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Select Committee on Treasury Second Report

2 The real economy

Economic performance and forecasts

4. The Government has downgraded its forecast for GDP growth in 2008, from 2½% to 3% at the time of the 2007 Budget, to 2% to 2½% in the 2007 Pre-Budget Report.[6] The 2007 Pre-Budget Report explained that the downgrade was in part due to the Bank of England's Monetary Policy Committee raising interest rates "by more than financial markets expected at [2007] Budget time", and that such increases in interest rates would "be expected to impact on growth in 2008".[7] As well as this unexpected rise in interest rates, the 2007 Pre-Budget Report also highlighted the recent disruption in financial markets, stating that "For the purposes of the economic forecast, it has been assumed that there will be some feed-through to tighter credit conditions and to household and company spending in the short term".[8] Despite this, the Government's forecast for GDP growth in 2009 remained the same at 2½% to 3%.[9]

5. Dr Martin Weale, Director of the National Institute of Economic and Social Research, when asked whether he agreed with the Treasury's forecast, told us that:

He did however warn that "the credit crunch could turn out worse than they are expecting and I am expecting".[11] Dr Weale then told us he expected growth in 2009 to be up to half a percentage point lower than that expected by the Treasury.[12] Ms Bridget Rosewell, Chairman of Volterra Consulting, expressed more significant concerns about the Government's forecast for economic growth in 2009, telling us:

6. In downgrading their economic forecasts to take account of the recent disturbance in financial markets, Treasury officials told us that they had "made a cautious assessment of [the shock to financial markets'] impact in 2008 by revising down our range for growth for 2008 from 2.5% to 3%, which was what we had at Budget time, to 2% to 2.5%".[14] However, on a more positive note for the economy, they also told us that there had recently been "a lot of momentum in the economy",[15] with the FTSE 100 "pretty close to record levels".[16] Looking further into the future, Treasury officials told us that "Our assessment is that it [the disruption in financial markets] will be a shock with a temporary impact in 2008 and we see good reasons for expecting growth to strengthen in 2009 back to trend".[17] We acknowledge that the Government has downgraded its forecast for economic growth in 2008 due to the effects of both the rises in interest rates in the first half of 2007, and the recent disturbance in financial markets. However, the risk remains that the credit crunch will have a greater macroeconomic effect than expected.

7. One element of the change to the economic forecast has been the effect of the recent financial markets disruption on the financial services industry. The 2007 Pre-Budget Report noted that, while the current financial market disruption would affect the financial sector, "it is notable that the UK's innovative financial sector was relatively quick to recover following periods of financial market disruption in 1998 and 2001".[18] The 2007 Pre-Budget Report outlined the potential risks to this important part of the United Kingdom's service sector:

8. Dr Weale supported the idea that the financial markets, while slowing from the strong growth seen in the first half of this year, would continue to be an important part of the UK economy, telling us that "that the financial sector has shown itself to be remarkably innovative in thinking of new things to do".[20] Ms Rosewell told us that she thought there were other, more important international risks, such as political changes in the Far East, than the recent credit disruptions.[21] Treasury officials confirmed to us the position as stated in the 2007 Pre-Budget Report and told us that, while each shock to the financial system might be different, "the resilience and responsiveness shown by the financial sector has been quite similar".[22] They added that:

9. The Treasury has forecast a stronger economy for 2009 partly on the basis that there will be only a temporary weakening in the financial sector due to the current problems in financial markets. There nevertheless remains a risk that the financial sector will remain subdued for longer than expected. We feel that the Treasury's optimism that the growth rate should revert to trend in 2009 has not been adequately explained.

Uncertainty

10. Given the disturbance to the smooth running of international financial markets that has occurred since 9 August 2007, we examined the risks associated with the economic forecasts presented in the 2007 Pre-Budget Report. The 2007 Pre-Budget Report itself considered several potential risks to the Treasury's forecasts for economic growth—both on the upside and the downside. One feature common to several of the risks identified in the 2007 Pre-Budget Report is the uncertain effect of the disruption in financial markets; other potential risks include weaker than expected growth in the United States, a potentially more resilient euro area economy and the effects on inflation of food and energy price movements.[24]

11. In regard to the overall level of uncertainty surrounding the economic forecasts in the 2007 Pre-Budget Report, Mr Chote told us that:

Treasury officials took a different view. Mr Nicholas Macpherson, Permanent Secretary to the Treasury, told us that at "this time I think there is more uncertainty than [there has been] for several years".[26] He went on to say that the Treasury's forecast had "tried to anticipate some effect from the credit events, but there is uncertainty. Inevitably, both the downside and upside risks are higher around our central forecast than they were at Budget time."[27] The Chancellor of the Exchequer told us that "we are going into a period of uncertainty which is why I revised downwards my growth forecast for next year".[28]

12. In discussing the Treasury's presentation of the risks associated with the economic forecasts in the 2007 Pre-Budget Report, Ms Rosewell highlighted her thoughts on the weaknesses in the Treasury's description of the risks:

Dr Weale also told us that there was "no real quantification of the sorts of things that could go wrong with the British economy and that might therefore adversely affect public borrowing and the fiscal position".[30] Treasury officials explained to us their presentation of the risks to the economic forecasts contained in the 2007 Pre-Budget Report, telling us that:

13. We note concerns expressed by some observers about the Treasury's presentation of the risks associated with the economic forecasts outlined in the 2007 Pre-Budget Report. We recommend that the Treasury recast the way in which it presents the risks to the economic forecasts in both Pre-Budget and Budget reports. Quantification of the effects of such risks, should they crystallise, on the Treasury's economic forecasts would be especially useful, so that the order of importance in which the Treasury regards such risks can be assessed.

Household sector balance sheet

HOUSE PRICES

14. Residential buildings remain the dominant asset on the balance sheet of households.[32] Movements in house prices are therefore important in determining the overall wealth of households. The 2007 Pre-Budget Report stated that "there is … evidence that house price inflation is easing, with monthly increases averaging 0.4% since May 2007, compared with 1.0% during the first four months of the year".[33] Looking forward, the 2007 Pre-Budget Report stated that "house price inflation is expected to continue to ease over the coming year".[34] Ms Rosewell told us that she was unsure that "the risk of a sharper house price correction [had] increased since the Budget".[35] Outlining her reasoning, she told us that "if you look at most bits of the housing market, unemployment is still low so people can finance their mortgages, and that is really what matters when it comes to sharp house price corrections".[36]

15. Treasury officials acknowledged that their past forecasts had been, "in terms of the range of outside forecasters … towards the optimistic end on house prices".[37] Although officials told us "house prices have continued to exceed even our expectations", they noted that "for the first time in this PBR we have some evidence that they are beginning to slow down".[38] Officials cautioned against a more pessimistic outlook than that outlined in the 2007 Pre-Budget Report, saying that "we certainly do not expect a disorderly correction in the housing market or house prices, although we must acknowledge that there will be regional differences".[39] Officials were keen to point out the differences between the United States and United Kingdom's housing markets, highlighting that "our sub-prime sector, which is really the big issue for the US, is much smaller; most estimates put it at about 0.6% or 0.7% rather than the double-digit size in the US".[40] They also pointed out that, while housing supply was limited in the United Kingdom, "housing supply is much more elastic in the US which means that potentially one gets a much greater effect in terms of quantity and price" from shocks to the housing market.[41] Finally, Treasury officials were keen to stress that the link between a house price fall and consumption might not be as strong now as it has been at other times:

16. The housing market finally appears to be slowing, with house price inflation expected to fall. Despite this, the Treasury is not forecasting a fall in nominal house prices. A risk remains that a fall in nominal house prices could occur, posing a potential risk to households' consumption and confidence, and we will continue to monitor the situation.

HOUSEHOLD DEBT

17. Another risk identified by the 2007 Pre-Budget Report was the effect of the rise in household debt levels should interest rates also rise. The Report stated that "if the effective interest rates received and paid by households and companies were to rise, the impact on disposable incomes could be larger than would have been the case in the past due to the growth of private sector balance sheets".[43] In other words, the rise in the level of household debt means that, should interest rates rise, households would see more of their income spent on interest repayments. Dr Weale was sanguine about the immediate effects of the potential increase in effective interest rates, telling us that "interest rates might be slightly higher, some people will be squeezed, but although I can see the consumer household sector wanting to rebuild its savings rate I cannot see a sharp fall in consumption growth coming".[44]

18. The Chancellor of the Exchequer commented on the structure of household debt, observing that "if I look at household debt, most of that debt is secured debt, it is mortgages; the unsecured debt, credit cards and so forth is coming down".[45] He suggested that current levels of household debt were affordable, saying that "if you look at the household sector, its interest payments are about 9.8% of their disposable income, they were about 15% in 1990, so I think we are in a rather better position than we were 17 years ago".[46]

19. While we acknowledge that most household debt is secured, and that interest payments on household debt have not reached the level of 1990, we remain aware of the risk as identified in the Pre-Budget Report 2007 that a rise in effective interest rates might have more of an effect on the disposable incomes of households than in the past due to the increase in household debt levels.

The world economy

20. One potential risk to the economic forecast outlined in the 2007 Pre-Budget Report is the effect on the United Kingdom's economy of material changes in the economic outlook of the United Kingdom's trading partners. While the 2007 Pre-Budget Report stated that "growth in the US could slow further if the effects of the weaker housing market were to spread to the wider economy", it also noted that "the monetary policy response in the US could reduce the extent of that slowdown".[47] At the same time, the 2007 Pre-Budget Report highlighted potential upside risks to the world economic outlook, stating that "macroeconomic fundamentals in many emerging markets have improved", and that "the euro area economy could prove more resilient to the US slowdown than forecast".[48] Ms Rosewell clarified the advantages of a more diversified global economy, stating that if "the US goes into recession, before all the moves to greater globalisation or diversity of global growth, there was probably a 100% chance we would go into recession and now there is only a 70-80% chance of going into a recession".[49] Dr Weale noted that "[the] immediate response of weaker growth or a recession in the United States is less demand for United Kingdom and European exports and therefore a weaker overall economy", but that "the world economy is perhaps in better shape to cope with weakness in the United States than it was at the turn of the millennium".[50]

21. Discussing the outlook for the United States economy, the Chancellor of the Exchequer told us that there was "a great deal of uncertainty".[51] On the downside, the Chancellor of the Exchequer highlighted the current problems in the US housing market, both from the fallout of the sub-prime mortgages crisis and increased numbers of unsold houses.[52] But, he noted that "commentators are still talking about the US economy growing, perhaps at a slower rate than they thought a year or so ago but still growing", and thought that the recent cuts in United States interest rates by the Federal Reserve ought to counter some of the recent economic problems.[53] The Chancellor of the Exchequer also pointed out the benefits of a more diversified global economy, noting that, while the "euro market … has slowed down", people were confident that the emerging markets would "continue to grow at quite a rapid rate and that is important too".[54] The current difficulties in the United States housing market remain a concern but we acknowledge that a more diverse global economy may mean that the emerging markets will remain buoyant in the face of a greater than expected slow-down in the United States.