Examination of Witnesses (Questions 40
TUESDAY 11 JUNE 2002
40. You do not interpret that statement as a
suggestion on the MPC's part that they are about to act in order
to bring about a cooling?
(Mr Bootle) No.
(Mr Walton) It is the same way that, when the exchange
rate is very high, the assumption is that the exchange rate is
going to fall. It does not necessarily mean that is what happens.
When house prices are up 18 per cent, it is more reasonable to
think that house prices are probably going to moderate over the
next year, than inflation is going to pick up.
41. I just want to finish off with a couple
of more general questions, some of which touch on what Roger was
saying only a moment agobut if anyone else wants to answer,
please do. I am looking at what David Clementi said about the
property market. He said: "Even if the property market gets
out of line, monetary policy adjustment is appropriate only to
the extent that property developments risk the inflation target
not being met". One could have added: "on a two to three
year view", because that is what they always talk about when
you ask about their time horizons and trying to work out where
inflation is going to be. I am wondering, first of all, what views
any of you have on the extent to which central banks should start
to take account of asset price inflation generally? Secondly,
is that really the only objective that we should be asking the
central banks to achieve? Should we not also be asking them to
look at the systemic risk inherent in asset price bubbles, which
inevitably means they should take a longer view? I may go on to
talk about Japan in a moment.
(Mr Walton) I agree with the general proposition that
you should only look at house prices to the extent it has a bearing
on the overall picture two years ahead. I personally do not think
you should suddenly start introducing additional targets for asset
prices. It is very difficult, when you have only got the one area
of interest rates, to say you are going to have to start targeting
things other than overall inflation. Why stop at asset prices?
Why not say you cannot allow investment to fall? You get into
all manner of problems. That said, I was slightly surprised by
David Clementi. While I think the general proposition is right,
I think if you are the person in the Bank responsible for financial
stability then if anyone is going to worry about the housing market
it probably ought to be him. I thought that speech he gave was
actually really very relaxed about the housing market; and that
seems a little bit odd, given his dual role of being concerned
about financial stability as well as his role of setting interest
rates and GDP inflation target.
42. That is the question I am asking you. Is
there tension between those two? To what extent are the MPC taking
account of it?
(Professor Miles) My view is that they should take
account of it because, going back to what happened in the late
1980s, the implications for the real economy of what happened
in the housing market were very significant, in the sense that
mortgage arrears and the problems in the housing market did, I
am sure, have a knock-on impact on overall levels of demand. There
would inevitably be real economic consequences to the wider economy
and to general inflation pressures from a major downturn in the
housing market. The Bank clearly cannot ignore something like
that, and does not. The rules of the game are that they set interest
rates to try to hit the inflation targets. I think his comments
are really not a great deal more than reiteration of the role
that the Bank has been given. It may be that the issues in the
housing market should be addressed more by the FSA than by the
Bank of Englandthat this is an issue for the lenders.
43. There is this tripartite rather murky committee,
between the FSA, the Treasury and the Bank of England, that meets
to assess this systemic risk. What in a sense you are implying
is that that group of people, led by the Government, if they believe
there to be systemic risk inherent in asset prices, should re-examine
the inflation target to see whether it should be altered to enable
the MPC to take the appropriate action, to the extent that interest
rates is the relevant instrument. Is that correct?
(Professor Miles) That is possible. I think my view
is that the appropriate action, if you really felt there was a
major bubble emerging as a real threat to the solvency of a large
part of the household sector, is that that might be most directly
addressed by the FSA.
44. Let us take one step back from solvency
and talk about huge dislocation to the macroeconomic framework
in the country, which is what we had in the late 1980s and early
1990s. In the old days we had the Treasury. They were in the frame
for all of this. We knew who was responsibleit was the
Chancellor's job to sort it out. It was very difficult to do,
but it was his job to do. Now, of course, we have had this very
gentle monetary run over the past five years and it has been pretty
easy on the MPC. Frankly; any old fool could run an inflation
strategy when there are strong deflationary pressures in the global
economy and you have gentle growth everywhere. It is when you
have got negative growth and huge inflationary or huge deflationary
pressures that it gets difficult. When we have a deep recession
we will find out whether we have got the thing right or not. What
we need to know is, when that comes, who this time should be taking
and integrating those decisions, and how should that be thought
through? Do you think the structure is in place to enable that
to be achieved? We have had the inklings, as you have said in
your paper, of some of the conditions that amount to having an
asset price bubble.
(Mr Walton) The only problem with all this debate
is, supposing we were to take Sushil's advice and interest rates
were being set at 25 base points lower, okay the GDP growth rate
would be stronger, inflation would be a little bit higher and
house price inflation would be higher. The implication of this
is, if you really want to sort out the housing market, you raise
interest rates. At some point that may be appropriate, but if
you are doing it just to stop the housing market when inflation
is below target, when the economy has been stagnating for the
last six months, I would have thought the MPC would be criticised,
and rightly so.
45. You are answering a different question.
I am not saying the policy has been wrong; I am saying, starting
from where we are now, do we have the structures to take the kinds
of decisions that might be required if we were to have an asset
price bubble, which everyone agrees would require action.
(Mr Walton) The policy structure is not that much
different really from the situation in the early 1990s. There
was no government policy to bail out people in negative equity.
46. With respect, it is very different. We have
got an independent FSA, so the regulatory side of systemic risk
has been removed from the Bank of England. We have the Bank of
England no longer answerable to the Treasury for the setting of
interest rates. We have a tripartite structure with divided responsibility
on systemic risk. We have very different circumstances.
(Mr Walton) My point is, even when you had it all
controlled by the Chancellor that did not stop the house price
boom in the late 1980s and subsequent very severe house price
crash in the early 1990s. If the system had remained exactly the
same there would have been no guarantee that you would have avoided
the situation we are in.
47. That is also a different question. I agree
that what we had in the past might have been wrong. I was a strong
supporter of Bank of England independence as early as the 1980s.
What I am interested in knowing is how the structure we have got
now will or should operate in order to tackle what could become
a more serious problem if the asset price bubble turns out to
be very serious. I do not think it will personally.
(Professor Dow) The Inflation Report does have
some material on financial stability, particularly in the housing
market. I assume that is a route through which the work of the
Bank and the FSA on financial stability should be fed through
into the monetary policy decision. Clearly, they have adopted
(Mr Walton) The last financial stability report from
the Bank of England was warning that the housing market did look
a bit worrying, and they were issuing warnings to lenders that
they should be quite prudent in their lending, and that last report
was about six months ago so we must be due another one shortly.
I am presuming they will reiterate that.
(Mr Bootle) I would not underestimate the power of
talkit can be overdonebut the Bank, to some extent,
has got some of that power still. Indeed, you could almost interpret
some of Mervyn King's apparent hawkishness in that regard as well
by indicating that the future outlook is for higher interest rates.
That should be putting some pressure on people in the housing
market to understand that affordability is not going to remain
quite what it is at the moment. On the question of the different
framework and looking at asset prices more closely, I actually
agree with an earlier remark that once you introduce asset prices
it complicates the process of monetary policy. But it is not obvious
to me that complicating it is necessarily wrong. The reason why
people are so loath to contemplate complicating it is because
of this extraordinary period of success over the last couple of
years. The question is how durable that is. I happen to think
we have been very lucky and that, in due course, we will experience
a much greater divergence than that. I feel quite sure that, as
and when we do, asset prices will play a huge role in that divergence.
If you wanted to introduce asset prices and yet still preserve
the fundamental framework, the aspect of it you really need to
tackle is, I think, the two-year time horizon. If you believe
that house prices in particular have got way out of line, you
presumably think that the danger of moving forward is a return
to the sort of thing that happened in the early 1990s, when consumer
spending was very low and, therefore, there will be major downward
pressures on the inflation rate. The nature of this will be that
you could not predict exactly when that would happen. It seems
to me you could, by working on that, make some reconciliation
between attention to asset prices and keeping inflation as your
central focus. You just have to be a bit fuzzier about the exact
time horizons. That brings all sorts of complications. Because
of the history of success of the last few years, I am sure it
is not something to be contemplated now but, if we ever went through
again a repeat of what happened in the early 1990s, my suspicion
is, indeed I am pretty sure, the performance of asset prices,
and particularly house prices, will be directly factored into
Mr Tyrie: I was trying to elicit some
of the thinking now, rather than in a few years' time, but I will
leave it there.
48. I am not sure it is relevant to that last
answer, but I understood you to start saying you felt housing
prices were a problem. I switched over to David and I understood
what you said in terms of the whole operation. You should not
be damaging the whole operation, of inflation and interest rates,
because of one sectorbut the sector does seem to be overheating.
What can you do? If you are all saying, in terms of the Monetary
Policy Committee, they are quite right to stay calm about this
and not to start tampering, because we have got overheating in
one sectorsay we are pulling out of the Monetary Policy
Committee ambitfor example, if the Bank does not do itshould
the Chancellor be doing it; should he be doing something, taking
measures, and what measures would you suggest he takes? There
is some worry out there of people not being about to get on board.
The other thing is, if anything happens to interest rates and
the bubble bursts, we have negative equity and so on with people
losing their houses etc. Roger, do you want to respond?
(Mr Bootle) I suppose there are various things that
could be doneindeed the Chancellor has done a few of them,
with increased stamp duty on a number of occasions, which ought
to have helped directionally but does not appear to have had very
much impact. I think the truth of the matter is, it goes back
to what David was saying about the nature of these markets, that
when you have got price rises of the sort of size you have had
and you had a history of building up that sort of price rise and
expectations that is going to continue, then the idea of paying
3 or 4 per cent stamp duty, or even more, gets easily swallowed.
Theoretically, that is one thing that could be done. Surely something
could be done on supply and finance with regard to lenders. There
could in principle be regulations about lending behaviour. There
could even be something with regard to the capital requirements
of lenders against housing assets. There are a number of things
which I guess theoretically could be done, but none of them, frankly,
is very easy or appealing.
49. Do you mean politically?
(Mr Bootle) Not just that, I think in other respects
too. We used to have a housing market which was very highly regulated
and extremely inefficient. I think most people would agree that
terrific improvements have been made, because the thing has become
more deregulated and freer and more competitive. At the same time,
of course, the problems with deregulated financial markets is
that they do have a history of generating considerable instability.
It is really trying to get the appropriate balance between those
(Mr Walton) I think the notion of introducing regulation
is going to be very difficultin the sense that you could
say, okay, all of these building societies on the high street
cannot lend more than X times income, but people would just go
on the internet and borrow from some special vehicle set up. The
notion of being able to regulate in practical terms is really
quite hard. The only point I keep making is that the manufacturing
sector has been under-heating for the last several years, and
people have asked the MPC to not raise interest rates on occasion
in order to protect manufacturing; and the MPC's response has
always been, "Well, we have to look at everything. We can't
just focus on one sector of the economy". The housing market,
frankly, is not that much different from this. It is one bit of
the economy; it is an important bit. Certainly if we get into
a situation where house prices fall then that is going to be quite
damaging for consumer spending. It is going to be part of the
pay-back of consumer spending, having grown at such a rapid rate
for the last several years. At the end of the day, when the MPC
has one target and one instrument, to expect them to be able to
deal with all these different bits of the economy, which at any
point in time merit special attention, is asking too much.
50. The MPC said in its minutes of May that
continuing strength of consumption growth in this quarter would
be "not unwelcome", but added that "the immediate
issue, of whether UK consumption growth would ease as world demand
recovered, or would need to be restrained by policy action, remained
much as before". Given these sorts of messages, if retail
sales are strong in the coming months, would you expect that to
cause a rise in the interest rate?
(Mr Walton) The answer is, yes, providing the bits
of the economy which have been very depressed over the past year
actually recover; and that, in turn, is going to be related to
the strength of the global recovery. I personally think there
is no question that if you get these other bits recovering, given
this aim of trying to keep the economy overall growing at close
to trend rates, then that must necessarily mean the consumer growth
has to slow; and it either slows of its own accord or it slows
because policy is tightened to bring growth down.
51. What are the mechanisms by which you could
slow it down?
(Mr Walton) One obvious one is, people may just see
that the housing market is over-extended and the housing market
could start to slow.
52. What about retail growth?
(Mr Walton) With a lot of what has been going on in
the housing marketbecause the supply of credit has been
very free and cheap, there has been a lot of it and it has been
very competitiveyou have had people who have basically
borrowed against the increased value of their houses and used
that to finance consumer spending. One mechanism which could happenalthough
I do not think it will happen myself without higher interest ratesis
people could just decide, "Well, actually, these housing
markets look a bit top-heavy; we've borrowed perhaps more than
we should have done; we should actually begin to pay back some
of that". That, in turn, would take away some of the financing
for consumer spending. That would be one of the self-regulatory
mechanisms. My big question is: will that happen of its own accord,
or do people need a signal that they should be doing this? The
signal would come from higher interest rates
53. What is your opinion?
(Mr Walton) I think also that interest rates will
need to rise in order to send that message to people; that finance
will not remain as cheap as it has done for the last few months.
(Mr Bootle) I largely agree with that, but there is
one other possibility which is in the labour market. The labour
market has been pretty tight now for some while; on some measures
unemployment has started to rise a bit and in others really has
not. It is possible if the economy remains weak over the next
couple of quarters, I think, unemployment will rise, and that
will of course tend to moderate retail sales. Frankly, I cannot
be very confident about that happening, not least because of the
uncertainty about the figures. The sort of thing that would lead
you to think it is a real possibility is the idea that the economy
has been at a standstill for six months. If that is correct, and
if growth remains pretty weak over the next couple of quarters,
then I would expect there to be definite consequences in the jobs
market which will then lead to moderating retail sales.
54. Could I move to the exchange rate. Again,
in the MPC minutes in May it said: ". . . it was notable
that the euro had strengthened against the dollar at a time when
the US economy appeared to be growing more strongly and against
a background of political uncertainties in the euro area. This
suggested a possible change in market sentiment". Do you
believe there is a change in market sentiment which is causing
the euro to strengthen against the dollar?
(Mr Walton) The euro is now quite some way off its
low point, about 8 per cent or so above its low point against
the US dollar. On a trade weighted basis it is up about 5 per
cent from its low point. I think all the things you mentioned
were true, but the other thing that has also happened is that
this US recovery is a very import intensive recovery. We are seeing
quite a bit of deterioration in the US balance of payments, from
what is already a very large deficit. I think that is starting
finally to have an impact on the dollar. I think the other thing
is that investor confidence has been shaken in the US. As a result
of things which are quite well known, there is a questioning of
whether or not the kinds of returns that people have had on US
investments are really as true as the stated profits numbers suggested.
It is reflected in the US equity market. That was a magnet for
capital to flow to the US during the second half of the 1990s.
I think it is much less of a magnet now. I think the two things
have helped to turn things around. On most measures the euro did
look to be considerably undervalued versus the dollar, and it
still does. The kind of correction we have seen is not actually
that great really in the context of where the euro started from
at the beginning of monetary union.
55. You think that the fall in equity prices
in the States is an indicator of diminishing confidence in the
(Mr Walton) I think certainly you had a period, particularly
during the technology boom and the whole new economy era, where
there was a desire by investors to invest in the United States
because of lot of these things that were going on in the US economy.
Those things will probably come back but, at the same time, I
think there has also been a questioning about accounting practices,
and whether the return on capital they were thinking they were
getting is really true. To the extent that that questioning is
going on, that is just raising questions in investors' minds about
whether or not the US is such an attractive place to invest in.
At a time when you need an increasing amount of money each month
to finance the current account deficit that can have an implication.
56. What are the implications for sterling,
do you believe?
(Mr Walton) My own view is, the pound has traded very
closely with the dollar for a number of years now, and if we are
genuinely seeing the euro mount a recovery against the dollar,
I think it will probably mount a recovery against sterling. What
we tend to see is the pound not moving that much against the dollar.
(Mr Bootle) I largely agree with what has been said,
although I would stress it is very difficult, I think, to have
firm views about exchange rate prospects and the euro has had
a number of bouts of apparent recovery over the last couple of
years, only to slip back again. It would not be beyond the realms
of possibility to see the same thing happening again. Having said
that, I would agree with David's remarks. I think there is evidence
of a change of tone and attitude. In particular, what seems to
have sunk in is the difficulties posed by the US current account.
If you think that investment in the States is going to be pretty
attractive then you have probably got to believe that the US economy
has got to be reasonably strong and the recovery in corporate
earnings has got to be reasonably strong. If that happens, if
the economy is strong then the current account deficit is going
to be even wider and the amount of capital that needs to be sucked
in is going to be greater. If the US recovery, by contrast, is
going to be weak, okay, the current account deficit is not going
to be under the same pressure but it will still be at a high level,
although not increasing very much. What are the prospects for
investment returns? Not very good, is the answer. All along I
think there has been a sense in which the weakness of the euro
had something about it of a stock adjustment process. I have written
a note for this Committee some while ago on this subject. That
is to say, when the euro was formed there were lots of bullish
views bandied about, about how investors would pile into the euro
in substitution for the dollarparticularly in relation
to Far Eastern central banks. Very few people paid attention to
what was going to happen in the euro capital markets. By contrast,
what has actually happened, is that those Asian central banks
have been slow to adopt the euro as an alternative to the dollar.
Meanwhile, because of the deepening of euro capital markets, there
has been a great surge of borrowing in euros to invest in other
currencies. There has been a stock adjustment process going on
against the euro in world capital markets; at some point or other
that is going to run its course and may now have run its course,
in which case the fundamentals, which David addressed earlier
on, are likely to come into play and the euro is likely to strengthen
further. One quick comment on the exchanges, it seems to me that
what happens to the pound you can depict in terms of where it
falls within two extremes: in one extreme it sticks to the dollar,
in which case it falls quite sharply against the euro; in the
other it sticks to the euro, in which case it rises quite a lot
against the dollar. To some extent where it is positioned on the
spectrum will be influenced, I think, by perceptions about the
question of euro entry and euro referenda etc. In many ways, the
most favourable outcome for this country, which I think is actually
a serious possibility, is that it behaves somewhere in betweensuch
that it rises somewhat against the dollar and falls quite a lot
against the euro. If that were to happen it would actually serve
to alleviate many of the difficulties and imbalances that the
MPC has had to grapple with over the last couple of years.
57. If there were a fall in sterling, is the
MPC capable of addressing that sudden impact of a very rapid rise
in prices and fall in the value of sterling?
(Professor Miles) I think it would be not unwelcome
for the reasons that Roger has just said. It would allow us to
re-balance. It would mean that interest rates could be increased,
which would be helpful in terms of cooling the housing market,
whilst growth was being re-balanced towards more demand for UK
exports as sterling became cheaper. It would be particularly helpful
to the manufacturing sector, which is still fairly weak. I think
it would be rather a welcome event if sterling were to fall quite
58. How significant is "significantly"?
(Professor Miles) What have we seen8 per cent
so far this year? Estimates of where the long-run equilibrium
level of sterling against the euro might be suggest that sterling
may still be over-valued by as much as 15-20 per cent or so. So
"significantly" might be seen in the context of those
kinds of numbers. Not 3 or 4 per cent, but double figures perhaps.
59. Do you believe, following Roger Bootle's
comments, that if we do in the next 12 months, as is likely, move
into a phase of campaigning openly about the euro, then that would
further push sterling down in relation to the euro?
(Professor Miles) That is certainly possible, Yes.