Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 60 - 69)



  60. It is possible but not likely?
  (Professor Miles) The reason I am hedging is because I think we have no good stories as to what has happened to the sterling exchange rate for at least the last three or four years, and possibly no good story for a much longer period. To sound more confident than, well, "that is a possibility", just overstates one's knowledge.

Dr Palmer

  61. If I could just pick up the point made by David Walton earlier, that traditionally the pound has moved in correlation with the dollar, there is a very interesting chart 1.20 on page 10 of the Inflation Report which appears to show that over the last nine months there has been a significant change in market expectations; and that the market now appears to expect the pound to move much more strongly correlated to the euro than correlated to the dollar. If that is correct that would certainly be a significant factor in euro debates. Do you think that is correct?
  (Mr Walton) With all due respect, when you have only got 18 months' worth of data on a chart you have to be a little bit suspicious of the chart. I do not think this chart proves one thing or another. It certainly does show, as you say, in the most recent period a slight change in correlation. I would very much like to see this chart going back a few more years.

  62. Are you saying this particular chart is misleading, and you do not think this reflects a change?
  (Mr Walton) It is not necessarily misleading, but I think it is a bit much to draw any strong conclusion on what is a relatively short period of time. There is no reason over time why the pound has to be correlated one with the other. If Britain joins the single currency clearly at some point the correlation between the pound and the euro will go to one; and the correlation with the dollar is going to drop quite a bit. Indeed, during the ERM period these correlations change quite a bit. Ultimately a lot depends on the relative economic conditions in the UK versus the US versus Europe. It is very difficult, looking at any chart, to really infer too much about the future.

  63. Might this not reflect a hedging of market bets in view of the increased possibility that we would be joining the euro if those people are edging towards one market?
  (Mr Walton) I think it would be interesting to extend this chart to cover the most recent period, bearing in mind that the pound was quite stable versus the euro until a few weeks ago when the euro suddenly started to recover. I suspect that the correlation of the pound with the euro has actually fallen back quite a bit in recent weeks.

Mr Laws

  64. Could I ask the witnesses about a comment that Sheila Dow made to us. I am sorry to go back to housing again, but she said in her note that much of the price increase is due to speculative activity in the market. Could I ask all of you: can you think of any ways in which the Bank and other economists could assess at the present time how much of the price increase and how much of the activity in the market is speculative rather than simply because we have got very low interest rates?
  (Mr Bootle) It is very difficult to pin down the term "speculation". One is tempted to say one could do it by looking at things like the degree of overseas investor interest in UK property, the extent of the buy-to-let market and so on. Frankly, I do not think that does really get to the nub of the question of speculation. After all, the UK owner-occupier who increases the size of his mortgage and trades up can be just as "guilty" of speculation as the overseas investor. Speculative activity can drive the ordinary parts of the market. Indeed, I think it is characteristic of the housing market that this does happen. It is precisely what occurred at the end of the 1980s boom, where people brought forward their purchases; they moved up; and people who would not normally be in the housing market pre-empted their potential future need for housing by jumping in because they were anticipating future gains, or they were fearful of being shut out of the market if it carried on rising at the same pace.

  65. Some of that could be an enduring factor as a consequence of people anticipating these low interest rates would endure. Many of you would probably think they are going to. One needs to distinguish between that and more obvious speculation.
  (Mr Bootle) I do not know how you begin to do that. You could always conduct various surveys but I do not think they would get you very far.

  66. Sheila, are you a bit unhappy with the definitiveness of your statement?
  (Professor Dow) No, I intended to use the word "speculation" in the broader sense of the word—I just used it. There is clearly a core speculative market in the buy-to-rent market, but there is speculation much more generally. Unfortunately, the evidence is somewhat patchy but there are various pieces of evidence of households being over-extended. This is why I suggest it would be useful to have a disaggregated set of data on debt/earnings ratios. Because of anticipation of capital gains households are over-extending themselves and leaving themselves very vulnerable.
  (Mr Walton) I think "speculation" is a difficult word actually. I would not characterise what Roger said as speculation. If somebody thinks they need to get into the housing market now because if they do not the prices are going to be running away from them, which is my experience of the late 1980s, that is not speculation—that is just fear that they are not going to be able to own their own house in a property owning democracy. Clearly there are some elements of speculation at the margins and it gets exacerbated by David's point earlier, which is that the supply is largely fixed; and if you suddenly get people being more active when the supply is fixed then that tends to push prices up.

  67. Impossible to measure that speculation?
  (Mr Walton) Absolutely.

Mr Cousins

  68. In the very interesting discussions we have had this morning it has been quite clear that you all see great uncertainties about the growth, great uncertainties about house prices, indeed some rather confusing signals from the MPC about how those issues should be addressed. Do you actually think that the risk of a major period of economic instability, and a real test of the margins of the strength of the financial sector, is greater now than it was a year ago?
  (Mr Walton) I always think there are uncertainties.

  69. There are always uncertainties, but are those uncertainties greater now than they were a year ago?
  (Mr Walton) If you go back to when we had the Asian crisis and LTCM, that also posed some risk and uncertainties to the financial system—perhaps more globally than the specifics of the UK housing market now. Banks generally are very well capitalised in the UK. The notion that there is much danger of systemic risk to the UK financial system I think is pushing it a bit at the moment. I guess the risks are a bit higher now than they were a year ago, just because house prices are that much higher and look overextended. There is some risk you would get an increase in bad debts. I personally would not think there is much danger to the real health of the financial system presently.
  (Professor Miles) I do not think it is so much a danger to the financial system, if one means financial institutions. I think it is more of a risk to parts of the household sector, where you come back to the whole discussion about the implications of a rise in interest rates with so much more household debt than there was even a year or so ago. I think the danger is more for distress within parts of the household sector, rather than distress amongst financial institutions.
  (Mr Bootle) I think I largely agree with that, although I probably am more inclined to answer, yes, to your question about is the outlook more uncertain than it was. Putting aside considerations of September 11th and so on, from a purely UK point of view, I think what makes it rather more uncertain is that we may be at the beginning of the process of the unwinding of the imbalances of the last couple of years. For some while now there have been some fixed points in uncertainty, namely, we have had a strong pound, and we have had a very strong consumer sector. Much of what we have been talking about this morning is about those two things perhaps changing at the same time for not totally unrelated reasons. Certainly if we get a much weaker exchange rate then I guess the MPC will feel inclined towards a higher interest rate. Indeed, a weaker exchange rate will itself bring processes to bear on the consumer, because it will tend to increase the price of goods in the shops. We have then got tax increases coming from the Chancellor and higher interest rates as well, and house prices are not performing as they have done. You can see circumstances in which the consumer is under pressure on several fronts in a way we have not seen for a long time. I do not think it is surprising or inconceivable to imagine a scenario in which we have a period when consumers in general go through a very rough time. Given large parts of the economy have been doing pretty well on the back of strong consumer spending, I do not think it will be surprising to find some parts of the economy, not just banks or lenders but also retailers, having a very difficult time. My experience, talking to companies over the last year or so is that, by and large, people at the retail end have not appreciated (just as they did not at the end of the 1980s) the extent to which they have been through a fantasticly favourable macroeconomic period. They think it is all to do with the brilliance of their product or their sales marketing process or whatever it might be. They do not realise that they have had it really very, very comfortably indeed because of macroeconomic circumstances.
  (Professor Dow) I would add, there are elements of systemic risk at the moment which were not present earlier on, and we are talking about currencies and the relative absence of safe havens for savings. There is a lot of uncertainty globally which affects UK markets. Within the UK economy, if you look at regional economies, there has been a very different experience in different parts of the economy. There was an interdependence between earnings experience, employment experience, house prices, expenditure and monetary policy which is geared to another type of experience which can hit that kind of situation rather badly. The Bank of England has been quite sensitive to that in the past, but this is a particularly difficult time, in that we do not know the future of house price inflation at the moment. It may be that the Bank will feel it has to act on interest rates in a way which will have a systemic effect on particular pockets of the UK economy.
  (Mr Walton) There is one very big difference with the late 1980s which is that the UK economy was very substantially overheating. The risk that interest rates have to double, which they did essentially between May 1988 and late 1988, the risk of that is so much less these days, so much that you are unlikely to put in place these very severe adjustments in the housing market.

  Chairman: On that reassuring note, thank you very much for your appearance this morning. We will be better informed on Thursday when the Governor and his colleagues come; and no doubt the Governor and his colleagues will be better informed through his emissaries who are here this morning reporting back! Thank you very much.

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