Memorandum submitted by Professor S C Dow, University of Sterling
1. Inflation analysis at the regional level is impossible in the absence of regional price indices, so that attention needs to focus instead on output and on structural trends. The aggregate picture this quarter, as far as output is concerned, masks a diversity of regional experience. In particular, the household debt burden poses the danger of creating a more fragile financial structure in regions where wealth is lower, and income prospects weaker. Should this fragility increase, leading to increased defaults, asset sales and expenditure cutbacks, the stability and performance of the UK economy as a whole would be adversely affected.
2. There is a limit to how far manipulating the repo rate can help the situation, since it is uncertainty (among companies and lending institutions) about future demand which is the greatest problem. A rise in rates would hit cash-flow and thus potentially increase financial fragility in some regions. But it is not clear how far a reduction in rates would be passed on, easing cash-flow. In the current climate of uncertainty, the best approach seems to be to keep interest rates steady, presented in such a way as to reassure the company sector that efforts are being made to promote the financial stability which is necessary for planning investment.
3. The regional dimension to the analysis of demand-led inflation in the UK, and the effect on it of monetary policy, stems partly from the regional dimension of the "two-speed economy" and partly from the regional dimension of financial fragility.
4. The Inflation Report (section 2.4) refers to the diverging trends between the manufacturing and service sectors, with output declining in the former. The relationship between sectoral composition and regional growth is not a simple one. Nevertheless, the continuation of the decline in manufacturing is adding to regional disparities. While the continued strength in the service sector appears to be promoting continued growth at a UK level, we need to consider the effects on the UK as a whole of a widening gap in regional growth experience.
5. The main source of expenditure growth continues to be consumer demand. But there has been mixed evidence since the publication of the Inflation Report about retail spending in January which casts doubt on how resilient consumer spending is. The latest quarterly CBI survey indicates continued uncertainty among companies about the sustainability of demand. While at the UK level there has been some moderation of this pessimism, this is not uniformly the case, with greater pessimism expressed in the Scottish survey, for example. Whatever one makes of these surveys, it is clear that continuing uncertainty has had the consequence of a tremendous weakness in investment. Indeed it is the reduction in purchases of capital goods which has most seriously affected industrial production (Chart 2.20). Quite apart from the immediate effect of falling investment on output and employment, it presents a worrying prospect for the future capacity of British industry to grow in the future.
6. The ambiguity over the current strength of consumer demand raises the question as to whether a reduction in interest rates would now provide a boost to manufacturing without risking a (potentially-inflationary) retail boom. The CBI survey indicates that it is uncertainty about demand which dominates over interest costs in terms of business planning. While the business sector, particularly in regions facing poor growth conditions, has been calling for interest rate cuts, there is no reliable evidence that this in itself would encourage investment. Similarly, while a fall in the value of sterling would benefit the export sector, other factors could limit the effect on the exchange rate of an interest rate cut. The more secure benefit would come from a boost to business expectations about demand, as long as it was not accompanied by an expectation of interest rate reversals in the near-term to control inflation.
7. A fall in the repo rate in February could have counteracted business pessimism and thus encouraged investment only if it had been presented with some assurance that it would be sustained rather than reversed in future months. But the Bank of England also suffers from uncertainty. Its monetary policy rests heavily on projections particularly of consumer demand.
8. How far a change in the repo rate affects expenditure depends also on financial institutions' expectations. These affect both the cost and availability of credit. Although banks' base rates follow the repo rate, actual average rates charged on loans do not follow it so closely (Chart 1.7); how collateral is valued, and default risk assessed, affects the cost and availability of credit. Rates on secured loans fell by more than the repo rate in 2001 but actually rose for unsecured personal loans (Table1.B), although the latter had the highest rate of growth at 16 per cent in 2001.
9. The MPCs discussion (Minutes, paragraphs 8-14), refers to financial structure at the UK level, without considering the possibility of differing regional conditions. To the extent that there has been a weakening in growth of some consumer demand in January, it is likely to be due to cash-flow problems caused by heavy borrowing. In regions with weaker pay and employment conditions, and lower stocks of wealth (notably those more dependent on manufacturing), high consumer borrowing has created a potentially fragile financial structure. A reduction in the cost of debt for these borrowers is not necessarily achievable through a fall in repo rate. But a rise in repo rate would be much more likely to be passed on, causing cash-flow problems for households and in turn for firms selling to the local market, further increasing regional disparities.
QUESTIONS FOR THE MPC
10. The degree of uncertainty about global and UK economic conditions is less than it was in November, which was so soon after September 11. Why is this not reflected in a lower amplitude in the fan charts?
11. Is there any evidence on the composition of household debt? In particular, how far is the current level of credit card debt and personal loans due to rolling over past debt as opposed to new expenditure?