Examination of Witnesses (Questions 104
TUESDAY 23 APRIL 2002
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 datafor
example, from the States we had daily data on salesand
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 favourthat 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
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 therethe situation in the Middle East,
oil prices, global imbalancesso there are still downside
risks; I just think the degree has diminished.
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
(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
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 2000a wonderful year12 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
115. Is the Treasury's policy towards sterling
still to achieve a stable and competitive pound in the medium
(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.
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
119. Well, what does this tell us about the
fiscal stance of 2002-3 and 2003-04, if we take 2001-02 as the
(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.