Oral evidence: Budget 2016, HC 929Tuesday 22 March 2016

Oral evidence, 22 March 2016.

Witnesses

Robert Chote, Chairman, Office for Budget Responsibility, Sir Stephen Nickell, Member, Budget Responsibility Committee, Office for Budget Responsibility, and Graham Parker, Member, Budget Responsibility Committee, Office for Budget Responsibility, gave evidence.

Chair

Thank you very much for coming in this morning. There have been a few noises off since we saw you last, particularly in the last few days—but you will have seen a good number of these politico‑economic events before. I would like to begin by asking you about your treatment of the fiscal surplus rule. Correct me if I am wrong but, as I understand it, you are attaching a 55% probability to the likelihood of the fiscal surplus rule being met—that is, the rule that there will be a surplus in 2019-20. As I understand it, that was predicated on the view that the Government was building in a margin for error by putting a surplus of £10 billion into the bottom line. As I understand it—and correct me if I am wrong—on a full-year basis, that figure is now £8.7 billion because we have just lost £1.3 billion per year in PIPs, in the full year. Your probability will have been based on some assumptions, and presumably a model. What is the percentage probability at £8.7 billion?

Robert Chote

The probabilities are essentially based on mechanically applying the average size and distribution of forecast errors in the past. Rather than us saying, “Given our own subjective view of the uncertainties around the central forecast, we think that there is an X% probability,” it is, “If this forecast is as accurate as past official forecasts over the previous 20 years have been, that suggests there will be a 55% chance—to the nearest five percentage points—of there being a surplus,” i.e. that 10 turns out to be a number that is merely greater than zero.

Chair

Of course. I understand this is a relationship between two huge variables of about £750 billion of public expenditure, and £600‑and‑something billion in tax.

Robert Chote

Exactly—which explains why the fan is as wide as it is when you get out to that distance. If you take away the 1.3—

Chair

That is the 5% either side.

Robert Chote

Yes, that is right. Essentially speaking it would still be 55%, to the nearest five percentage points. 1.3 is not a large number at that sort of a time horizon. Clearly if you were to go down to the nearest probability—which we do not do—to the 0.X%, it would be a lower probability as a consequence of the fact that the 10 is no longer 10 if you take just that chain into account, as you say. That is absolutely right.

Chair

Although there is a great deal of political activity going on, quite understandably, about the merits or otherwise of cuts and increases in disability, this morning you are arguing to us that this is de minimis for the purposes of the 55% probability that you have attached to delivery of the fiscal surplus rule in 2020.

Robert Chote

Yes, exactly. Given the average forecast errors over a four-year time horizon, a 1.3 difference is not large in the context of the other uncertainties. However, as you say, that is not to understate the importance of the measure and its other ramifications.

Chair

When you model this—and you say that it is, on a strict basis, derived from forecasting errors across the piece—is that methodology in the public domain?

Robert Chote

Yes. We published a paper on it quite a while ago.

Graham Parker

In 2010.

Robert Chote

When we first adopted that, we produced a working paper on how we reflect uncertainty, which I seem to remember.

Chair

I should have remembered that you published it in 2010, but I noticed that you had trouble remembering it yourself.

Robert Chote

Forgive me for that, Chairman. Not many people would.

Graham Parker

We produced a fan chart of public borrowing since 2010.

Chair

This Committee would like you to take another look at the methodology that you set out there, and to come back to us with a considered view on whether anything needs to be altered in it; and whether, as a consequence, anything needs to be altered with respect to your 55% probability. At least once per Parliament, we should properly re‑vamp this. It may be that you will want to change nothing, but you will need to set out why you are not changing anything.

Robert Chote

Sir, I am certainly very happy to give that methodology a spring clean. In terms of the treatment of the new news that has emerged over the last couple of days, there we will have to treat the PIP change as we treat any other change announced between one fiscal event and the other—which is that we hoover that up in the next forecast that we do, rather than consistently change it. The Government announces measures between events, from time to time, anyway and we do not update the forecast, partly because other things will have changed at the same time. We will take that into account, along with a re‑assessment of the welfare cap, which this also affects.

Chair

I have what I think is a direct quotation of what you said about corporation tax. You said, “The chancellor remains on track”—this is on track to the £10 billion he aimed for in July and November of last year—“thanks to further measures,” by which you are primarily referring to corporation tax, “that shuffle spending out of the fiscal mandate year and shuffles receipts into it.” I found that phrase very interesting. Could you perhaps elaborate on what you meant by this “shuffling” that was going on?

Robert Chote

Yes. Essentially speaking, on the corporation tax, there was a previous measure announced that said that large companies had to pay their corporation tax three months earlier than was previously the case. That means that in the first year that you do that, a large company is in effect paying five quarters of corporation tax, and then in every subsequent year you are back to paying four of them. This generates a one‑off lump of revenue. It is a tax increase where it is neither reversed, nor repeated. That produces a chunk of money that does not affect the long‑term revenue position.

Chair

Is there not an element of artificiality about something that has not appeared before and will not appear again?

Robert Chote

At one level it is not purely an accounting change, in the sense that companies will be handing over money at a different time from when they previously would have been. The fact that this shows up in the numbers in the way that it does is a reflection of the fact that the official figures do not treat corporation tax receipts on an accruals basis, in which case the money would be applied to whichever year the profits were generated on which that tax was assessed, not on when the tax payment was made. If you had accruals treatment of corporation tax, you could not move money in this sort of way—even though you are affecting the time at which the company hands over the cash. The Government has delayed implementation of this measure, which the Treasury said was, “To give businesses more time to prepare.” The effect of that has been to shift to this £10 billion one‑off slug of revenue from 2017-18 and 2018-19, to 2019-20 and 2020-21. The largest single chunk of that is £6 billion in 2019-20.

Chair

Why did you use the word “shuffle”?

Robert Chote

It was to make the point that you are moving money around within the five‑year forecast horizon, in a way that does not affect the ultimate position that you end up with and the long‑term health of the public finances. On the capital issue, there was a plan to do a particular amount of capital spending in that year; some of this is now being moved into the earlier two years. It is the same sort of effect, but moving in the opposite direction. However, again, it is not an accounting fiction. Money is being spent at different times from what it would have been before, but it is something that makes that year look better and does not affect the underlying long‑term position.

Chair

Therefore, although you are describing this as a shuffle, you are not describing it as an accounting wheeze.

Robert Chote

No. The treatment is straightforward. With corporation tax, as I say, it is worth making the point that it is only because we do not do accruals accounting of this that you can do this at all, or that this would show up in this way. However, the contribution that we can make is to be transparent that this is how these numbers have changed. It is for others to reach views on whether or not it is an appropriate thing to do.

Chair

That brings me to my last substantive question in this area. If you look at the fiscal outlook for revenue, you are accepting, and the Government is relying on, are they not, that there will be a very large increase in revenue over the forecast period? The outturn for 2014-15 was £600 billion. In order to get these numbers to add up by 2019-20, we need that to be £761.4 billion, which is an increase of almost a quarter. That is an extremely large increase in revenue. We have both seen this happen before; we have seen increases in the past of more than 25% over a five‑year period, but that is very large.

Robert Chote

Absolutely. We are of course reflecting here both the consequences of a rise in the cash size of the economy, and therefore the cash size of consumer spending, labour income, profits, investments etc.; and then changes to the amount of tax you get per pound of GDP. There are some reasons to expect the latter to go up as well: if you get back to a position in which you have real wage growth, that starts to generate more receipts for you on the income tax side as well. However, the bulk of the cash increase is a reflection of the fact that, over time, the cash size of the economy gets larger. As you rightly point out though—and as we have another fan chart around the receipts numbers—there is a lot of uncertainty both in terms of the impact of the behaviour of the economy, and how much tax you are getting out of any given pound of the economy.

Chair

On every previous occasion that you have come before us while I have been Chairman of this Committee—and that almost exactly coincides with the whole time you have been in your current job—I have asked the same question at the start of the meeting: have you come under any undue influence or pressure from the Treasury to alter your forecast in any way?

Robert Chote

Not at all.

Chair

You have in the past though, have you not? We have had an exchange about it, and you brushed it off, saying, “I am quite robust enough to deal with minor mischief of this type.”

Robert Chote

The first point to make is that that was talking about the description of the forecast and not the report, as some people interpreted, which is not what you said—that this was pressure to change the numbers. As I say, in terms of the description, I was relaxed about that and with suggestions of sort. You take them on their merits and not on their provenance. However, the recommendations you make about re-examining the memorandum of understanding and the clarity of who gets what and on what basis are very sensible. Now we are out of the way of the forecasts, we will get under way with that.

Chair

To put it another way: there is a line between what is acceptable and what is not, which appeared to have been made a little elastic here. We have felt the need to tighten it up by beefing up the MoU. That is what has happened here.

Robert Chote

That is right, and beefing up the MoU and re‑visiting it is very sensible.

Chair

We hope that nothing else comes out of the woodwork that would in any way qualify the unambiguous answer you have given to the question. Among other things, we are here to safeguard your independence. We want you to make sure that you are extremely alert to any attempts and that you come to us if you notice anything.

Robert Chote

Indeed. You will not be surprised to know that the attention you have addressed to this issue already has discouraged quite a lot of that traffic.

Chair

That was part of the purpose, and that is behind this exchange.

Helen Goodman

I would like to ask some more questions about the fiscal consolidation. There is a number of £3.5 billion savings in 2019-20 in the great big table of all the measures. At what point did the Treasury inform you that they were planning to make those further savings in 2019-20?

Robert Chote

Is that the reduction in departmental expenditure?

Helen Goodman

Yes.

Robert Chote

We have deadlines by which we need to know of changes that would be economy‑moving. I forget when the deadline for that was, but we were notified in time, so this was not something that contravened that in any way.

Helen Goodman

Do you think that if they were absolutely clear about where they were going to find that £3.5 billion they would have set it out, rather than just putting it in as a single number in 2019-20?

Robert Chote

You would have to ask them that. From the perspective of the way in which we forecast DEL spending—which, as you know very well, is the envelope for public services expenditure—we have to do this in an effectively top‑down way rather than building it up from all of the different elements that any given department is going to spend, a departmental total, and then adding those things up. Obviously, in 2019-20 you do not know the detail of what every department is going to spending on every bit of their activity anyway. Being able to say precisely where it would come from is difficult when the underlying baseline that you are talking about is not precisely laid out as well. The decision that we took in terms of the way in which we responded in the forecast to that particular policy decision was to say that, on the basis of the Treasury’s track record of ensuring that DEL numbers do come in—and almost always underneath the limit on which they finally decide—it was appropriate to put that in. We did make an adjustment to the assumed underspend against the total, because that puts things under a bit more pressure. Therefore, we slightly offset that with a change to our adjustment on the underspend. The other point to make is that the Government has described this as an efficiency review. It is not our role, beforehand or after the event, to say whether these are efficiency savings or cuts that affect the quality and quantity of public services. From our point of view, we are interested in the net effect on the fiscal target. It is for the NAO and others to judge whether this is getting more bang for your buck, or just less buck.

Helen Goodman

If somebody was to say to you that they have put this number in because it is the number that they needed in order to hit the fiscal target in 2019-20, what would your comment on that be?

Robert Chote

As in every forecast we do, the policy choices the Government have to make in terms of where it ends up is what it allocates as the total envelope for public services expenditure. Those envelopes were set out through to 2019-20 in the spending review. There was an assumption for 2020-21, and the Government have changed what it is pencilling in for 2019-20 and 2020-21. As you see, we highlight that, the impact that it is having, and the fact that it is having a particular impact in a particular year. However, on the track record, we would not have the evidence to say, “We do not think they will deliver that if that is the policy they stick to,” because that has not been the historical experience.

Helen Goodman

They have a number of things they are going to have to find in 2019-20. They have that £3.5 billion and they have £2 billion just below it for public service pensions—which, in effect, is going to come off all these different departments, is it not?

Robert Chote

Yes.

Helen Goodman

Do you know how that will be distributed between departments at the moment? That is not in proportion to how much money you have; that is in proportion to how many people you employ.

Robert Chote

Yes. We have not looked at the distribution by department. As you say, the way in which that thing works is that the Government or GAD have reviewed the discount rate you would like to apply to future pension contributions. The Government have to then make a decision on that. The Government have chosen to lower the discount rates that will be applied to future contributions from CPI plus 3.0 to CPI plus 2.8. That means that this shows up as a saving because the line in our forecast for the net public service pension contribution is pension spending minus the contributions. Contributions are bigger, therefore there is a saving. The decision the Government then have to take is, “That also implies extra costs to the departments employing the people who are in these schemes.” The reason it shows up as a reduction in borrowing on the bottom line is that the Government have chosen not to compensate the departments for the additional costs they will face. You have not had a reduction in net pension spending offset by an increase in DELs; you have the one side but not the other. That is why it feeds through as a contribution to the consolidation.

Helen Goodman

Following the weekend’s event, we now also have in that year a number for PIP, which is about £1.2 billion per annum. That takes us to total savings—as yet unidentified—in 2019-20 of £6.7 billion.

Robert Chote

That would depend on what other decisions the Government makes in response to not having the PIP revenue. As the Chairman said, they could end up aiming for a slightly smaller surplus in that year, or they could try to stick with the £10 billion—other things being equal.

Helen Goodman

Or they could put taxes up.

Robert Chote

Yes. However, this is now one element of policy that goes into our next forecast, and there will be lots of other elements of policy that go in as well.

Helen Goodman

The £3.5 billion and the pensions are bound to come from public spending savings, but the £1.2 billion for PIP could come through any one of three routes: tax increases, extra borrowing, or public spending reductions somewhere else.

Robert Chote

That is right, yes.

Graham Parker

Yes.

Sir Stephen Nickell

Yes.

Helen Goodman

I want to ask you about business rates, because I am slightly puzzled by what is going on with them and the commitment that the Government is making to fully compensate local authorities. The Government have proposed reductions in business rates, particularly for small businesses. This is very welcome. There is consensus that this is a good thing to do. However, business rates were the strand of income that they have said they want to hand over to local authorities to pay for the services local authorities deliver. I know the phasing of this is not sorted out. Next year there are going to be three local authorities—one of which is Manchester; I cannot remember which the other two were—where they will make this translation. But they have said that the whole translation will be made by 2020. I am interested in how they can make this saving on the business rates, which will benefit the small businesses by about £1.7 billion—if you look at all the different elements added together—and compensate local authorities fully without that appearing somewhere else in the arithmetic. In the Chamber yesterday afternoon the Secretary of State said on several occasions they could do that, as did Treasury Ministers. How is that possible? Should there not be a line somewhere? I have read your box 4.3 in the OBR. Logically, if they are going to be compensated, that should appear somewhere, should it not?

Graham Parker

We are covering the whole of the public sector here, so it is consolidated.

Helen Goodman

That may be an answer to my question, but I cannot see any connection between my question and your answer.

Graham Parker

The flow from central government to local government does not appear in the overall numbers. We are looking at the whole of the public sector as an entity. If central government give local government more money, what matters is how much local government spends, which is basically unchanged by this measure. We are talking about how much the public sector spends outside of the public sector, so a flow within the public sector does not appear within our numbers.

Helen Goodman

It should appear in the Government’s numbers.

Graham Parker

It would appear if we were showing central government numbers, but we are showing general government numbers and public operations.

Helen Goodman

I thought that the OBR looked at the red book and what the Government is proposing. The Government set out clearly what the DCLG grant is, for example. If the DCLG grant needs to be adjusted because business rates are being handed over—or not, as now seems to be the case—I would have thought you might notice that and comment on it.

Graham Parker

We are looking at the arithmetic for the whole of the public sector. There is enough to look at there without looking at all the flows in between different bits of the public sector. We look at the scorecard. If you look at the Treasury scorecard, it does not appear on there because it does not reflect overall public sector spending.

Robert Chote

The scorecard includes those things that affect public sector net borrowing. A shift of this sort would not would not affect that.

Helen Goodman

Let me try asking the question in a different way. If the Government is going to fully compensate the local authorities for this £1.7 billion reduction in business rates come 2020, they will have to look for savings elsewhere—in other government departments—will they not?

Robert Chote

Correct me if I am wrong: there is a DEL increase to pay for this, which is one of the things that is in effect funded by the £3.5 billion of reduction. Is that not right?

Graham Parker

It is not on the scorecard.

Robert Chote

It is still in part of the DEL. You have a selection of specifically identified additional DEL spending: smart motorways, cathedrals, etc.

Graham Parker

This extra local government grant is not in the scorecard because it is a within‑public‑sector thing.

Robert Chote

Yes.

Graham Parker

You may be right, but we do not look at the make‑up, as Robert said. We just do a top‑down look at DEL. We do not look at the make‑up of DEL.

Robert Chote

In the top paragraph of page 7—

Helen Goodman

Of the red book, or of your book?

Robert Chote

Our book, top of page 7, first bullet point: “Cut departmental spending limit by £2.3 billion.” As I mentioned, with our underspend adjustment, that comes out as an effect of £2.8 billion. You have a selection of new spending commitments that include the school day, cathedrals, blah blah blah, and this would be another one of them—even though it does not appear on the scorecard. I am not 100% certain.

Graham Parker

Neither am I.

Robert Chote

That is effectively paid for by a combination of the £3.5 billion of “efficiency savings” and reduction in overseas aid—the cash level of overseas aid in that year. We can certainly go back and check this, but I think the money you are referring to is in that component. We can certainly go back and look at that.

Helen Goodman

I would be extremely grateful. I think every local authority treasurer in the land would be extremely grateful if you would do this, because they have been promised this money but nobody can work out where it is coming from. This is quite important for them.

Robert Chote

We will do what we can. As Graham says, the guiding principle of everything we are doing is to look at its impact on the public sector’s finances in entirety, which means that a lot of flows essentially net out.

Helen Goodman

Yesterday the new Secretary of State for Work and Pensions repeated several times that the Government is not going to revisit the DWP for welfare savings, or look at reductions in rates, or changes to entitlements to social security benefits. There are no plans to do that. In effect, that increases the ring‑fence from DFID, health, education, defence and pensioners to the whole DWP budget. My arithmetic takes that to about £400 billion. These savings that need to be found—whether we are talking about £5.5 billion, which you thought originally, or £8.5 billion if we included the PIP and business rates, as is my suggestion—have to come from an even smaller part of the public sector. Do you think that it is credible to find £5 billion to £8 billion worth of savings from a smaller and smaller group of government departments?

Robert Chote

It is not for us to say whether that is credible. It is a matter of arithmetic that the more you protect, the more you have to get money out of the remainder. You are back to the other issue of: if you have lost this money from PIP, the Government can borrow more, tax more, or could spend the equivalent amount less somewhere else. Whether it has that effect on other areas of spending depends on which of those routes you end up going down. It need not be that this feeds through inexorably to unprotected DEL—RDEL. It could come from somewhere else. We will wait until the audit to find out.

Helen Goodman

It does mean that unprotected DEL is smaller.

Robert Chote

Not necessarily.

Graham Parker

The Secretary of State was talking about social security AME. It does not necessarily have any effect on DEL.

Chair

The general point that Helen is making is correct, isn’t it? The ring‑fencing is making life more and more difficult for non‑ring‑fenced budgets, in an era of fiscal restraint.

Robert Chote

Within any given amount, the more you protect—and there are different definitions of protect—the more the unprotected bits get—

Chair

We have had numerous exchanges on this point and the credibility or otherwise of sustaining that policy over a long period. This Committee has expressed deep concern about it and about the consequences for the remainder—the un‑ring‑fenced part.

Robert Chote

From our point of view, all we can do is show what the numbers imply. It is for you to draw that conclusion—which you have done.

Chair

We have been drawing that conclusion, and it has been quite unambiguous. It is even more unambiguous now than it was four or five days ago.

John Mann

Mr Chote, what is the current percentage probability of the Government hitting its surplus target?

Robert Chote

As I say—on the basis of the average size of forecast errors in the past—if you are, roughly speaking, aiming for a £10 billion surplus, 55% to the nearest five percentage points. At a larger number of decimal places it would be somewhat lower as a result of losing the PIP money but essentially still around 55%, because of the level of uncertainty at the four-year horizon.

Chair

We are going to have a look at the modelling of this again, aren’t we?

Robert Chote

Yes.

John Mann

“Somewhat lower”—how much lower?

Robert Chote

I do not know, given the level of uncertainty at that level. The whole point is to emphasise uncertainty, so giving a very precise answer to precisely how uncertain it is would defeat the object.

Chair

But you have done that with the 55%.

Robert Chote

Yes, but we do not say that the probability is 54.1%, in which case I could tell you to a different number exactly what it would be on that basis.

John Mann

Can we conclude that it is less than 55%?

Robert Chote

As I say: to the nearest five percentage points it remains 55%, but you are absolutely right that it is lower. If you have less money there, the number of the probability would be somewhat lower, but not necessarily materially so at that time horizon.

John Mann

For decision-making, a difference between 55% and 50% is significant in terms of a risk profile.

Robert Chote

The Government have to make their mind up how much wiggle room or margin for error they want to put in at that horizon. They have revealed a preference to have a little more than £10 billion in the last couple of forecasts.

John Mann

Parliament does when it votes. You are a parliamentary body established by Parliament, but Parliament has not voted yet. You said 55% and I am trying to get a clearer indication of how far that has come down.

Robert Chote

For a number to the nearest 5%, it has not come down because it is still 55%, to the nearest 5%. However, if we presented this to a much greater level of granularity, the number would have come down. The whole point of this is to underline the uncertainties and to give a broad idea of what the accuracy of past forecasts would suggest. We do not know whether this forecast is going to be more or less accurate than the average of the previous 20 years.

John Mann

How many of your other projections can we take as having a 45% chance of not being met?

Robert Chote

We have provided this percentage number in every forecast that we have done. How many of them were 55%/45%? I cannot remember off the top of my head.

Graham Parker

Probably a lot.

Robert Chote

Quite a lot, in that it has been around that 60%/40%, 55%/45% number for most of the time, because the Government tends to aim a little above hitting the surplus exactly.

John Mann

Something that heads towards a two‑thirds possibility, as against something that is heading towards an evens possibility, is a significant difference in terms of a risk profile for decision makers. Do you intend to give more such statistics in terms of percentage probabilities?

Robert Chote

We have provided this one as a guide. It is for the Government to decide what they believe the appropriate margin for error is. It is for them to decide whether 55% is too high or too low, or what the right number is. It is not for us to say how much they should aim to overdo this. It is to give a best judgment as to what we think the median outcome is, i.e. equally likely either side, and on the basis of the accuracy of past forecasts give some indication—we do not have to but we thought it would be helpful—what confidence you might want to place in it.

John Mann

It also seemed reasonable to project that, with this £4.4 billion additional hole, those probabilities would be shifting towards 50% now.

Robert Chote

Yes, as we have discussed, they would be lower: if you have effectively now got something that looks more like eight‑and‑a‑bit billion pounds rather than £10 billion, the probability will be lower. However, at that time horizon with the fan chart as wide as it is at that point, it does not make a huge difference to the precise number. But the underlying substantive point is that, if you have a lower surplus, the chances of that turning out to be a surplus are lower.

John Mann

From looking and calculating the figures in my head, it would seem to me that what Parliament has been asked to vote on today, and with your 55% probability given last week, in fact becomes 50:50 in terms of probability to the nearest 5%. We are now at a 50:50 scenario in terms of the Government meeting its target surplus.

Robert Chote

If you look at page 201—

Graham Parker

We produced a fan chart.

Robert Chote

If you shift that—

Graham Parker

The black dot.

Robert Chote

£1.2 billion in 2019-20 is going to be less than 0.1% of GDP by then. You will be shifting this line by less than 0.1%, and you can see that per cent of GDP is 0% to 2%. You are not moving substantively closer towards or away from the edges of that black—the dark—

Chair

Your answer to John’s question is “no”. Is that right? Or “yes”?

Robert Chote

The answer is that the probability of achieving a surplus is lower, but to the nearest five percentage points it remains 55%. However, he is right. It is closer to 50 than it was before yesterday.

Sir Stephen Nickell

But it is closer to 55 than 50, and remains so.

John Mann

As I read it, you are suggesting that interest rates are going to be cut. Is that built in to your projections?

Robert Chote

At the time we close the forecast, we take the market’s expectations of interest rates based on interest swap prices. At the time we the closed this, those were moving closer to 0.25% than 0.5%—where they are now. That was plugged in to the forecast.

John Mann

Are you projecting that interest rates will be cut?

Robert Chote

We were following our usual process of taking the market’s expectations, and that is right. In that sense, we are taking on their expectations that rates are—or were then—more likely to fall than to rise at the next move.

John Mann

Sir Stephen, you have sat on the Monetary Policy Committee. I cannot recall anyone in the last 10 years suggesting there would be a further cut. The Governor has indicated there will be an increase. He has indicated that very strongly and has done so for the past two or three years. You are projecting a cut, but the evidence from the governor is projecting an increase.

Robert Chote

The banks said in the 2015 inflation report that the committee could also decide to expand the asset purchase facility, or to cut bank rate further towards zero, from its current level of 0.5%. If you go back a bit, they were guiding against the idea that you would have a further cut in interest rates, I think because of concerns about the profitability of particular banks. We have taken on board the fact that the committee has said, consistent with the inflation report, they may feel it is sensible to cut below that. However, we looked carefully at that to see whether we should essentially apply a floor at 0.5% and ignore the market expectations of it going below; but given that the Bank has clearly signalled in print that it is willing to consider going below 0.5%, it was sensible to do that.

John Mann

The Chancellor has built in a significant additional tax take in 2019-20 that appears to be rather woolly in its detail. What percentage chance are you giving that that will be met?

Robert Chote

That is the percentage chance that the Government changes policy again, which is well above my pay grade. We have put in their current stated policy, which is to implement this change in corporation tax—which accounts for £6 billion of the £6.3 billion net tax increase in 2019-20, so you are right. The vast majority of it is down to that. We have to do the forecast on the basis of current policy. Policy can change, as you can see from the fact that they have moved the £6 billion to somewhere else. It is not impossible that could change, but our job is to show the implications of current policy.

Chair

Is there any particular reason that, whenever we talk about this shift or shuffle in corporation tax, you seem to break out into a broad grin, or should we completely ignore these human signals?

Graham Parker

Yes.

Robert Chote

Natural joie de vivre—no more than that.

Chair

It breaks out from time to time when we are discussing corporation tax shuffling.

John Mann

You will understand. Parliament has passed legislation now, so these things are far more significant than they were before—some would say—by definition.

Robert Chote

Because you have a target in that year.

John Mann

Correct, and with your remit given by Parliament, the woolliness or preciseness of such projections and their likelihood of being met is now a significant concern, where one could have perhaps said five to 10 years ago it was of interest but one should not worry too much because politicians come and go, and there will be changes. That scenario has now changed. Parliament has changed that through legislation. I am interested in the percentage probability of the Government getting that tax take in 2019‑20, in terms of your projections of what the surplus will be.

Robert Chote

There are two issues there. There is the probability that the Government stick to that policy, which is something that you/Parliament have told us not to consider. There is then the probability that, if you go ahead with this, that is exactly the amount of money that is going to come in. Clearly, one cannot be entirely certain what the level of profit is that generates you the £6 billion. I cannot remember—what rating did we put on this?

Sir Stephen Nickell

Medium low.

Graham Parker

Medium low. The real answer is our forecast of corporation tax. There will always be some uncertainty in the forecast of profits. However, given that forecast, there is not much uncertainty in the actual policy. Companies have to pay their quarterly instalment payment, and they just have to pay five of them, not four.

Robert Chote

There are a lot of other money‑raising tax measures that have much higher uncertainty than that one, let’s put it that way.

John Mann

Sir Stephen, I will not ask the probability in your assessment of us leaving the European Union, but the surplus is predicated on net migration of 900,000 new people entering the country. You are projecting that unemployment will rise over the five years, so it is a net 900,000 new people entering the country. How are you building into the calculations the possibility that those people may not come? Critically, what would be the impact on the Government surplus target if there was a significant fall in net migration up to 2020?

Sir Stephen Nickell

First of all, we are making our forecast based on current Government policy. Current Government policy is to remain within the EU. Our migration forecast is based on the ONS forecast of migration. With those two things, that is how we make our forecast. What exactly do you want?

John Mann

In a scenario where there is a significant fall in net inward migration, can the Government surplus target be met?

Sir Stephen Nickell

Interestingly, you do have a scenario where we look at what happens to the public finances were the ONS low migration and the ONS—

Robert Chote

If you go to page 205—

Sir Stephen Nickell

There is a fourth one as well.

Robert Chote

It is not relevant for a policy; it is natural. What you have there is that the central forecast is based on the ONS’s principal population projection. The way the ONS tends to do these things is that they assume that net in‑migration starts at the rates you have seen in relatively recent years, and then moves over time to what you have seen over a longer average period. You have three variants here. The principal one has it falling to 185,000 by the end of the forecast. There is a lower migration variant, which is at 105,000. There is a higher migration variant that is 280,000 or thereabouts.

Sir Stephen Nickell

The Government hits its target in all three cases.

Robert Chote

Yes, and it makes around £4.5 billion difference in 2019-20, up or down depending on which of those you use.

Chair

Rachel Reeves, try to bring some joie de vivre out of Robert if you can manage it.

Rachel Reeves

I will do my best, Chair. I am going back to the issue of welfare, so I am not sure that I will succeed. Mr Chote, on the welfare cap: how much will the Government miss the welfare cap by in the last year of the forecast period?

Robert Chote

Shorthand: the forecast that we have produced ended pre‑measures forecast. Even after the PIP measure, assuming it went ahead, you have the welfare cap being breached. Taking the loss of money from the PIP into account, you breach by about £4 billion in most years. It bobs up and down, but is essentially £4 billion a year.

Rachel Reeves

Not going ahead with the PIP means that it would be move from £2.7 billion to £4 billion.

Robert Chote

It moves from £2.X billion up to £4 billion.

Rachel Reeves

Over a five‑year period, the Government would be spending something like £20 billion more on welfare than if they had met their welfare cap. Is that right?

Robert Chote

Yes.

Rachel Reeves

On the forecasting of PIP—and this is regardless of what the Government do in terms of aids and appliances—for the last five OBR forecasts, spending on disability benefits has been revised up. I wanted to ask you about your modelling and why those sorts of revisions keep having to be made in the same direction.

Robert Chote

Essentially speaking, the difficulty with all of these sorts of reform programmes is that to start with you do not have any, or very much, outturn data to go on. You can start with some views of what sort of impact previous policies that have a similar role have, and that gives you some idea. You then get in to the situation of the forecast that we did back in November, where the crucial judgments you make are: how likely is it that somebody applying for PIP gets it, or somebody being transferred from DLA to PIP gets PIP; and how much money are they likely to get? That can vary because there are some more generous payments than less generous ones.

Rachel Reeves

Are you using DWP assumptions or your own?

Robert Chote

DWP bring us evidence, we quiz them, we take our own views, we reach our own ultimate judgment. In November, the main evidence base we had to go on was an analysis of 900 DLA cases. What has changed in this forecast is that you now have 7,300 actual cases of people transferring under the controlled start. That has shown two things. First, the probability of getting PIP is higher in the 7,300 sample than it was in the 900 sample; and secondly the average amount is higher—100 versus 86, or thereabouts. That is because more people are getting the enhanced mobility, i.e. the more generous version of PIP. Both the average amount and the probability of qualifying for it are higher than anticipated. We have taken those two things into account, and that is why it has gone up since November.

Rachel Reeves

We will know the answer in the autumn, but do you think that you have now got the information you need to make a—I do not want to be unfair, because I know you are dealing with uncertainties—

Robert Chote

We have to go on the basis of the evidence that we have at the time. 7,300 is a lot more than 900, but a lot less than the 1.5 million people who are eventually going to make this transition. As more people come through this and more votes come in, it will be clearer where it is coming out. I would certainly not rule out the possibility that this moves again.

Graham Parker

There are other uncertainties as well because of these controlled start people. They have had the initial assessment, but the ones who have not been given PIP can appeal etc. Of the initial results, it is 74% of them—no, a bit lower. We had to estimate how many more are going to get it after the appeal process. For these cases, they have not yet gone through the appeal process.

Rachel Reeves

Mr Parker, what assumptions are you making about the appeal process?

Graham Parker

We make an assumption about—which, again, is very uncertain—how many of them will be successful.

Rachel Reeves

What is your assumption?

Graham Parker

I cannot remember. I am sorry.

Robert Chote

It is generally based on what the recent rate has been, unless there is a good reason to depart from that.

Graham Parker

Yes.

Rachel Reeves

That might be based on the 900 people, rather than 700—

Robert Chote

As Graham says, the 7,000 have not gone through yet, so it would be based on that.

Graham Parker

It would be based on that but we would aim off it, because the 900 had a much lower initial success rate. You might expect a higher proportion of them to be successful on appeal. However, now some of the more borderline cases appear to be getting it. It is not necessarily the same as that, but we do look at all this.

Rachel Reeves

We should not be surprised if we see another upward revision.

Graham Parker

Or downward.

Rachel Reeves

Or downward?

Graham Parker

It is possible.

Sir Stephen Nickell

I know that from history it does not look likely.

Robert Chote

This is our best judgment of a central forecast at the moment.

Rachel Reeves

You may make the Chancellor happy yet. The Government have promised to half the disability employment gap over the Parliament. How achievable is that, based on your forecasts, and what assumptions have you made about how many ESA recipients will move into work over the period?

Robert Chote

I do not think we have made an assumption. We can check whether there is an assumption that is implicit in this, but I am not sure that we have—in order to get to the numbers we need to do for this—had to make a judgment on that. I can certainly check.

Rachel Reeves

You do not use the Government’s promise to half the disability employment gap in your forecast about employment.

Robert Chote

We do not use promises of that sort in forecasts generally. It is on the basis of the policies they announce. They may have made that promise on the basis of some evidence that is also incorporated here, but I do not recall that being the case.

Graham Parker

It would be in our participation rate forecast, wouldn’t it?

Robert Chote

It could be.

Rachel Reeves

It would be interesting to know what proportion of disabled people you have implicitly or explicitly in your forecast, by the end of the forecast period—if that is possible.

Robert Chote

The most we would do is have some sense of what the percentage success rates are in the particular judgments. Whether that answers that question, I do not know. We can certainly look at it.

Graham Parker

People get PIP whether they are in work or out of work.

Rachel Reeves

Yes, but ESA is different.

Graham Parker

Yes.

Rachel Reeves

The question is what assumptions you made about how many ESA recipients would move into work over the period, and what that means for the disability employment gap.

Robert Chote

On the disability employment gap, I am pretty certain we would not have an estimate on that; but we might be able to help on the first bit.

Rachel Reeves

Moving on to issues around the changes around ISAs, the estimated cost of the change to ISAs—both raising the allowance and the Lifetime ISA—is around £2 billion over the 2017 to 2021 period. If you broke that down, how much of that £2 billion is from increasing the ISA limit from £15,000 to £20,000, and how much is from the Lifetime ISA?

Graham Parker

I am not sure about the exact figures, but the majority of it by far is the Lifetime ISA.

Rachel Reeves

Is it 80% or 90%?

Graham Parker

Something like that. It is of that order of magnitude—very much the majority of it.

Rachel Reeves

Would you be able to come back with the costings? I am particularly interested in the costings of increasing the allowance from £15,000 to £20,000.

Robert Chote

We can check whether that is something that comes out of the numbers we have done.

Chair

Could you either come back to us with it, or come back to us with what exactly we should demand of the Treasury to secure it? The Treasury will have a number, even if they have not divulged it to you.

Robert Chote

Yes, we can do that.

Rachel Reeves

The reason I am interested in the cost of raising the allowance from £15,000 to £20,000 is that HMRC numbers show that 8% of savers used their maximum £15,000-odd last year. 29% of savers with incomes between £100,000 and £150,000 used their full allowance, and around half of those with incomes of more than £150,000 saved the maximum—just over £15,000. It seems to me that raising the limit to £20,000 will largely only benefit those on the highest incomes. I am interested in the cost of a measure that looks like it benefits only a small number of people. I am keen to interrogate that further, if I could have that.

Graham Parker

It is clearly only the people who put the maximum in now.

Rachel Reeves

Only they will benefit, will they?

Graham Parker

Yes.

Rachel Reeves

Yes. I am interested in how much a measure would cost that seems to benefit only those on the very highest incomes. Looking at the savings ratio and savings policy more generally, you are forecasting that the savings ratio will fall further. It is currently at its lowest level since 1963, at 93.5%, but you expect it to fall further between 2015 and 2020. The savings ratio is revised down in every year of the forecast period, compared with November. Can we assume that your verdict is that the measures to boost savings do not seem to be doing very much?

Robert Chote

I would not read too much into the effects of individual measures in what is driving those sorts of movements. A lot of it has to do with the recent outturn data and the broader picture of the flow of funds. We have a larger central household deficit through the forecast. It was roughly 2% of GDP last time. It is up to 3%. That is not particularly driven by recent policy changes. It is about the broader macro make‑up.

Sir Stephen Nickell

If you include the pension equity adjustment, the savings ratio goes up over the forecast.

Rachel Reeves

The savings ratio is falling from 4.2% in 2015 to 3.9% in 2020, and it has been revised down in every year of the forecast period.

Robert Chote

If you go to page 67—

Sir Stephen Nickell

On page 67, it does not seem to be the case. When you say it was revised, do you mean it is lower than we—

Rachel Reeves

It has been revised down.

Sir Stephen Nickell

It is not going down; it has been revised down.

Rachel Reeves

It has been revised down in every year of the forecast period.

Sir Stephen Nickell

Yes.

Rachel Reeves

The Government are spending £2 billion on changes to ISAs in this budget, but the savings ratio is falling.

Sir Stephen Nickell

It is not falling.

Rachel Reeves

It has fallen compared with your previous forecast.

Sir Stephen Nickell

The savings ratio is going up. Our estimate of it is lower than it used to be.

Rachel Reeves

The impact of the measures in this budget only see the savings ratio being lower than you were forecasting four months ago.

Sir Stephen Nickell

Yes, but by and large most of that fall has nothing to do with the measures.

Rachel Reeves

The Government are spending £2 billion on measures to boost saving, but your verdict is—

Robert Chote

You would have to ask them whether this policy is aimed at the overall saving rate or particular people that they want to aim particular incentives at. In terms of the forecast revision, as you can see from paragraph 380, part of this is a judgment as to what has happened on the saving ratio in the final quarter. We do not have the numbers for that yet, but the evidence from what is going on with consumer spending and labour income is that consumer spending is growing more rapidly; therefore, the starting point for the forecast is lower and that naturally pushes through the rest of it. I suspect that is dominating the movement—rather than any judgments we have made.

Sir Stephen Nickell

Yes, definitely.

Robert Chote

Yes, it absolutely dominates.

Rachel Reeves

The Government say about their Lifetime ISA that there is going to be a 5% exit penalty if you take your money out before you are 60, but not if you are buying a house. Have you made any assumptions about whether people will keep their money in ISAs or is it just too early to say? What does that 5% exit penalty mean? Does it apply to the full amount in the ISA or the Government’s contribution?

Graham Parker

I am not sure. We did not look at this too much, because it is not going to have any effect over this scorecard period.

Rachel Reeves

Only to the extent to which people will put their money into it.

Graham Parker

There will not be any significant effect. There will not be many people who start one in a couple of years’ time or whenever and then withdraw it before the end of this forecast. We have not really looked at it.

Chair

We have already been going over an hour and we have a number of other colleagues who want to get in. I am going to call Mark Garnier, who has one or two follow‑up questions to what has been asked, and then George Kerevan.

Mark Garnier

Carrying on with household debt, savings, balance sheets and all the rest of it, when you look at 2020, you guys forecast that net lending from the rest of the world—i.e. the current account deficit—is going to be 3.5% of GDP, while the government surplus will be 0.5% of GDP, and this is going to be offset by a 1% of GDP deficit in the corporate sector but a 3% deficit in the household sector. Is that a sustainable position for households to be in?

Robert Chote

Having a household deficit of that size over a period that protracted is not something you can see easily in the historical data, so to that degree it is unprecedented. On the other hand, also unprecedented is the combination of a fiscal consolidation continuing over the next few years and very loose monetary policy. In that sense, it looks the best rationalisation of how all of these central balances add up. However, in this forecast and in previous ones we have identified as one of the risks to the central forecast the fact that clearly you could have these sectoral balances adjusting in different ways. Some outside commentators will look at this picture and say, “That looks to me like a recipe for a fall in the exchange rate,” which could result in a different contribution, for example, from the “rest of the world” sector. It is in there; it is our best guess. It seems consistent with the policy settings and the rest of the forecast, but we recognise that things could turn out differently—and other people, as I say, have particularly advanced that. In terms of the rest of the balances, it is worth making the point that another bit of new news since the last time we did a forecast is that the trade deficit looks worse in the most recent period. We have been focusing quite a lot on when the income balance was going to improve the results of the net overseas investment. What we have had in this forecast is more disappointing news on the trade side as well. That feeds through and means that you end up with the other elements of the sectoral balances taking the strain.

Sir Stephen Nickell

Another point worth making in terms of sustainability of household positions is that the household balance sheet is in an unprecedentedly healthy state—in the sense that assets, relative to liabilities, are at an unprecedentedly high level.

Chair

We have had dramatic price inflation.

Sir Stephen Nickell

Well, yes.

Mark Garnier

This is a point I wanted to come to. You are right. Your March forecast has increased that; it is 825% from 800% in the November forecast, which is quite encouraging. Does this not have a sniff of the financial crisis about it, however? You see the requirement for households, through household consumption, to sustain the economic recovery. We do have rising wages—that is good—against zero inflation. Households do have more disposable income, but they are saving less. If you take out pensions, you have negative savings. It will be -2.5% by 2020, according to your chart on page 67. Ultimately, it seems to require more debt and more rising asset prices in order to fuel household consumption to try to continue the economic recovery. As you rightly say, we could see a collapse in sterling, which could obviously have an effect on the trade balance, but it could also have an effect on how the Monetary Policy Committee treats interest rates in order to try to stop importing inflation. In that case, you would have highly stressed households, which we are asking to buy stuff in order to keep the economic recovery on track, that cannot buy stuff because the cost of their mortgages has gone up. Discuss in under five minutes.

Robert Chote

I will let Steve take most of this. There is an issue about higher interest rates etc. and the stress that causes. We have discussed this but, obviously, if interest rates rise more rapidly than is currently anticipated because the economy is doing better—

Mark Garnier

That is a good thing. I am not worried about that.

Robert Chote

It is not necessarily a source of stress. If they rise for reasons that are not related to a stronger performance in productivity and wage growth, you would be more concerned.

Mark Garnier

You would have a problem. If you look at the 2014 stress test the Bank of England brought out, which we were discussing with the governor last week or the week before, this could create a scenario—I am not going to try to draw the EU referendum debate into this—where things go wrong. This is exactly the case. If people worry about sterling and about the UK trade balance, as you have just said, and you saw a fall in sterling, that could prompt a reaction from the MPC to raise interest rates to try to salvage the sterling exchange rate. That is exactly the kind of bad scenario that sees a rise in interest rates when households are not prepared because the economy is not getting better; it is getting worse. You then need a rise in interest rates for the wrong reasons.

Robert Chote

Obviously, the Bank would be making its judgments based on what they thought the prospects were for inflation, presumably looking through any resulting one‑off price‑level effects and whether they saw a need to deal with underlying domestic inflation. Steve, do you want to add anything on that?

Sir Stephen Nickell

No, you are right in the sense that if, as we forecast, household gross debt—not net of the assets—is on an upward path relative to incomes and, for whatever bad reason, interest rates go up to a relatively high level, obviously that will have an impact on households and will reduce household consumption. Although some people will argue that higher interest rates also benefit lots of households, the fact is that the benefit is outweighed by the negatives in this particular context. Overall consumption would fall and that, of course, would not be good for overall economic growth; it would probably lead to a recession. There is that danger. Obviously, on our central forecast, that danger does not crystallise, because the interest rate path the markets expect and so on is such a minimal rise that the implications for households are tiny.

Mark Garnier

Ultimately, you cannot hypothecate on every single scenario like in a stress test; that is just not the job you are being asked to do, is it?

Sir Stephen Nickell

Yes.

Mark Garnier

Nonetheless, you do see the point. The fundamental question, I suppose, is this: do you agree that there is a bit of a sniff of the financial crisis about what is going on with households?

Robert Chote

I certainly would not use the phrase, “I see a sniff of the financial crisis.” You can read the paragraphs on the risks, we see and the way we have outlined is not the only way the flow of funds could evolve.

Chair

It is only a small step from shuffling to sniffing. Could I follow up on that? Sir Stephen, are you saying—I am not sure you were saying this—that, in your view, if we start to raise interest rates to a substantial degree, we are at risk of a recession?

Sir Stephen Nickell

No. I said if there were a sharp rise in interest rates brought about by the kind of scenario we are suggesting—

Chair

I just wanted to clarify what you were saying. For the avoidance of doubt, just say again what your view is.

Sir Stephen Nickell

If there were a sharp rise in interest rates brought about by some scenario that involved a large trade deficit, trying to stabilise the pound etc., that would have a negative impact on household consumption.

Chair

I realise you do not want to be pinned down on this, but give us some order of magnitude about time and numbers for what constitutes a sharp rise in interest rates from 0.5%.

Sir Stephen Nickell

I mean 5%.

Chair

So, back to normal levels, but in the space of how long?

Robert Chote

A year.

Chair

It is just helpful to have clarification about what you were, in fact, talking about. It could have been misunderstood.

George Kerevan

Your report says that the most important uncertainty in our economic forecast is the timing and strength of the long‑awaited return to sustained productivity growth. You also say that in the eight years since 2007 UK productivity has grown by barely 0.1% a year. We have accumulated less than 1% since the top of the boom, yet your forecast, this most uncertain of forecasts, is saying that in the next three years we will suddenly, from nowhere, ramp up to near historic‑trend levels of productivity growth in the UK. Why do you think that?

Robert Chote

One of the big judgments we have taken in the forecast is to essentially place more weight on the weak period of productivity growth that has taken place since the crisis as a guide to what is likely to happen over the next five years or so. The view we had effectively taken until this forecast was that there is no obvious reason to believe, or no reason to be confident, that in the end the economy is not going to get back to the sorts of productivity‑growth rates we have seen in the past prior to the crisis.

George Kerevan

Tell me why, please.

Robert Chote

Because over a very long period, that has been a relatively stable relation. This changed sharply at the point of the crisis. If you go back to the set of information we had available to us at the time of the November forecast, you had signs of productivity growth and, along with it, earnings growth picking up in the middle part of last year. At that stage we took the view that there was not a strong case at that stage for pulling down your view of where you were going to end up over a five‑year horizon. The outturn data we have received since then has basically wiped out the improvement in productivity growth in the middle of last year. Earnings growth, which was at 3%, has fallen back to about 2%. Therefore, it looks sensible to place a bit more weight on the last eight years, relative to the previous 100, in terms of where you think you are likely to be going. It remains very uncertain, however.

George Kerevan

I will come to your revisions. I am just trying to work something out. You appear to be saying that, historically, productivity growth has been 2.2% or in that ballpark and, because it has always been that way, despite the fact it has not been there for eight years, suddenly in the next three years it will ramp up to something like 2%. Apart from, “It has always been this way so it has to happen sometime,” do you have any concrete proof that is going to happen?

Robert Chote

We do not have concrete proof.

George Kerevan

What weight should we place on your judgment that, suddenly, after eight years, average annual productivity growth in the UK is going to go from 0.0% or 0.1% to 2%? That is a 20‑fold increase.

Robert Chote

Yes, if you were returning to 2% from a negative, it would be more than 100%. The point, however, is that there are explanations that people come up with for why productivity growth has been weaker in this period than it has been previously. As I mentioned, one of those is that a legacy of the financial crisis has been that the financial system is not as effective as it might be at getting capital reallocated from not terribly well performing firms to potentially higher growth and more innovative ones. As the financial system mends, you would expect that drag to become less important and for productivity growth to pick up that much more. That would be one reason. It is an ebbing of the factors holding it back, as distinct from new factors driving it up.

Sir Stephen Nickell

One point is that, although productivity growth collapsed in the last quarter, our best estimate of actual productivity relative to the year before is 0.8. The jump or the increase in productivity over the next three years, to some extent, has already started. Robert is right. The fact is that, fundamentally, productivity growth slowed down. It must have been because of the financial crisis, in the sense that it happened everywhere in the world.

George Kerevan

Apart from China and Brazil.

Sir Stephen Nickell

China perhaps did not have quite as much of a financial crisis then. We will see what happens in the future. It certainly happened all over the developed world. There was certainly a slowdown in productivity growth. There are many hypotheses, but a lot of them come back to the financial crisis as the common cause. The impact of the financial crisis is ebbing, in the sense that credit and so on are becoming much freer and there are improvements across the board. Therefore, if this tightness of credit was one of the fundamental factors underlying the slowdown in productivity growth, it seems quite logical that as this ebbs productivity growth will come back.

George Kerevan

I understand it in theory. In practice, in the last two quarters for which we have data—hard evidence, as you said, Mr Chote—productivity growth has slumped again in the UK and wage growth has slowed again.

Sir Stephen Nickell

Yes, along with it.

George Kerevan

The quarters we have evidence for go against your prediction of what is going to happen over the next three years.

Sir Stephen Nickell

The quarter‑by‑quarter measures of productivity growth go up and down all the time. Even in normal times they go up and down quite a lot. It is much better to smooth it. On a smooth basis, 2015 was a lot better than we have seen in the past. I admit, however, that the last quarter was very disappointing—in the sense that, along with many other people, we thought that, given the middle two quarters of the year, we had turned the corner and so on. That proved not to be the case. Nevertheless, 2015 was better than a number of previous years. Therefore, whilst we adjusted our projections a little, we did not lose faith completely in the view that we are going to get back to something like the norm.

George Kerevan

Okay, let us move on then. Nevertheless, you have come back since your previous forecast at the end of last year to tell us that you have decided that long‑term trend growth in productivity is going to be less than it was historically. You have made some kind of calculation. How did you calculate that?

Robert Chote

As I say, it is a judgment based on the fact that, as the period of weakness you refer to gets longer, you have to place a greater weight on it. We are not saying we do not believe we will ever get back to historic rates of productivity growth. However, in making a judgment as to how far you think you are likely to go over the next five years, as this period of weakness since the financial crisis gets longer, it seems only logical to place a bit more weight on that relative to the earlier period as a guide. As I say, whichever forecasting methodology you are bringing to bear on this, whether you are doing a statistical approach or drawing lines through things or doing things that are more sophisticated, essentially speaking you have two historical periods that are very different from each other: a weak recent period and a stronger earlier period. It is not very easy to explain quite why things are so much weaker in the new period than in the previous period. Therefore, saying, “Right, the last eight years are now representative of all we have to look forward to in the future,” seems to go too far in one direction. However, we felt that snapping back relatively quickly to the old long‑term historical average as the new weaker period gets longer does not look particularly attractive either. You have to make a judgment and be transparent about where you draw the line between those two things. The idea that there is some very technical calculation that suddenly drops out “2” as the optimal number at the end is wrong. No, you are making a judgment: “We think you probably have to nudge this a bit lower.”

George Kerevan

I do not want to put words in your mouth, but I want to see whether I understand you correctly. It is an exercise in averaging. The traditional average was 2.2%. Because, against all your predictions and the predictions of December, the collapse in productivity growth continued, you have decided that the new average is 2% rather than 2.2%. However, that is not based on an analysis of real factors in the economy; it is simply statistical averaging of the long‑run data series you are looking at.

Robert Chote

Quarters of productivity data are real facts. That is what you have to go on. Looking at how that has evolved, yes, you are having to decide what weight you place on those two things. As you say, there is a whole variety of potential explanations for why productivity growth has slowed. We have talked about the reallocation of capital. People have composition stories to tell; they have other stories to tell as well. In terms of making what seems to be a sensible judgment for a five‑year horizon, weighting in that way is interesting. It is striking. One of the most surprising things I discovered when we were putting together this report was how similar that judgment ends up being to the one the Congressional Budget Office has taken for the data in the United States over the same period.

George Kerevan

I noticed that was your defence: “It is happening in America, so it must be happening here.” I do not buy that as a defence.

Robert Chote

It is not a defence; it is information. I am not saying we are doing this because the CBO has done this in the US.

George Kerevan

I appreciate that.

Robert Chote

I am pointing out this phenomenon is not unique to the UK. That is important to state.

George Kerevan

I have deep respect for the OBR. I am just doing a bit of testing. The trouble with that kind of courtroom judgment is that you get to choose the evidence that supports your case, rather than choosing other countries that do not support your case, which is why I am dubious about using US data to underpin your decisions.

Robert Chote

As I say, we are not using it to underpin the decision. We took the decision and then I said to my staff, “It would be interesting to see how this compares with what is happening in the US,” and it turned out to be almost exactly the same. That was something that emerged after we had taken the judgment, not before it.

George Kerevan

My interpretation of the report is that you seem to be suggesting that, with the revision down, in your view, of the trend for productivity growth, wage growth will also slow and that will have an impact on budgets. Is that correct?

Robert Chote

That is right. Fundamentally, we assume that it is productivity growth that drives wage growth and, therefore, while it is not quarter‑by‑quarter exactly the same, it follows automatically.

George Kerevan

We are looking at a period of lower wage growth than previously forecast.

Robert Chote

Yes, lower trend productivity growth feeds through to lower potential output growth, and that means lower growth in both the income and expenditure components of nominal GDP. On the income side, it shows up in wages; it also shows up in profits on the expenditure side; it shows up in consumer spending and business investment.

Chair

I have three more colleagues who want to chip in. Halfway through your extended exposé on productivity, Sir Stephen, I had the impression that you were pregnant with another thought and were cut off.

Sir Stephen Nickell

I do not think so. If I was, I have forgotten.

Chair

In that case, it cannot be that important. We will move on.

Mr Baker

Congratulations on another excellent report. It has been a fascinating session already. I want to ask you about your forecast assuming that monetary policy will be cut by the Bank and not raised above its current level until 2019. The governor has told us that the next move is more likely to be up rather than down. Do you agree with Mark Carney that your forecast is likely to be wrong?

Robert Chote

As I say, the approach we have always taken with the forecast is to take the market’s expectations of where interest rates are going and not to make our own subjective judgment on that. On the basis of what swaps rate prices were telling you at the time we closed the forecast, it went down and it went closer to 0.25% than to 0.5% for a period. We have plugged that into the forecast. It has subsequently moved back up and then back down again. I am not quite sure where it is now, but on the basis of what we had at the time it was more likely down than up.

Mr Baker

The governor would clearly like us to expect interest rates to go up. That is why he has told us what he has. I am just looking at your very helpful chart on page 43, which gives successive market expectations for bank rate. It shows us that, over a period of years now since sometime in 2010, the market has expected interest rates to rise and they conspicuously have not. How does this affect your forecast and your expectations of what interest rates will do versus what the governor has said, which is that he expects they are more likely to go up than down?

Robert Chote

We have plugged in these successive lines as we have gone along, because we have continued to take the approach that the market expectations are the sensible guidepost. As we put on the right‑hand side—coming back to Mr Kerevan’s questions previously—this is obviously related to the fact that there have been a succession of disappointments and people taking a less optimistic view of the path of growth in the medium and longer term as well. The two are related in that sense.

Mr Baker

That is a very good point, because next to that chart you put the successive disappointments on hourly productivity. When I look at page 53, on the oil‑price assumption and how that has changed, the changes are so wild as to make one wonder whether the forecast had any value at the time.

Robert Chote

Again, for the oil price, we take futures prices for a couple of years and hold it flat thereafter. As you can see here, that works some of the time and does not work other times. The evidence, certainly from the IMF, is that is probably about the best approach to take.

Mr Baker

I think you would agree would me, however, that markets have been wildly wrong on a number of important prices for a while.

Robert Chote

Indeed, yes. If I could be confident of that ex ante, I would be a very rich man. On that basis, taking the expectations is the sensible thing to do.

Chair

That is why we need you to tell the public that they really should not be relying on forecasts. You should put that message across more than you have so far in the first five years—though you have been doing a great job. It is a point we have been making over and over again to you.

Mr Baker

I would certainly recommend these records of how forecasts have changed to any student of economics and, indeed, astrology. I do beg your pardon.

Robert Chote

You slipped that one in there.

Mr Baker

Yes. In the Autumn Statement report by this Committee, we recommended that you should share your assumptions on the future path of monetary policy with the Bank of England and discuss whether they are reasonable. Have you had those conversations on this occasion and was the particular path of monetary policy discussed?

Robert Chote

The issue there, which you rightly raise, is your interpretation of what they have said about, but not the actual level of, rates. We continue to use the market expectations, but how do we interpret that in terms of policy? We check with them here that we have interpreted the chunk of the February 2015 inflation report that I read out a few moments ago, and that it was appropriate—given current guidance. The Bank was not leaning against us saying that we are choosing to follow the expectations going down rather than up, because they had said, “If rates need to go down, we will take them down.” That is slightly different guidance from what they were giving in earlier periods, when they had greater concern about the profitability of particular banks and were steering people away from the expectation that rates might go down. What they have said there is, “We are not pre‑judging it, but if that is what is needed for the inflation target, that is what we will do.”

Mr Baker

From your answer, what I infer is a quite considerable difference of approach. On the one hand you appear to be quite mechanical: you look at market expectations; you plug them into the forecast. Mr Parker, I hope you will not mind me saying for the record that you are nodding. On the other hand, from what you have just told us, the Bank is in the business of manipulating expectations within the market. Whilst the Bank is trying to set market expectations and you are mechanically plugging those expectations into your model, do you recognise that that leaves you vulnerable to the words the governor of the Bank might use and how that might shift market expectations? Indeed, that is his stated purpose on occasion.

Robert Chote

Yes. To what extent you believe that what central bank governors do does shape the curve over that period of time is obviously an interesting debate and one that is quite hard to verify one way or the other. In the end, people put their money where their mouths are. There are technical reasons why swaps‑rate prices might not give you exactly what the market thinks is happening here, but in terms of what we need out of this and the broad set of assumptions we need, it is a sensible one to use. Certainly, we would not rule out ever doing it in the future, but rather than coming up with our own guesstimate of exactly where rates are going to be at each stage, putting in the market rates is the sensible approach.