the
fact that, when we use central forecast, curiously enough we tended
to build in excessive optimism and that led to problems in the
past and we are trying to avoid the errors made in fiscal policy
previously by erring on the side of caution.
Chairman: I personally think that is
quite a good thing.
136. You did not make any reference at all this
year to exchange rate policy. Why was that?
(Mr O'Donnell) There has been no change in it, that
is why. The government's macroeconomic framework is to deliver
macro-economic stability with, on the monetary side, having the
MPC target, the symmetric target of 2.5 per cent inflation and,
on the fiscal side, a fiscal policy driven by the golden rule
and the sustainable investment rule. What we hope is that by delivering
stronger macro-economic stability that will be the right policy
to deliver exchange rate stability. If you look at what has happened,
sterling has fallen somewhat against the dollar but the euro has
still remained rather weak.
137. What was the last Red Book that did not
mention either sterling or exchange rate policy?
(Mr O'Donnell) I have no idea.
138. So it is unusual?
(Mr O'Donnell) Well, ever since the period of inflation
targeting, the exchange rate has been treated in exactly the same
way so this is something that goes with an inflation targeting
139. But if you do not even mention it, it sounds
as if you do not really care?
(Mr O'Donnell) We do.