Economic outlook and the resilience of the economy

FORECASTS AND UNCERTAINTIES

3. In the 2008 Budget, the Treasury forecast GDP growth of 1¾% to 2¼% in 2008, 2¼% to 2¾% in 2009 and 2½% in 2010.[5] This represents a downgrading of the Treasury's expectations since the 2007 Pre-Budget Report, which itself featured a downward revision to growth forecasts made in the 2007 Budget, as Table 1 shows.

Sources: Budget 2007, p 26, Table 2.2; Pre-Budget Report 2007, p 21, Table 2.1; Budget 2008, p 19, Table 2.1

The Chancellor of the Exchequer explained that the Treasury had downgraded its growth forecast, both in the 2007 Pre-Budget Report and again in the 2008 Budget, because

we were acutely aware that the present uncertainty and turbulence, which is unprecedented in recent times, will have an effect over the coming year and it will affect the growth not just of our country but of countries right across the world … There is a great deal of uncertainty and turbulence in the financial markets at the moment.[6]

4. Some evidence suggested that the Treasury's growth forecasts remained optimistic despite the downward revisions. The average of independent economists' recent forecasts for GDP growth was 1.6% in 2008 and 1.8% in 2009, both lower than the lower boundary of the Treasury's forecast.[7] Ms Bridget Rosewell of Volterra Consulting thought that it was "quite odd that the [Budget] forecasts should be as optimistic as they are", suggesting that this might have been because a less optimistic forecast would have "shown up rather more obviously" strains in the public finances,[8] an issue which we consider in the next chapter.[9] The CBI contended that the Treasury's forecast was "a little over-optimistic":

The consensus GDP growth forecast for 2009 is just 2%. Given the constraints on real household disposable income and the shifting attitude to borrowing and debt here in the UK, plus unhelpful developments in the global economy, we would not be at all surprised to see at least two years of clearly below-par growth.[10]

Dr Martin Weale of the National Institute of Economic and Social Research was less concerned about the growth forecast in the Budget, arguing that the Treasury was "slightly more optimistic than the consensus, but justifiably, so on that basis the Treasury is optimistic but not over-optimistic".[11] He was, however, critical of the Budget's consideration of the risks and uncertainty prevalent in the economy, in particular the "significant downside risk that a prolonged financial credit squeeze will create". He characterised the Budget report as a "document that says very little about how things might go wrong",[12] contending that the Treasury "do not give enough attention to alternatives, or any attention to alternatives".[13] Ms Rosewell agreed that "the failure to discuss some of the risks which are in this Budget Report at this particular time seems to be so complacent".[14]

5. The Chancellor of the Exchequer defended the Budget's forecast, and cited the strong track record of previous Budget forecasts:

If you look at the range that we set out, the growth for this coming year and thereafter, I believe that what we have done is realistic. If you look at the Treasury's forecasts over the last few years in relation to growth they have been pretty good and they have been recognised as such.[15]

Mr Dave Ramsden, Managing Director, Macroeconomic and Fiscal Policy at the Treasury, acknowledged that, in compiling the Budget forecasts, the Treasury has been required to take account of an "incredibly challenging global environment" and "a period of exceptional uncertainty in the global financial markets".[16] He admitted that the current uncertainty surrounding financial markets was "unlike anything I have seen in the last 15 years that I have been working in the Treasury".[17] He identified two particular issues that would affect economic performance: the duration of "these extremely unusual credit conditions" and their impact on the real economy. According to Mr Ramsden, the Treasury forecast differed from those of outside forecasters by paying close attention to data on the real economy and the resilience of the UK economy. He believed that this resilience, combined with momentum from 2007, demonstrated by strong business surveys and a robust labour market, justified the more upbeat forecasts of the Treasury compared with those of some independent forecasters.[18]

6. The continuation and intensification of turmoil in the financial markets threatens to affect the real economy via the price and availability of credit, which has already begun to dampen private consumption and investment. At the time of the 2007 Pre-Budget Report, the Treasury assumed that there would be "some feed-through to tighter credit conditions and to household and company spending in the short term".[19] Since then, the disruption in financial markets had continued. The 2008 Budget reported that

conditions in credit markets [have] deteriorated and a number of markets remain effectively closed. There has been further evidence of developments in financial markets feeding through to tighter credit conditions facing households and companies. The Budget 2008 forecast assumes the negative impact on growth from these developments will be somewhat larger and more prolonged than expected in the 2007 Pre-Budget Report.[20]

Mr Ramsden explained that the Treasury was assuming "a normalisation of conditions by the middle of 2009 and with a start in that normalisation from the end of this year". Normalisation in this context would not mean a return to the interest rate spreads seen in mid-2007, but would see a reduction from the current unusually high levels.[21] Mr Ramsden argued that the Budget forecasts had taken full account of the ongoing credit crisis:

Because of the interconnectedness of global financial markets we can expect that the credit problems that have spread out across the world financial sector are going to have more of an impact on us than we thought at PBR time … I really want to get across to this Committee that we are not under-estimating the impact of the difficult credit conditions at the moment, but we have made judgments based on both the latest data and our expectations of how the credit market positions are going to unfold and normalise to lead to that forecast judgment.[22]

7. Since the publication of the 2008 Budget, the US investment bank Bear Stearns has been forced to request emergency funding from the US Federal Reserve in order to fund its liabilities. Upon the Federal Reserve acceding to the request, investors and counterparties rushed to extricate themselves from Bear Stearns, resulting in the bank's proposed takeover by a competitor investment bank, JPMorgan Chase.[23] Ms Rosewell highlighted the potential threat posed by a continuation of "the credit crunch crisis", with banks requiring public support: "That is the bit that we should hope will come to an end in the next few months because if it does not come to an end in the next few months we really are for the high jump".[24] When asked whether the events surrounding Bear Stearns had caused the Treasury to reconsider its 2008 Budget forecasts, both Treasury officials and the Chancellor of the Exchequer replied that their view had not changed as a result of those events.[25]

RESILIENCE

8. As we have already noted, the Treasury's confidence in the capacity of the UK economy to weather the current market flows in part from its assessment of the resilience of the economy.[26] The Chancellor of the Exchequer's 2008 Budget Statement referred to the "resilience" of the UK economy on six occasions.[27] Alongside the 2008 Budget, the Treasury published a Working Paper comparing the resilience of the UK with that of other OECD countries. That paper defined resilience as

the capacity of an economy to maintain levels of employment and to keep actual output close to its potential level in response to shocks that affect both the demand-side and supply-side of the economy.[28]

The key conclusion from the Treasury's Working Paper was that, over the last couple of decades, the UK's resilience had shown a "marked improvement", linked to improved macroeconomic policy and reforms to improve the flexibility of labour and product markets.[29] Mr Ramsden expanded on why the Treasury thought that the UK was now more resilient than other OECD countries and compared to previous decades:

The conclusion of people like the IMF and the OECD is that the combination of a long-term agenda on microeconomic reform, starting with the labour market reforms that were instituted in the 1980s and feeding right through to the present day, has over time improved the working of the UK as a market economy. At a macro level particularly the reforms instituted since 1997 where you have seen a monetary policy framework and a fiscal policy framework which enables you to support and encourage stability has led to this position where the UK has had very, very stable outcomes in terms of a growth in inflation. The fact that we have had 62 quarters of successive growth sounds like a sound bite, but when you contrast that with Germany, which has had technical recessions this decade, Italy, which has had technical recessions this decade, and France that has seen quarters of falling output, we have not seen any of that in the UK going back to 1992. We think that that resilience is still there today.[30]

9. Ms Rosewell argued that, during the dot-com collapse of 2001, the UK had suffered "quite a sharp fall in output", but had been shielded from the worst effects by significant increases in public spending.[31] She was worried by the "complacency" implied in an exercise which was backwards looking, arguing that performance in the face of previous difficulties did not assure resilience in the future.[32] Dr Weale did "not understand the argument about the resilience of the UK economy".[33] He contended that the UK economy was more highly leveraged than those of its competitors, including Germany, and had had a house price bubble even more pronounced than that of the United States.[34]

10. The Chancellor of the Exchequer saw ample evidence of the UK's economy's strong resilience, including the continued economic growth in the face of both the Asian crisis of the late 1990s, and the dot-com bubble bursting in the first years of this century. He also noted that, following the terrorist attacks in the US on 11 September 2001, UK stock markets had suffered a dramatic drop, but "were able to come back quickly because we have a resilient economy, we have much more flexible labour markets, we have flexible capital [and] employment markets, which we simply did not have [before] then".[35] He also referred to the recently published labour and output statistics:

if you look at two of the indicators that are very important—the employment and unemployment figures which were published this morning, which yet again show strong growth, particularly an increase in jobs over the last quarter, which is during this period of financial instability—I think 166,000 extra jobs—in addition to that you will see that unemployment is the lowest it has been since 1975. The other thing is the CBI's Industrial Survey published today again shows, especially in relation to output, some very healthy figures. I have always made the point that you cannot read too much into any one set of figures but I think if you look at the data that is published today it bears out our forecast and that is that there will be a slowdown but our economy remains fundamentally strong; it remains resilient and we are well placed to deal with a period of great uncertainty.[36]

The Chancellor of the Exchequer argued that "Inevitably, if you want to examine how resilient the UK economy is you do need to look backwards to see what happened when there have been shocks in the past".[37] Mr Ramsden concurred: "If you are trying to make a judgment about the future you typically do focus on the track record of the recent past".[38]

CONCLUSIONS

11. In our Report on last year's Pre-Budget Report, we noted the risk that the credit crunch would have a greater macroeconomic effect than the Treasury was then forecasting. We argued then that, in view of the risks in the financial sector, "the Treasury's optimism that the growth rate should revert to trend in 2009 has not been adequately explained".[39] Our concerns have been largely borne out by subsequent developments, and the further downward revision of the Treasury's forecast. We also argued that the Treasury should improve the presentation of risks to its forecast, including through quantification.[40] We note that the lower boundaries of the Treasury's forecasts for economic growth in 2008 and 2009 remain above the average of outside forecasters, and we are concerned that the Treasury has provided little evidence of analysis of upside or downside risk and specifically may have given insufficient weight to the risks of continued financial market turbulence and has failed to be more specific about the risks associated with such continued turbulence. The Treasury's optimism is based on its contention that the UK economy is better placed than other OECD economies in the face of market turmoil. We remain concerned that some of the economy's characteristics that have proven beneficial during past crises (rapidly rising residential property prices, close links with the US and an increasing reliance on the financial services industry, for example) might prove to be conduits through which the current problems in global financial markets are transmitted to the United Kingdom real economy.

The international economy and net trade

PROSPECTS FOR THE US ECONOMY

12. The US economy is currently undergoing significant difficulties resulting from the sub-prime crisis and the market turbulence since mid-2007. Treasury officials told us "that the position of the US economy is considerably weaker than we were expecting at PBR time".[41] The 2008 Budget observed that the consensus forecast for US GDP growth in 2008 had been cut by 0.8 percentage points and was now 1.6%, with growth expected to be very weak in the first half of 2008. Thereafter, the consensus among forecasters is for US economic growth to recover, with that economy growing by 2.6% in 2009, close to estimates of trend growth in the USA of around 2¾%.[42] Ms Rosewell saw that the outlook for the US economy as "finely balanced", adding that:

if the economy recovers and business as usual returns in the back end of this year, then the American economy is very flexible and it could bounce back in 2009, and you would have a picture much like the end of the dot-com boom, for example, a sharp decline and then a bounce back.[43]

However, she went on to say that that conditions in the US economy were "clearly getting worse at the moment".[44]

PROSPECTS FOR THE EURO AREA

13. The 2008 Budget noted solid growth in the euro area of 2½% in 2007.[45] Mr Ramsden told us that the Treasury was forecasting euro area growth of 1.75% in 2008, reflecting the fact that current "credit conditions will have an impact on the euro area".[46] However, he cited the latest data on industrial production for the euro area in January which "was actually really quite strong", following strong performance in December 2007, adding that "there have also been encouraging business surveys in Germany".[47] The Government has predicted that euro area GDP growth will return to its estimated trend rate of growth of 2% in 2009.[48] Dr Weale believed that the forecasts for euro area growth, like those for the US economy, were "contingent upon how you expect the credit crisis to play itself out", and suggested that the Treasury had not paid sufficient attention to alternative scenarios for the euro economy.[49]

EXPORTS AND NET TRADE

14. The slowdown in the US and euro area economies will impact on the UK, with year-on-year growth in UK export markets expected to slow to 5¾% in 2008, compared with 6¾% in 2007. This moderation is expected to exceed that in world trade overall, because around two-thirds of UK exports go to the US and the euro area, where demand growth is expected to slow more than in emerging economies.[50] Mr Ramsden, while acknowledging that "16% of our exports are to the US" so that there would be an impact from the US slowdown, emphasised that "our key trading partner is very much the euro area which accounts for at least 50% of our trade". This meant that the downturn in the euro area was of potentially greater significance than that of the US economy.[51] He concluded that "the US is probably a source of downside risk to our growth forecast and the euro area is potentially a source of upside risk to our forecast".[52]

15. In the 2008 Budget, the Treasury forecast that net trade would contribute positively to GDP growth in 2008.[53] This compared with an estimated negative contribution of half a percentage point to GDP growth from net trade in 2007.[54] Treasury officials attributed the positive contribution net trade would make to growth in 2008 to the 7% depreciation of sterling since the time of the 2007 Pre-Budget Report, telling us that "the position of the UK economy in terms of the contribution from exports and net trade will improve as a result of that exchange rate depreciation".[55] The Budget also forecast that UK export growth would strengthen further in 2009 and 2010 as demand growth in the US and euro area recovered.[56]

Business investment

16. Despite recent profit growth remaining strong and surveys of investment intentions remaining consistent with sustained growth, this year's Budget forecast that business investment growth would slow more than had been assumed at the time of the 2007 Pre-Budget Report. The main causes of this slowdown were cited as uncertainty over demand prospects and the potential impact of tighter credit conditions. The Budget forecast showed a significant slowdown in annual business investment growth from 6¾% in 2007 to 1¾% to 2¼% in 2008.[57] However, Mr Ramsden found the official data on business investment "a little bit puzzling", because that data did not accord with the more upbeat surveys of business investment.[58] Ms Rosewell commented that the Government "may be being too optimistic about investment", and was particularly concerned about firms' ability to raise finance for working capital in a tighter credit environment.[59] Dr Weale pointed out that "the business sector as a whole is fairly flush with funds at the moment", but warned that if the premium on lending rates persisted for a substantial period, then investment "undoubtedly will be rather weak".[60]

Labour market

17. Employment growth was strong in 2007, with the number in employment rising by nearly 300,000 over the course of the year, to a record high of almost 29½ million.[61] The Chancellor of the Exchequer was upbeat about the state of the UK labour market:

the employment and unemployment figures which were published this morning … show strong growth, particularly an increase in jobs over the last quarter … I think 166,000 extra jobs—in addition to that you will see that unemployment is the lowest it has been since 1975.[62]

Asked about the outlook for employment, Mr Ramsden told us that:

The business surveys suggest a bit of softness compared to the recent strength in employment. I think it is fair to say that I would be surprised if we were still having the kind of growth rates of 300,000 in employment that we saw a year earlier in 2007 Q4, in 2008 Q4.[63]

While employment growth was not expected to be as strong as in 2007, Mr Ramsden did "not expect anything more worrying in the UK labour market other than a slowdown in employment growth".[64] He attributed this to the resilience of the UK labour market, which had strengthened over time as a result of the "labour market reforms that were instituted in the 1980s and feeding right through to the present day".[65] Dr Weale agreed that employment would probably be more resilient in an economic slowdown than previously, but warned that "it is unclear because the slowdown may be of a nature that we have not had for a while … and things like the minimum wage do significantly reduce flexibility".[66] Ms Rosewell was also worried about labour market flexibility, telling us that in a severe downturn individuals tended to move into self-employment or part-time work, but that "with part-time and temporary workers increasingly being treated as if they are permanent workers, people may be less willing to offer that kind of employment flexibility in the future".[67]

The property market and housing finance

PROSPECTS FOR THE HOUSING MARKET

18. The 2008 Budget observed that annual house price inflation had slowed, from above 10% in August 2007 to around 2½% in February 2008, and that commercial property prices in the UK had fallen. In addition, the Budget noted that the effective closure of markets for securitised assets had put added strain on banks' funding positions, which could affect house price inflation in coming months, and seemed likely to reduce the volume of activity in property markets.[68] Mr Ramsden said that the Treasury was not forecasting a fall in house prices, but was expecting them to be a little bit weaker in the short term than forecast in the 2007 Pre-Budget Report.[69]

19. When we asked witnesses whether the UK property market was vulnerable to the problems that had afflicted the US property market in 2007 and early 2008, the consensus was that UK property markets shared some features with the US, but differed in vital ways. Professor David Miles of Morgan Stanley argued that the risks facing the UK property market had not yet crystallised:

there really is no firm and strong evidence of sharp rises in defaults on mortgages. As yet in the UK although people are very worried about that, we really have not seen a very significant deterioration and we are still in a position where bad debts and arrears on mortgages and repossessions of property are still running historically at a really rather low level. So it is a risk as opposed to the situation in the US something that really is already playing out in front of our eyes.[70]

He noted that the UK was one of the few countries apart from the US that had a recognisable sub-prime mortgage market, where individuals with impaired credit histories and county court judgments against them could borrow.[71] In October 2007, Hector Sants, the Chief Executive of the Financial Services Authority, told us that around 8% of the UK housing market was characterised as sub-prime, compared to 25% in the US.[72] Professor Miles noted that the UK did not suffer from the "toxic" mortgage products that had caused problems in the US, where people were given mortgage debt with very little prospect of repayment. He concluded that he was "a little bit more optimistic than some that we can avoid the worst aspects of what is playing out in the US".[73] The Chancellor of the Exchequer disputed the notion that the UK housing market was very similar to that of the US:

In our housing market clearly there are similarities but there are quite big differences between us and the United States, and I would highlight three of them in particular. One is in this country we have historically had more people wanting to buy houses than there are houses there to be bought; in other words, the supply of housing is not meeting the demand and that is what has pushed house prices … growing at about 10% a year. In America at the moment they have thousands of unsold houses and in parts of the country people are handing back the keys and you simply cannot sell houses for anything ... The second thing is that our regulatory regime here in relation to the selling of mortgages is tougher than it is in the United States. The [Financial Services Authority] has made changes to try and avoid people getting themselves into a position where they take on a mortgage that they cannot pay, and if you look at the default rates in this country they are at a historically low level. The third thing I would say in relation to housing is that if you look at the root cause of the present difficulties, the sub-prime problem, we just have not had this problem on anything like the scale that has happened in the United States.[74]

20. Professor Miles thought that a prolonged period of slowly falling house prices was "not at all implausible" and "would not be such a bad thing", suggesting that it would help improve affordability for first-time buyers and arguing that there was not a very strong link between movement in house prices and people's general spending, so that consumption would be unlikely to suffer too much of a decline in the face of slowly falling house prices.[75] This strength of this link between house prices and household expenditure is important, not least because it has a bearing on the prospects for economic growth. Mr Ramsden explained why the Treasury did not believe this link to be very strong:

In the past when there has been an apparent link between house prices and consumption that has been more the result of third factors such as a wider instability or a wider weakness in the labour market. The wider instability would mean high interest rates. I do not see those conditions now. We have the conditions for stability in the UK economy and, as I have said, I think we have a strong and resilient labour market … We would recognise that if in the UK there were to turn out to be a collateral effect, so it was harder to borrow on the back of a lower evaluation of housing assets, then there may be some impact there, but we are factoring in quite a significant slowdown in consumption already.[76]

HOUSING MARKET FINANCE

21. The Government has long been examining ways of improving mortgage finance. At the time of the 2004 Budget, the Government published a Review by Professor David Miles of methods of improving the supply of, and demand for, fixed-rate mortgages,[77] and the Government and the Financial Services Authority subsequently acted on some of his recommendations.[78] The case for action in this area has been strengthened by the impact on mortgage markets of the tightening of credit conditions since mid-2007. As the Chancellor of the Exchequer put it in evidence to us, measures to improve housing finance "were important even before the recent events and they are extremely important now".[79] This year's Budget examined measures with the aim of enabling the mortgage market, in the Chancellor of the Exchequer's words, to operate "as efficiently as possible because that … would apply downward pressure on the costs of getting mortgages and therefore the amount of money that people actually pay".[80]

22. The dependence of mortgage lenders on securitisation[81] increased markedly between 2005 and mid-2007.[82] In 2006, nearly one third of all UK mortgages were funded through secondary markets,[83] in other words, markets where the lending institutions seek finance from outside sources using securitisation. The main forms of secondary finance are "covered bonds"—a class of bond issued by the credit institution and backed by a pool of assets, generally mortgages or public sector loans—and residential mortgage-backed securities. Since the start of the current financial market disruption, these markets have effectively been closed to new issuance.[84] The Government has already taken action to assist the covered bond market through a new legislative framework,[85] and in the Budget the Chancellor of the Exchequer announced the creation of a Working Group to take forward market-led initiatives to improve liquidity in the mortgage-backed securities market.[86] The Working Group will report initially to the Chancellor of the Exchequer in the Summer of 2008 and present proposals at the time of this year's Pre-Budget Report.[87]

23. In January this year, Professor Miles noted the possibility of radical measures being taken to unblock the market for mortgage-backed securities, including a very substantial increase in the scale of Bank of England lending against a much broader range of collateral or the establishment of a State agency to lend to mortgage institutions.[88] In evidence, Professor Miles characterised the establishment of the Working Group as "sensible", while also noting the importance of recent actions taken by the Bank of England to extend its lending activities.[89] He speculated that "we may see more announcements by the Bank of England in due course".[90] Ms Rosewell also emphasised the importance of Bank of England action in this context, not least because the problems of housing finance were linked to the difficulties the banks faced in obtaining finance on a "business as usual" basis.[91] The Governor of the Bank of England told us:

It is unrealistic to assume that markets for many asset-backed securities are likely to re-open speedily or, when they do, to their previous levels of activity. So we are discussing with the banks how a longer-term resolution of the problem might be reached. It is too soon to say where those discussions will lead, but two principles would underlie any central bank role. First, the risk of losses on their lending should remain with banks' shareholders. The banks neither need nor want the taxpayer to insure them against these losses. Second, a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets. One of the lessons of this financial crisis is that providers of mortgage finance had underestimated the risks, and hence the true cost, of the securitisation process.[92]

We note the establishment of a Working Group to examine market-led initiatives to improve liquidity in the mortgage-backed securities market. We expect to continue to monitor developments in asset-backed securities markets and their impact on housing finance. We believe that the Working Group should also consider any need for new mortgage support schemes for low-income homeowners in difficulty. We look forward to the Working Group reporting back to the Chancellor of the Exchequer in the Summer and producing a final report at the time of the 2008 Pre-Budget Report.

24. In the Budget, the Government also sought to promote the market for long-term fixed-rate mortgages, following the earlier proposals in the 2004 Miles Review. Over the last five years, the popularity of 2-year fixed-rate mortgages has increased, but the UK has a low percentage of long-term fixed-rate mortgages compared with countries with similar income levels.[93] The Government has pointed to evidence of "latent demand" for longer term fixed-rate mortgages.[94] In order to increase supply, the Government has announced its intention of working with industry to investigate whether data on prepayment behaviour can be pooled and published, which could benefit lenders, investors and ultimately borrowers. The Government has also invited views on options for a UK framework to deliver more affordable long-term fixed-rate mortgages, including the lessons to be learned from international markets and institutions.[95] Professor Miles thought that there was "good reason for the Government to continue to be concerned about this area", not least because the tightening of credit conditions would lead to an increase in the risks to consumers associated with variable rate mortgages, regardless of movements in the Bank of England's short-term interest rates and because of the general unpredictability of interest rates.[96] However, he also emphasised that the Government and the Financial Services Authority had to continue to examine factors affecting the demand for fixed-rate mortgages, including consumer understanding of risks and incentives.[97] We expect to continue to monitor endeavours by the Government and the Financial Services Authority to promote the supply of, and demand for, long-term fixed-rate mortgages.

Inflation and monetary policy

25. Measured by the Consumer Prices Index (CPI) annual inflation fell from its March 2007 peak of 3.1% through 2007, but has now started to rise again. On 18 March 2008, the ONS announced that CPI inflation had increased to 2.5% in February 2008, from 2.2% in January. In the year to February 2008, Retail Prices Index (RPI) inflation was 4.1%.[98] The increase in CPI inflation to 2.5% had been foreshadowed in the 2008 Budget, which had stated that "significant increases in global agricultural commodity and energy prices are expected to lift inflation in the short term".[99] The 2008 Budget also cautioned that the recent depreciation of sterling would exert continued upward pressure on prices.[100] The Governor of the Bank of England has acknowledged the possibility that inflation could again rise above 3% in the short term, saying "inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the Chancellor".[101] The Chancellor of the Exchequer told us that, following the expected rise in inflation during 2008, he expected inflation to "return back down to the target towards the end of this year".[102] The Budget forecast that inflation would fall back to 2.5% by the end of 2008, returning to its target level of 2% in 2009 and remaining on target thereafter.[103] Ms Rosewell broadly endorsed these forecasts.[104] Dr Weale pointed out that there was also a risk of inflation falling below target if a marked collapse in demand were to occur.[105]

26. Since November 2007, sterling has fallen sharply, recording its largest three-month fall since sterling's exit from the Exchange Rate Mechanism in 1992.[106] Sterling depreciated by 7% between the 2007 Pre-Budget Report and the 2008 Budget.[107] Mr Ramsden acknowledged that the depreciation of sterling did result in the risk of "imported inflation", but said that the inflationary impact "would depend on how in the production pipeline those factors are taken into account". He noted that "over recent years there have been real squeezes on margins throughout the pipeline which has meant that inflation has not picked up in the UK".[108] Professor Miles believed that, while a "steady and gradual decline in sterling" was the most desirable outcome, a sharp depreciation over two or three months would "generate a lot of inflation six or 12 months down the road".[109]

27. Ms Rosewell believed that there was limited scope for the Bank of England to cut rates and said further cuts would be "more or less consistent with what the market is expecting, which is another two cuts this year".[110] She went on to speculate that declining economic growth in the UK could even result in the Bank of England becoming "more willing to break its inflation target in order to try and maintain some pace of growth if things look particularly bad".[111] Professor Sheila Dow, from Stirling University, summarised the problems facing the MPC at the present time:

The MPC faces two conflicting problems, which are clear from the [February 2008] Inflation Report. First, in relation to the inflation target, cost-push inflation is building up, particularly with respect to energy and food. Second the financial turmoil which started last year continues to build up forces which can reasonably be expected to weaken demand over the coming year. The first might suggest a tighter monetary policy and the second a looser monetary policy.[112]

28. One perceived risk to the economy from rising levels of inflation is that increased inflation might push up inflation expectations and lead to upward pressure on wage settlements and earnings growth. The Government acknowledged this risk in the 2008 Budget, stating that recent survey measures of inflation expectations had risen following the period of above-target inflation earlier in 2007. The 2008 Budget went on to warn that:

With CPI inflation expected to rise again in the near term, there is a risk that higher inflation expectations could feed through to second-round effects on wage settlements and earnings growth, though there has been no evidence of that as yet, with underlying earnings growth remaining stable and subdued.[113]

According to the 2008 Budget, underlying earnings growth was "stable" and "subdued", despite the increase in inflation and inflation expectations, with average earnings growth excluding bonuses, ranging between 3½% and 3¾% on a year earlier.[114] The Bank of England's February 2008 Inflation Report told a similar story, stating that "private sector pay growth remained muted in late 2007, rising by 4.2% in the three months to November, compared with a year earlier". That document also reported that the Bank's Regional Agents "expected little change in settlements this year compared to 2007".[115] Professor Miles told us that "expectations about where inflation will go remain pretty well controlled", saying that "if you look in the government bond market the yields on government bond levels have stayed at an exceptionally low level which suggests to me that most people believe inflation will stay very low in the UK".[116] He concluded that this had allowed the UK to avoid a "catastrophic situation" where a combination of economic difficulties combined with the fact that people had lost faith that inflation would stay low resulted in a much tighter monetary policy to curb inflationary expectations, compounding the pressures on the UK economy resulting from economic slowdown.[117]

6   Q 297 Back

7   HM Treasury, Forecasts for the UK economy: a comparison of independent forecasts, March 2008, p 1, Table 1 and p 4, Table 4 Back

8   Q 2 Back

9   See paragraphs 30-31. Back

10   Ev 79 Back

11   Q 3 Back

12   Q 3 Back

13   Q 16 Back

14   Q 17 Back

15   Q 298 Back

16   Q 122 Back

17   Ibid. Back

18   Ibid. Back

19   HM Treasury, The 2007 Pre-Budget Report and Comprehensive Spending Review (hereafter Pre-Budget Report and Comprehensive Spending Review 2007), October 2007, p 23, Box 2.3 Back

20   Budget 2008, p 14, para 2.4 Back

21   Q 123 Back

22   Q 134 Back

23   See "Rescue for troubled Wall St bank", BBC news online, 17 March 2008. Back

24   Q 34 Back

25   Qq 125, 297 Back

26   See paragraph 5. Back

27   HC Deb, 12 March 2008, cols 285-298 Back

28   HM Treasury, Resilience in the UK and other OECD economies: Treasury Economic Working Paper No. 2, March 2008, p 3 Back

29   Ibid., abstract Back

30   Q 140 Back

31   Q 4 Back

32   Q4 Back

33   Ibid. Back

34   Ibid. Back

35   Q 300 Back

36   Q 297 Back

37   Q 301 Back

38   Q 141 Back

39   Treasury Committee, Second Report of Session 2007-08, The 2007 Pre-Budget Report, HC 54-I, paras 6-9 Back

40   Ibid., para 13 Back

41   Q 134 Back

42   Budget 2008, p 143, para B.13 Back

43   Q 14 Back

44   Ibid. Back

45   Budget 2008, p 143, para B.8 Back

46   Q 135 Back

47   Ibid. Back

48   Budget 2008, p 143, paras B.8-B.9 Back

49   Q 16 Back

50   Budget 2008, p 145, para B.23 Back

51   Qq 134-135, 142 Back

52   Q 135 Back

53   Budget 2008, p 160, Table B.4 Back

54   Ibid., p 159, para B.63 Back

55   Qq 138-139 Back

56   Budget 2008, p 165, para B.80 Back

57   Ibid., pp 163-164, paras B.73-B.74 Back

58   Q 142 Back

59   Q 35 Back

60   Qq 36-37 Back

61   Budget 2008, p 156, para B.51 Back

62   Q 297 Back

63   Q 143 Back

64   Ibid. Back

65   Q 140 Back

66   Q 25 Back

67   Q 27 Back

68   Budget 2008, p 20, para 2.23 Back

69   Q 145 Back

70   Q 7 Back

71   Q 31 Back

72   Treasury Committee, Fifth Report of Session 2007-08, The run on the Rock, HC 56-II, Q 245 Back

73   Q 31 Back

74   Q 301 Back

75   Q 29 Back

76   Q 148 Back

77   HM Treasury, The UK Mortgage Market: Taking a Longer-Term View: Final Report and Recommendations, March 2004 Back

78   HM Treasury, Budget 2005, pp 75-76, para 3.116 Back

79   Q 337 Back

80   Q 383 Back

81   For a definition and discussion of securitisation, see Treasury Committee, Sixth Report of Session 2007-08, Financial Stability and Transparency, HC 371, para 35 Back

82   HC (2007-08) 453-i, Q 17 Back

83   HM Treasury, Housing Finance Review: analysis and proposals, March 2008, p 21, para 2.1 Back

84   Housing Finance Review, p 21 Back

85   Ibid., p 32, paras 2.38-2.42 Back

86   HC Deb, 12 March 2008, cols 294-295 Back

87   Housing Finance Review, p 21 Back

88   Institute for Fiscal Studies, Green Budget 2008, January 2008, pp 126-127. The chapter cited was co-authored by Laurence Mutkin. Back

89   Q 9 Back

90   Ibid. Back

91   Ibid. Back

92   HC (2007-08) 453-i, Q 1 Back

93   Housing Finance Review, pp 16-17, paras 1.25-1.26 Back

94   Ibid., p 40, para 3.11 Back

95   Ibid., pp 46-47, paras 3.34-3.41 Back

96   Qq 10-11 Back

97   Q 10 Back

98   Office for National Statistics, First Release, Consumer Price indices for February 2007, 18 March 2008 Back

99   Budget 2008, p 19, para 2.22 Back

100   Ibid. Back

101   Speech by the Governor of the Bank of England to Institute of Directors South West and the CBI, 22 January 2008 Back

102   Q 304 Back

103   Budget 2008, p 19, para 2.22 Back

104   Q 5 Back

105   Ibid. Back

106   Bank of England, Inflation Report, February 2008, p 11 Back

107   Q 138 Back

108   Q 139 Back

109   Q 20 Back

110   Q 6 Back

111   Ibid. Back

112   Memorandum for the Treasury Committee from Professor Sheila Dow on the February 2008 Inflation Report, to be published in HC (2007-08) 453-i. Back

113   Budget 2008, p 171, para B.104 Back

114   Ibid., p 150, para B.33 Back

115   Bank of England, Inflation Report, February 2008, pp 35-37 Back

116   Q 21 Back

117   Ibid. Back