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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 453-i House of COMMONS MINUTES OF EVIDENCE TAKEN BEFORE TREASURY COMMITTEE
THE FEBRUARY 2008 INFLATION REPORT
Wednesday 26 March 2008 MR MERVYN KING, MS RACHEL LOMAX, PROFESSOR CHARLES BEAN, DR ANDREW SENTANCE and PROFESSOR DAVID BLANCHFLOWER Evidence heard in Public Questions 1 - 70
USE OF THE TRANSCRIPT
Oral Evidence Taken before the Treasury Committee on Wednesday 26 March 2008 Members present John McFall, in the Chair Nick Ainger Mr Graham Brady Mr Colin Breed Jim Cousins Mr Philip Dunne Mr Michael Fallon Ms Sally Keeble Mr Andrew Love John Thurso Mr Mark Todd Peter Viggers ________________ Witnesses: Mr Mervyn King, Governor of the Bank of England, Ms Rachel Lomax, Deputy Governor of the Bank of England (Monetary analysis), Professor Charles Bean, Chief Economist, Bank of England, Dr Andrew Sentance, external member of the MPC and Professor David Blanchflower, external member of the MPC, gave evidence. Q1 Chairman: Governor, good morning to you and your colleagues and welcome to this session on the Inflation Report. Can you introduce your colleagues for the shorthand writer, please? I believe you have an opening statement. Mr King: Indeed, Chairman. On my left is Rachel Lomax, Deputy Governor for Monetary Policy, on her left is Mr Andrew Sentance, one of the external members of the Monetary Policy Committee, on my right is Professor Charles Bean, the Executive Director for Monetary Policy, and on his right Professor David Danny Blanchflower, another of our external members. If I may, Chairman, I would like to make a short opening statement. The past week has seen significant volatility in financial markets, a further sharp cut in interest rates in the United States and at home the news that inflation rose to 2.5% in February. I would like to explain our own interest rate decisions. We have cut bank rate twice to its present level of 5.25% since the Monetary Policy Committee last appeared before you in November. Following increases in gas and electricity bills, consumer price inflation has risen. The central projection in our February Inflation Report is for it to rise further to around 3%. That pronounced pick-up stems from sharp rises in commodity prices around the world - food prices on world markets are more than 50% higher and oil prices two-thirds higher than they were a year ago. The time lag between changes in interest rates and their impact on inflation means that the MPC can have little effect on the short-term path of inflation. What is crucial is that the pick-up proves to be the temporary, just as the rise in inflation last year was. Even if commodity prices remain at their present high levels in the face of a slowing world economy, our central projection is for inflation to fall back towards the 2% target, starting later this year. In judging where inflation is likely to settle, we have to gauge the balance of two risks. The first is that a sharp slow down in the economy this year, driven by the credit crunch, creates a margin of spare capacity that pulls inflation down below the target next year. The second is that rising inflation enters the expectations of those setting prices and pay and that, without some margin of spare capacity, inflation persists above the target. Our central projection in February was for economic activity to slow quite sharply this year as the world economy turned down and credit became less widely available, but we also judged that some slowing in the pace of activity from the rapid rates of last year would be necessary to make sure that inflation returned to the target next year. Surveys suggest that the economy has slowed but, so far, modestly. The world economy, particularly the United States, has weakened, but the recent fall in sterling should help to cushion the impact on exports, and the official data on retail sales show that spending has this year been surprisingly resilient. In contrast, both activity and prices in the housing and commercial property markets continue to weaken. That stems in part from the continued tightening of credit conditions, reflecting the turmoil in financial markets. The financial crisis has moved into a new and different phase. Across the world confidence in financial markets is fragile. It is not that banks, at least in the United Kingdom, have made loans that are likely to result in unsustainable losses. The heart of the problem is not in the real economy, it is in the financial sector itself. It stems from an overhang on banks' balance sheets of assets in which markets have closed. These assets cannot now be sold or used to secure funding in the market, they are difficult to finance and that has created uncertainty about the strength of banks' financial positions. These are the sort of circumstances I described in my statement to you in September as those in which central bank action is necessary to prevent a major shock to the system as a whole. I want to assure you that the Bank will provide the liquidity assistance that the system needs in order to restore confidence. Such lending can be only a temporary measure, but it can be a useful bridge to a longer-term solution, which is why the Bank expanded the range of eligible collateral to include mortgage bank securities in its three-month lending operations in December, January and March. I can confirm that the January auction will be rolled over on 15 April with the size of the auction to be decided in the light of market conditions nearer the time. It is unrealistic to assume that markets for many asset-backed securities are likely to reopen speedily or, when they do, to their previous levels of activity, so we are discussing with the banks how a longer-term resolution of the problem might be reached. It is too soon to say where those discussions will lead, but two principles would underlie any central bank role. First, the risk of losses on their lending should remain with banks' shareholders. The banks neither need nor want the taxpayer to insure them against these losses. Second, a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets. One of the lessons of this financial crisis is that providers of mortgage finance had underestimated the risks and, hence, the true cost of the securitisation process. Chairman, I am grateful for the opportunity to make those remarks, and now I and the other members of the MPC here today stand ready to answer your questions. Q2 Chairman: Thank you very much, Governor. I am interested in your opening statement where you used the phrase "credit crunch". Previous witnesses to this committee, whether it be officials from Her Majesty's Treasury or the Chancellor, seem to have taken an oath not to use that phrase. When did you decide that this was a credit crunch? Mr King: We have set up, as you will have seen last year when we came to see you before Christmas, a special report that we publish regularly on credit conditions, and it has been clear that in the last couple of months there has been a further significant tightening of credit conditions both in respect of the margin which banks charge above bank rate for interest rates which they are willing to lend to the private sector and in terms of the quantity of credit which they are willing to make available as banks now look to slow down the rate of growth of their total lending in order to prevent the capital which they have proving inadequate relative to the total liabilities. Q3 Chairman: One of the newspapers today focuses on the continued hoarding by banks of liquidity. To what extent does such hoarding frustrate your attempts to provide extra liquidity to the market by your money market operations, and when the banks came to see you last Friday did you ask them the question why they were not lending to one another and make the comment that, if they did lend to one another, then a bit of the problem would go away, so may be the responsibility is not yours but theirs? Mr King: I do not want to say that people that decide at this stage not to lend to one another as an individual institution are behaving irrationally. I think collectively, clearly, it is not serving a common cause, but the problem we face is that people who supply funds to the banking system have become extremely cautious about the length of time for which they are willing to lend money (certainly on an unsecured basis) to another financial institution. This is not a question of the United Kingdom, this is right across the developed financial world in all the major financial centres now; there are very large spreads between policy rates and the rates at which banks say they may be willing to lend to each other but, more importantly, fragility and inability of banks to finance themselves really anything now above overnight periods, and that is a situation of great fragility and it is one that we need to try and consider how we can best address. Q4 Chairman: I put this question to you, Governor, because it has been mentioned in the press and elsewhere that the actions of the Fed in aggressively cutting interest rates in response to concerns about the growing weakness of the US economy perhaps has not been replicated by the Bank of England. Should the Bank of England adopt a similar approach to the Fed? Mr King: No, I think there are two quite different types of policies and two different sets of circumstances. The first is the state of the economy and the outlook for economic activity and inflation, and the second is the fragility of the banking system as we currently see it. The second, the fragility of the banking system, is about the supply of liquidity. That is a problem which is shared by all financial centres and all central banks, and all central banks are taking steps to deal with that problem. In terms of the level of the policy rate, of interest rates, that depends on the outlook for inflation and activity that varies quite markedly across different countries. Almost any dimension of the housing market that you look at is markedly worse in the United States than it is here. Even if you look at the latest data for the United Kingdom, you can see this very difficult balancing act that I have talked about before that we have to meet. On the one hand, there are signs that a tightening of credit conditions will depress the rate of the growth of spending - we see that very clearly in the housing and commercial property markets. On the other hand, in terms of activity, retail sales in January and February this year have been remarkably resilient. The latest growth rate in the official data, the post-war average rate, employment rising, unemployment falling: this is not an economy that has completely ground to a halt, but we are looking ahead and would expect some slowing that was spelt out in detail in our February Inflation Report. That is the activity side, and that will affect inflation further ahead. Complicating our problem is that in the short run we have already started to see (and we would expect this to continue) a pick up of inflation to a level who knows precisely where, but around 3%, well above our 2% target, and we think in our central view that that is likely to come back to the target over the next couple of years; but that can only be a central view and it is absolutely vital that the course of interest rate setting that we pursue does nothing to undermine people's belief that we are prepared to take whatever action is necessary to bring inflation back to the target, and I can assure you we will do that. Q5 Chairman: Professor Blanchflower, you have the luxury of spending half your life in America and half your life here. Given your bird's eye view of what is happening in the United States, do you agree with the Governor's statement about the different policy approaches between the US and UK to stabilise the economy? Professor Blanchflower: Yes. Thank you, Chairman. Certainly I agree with what the Governor has said. The situation in the US is markedly different. There are some similarities, but the data now coming out of the US is substantially worse, especially in the last couple of days. Notably, the rapid decline in house prices in the US, the Shiller index has had the largest drop that has ever happened, we are talking about a national drop of about 11% in house prices and in some major cities 18% or so, as in Los Angeles. So, that is the first thing. I think the labour market data in the US are much worse, consumer confidence reports are much worse, so I certainly see that situation has worsened and I think my view over the last week is that it has fundamentally worsened and confidence is really at very low levels. I would say there are some similarities. Particularly, perhaps, if you look at the US some months ago, there are some similarities with where we are here, and certainly things look much worse there, but I am concerned that some of the soft survey data, particularly consumer confidence data, some of the surveys about the labour market here show some similarities to what occurred in the US some months ago. So, yes, there are some similarities, but I agree with the Governor, we certainly have not seen hard data of the kind that we have seen in the US, and that is why, I guess, my votes have been for small changes, small cuts rather than the aggressive cuts that the Fed has done and, in my view, probably had to do. Q6 Mr Todd: Can I follow up the question to Professor Blanchflower. You have been on your own this year in your voting on two occasions and with one other member on another, so you pursue a solitary path on the committee. Could you explain your difference from your colleagues? Is it the American experience that you obviously have in much closer terms than the others? Professor Blanchflower: I would not call it a solitary path. Being an independent member, one tries to persuade one's colleagues, and certainly on a couple of occasions we have voted unanimously. I think my views have been well documented. I have obviously taken the view that the US was much more likely to go into recession. I said that on a number of occasions, I said that several months ago and that has been a concern to me, and I think my views have been about the degree of slack in the economy. There has not been a fundamental difference about how we operate policy, but in comparison to my colleagues, my view has been that the risk to the down side and to growth has been greater than they have felt. That has been my view and I have expressed it on a number of occasions. My views have been especially about what was going to happen to the labour market and whether wage growth was going to take off, and I have said it to this committee on many occasions over the last year. Q7 Mr Todd: You have been right, by and large, on that, have you not? You have tended to counsel that expectations of wage inflation have been exaggerated and that slack within the labour market would dampen inflation expectations. Is that your perception? Professor Blanchflower: My view of the labour market is that it has been rather complicated to work out what is going on in the labour market. It has been helpful to be a labour economist to look at it. What happened a year or so ago about employment has been complicated: the role of migration and its effect on wage bargains has been complicated. It has been tough to call, but I guess someone who is a wage curve person, who tries to understand how labour market slack affects wages, was a good position to come from and it did not seem to me (and probably turned out to be right) that wages were going to take off, but it is a call that I made. Q8 Mr Todd: Ms Lomax, you have highlighted in your speech to the IEA that the fan charts of both GDP and CPI have broadened recently. Does that reflect, in your view, the increasing uncertainty of any predictions at the moment as to how this country's economy will perform? Ms Lomax: I have to apologise for my voice; it has completely disappeared. Yes, that is exactly right. We widened the fan chart in November precisely to reflect our uncertainty about the impact of the financial crisis: firstly, the duration of the financial crisis and, secondly, its likely impact on the economy. The other big uncertainty has been about the impact of another spike in inflation on inflation expectations. Q9 Mr Todd: This is parcel of energy prices and--- Ms Lomax: That is right. The point the Governor made in his earlier remarks about the way in which it might affect the way that people perceive the credibility of the MPC. Q10 Mr Todd: We saw what happened with the last spike on energy prices, which had a rather lesser effect than people had expected, but that does not necessarily indicate what will happen in the future. Ms Lomax: I think inflation expectations did move up, but not dramatically. What I think is a little disturbing is that they did not fall back in the way that one might have hoped when inflation itself fell back. There is also the question of how many times can this happen before people begin to take a different view? I think it is beginning to get into the popular political debate now, the concerns about inflation, in a way that we have to take notice of. Q11 Mr Todd: Dr Sentance, you are appropriately placed at the other end of the table to David Blanchflower! Dr Sentance: Do not read too much into that. Q12 Mr Todd: In terms of your voting patterns, and we will explore that, no doubt, later on this morning. You have pronounced that just at the moment the monthly frequency of the MPC has been extremely valuable in being able to respond to crises. You will obviously have noted the rather different and more emergency behaviour pattern in the USA. Do you actually incline towards the view that the MPC should meet more frequently than once a month, because you will be aware that many people actually suggested once a month as being too high a frequency in the past? Dr Sentance: Yes, I think my comments should be seen in that context. I joined the committee after there had been a period of quite a degree of stability in interest rates, and I think that led to the view: is the committee meeting too often? Should it have more flexibility? Over the period I have been on the committee, over the last 18 months, we have seen an awful lot of change in the economy and we have needed to respond to that change. I went bank and I looked over 18 meetings I have attended. We have changed interest rates on six of them, but there has been at least one vote for a change in interest rates in all but four of the meetings I have attended, so I think the monthly frequency that we have fits in with the monthly data cycle. I would rather we were meeting more often and then sitting there and saying the economy is more stable than we expected, rather than being in the position of often having to have emergency meetings, and I think the monthly meeting strikes the right balance, in my view. Q13 Mr Fallon: Governor, can I come back to the Chairman's question of the difference between the approach of the authorities here compared to the approach of the authorities in the States where Bear Stearns were sorted out within 48 hours. The Federal Reserve has been cutting rates aggressively and providing much more liquidity at a wider range of collateral. What is it about the United Kingdom position that makes your reaction so different? You said here that the crisis is now in a new phase. What is it that you are not prepared to do that the banks want you to do? Mr King: I do not think there is anything. We have had very useful discussions on that, but I think it is very important to distinguish between interest rates and the provision of liquidity. These two things are not the same, and it is absolutely vital to distinguish clearly between them. You will lose control of inflation if you are not careful to distinguish between them. In terms of interest rates, we have cut interest rates twice, the Federal Reserve have done it more often and by larger amounts, the European Central Bank has not cut at all. Those decisions reflect differences in the economies of those three areas. I think the broad approach to monetary policy is very similar in all three, so I do not think in terms of interest rates there is a real difference. Central banks are looking at the outlook for inflation in all three cases. In terms of the provision of liquidity, our system is much closer to that of the European Central Bank and in terms of the comparison between the ECB and ourselves the response has been virtually identical. The total lending by the Bank of England to the banking sector now constitutes about 1% of the assets of the banking sector. That is exactly the same level of support provided by the European Central Bank. In terms of the proportion of the total liquidity that is extended by central banks to the banking sector, that is provided at three months or longer, longer-term horizons, to the full-term funding. The proportion provided in that way by the ECB is between 50% and 60% of its total lending. The proportion at three months and longer provided by the Bank of England is also between 50% and 60%. I do not think there is any significant difference at all. One of the reasons why this myth has grown up is because back in August and September a great deal of publicity was given to the very large injections made, particularly by the ECB, without anyone taking on board the fact that whatever money they put in with the one hand they have to take back with the other in order to maintain the total amount of money injected into the system to retain control of interest rates against inflation. The ECB have been very open about that - you explain that very clearly in your report - so I do not think there is any significant difference between the approach of the different central banks. The Federal Reserve in the last couple of weeks has taken particular action to deal with the failure of one of its major investment banks, and that was a series of measures which in many ways are not that dissimilar to the steps that were taken to deal with Northern Rock back in the autumn. Q14 Mr Fallon: But it is not working, is it? The inter-bank rate now is near 6%. Banks are not lending to each other. Mr King: It is not working in any financial centre, in the sense that there is still a sense of fragility, and that is why central banks need to be willing to provide the liquidity that is necessary - we are in that position too - and to monitor it, and, as I said, we are talking with the banks about possible longer-term solutions. Q15 John Thurso: Governor, in the November 2007 press conference on the Inflation Report you said you welcomed the cooling of the housing market. Does that remain your view? Mr King: I certainly would welcome a period of stability in house prices, yes. Q16 John Thurso: How long and how sharp do you believe the current slow down in the housing market is likely to be? Mr King: I think it is almost impossible to make any quantitative forecast of what will happen, but, as I said in the recent Inflation Report press conference, I would be surprised if in a few years' time house prices were markedly above where they are now. I would expect, without being able to forecast the short-term path that they might follow, that we will be seeing broadly stable house prices over the next few years. If that were to happen, then you would, of course, see quite a significant adjustment of the ratio of house prices to average earnings, for example. That ratio could come back to something much closer to what economists might think of as a normal ratio, with broadly stable house prices and the sort of rate of increase in average earnings that we have seen in the last few years. Q17 John Thurso: To what extent do you think over exuberance in the lending market has been a factor in the overheating of house prices and what lessons could be usefully learned for the future from that? Mr King: I think, undoubtedly, it was. As I said in my opening statement, I think that financial markets in general, house lenders in particular, underestimated some of the real economic costs associated with the securitisation process, and although that process does have real benefits, by ignoring the costs that came and looking only at the benefits, I think a good deal of mortgage lending at the time was under-priced and, I think, if you look at the quite remarkable expansion of the issuance of mortgage-backed securities in 2006, to some extent 2005, but it is not before that, it is 2005, particularly 2006 and the first half of 2007, the very substantial increase in the rate of issuance of these securities which have turned out, in economic terms, to be much more costly than people thought at the time. Q18 John Thurso: You, rightly, made the distinction between what you call "the real economy" and "the financial sector", but house prices and that lending market are where the two collide, as it were. Mr King: Yes; exactly. Q19 John Thurso: Do you think that we should simply hope that the market has learnt its lesson and will behave better next time round or is this of sufficient severity and seriousness that we should be looking at something more than that? Mr King: I think you can probably rely on the fact that the pain that will be suffered by financial institutions this year will be enough to keep people's minds focused on it for a number of years. There will come a time, I am afraid, when the people actively involved will have forgotten what it was like, or will not have been working when these problems were experienced, and we will go through the same again. There are very many lessons to be learned from this episode, and I think the conclusions that will come out of this inevitably tend, in my view, in the direction of saying financial institutions will have to hold more capital in the longer run and that these activities will need to be monitored much more carefully. Martin Wolf's piece this morning in the Financial Times strikes a chord, and I think it is important that people reflect on that. There was a lot of hubris around in thinking that the expansion of financial services was a good in itself. It is not; it is a means to an end and there are a lot of lessons to be learned in what has happened in the financial sector, not just in the United Kingdom, but very much in the leading financial centres of the world. This financial crisis did not come from bad lending to, or by, Latin America, or an Asian crisis, or emerging markets in general, it arose out of the heart of the financial systems in the main financial centres. Q20 Peter Viggers: Looking at sterling, you have examined the factors which underlie the fall in sterling since November in your Inflation Report. Would you talk us through the key factors which have affected the price of sterling? How many of these do you welcome and how many are a cause of concern to you? Mr King: It is very difficult, even after the exchange rate has moved, to know precisely why it has moved. I think the first thing that is worth saying is that, although it has fallen quite significantly, it has moved around a lot quite, it is quite volatile, almost 10% it has fallen since this time last year. It is actually nowhere near as low as that relative to where it was two or three years ago. So, 2006 saw a rise in sterling which has unwound, sterling has gone a bit further than that, but, nevertheless, much of what has happened has been an unwinding of an appreciation which in 2006 we found very hard to understand. I think, inevitably, with the publication of larger trade deficits towards the end of last year, as the numbers came out it became more obvious that the factors that we had been talking about for some time, namely the need for a rebalancing, for a switch of demand away from consumer spending and towards exports and business investment, was going to be part of a readjustment, and I think that people in the second half of last year could see that the movements in financial markets were suggesting that, along with the problems in the banking sector, we were beginning to see some of the unwinding of the large international imbalances that we had seen build up over many years, and although there was an appreciation that these were not sustainable, no-one quite knew when the unwinding would begin. We are seeing a bigger appreciation of the Renminbi by China against the US dollar - they have allowed that appreciation to occur to a larger extent than I think many had expected - we are beginning to see the unwinding of the imbalances and I think people came to the view that, if that process was underway, it would not be surprising that the real adjustment in the British economy would need to be accompanied by some changes in relative prices, one of which would be a fall in the real exchange rate of sterling. I think that is the bigger picture analysis, but, clearly, we are not indifferent to the exchange rate. Q21 Peter Viggers: Some commentators have pointed out that we have stronger links with the United States than many of our European partners, that we are more closely linked with the housing market, housing is a more important element in our economy than in others, and, of course, we are more reliant on financial markets than many of our European partners. Does this make us more vulnerable than our European partners? Mr King: I think the housing market point has some validity, but I think it is easy to exaggerate that. The housing market is important, but I think its impact on spending in the economy as a whole is much more through its effects on confidence, expectations of what might happen to job prospects and incomes than it is directly through a change in prices. I do not think that the direct impact on the size of the financial sector is likely to be sufficiently substantial, apart from certain parts of central London, to be that significant. It is really the effect overall of the slowing of the world economy at a time when we need to adjust away from domestic demand to external demand. It is a difficult period for us to try and make that adjustment. Q22 Peter Viggers: How concerned are you about the widening current account deficit? Mr King: We have been concerned for some time. It indicates that a rebalancing is required. The data have been revised, which suggests that the current account deficit is worse than we had previously thought and there will be need to be an adjustment, but I think our central projection in the February report is quite consistent with that adjustment. In the retail sales figures we have not seen much slowing of consumer demand, but we would expect to see it through the course of this year as real income growth is held back by what is happening both on energy and food prices but also through the tightening of credit conditions. Q23 Peter Viggers: Could I ask each of you, as members of the Monetary Policy Committee, how many of you anticipate further declines in the value of sterling, and is this a matter of concern to you, perhaps causing inflationary pressures? Professor Bean: Perhaps I could start. Q24 Peter Viggers: The Chairman will insist that you are very brief indeed. Professor Bean: Yes. I would certainly say the risks are balanced to the down side, and that is something which is also priced into markets. There is a chart in the Inflation Report of so-called risk reversals, the price you have to pay for insurance against the appreciation of sterling or the depreciation of sterling in the financial markets, and the financial markets certainly are pointing, if anything, to the risks being to the down side. Given the size of the current account deficit, I would share the view that, if anything, the risks are tilted to the down side and in fact, of course, our projection is conditional on the assumption that sterling continues to depreciate at a moderate pace over the forecast period. Dr Sentance: I would agree with that assessment. In my business life I used to say my exchange rate forecast was always right but the timing was sometimes a bit awry. I think, over a period of time, for the reasons that the Governor has set out, you would expect to see some further decline in sterling. Predicting exactly what will happen over the next six to nine months, or 12 months, or couple of years is very difficult, but as Charlie said, the pressures seem to be in that direction. Ms Lomax: I would be very wary of forecasting the exchange rate in anything. I think it is well documented as the most difficult, if not impossible, thing to forecast. Professor Blanchflower: It is hard to forecast. I agree with Charlie. Q25 Ms Keeble: I wanted to ask a bit more about domestic demand. What weight do you attach to the different components of aggregate demand in explaining the slow down in demand in the UK? Mr King: Let us hear from some of others. Charlie, why do you not start and then maybe Andrew or David? Professor Bean: The first thing to be said is that consumption is the biggest single component of domestic demand, so what counts for consumption is particularly important. So far, as the Governor has said, consumer spending has stayed remarkably resilient. Although it apparently slowed in the fourth quarter, that was after a particularly strong growth in the third quarter. If you average the two together, the quarterly growth rate is a little bit above half a percentage point, so 2% of the annual rate, and retail sales growth has been relatively strong in January and February. Some of the other consumer spending indicators suggest a bit more softness, but no sign of that having decelerated sharply yet, but we would expect consumer spending to slow as we go through this year, essentially because real income growth is going to remain muted as energy price increases, food price increases, eat away at real purchasing power. On top of that, of course, there will be the impact from the reduced availability of credit also bearing down on consumer spending. Investment spending is a smaller fraction of overall demand, but it does tend to be more volatile. Quite often when you get sharp slow downs it is associated particularly with a turn round in investment - that, of course, was the case in the United States where the slowing in GDP growth last year was predominantly driven by a sharp decline in residential investment. Consumer spending stayed robust through most of last year, but there was a very sharp fall off there. We expect investment to ease, particularly in property, both residential and commercial, but to go back to an earlier question, whether we were a few months behind the US, I think it is worth noting that investment in property in this country tends to be much less volatile than the US. That is a by-product of the planning system. Maybe, if you like, it is the silver lining which will probably help to limit any sharp downturn, but we do expect, as we go through this year, to see those components relating to investment particularly easing and also probably some easing of business investment as well. Q26 Ms Keeble: There are two points I want to follow up and one is specifically for the Governor. When we have talked previously about public response to some of the macro factors, you have been quite dismissive of them, in particular around impact on the housing market. All the commentators now will say that one of the factors in slowing down is public confidence, which is very nebulous. What regard have you had to public confidence in the economy and in financial stability? Have you given any consideration to the impact that that will have on overall economic performance? Mr King: Yes, and we look very closely at measures of confidence, but I think it is important to distinguish between what I described in my opening statement as confidence in the financial system from people's confidence in the economy and their own prospects for jobs and incomes. These are two very different phenomena. They may interact but they are reflecting different outcomes. So, we do look closely at confidence, and if you look at our projections for consumer spending which are embodied in our forecast for growth in the February Inflation Report, we have a pretty sharp slowing of consumer spending built into our central projection which very much reflects the fact that there is not only a squeeze on household real disposable incomes, which has already started and is likely to continue for another year, but also reflects the impact on confidence that that experience generates. Q27 Ms Keeble: Given John Thurso's point about public confidence in the financial systems colliding with the housing market, would you accept that what made Northern Rock turn from a problem into an unmanageable crisis, with knock-on consequences for public confidence in the system and the economy, was the queues forming outside Northern Rock, which nobody factored into the equation? I wonder now how much you factor the confidence factors into the on-going performance--- Mr King: There is certainly no doubt that it was the queues on the street that made the story about Northern Rock a very prominent one. How far that impacted on consumer spending is very hard to judge. As Charlie said, if you actually look at the data, quite remarkably the figures on consumer spending on retail sales in January and February were surprisingly resilient, much stronger than we have embodied into our February central projection. That may well be very temporary, and we will have to look at all the data, but I think it is just worth looking at the numbers and seeing what is happening. Q28 Ms Keeble: One further question on the housing market. The Financial Times carried a story recently about the impact of the credit crunch on the availability of financing for new housing development, which is obviously a really big factor in house prices, not perhaps at the luxury end of the market but for most people that is a major factor. Have you looked at that and do you consider that to be a major threat to housing supply and, therefore, to house prices with knock-on consequences for a range of different factors? Mr King: Of course, if housing supply is restricted, then prices may rise more quickly, not fall, so those things go in opposite directions. Q29 Ms Keeble: Exactly. Have you given any assessment to that? Mr King: We certainly look very carefully at credit conditions, both to existing home owners or would-be first-time buyers, to see whether they can get access to credit in order to buy a house; and we also look at the access to credit of those involved in the construction of housing, yes. I would say that one thing that is a signal of slowing in the economy is that our survey of credit conditions shows a distinct tightening of credit conditions to all kinds of borrowers, and that shows up not just in the quantity of credit but also in the price. Broadly speaking, I think it is fair to say that the reductions in interest rates that we have made so far, the 50 basis point reduction, has offset the impact of the tightening of credit conditions on the cost of mortgages. Of course, there are many different mortgagees in different positions, and I do not want to deny that, but if you just average across all the mortgages, the average rate across all mortgages, the average interest rate paid on mortgages now is pretty much the same as it was last August. We have offset the tightening that would have taken place had we not acted by the 50 basis point reduction of bank rate that was made, broadly speaking. Q30 Jim Cousins: Professor Bean, we have now heard three times this morning the Governor saying that he does not think conditions in the housing market will affect consumer spending, and, of course, the Chancellor takes the same view and took the same view when he was in front of us, but your colleague, Professor Besley, appears to take a slightly different view and, in a very interesting presentation in the Bank's quarterly report, he drew the conclusion that, with credit conditions tightening, we might expect a significant reduction in consumption growth over the coming months. What is your view? Professor Bean: Can we separate two issues? The first is the impact of house prices on consumer spending, where I think you have slightly overstated our view by implying that it would have no impact on consumer spending. We would certainly expect it to have some impact, and that is potentially embodied in our projections, but where we have departed from some outside commentators is that those outside commentators have often taken the view that there is a very strong link between house price inflation and consumer spending, whereas we have tended to think that when you look at that correlation in the past they are both reflecting a common third factor, which is basically optimism about future income growth. Having said that, there probably is a structural link between house price and consumer spending which comes through the availability of collateral against which to borrow. So were house prices, say, to fall sharply, that would limit consumers' ability to borrow against that housing equity. We think there is some mechanism there. Tim Besley's speech that you referred to and the research that he has been pursuing has been trying to focus more clearly on the mechanisms that are involved there in the availability of credit from banks to households and, in particular, were there to be a relatively sharp cut back in the availability of credit, then his work and I think our view on the committee would be that that could translate into quite a strong impact on consumer spending. There are two separate elements here: the impact of house prices and the impact of a reduced availability of credit. Q31 Jim Cousins: Professor Besley goes further than that, it seems to me. He clearly expects credit conditions to tighten and, therefore, also expects a reduction in consumption growth. Are you of that view? Professor Bean: Yes, and we have a reduction in consumption growth in our central projection and also a downside risk that it may be a more steep slow down than in the central projection. We certainly recognise that as a possibility. Q32 Jim Cousins: The Governor in his opening statement made it clear that he took the view that banks, so far as lending in the mortgage market were concerned, should, so to speak, bury their own dead. However, their dead are likely to be thousands of ordinary people who have real difficulty in financing their home loans or taking out new home loans to sustain the housing that they are in. Do you think special measures will be required to assist, not the banks, but the people faced with the difficulties to get them through that, that more policy measures will be required to help people? Professor Bean: I think it is early days to move to that conclusion. My concern is the situations where things get very bad; so with very high default rates, if unemployed has risen a lot, you may want to introduce additional measures. Certainly the Governor's earlier remarks about the banks burying their dead, I think his view was that the banks' shareholders should bear the burden of past decision-makers in decision-making, not the customers. Q33 Jim Cousins: Professor Bean, we saw last autumn where all this talk about moral hazard gets you. Moral hazard is very fine, but when you are left with depositors who lose their savings, everyone runs away from the battlefield at that point: moral hazard is abandoned. Do not you think the same thing is true of the housing market? It is all very well to say the banks should bury their own dead and shareholders should bear the consequences, but at the end of it there will be thousands of ordinary people who cannot finance their existing home loans, and cannot finance new home loans, and cannot refinance the home loans that are coming to an end on the fixed rate deals, and cannot finance home loans to sustain the home they are in in terms of improvement and renewal. Do you not think special policy measures are required to assist that? I am asking Professor Bean. Professor Bean: It is a matter of balance between these two. Where we are at the moment is repossessions are still at very low levels, and I think that it is important to keep that in mind. House prices are flat, we are not in the position of a house price slump, unemployment is at relatively low levels, has not risen, the majority of households are not finding serious problems repaying their mortgages, so we are not in a position where any sort of special measures are required at this juncture. As we go forward in time the situation may well change. Policy-makers always have to balance off arguments. Moral hazard is an argument on one hand. The sort of arguments that you have been putting forward are arguments that go in the other direction and, as conditions change, so the balance of those arguments may shift, but where we are at the moment is not in a situation of an extreme slump in either the housing market or the economy in general and special measures are simply not called for at this juncture. Q34 Jim Cousins: Governor, you told the committee that you were operating on two fronts, which I well understand, that of policy interest rates and liquidity and the availability of credit in the financial markets, but at the moment you are losing the battle on both fronts, are you not, and people can smell it, and that is why confidence is going down in the economy? Mr King: I totally reject that. Let us take the two areas. We have a very difficult balancing act in order to set interest rates to meet the inflation target. That is the target that you in Parliament have voted for, your Government representing you have said that we should try to hit, and that is what we are going to do, Mr Cousins, and we are on track to do it. There is a difficult balancing act at present because there are big risks on either side and no-one can easily forecast the future. If the evidence moves in favour of one set of risks or another, we will respond - that is what we are doing - and I think most people's forecasts suggest that, far from panicking, people think there is plenty of scope for a difference of views about the right level of interest rates, that no-one is doubting that we are setting rates in order to meet our target. In terms of liquidity, as said to you before, there is concern and lack of confidence in all financial markets around the world, this is not a UK phenomenon, and all central banks are working together to deal with that. That fragility remains today, and we are continuing to work, working with the banks to deal with that problem. So, far from not having dealt with it, we are actively dealing with it day by day. Q35 Mr Love: Can I follow that up, Governor, by asking do you think, having accepted that there is fragility in world financial markets, that we have underestimated the impact of that on the real economy? Mr King: No, because I think at this stage, if the fragility continues and we cannot find a way of dealing with it, then the consequences would be more serious, but this fragility that has become serious in the last few weeks is quite different from where we were even in December. In December, when the central banks worked together and announced a series of joint measures to deal with the problem of liquidity, that action had a big impact and worked very clearly and brought down the spreads between inter-bank rates and the official policy rates quite markedly in all the major financial centres. In the last few weeks even the co-ordinated measures which the central banks took in March did not work, so there has been a much greater sense in the last few weeks of this lack of confidence, the fragility, and that is a matter for concern and it is a matter we are trying to deal with. What is so remarkable, I think, is the contrast between an objective view of what is happening now in the real economy and the concern in the financial sector. Of course there are links, but what is so marked is the difference in sentiment that you see between people running businesses and the outlook for their businesses at present and what is happening in the financial sector. Clearly, if we cannot deal with the problems in the financial sector, that might well have an effect that would jeopardise the future of those businesses, but it is our job to try to deal with that. At present what so is marked is the difference between the real economy and what is happening in the financial sector. Q36 Mr Love: One of the curious phenomena from past experience is that while you have put interest rates down twice, actually market rates are going up. What influence do interest rates today have when market sentiment out there is acting in reverse? Mr King: It certainly has an effect, and, as I explained just now, the cut in interest rates of 50 basis points that we have made offset the widening in spreads charged by banks between the rates at which they can borrow and at which they lend. To some extent that is unwinding the compression in those same margins that occurred in 2006 and in the first half of 2007. When we were raising interest rates not many people pointed this out, but when we were raising interest rates five times, the impact of that increase in interest rates, one half of that, was passed through to mortgage borrowing. Mortgage rates did not rise by the full extent of the increase that we made in bank rate. These differences will always occur, and they have always occurred in the past. We can only set the bank rate; it is the market that will then determine the rates on different kinds of borrowing. The massive expansion of securitisation and mortgage lending was on the back of a serious compression of spreads that was not sustainable and we are now in a position where those excessively narrow spreads are widening out, but I do not think that that means that changes in bank rate do not affect the borrowing rate. What that means is that you cannot assume that there is an automatic one-for-one link independently of the circumstances of the sector at the time, and we have to watch that and monitor it in order to work out by how much we should be changing bank rate. Q37 Mr Love: But in the current market conditions, does that not make the Monetary Policy Committee more predisposed to a cut in interest rates because of the attempt to decompress, as you have talked about? Mr King: Yes. Q38 Mr Love: It is interesting. Last week we interviewed Mr Strauss-Kahn of the IMF, who indicated that they had marked down world economic growth this year from 5% to 4%, and he said that the likely downturn would be longer and deeper than they had previously expected. What is your view of where the world economy is going, and are you tending towards the pessimism that I think was expressed by Mr Strauss-Kahn? Mr King: I do not think a down grading of a central view from 5% to 4% is wildly pessimistic, it is a modest reduction in the growth rate from the fastest growth rate of world trade in the world economy that we had seen in much of the post-war period, so we have been through a period of very rapid growth. It was not obvious it could be sustained. It might, Asia is still going growing pretty rapidly, but, no, we would expect some slowing of the world economy and I think that estimate is broadly the sort of figure that we would share, who knows precisely? This is a slowing of world growth, but it is very important for people not to confuse a slowing of growth of that relatively modest kind with words like "depression, "slump", "falls in output" - they are a million miles apart - and it is the patient monitoring of what is going on month by month and the adjustment of policy to those changes that matter. As we said before, in the United States the conditions have deteriorated much more markedly than in other economies and, quite rightly, the Fed have responded to that. I think the way we react to these things is actually quite similar across central banks; what is different is the conditions that we face. Q39 Mr Love: Let me take out the hypothesis that either the United States is in recession or it is going into recession and robust action is, I think, an indicator that they may feel that it is moving in that direction. If that then has an impact on the European economy, if business investment in this country turns down because of the difficult financial markets, if net trade does not make up but consumption goes down as well, would that not have quite a dramatic effect quite quickly on the British economy? Mr King: Well, it would have an effect, whether I would use the word "dramatic" I do not know. For us, far more important than the United States in terms of the impact on demand in the UK is the impact on the euro area because they have a weight three times larger than the United States in our trade-weighted index, so what happens in the euro area is much more important to us directly than the US economy. Of course, that will undoubtedly make life more difficult, and I mentioned it in my opening statement, but it is factored into our central view in the February Inflation Report. These things have been factored in. We have quite a sharp slowing of growth in the UK in our central projections, so we do see a sharp slowing of growth, yes, but that will come and gradually we will move out of it back towards trend growth again. Our February Inflation Report was very clear that we would expect to see a period now when the economy would grow at a rate below its long-run average. Q40 Mr Love: Can I take you to back to a comment you made earlier on. The Economist over the weekend did a piece on financial markets and the plea at the end of this article was, "Don't re-regulate". What is your view about the impetus that there will undoubtedly be because of what has happened at the core of the financial system to increase regulation? Mr King: A brief answer would be do not have knee-jerk reactions but think very, very deeply about the causes of this crisis and whether levels of bank capital and the sort of financial system that generated this crisis does not require some action. Chairman: We will probably be asking you that later on in a month, Governor. Q41 Nick Ainger: What is your outlook for business investment? Mr King: Let me ask Professor Bean to pick that up. Professor Bean: As I said earlier in response to Ms Keeble, we have a slowing investment in the projection which is in part down to slowing residential and commercial property investment. There is also a wider slowing of business investment reflecting the reduced availability of credit and the general deterioration in growth prospects. As compared to where we were in November, we see the recovery from that slowdown in investment to be rather more muted and that is one of the reasons that the growth profile in the February projections is weaker than we had in November. Q42 Nick Ainger: But if you set aside property, what about the rest? Professor Bean: I mean there is a slowdown in business investment. We have had relatively high rates of investment growth over the past year. Investment intentions have come off a bit but there is still a reasonably high level, so there is no sign yet of business investment falling sharply. There are indications from our Credit Conditions Survey that the availability of credit to corporates is declining. It has not shown up yet in corporate lending but that is probably because it takes a bit of time. Businesses often establish a line with a bank and then run it down and then they go to the bank at some stage in the future and say they want some more money and at that point the bank will say, "No, we will not extend your line further". Through the course of this year we expect to see the rates of business investment growth to be coming off noticeably. Q43 Nick Ainger: A substantial amount of public sector investment is now through PFI and obviously significant credit lines are required for that. Do you expect to see that PFI projects are now either in jeopardy or the actual price to the taxpayer is going to substantially change because of the credit squeeze? Professor Bean: I would think it is entirely plausible that companies would be less willing to bid for PFI projects or that the terms that are offered would be less attractive to the public sector, yes. Q44 Nick Ainger: The United States has been one of our sources of inward investment. Do you expect that the American economy will be retrenching and not seeking to carry out any further major outward investment into this country or into Europe as a result? Professor Blanchflower: I think that is a good way to characterise it. Certainly the feeling we have now is that is true and if you go back to your question about the public sector, certainly in the US now the public sector is having a lot of trouble with municipal bond rates that municipal powers are having to pay that are extremely high. A good word is retrenchment. The data on the last two days suggests the economy is slowing fast and despite all the things the Fed are doing it is trying to play catch-up and investment from the US outwards is going to be restricted. I certainly think the US looks that way. That has changed a lot in the last two weeks. Q45 Nick Ainger: What about other countries, Japan for example? Presumably, as the Governor said, this is a global problem affecting all financial centres. Is Japanese industry taking the same view that American industry is doing in terms of outward investment? Professor Blanchflower: I do not know, maybe Charlie can help. Dr Sentance: Perhaps I could make a comment here. We need to make a distinction between the financial sector and the pressures there. Clearly the financial sector is an important part of the economy and more general business investment trends. The UK has historically been very open to inward investment and has drawn investment across the business as a whole from a wide range of different countries and regions. As long as the business climate in this country remains reasonably sound, we keep low inflation and the micro side of the economy is functioning well, I would expect that to continue. The sources of that business investment may shift around, and we have already seen quite a shift, we now see Asian companies, Indian companies, Chinese companies investing. The more important thing for inward investment is the business conditions that we have here, that they remain stable and the functioning of the micro economy remains attractive to that investment. Q46 Mr Brady: Governor, you forecast a marked slowing in output growth through 2008, but that growth will subsequently recover as credit conditions improve and lower interest rates and weaker sterling work through. When do you expect that recovery to begin? Mr King: Well, in the projections that you see in the February Inflation Report it is later in 2009, but no-one can know precisely what will happen. Even there we do not have growth coming right back to what we might think of as trend. It is a pretty slow pick-up. There is now a period of slower growth and then a gradual pick-up, not a sharp bounce-back. Q47 Mr Brady: Has that expectation of picking up from February shifted in the last few months, the last couple of months? Mr King: Last couple of weeks! We have not been through another round where we could consider all these things. This is still the default picture on the table in big terms. We will come back to it again in May. Q48 Mr Brady: You have already spoken about the marked difference between the real economy and the financial sector and clearly the slowdown at the moment has been more concentrated on the financial sector and retail. Are there other sectors of the economy that you would say are particularly vulnerable? Mr King: Property, both residential housing and commercial property. I remember when we came here last to discuss the Inflation Report in November, I think, Chairman, you asked us each to nominate our one risk that we were worried about on the downside for the UK and I said then commercial property. I think you can see pretty sharp falls in prices of commercial property. There is quite a dramatic chart in the Inflation Report which shows the fall in commercial property prices. There clearly is a risk there. Q49 Mr Brady: Anywhere else? Mr King: Property and finance are the two areas which stand out to me as being the ones which are the weakest at present. Q50 Mr Brady: Thank you. Can I turn to Professor Blanchflower and ask what your assessment is for the outlook for the labour market over the next six months in the UK? Professor Blanchflower: In a way the surprise has been the resilience in the quantities that we have seen in the last two or three months. I perhaps had not been as confident that they would have remained as strong as they have done, but there are weak points in it, especially if you look at the total number of hours. We have seen total employment in the last numbers rising but total hours fell, so there are those points of strength. The survey data that we have seen have been somewhat softer, so the Agents Reports about recruitment and the number of staff they are going to maintain and the KPMG more recent reports on jobs have really been quite weak. I feel that we are at somewhat of a turning point and it certainly appears in the wage data that weakening has come even further. There has been some strength in the past with bonuses and those seem to have come off a little as well. My view is that we are probably at some degree of a turning point with some weakening coming, but quite where that will be I am unsure. It seems to me there is going to be weakening coming, I do not see any obvious surge in wages currently. I am not particularly optimistic about conditions in the labour market but it has been quite resilient and that has been a surprise. The concern to me is, despite that, we have started to see a decline in hours and that might just be the indicator of the turn. Q51 Mr Brady: So the turn might now be that we would start to see the total number of people in work starting to fall? Professor Blanchflower: The obvious thing one would be looking at would be what is happening to total employment, what is happening to hours, what is happening to unemployment, what is happening to the claimant counts. I am going to focus on part-timers: "Are you taking a part-time job because you cannot find a full-time job? Have you got a temporary job because you cannot find a permanent job?", and has non-participation risen. That is one of the big things we have seen in the US, that despite the fact the unemployment numbers fell there was a huge increase in non-participation. This is a time to focus on a large number of components of what is happening in the labour market. The headline I have in the KPMG report is the smallest increase in 50 months and declines in every one of the sectors. How far it will go we will see. It has been resilient, we will see as we go forward, but weakness coming is what I see. Q52 Mr Brady: How much of any reduction do you see being absorbed by reduction of levels of inward migration? Professor Blanchflower: I have tended to not like the word "migration", I prefer "people who have come from Eastern Europe" and I have written some stuff about that. In fact, in the latest numbers when you ask the people who have come from Eastern Europe, "How long are you intending to stay for?", only 8% say, "I intend to stay for more than a year" and about 60% say, "I intend to stay for three months or less". This is a question we are going to have to think about. There are three things that matter really: the number of people who are coming from Eastern Europe, how many times they are coming in a year and how long they are going to stay for. These are things that are hard to forecast. It looks to me that those numbers are relatively strong. The other thing to question is what is going to happen to wage levels and GDP levels in the donor countries because the relative gap makes a difference. If we see some slowing and they see some strengthening then you would expect to see those flows falling. That is what you would expect. These are tough times, we have only really seen this since 2004, but you might expect to see some of the slack being taken by those folks going back. Q53 Mr Brady: If they start to stay at home, stay in Poland or wherever instead of coming here as often or for as long, does that have an effect in helping to cushion any reduction in wage rates in this country? Professor Blanchflower: I would think particularly it might cushion any impact on unemployment. If the shortage means those folks are going back to Eastern Europe it might dissipate any effects on unemployment. This is a sign of a flexible labour market and why wages have kept low is because of the flexibility we have got in there. We will see, I will try and keep you posted. I will come back later and tell you what has happened. Chairman: There is always a welcome here! Q54 Mr Dunne: Governor, in your opening statement you highlighted early on the increase in food prices in world markets, I think you said up more than 50% on a year ago, and also oil prices two-thirds higher than a year ago, yet very little of this seems to have been reflected in the historic data to date, at least on the CPI measure of inflation. How useful is the CPI as a measure of inflation for households? Mr King: I think it is useful. You can always quibble about precise definitions. The impact on food prices can be seen in the CPI. The inflation rate for food in that index is running at a much higher rate than it was a year ago and we would expect to see more of that coming through. On energy prices, the issue there is that the behaviour of domestic gas and electricity prices has been rather different in the UK than on the Continent and the impact of higher world energy prices has come through more quickly there than here, but we are clearly seeing that now. You saw it in the February inflation number, up from 2.2 to 2.5, and we would expect that to rise markedly in the next few months. I think it is coming through now. Q55 Mr Dunne: You say in the February Inflation Report that you are expecting just under half a percentage point increase in CPI as a result of the January and February gas and electricity price increases which, from memory, were of the order of 15-20% for households. Mr King: 15. Q56 Mr Dunne: 15, thank you. If households are seeing their energy bills going up by 15%, and that is in the last quarter, and there were increases last year as well, food prices are not being passed through directly at these very large commodity price increases but the Inflation Report talks about a 6% annual increase in food prices which, again, I suspect is a lagging indicator. Perhaps you might comment on that. Mr King: Part of that difference, of course, is that when you buy food in a supermarket only a fraction of the cost of it is attributable to the raw materials. Q57 Mr Dunne: Indeed, but are you anticipating significant increases in household bills as a result of the food and energy increases that we have already seen? Do you think there is risk on the upside to the inflation target as a result of these two factors? Mr King: In the short run, yes. We say our central projection is to rise to about 3. It may well go above 3, who can be sure. A lot will hinge on the degree of pass-through of some of the costs that firms choose to make. As I said, we have talked about these two very big risks and identified one from the housing and demand sector which will impact on inflation on the downside looking further ahead if it happens, but the other risk, of course, is if the short-term rises in inflation start to colour the expectations of people about where inflation will stay in the medium-term, that will have quite a serious impact. These are two big risks, they are both important, and we have got to take both into account. You are right in highlighting that risk, it is a risk. Q58 Mr Dunne: Professor Blanchflower, that takes me on to the impact that this might have on wage inflationary pressures, which the Governor was just alluding to there. Do you see this as a significant risk in the short-term? Professor Blanchflower: Obviously it is a risk in the sense that people's living standards are being impacted, their real wages have been relatively low and prices have been rising, but it certainly does not appear that this is a point where people's bargaining power is going to be substantial, so obviously people are going to feel the hit in some sense when they have not had significant wage growth, tough times are here. Obviously we will keep track of it but it certainly does not look as if this is a time when workers are going to be able to bargain and get large, substantial increases, they need to be mindful of the fact that they need jobs. Q59 Mr Dunne: So the conclusion of the Committee, if you are speaking for the Committee, is that we are going to go through a period of tightening take home pay this year? Mr King: I think that is broadly the view. We have seen pretty low growth rates of real disposable income over the past year too. This is because we cannot insulate ourselves from what is happening in the world. When oil prices, energy prices, food prices are rising, as a country our standard of living is going to rise much less quickly than it would do if those rises had not occurred. On the bright side, looking forward the inflation rate will fall back and the growth rate and living standards will pick up again provided food and oil prices do not go on rising as fast. They do not even have to fall, they merely have to not rise as quickly as they have been doing for the inflation rate, other things being equal, to come back. As we say, the risk is if firms and those involved in pay bargaining start to think that the way we react to inflation is to take less notice of inflation than we have been doing in the past then they may say, "Well, actually we can afford to be a little bit more relaxed about the pay increases we agree to because general inflation will take care of it", and we cannot afford to get back into that culture of the 1970s and early 1980s where people felt, "Well, we can take gambles with what pay increases we agree and demand because in the end the government will give in and allow inflation to rise to validate those decisions". We cannot do that. We have to try to ensure that we are in a climate where people feel that, yes, we are looking at activity because it affects the outlook for inflation but we are not going to lose control of inflation in this country. Q60 Mr Breed: Just two questions. Dr Sentance, could I just return to the Household Savings Survey, which we have not concentrated much on. We all realise, of course, that the savings ratio has gone down and people have been saying for a long time it has been going down. In the Inflation Report, February 2008, you were saying that the Committee thinks there is some evidence that people might reappraise all of a sudden their whole income and we will start to see people saving again. I just find that somewhat remarkable bearing in mind we have got increased costs, all the pressures, potentially a slowdown in growth. Why are people suddenly going to decide that it is a good idea to save? Dr Sentance: In the central forecast underpinning the Inflation Report we have got a rise in the savings ratio. One of the factors that is underpinning that is a more precautionary approach by the household sector. That is one of the recognised identifying factors behind saving in the economic analysis. Q61 Mr Breed: We have had very good times over the last 10/15 years when there has been disposable income and everything else and it has just gone down and down. Why at a time when it is going to be under pressure is it suddenly going to go up? Dr Sentance: If I could just elaborate on that. When we look at the household savings ratio as a concept it is very important to recognise it is the difference between two big flows, there is the amount of gross savings that the households are making and netted off from that, if they are net, is their borrowing. Historically, if you look back you will find it is changes in that borrowing behaviour that have been the most significant factor behind changes in the savings ratio. The way in which this precautionary approach is likely to be reflected is in less willingness to borrow with confidence being reduced, as has already been referred to in this hearing, and also, of course, the constraints on the supply side from credit availability. That is what I would expect to see in the central forecast. However, I would also make another point that there is quite a degree of uncertainty around our forecast at the moment, we cannot predict exactly precisely how this will develop and there are a number of factors at play. There are factors on the supply side in terms of credit availability, factors in terms of willingness to borrow among consumers, but it is not unreasonable in the current climate to expect some increase as we put into our central forecast in the savings ratio. Q62 Mr Breed: Thank you. Could I just ask the Governor, going over the statements you have made this morning, I was quite intrigued about the long-term solution to the Bank's problem and then a longer term resolution of the problem and the fact you indicated it should not be to finance more business in this way but to deal with the present problem. Is that euphemistic language for saying you have got to find some more capital to get the balance sheets back, to get this stuff written off as quickly as possible? If so, who in their right mind is going to put huge amounts of capital into banks to write off their foolish losses rather than put it into businesses that are going to finance good business? If you are not going to allow them to do the new stuff, they have to deal with the old stuff, who is going to provide these major lumps of capital? Mr King: Banks do have capital and it is not euphemistic language for a statement about the amounts of capital, it is an observation that the problem of illiquidity that is being faced in financial markets, a certain range of financial markets in these asset type securities, not all financial markets but in this range of markets, is very great, but it is an illiquidity of a stock of assets that were created in the past and we need to find a way of dealing with that illiquidity. The way to do that is not to encourage the creation of yet more paper that will in turn become illiquid, but to deal with the stock. Q63 Mr Breed: It can be achieved without recapitalising the balance sheets? Mr King: Yes. I would not be opposed to a process in which the banks would find more capital, I think most Central Banks would regard that as a very desirable development. Q64 Mr Breed: A discount. Mr King: But it is not dependent on that. Q65 Chairman: Governor, this is the last question, maybe for all of you to comment on. You mentioned nominating a risk and it would be good if each of you had a go at that again. How far did this Budget allow fiscal policy to support monetary policy? I think we will start with Professor Blanchflower, or do you want me to start at the other end? Professor Blanchflower: I think I would rather you start at the other end. Mr King: Let me nominate the order in that case. Professor Blanchflower: I want to go last! Mr King: Professor Bean will start, then Ms Lomax, then Dr Sentance and then Professor Blanchflower. Professor Bean: What is important for us is that fiscal policy is essentially set with an eye to long-term sustainability and in that sense the fiscal rules need to be broadly respected. But within that we would certainly expect the automatic stabilisers to be allowed to operate and in that way they would be potentially acting to support our monetary policy decisions. Obviously when we set monetary policy we take the stance of fiscal policy as given and from our perspective that is a perfectly satisfactory position to be in. Q66 Chairman: What about your risk? Professor Bean: Sorry? What risks do you mean? Q67 Chairman: Governor, tell him what you mean. Mr King: What risks do you see? Professor Bean: You mean to the outlook in general? Q68 Chairman: Yes. Professor Bean: Oh, to the outlook in general. The two big risks that we have talked about repeatedly this morning, on the one side pressing down on activity from events in financial markets, the credit crunch may be deeper and more persistent. On the upside, the risk of de-anchoring of inflation expectations so that what we hope will be a short-term pick-up in inflation actually turns out to be more persistent. Ms Lomax: As usual, Charlie gives a model answer. In terms of adding to that, I think monetary policy has got quite a lot of room to respond to the present situation, so the question of whether it needs more support from fiscal policy is not at the top of my mind, the key thing is the longer term issues of fiscal sustainability, sticking to the rules, which has always been the point when we have come to this Committee. There is no great problem about the relationship between fiscal and monetary policy at the moment. On risks, they clearly centre on the impact of the financial crisis. I cannot help thinking, and I cannot put my finger on it, that there is a relationship between what is going on in financial markets and what is happening to commodity prices, that somehow or other these two big risks we face are related in a way which is very difficult to quantify. It would all be much easier if the financial crisis were to subside and maybe take some of the pressure off commodity prices as well. Dr Sentance: I would agree with Rachel's assessment that we have got quite a lot of scope with monetary policy to move to respond to changes in the situation of the economy. The worry would come if you felt that fiscal policy was going to be working in an opposing direction to that or swinging around in an unhelpful way, and I do not see that on the basis of the projections we have got in the Budget. When it comes to risks, I think Charlie summed it up on the two main risks that we are facing. I would draw them together in an observation that I have made while I have been on the Committee that we have seen an awful lot of impact from changes in the global economy and we have seen a lot of global inflation coming through, and on both sides of the equation I think we could see more impact from the global economy going forward both in terms of potential inflationary pressures, and we have talked about food and energy prices, but also if the global economy is more heavily impacted in general by developments in financial markets it could work in the opposite direction. Professor Blanchflower: I agree with what the others said on the fiscal policy. I prefer to talk about the risks. The difference between me and most of the members of the Committee in terms of the way the Inflation Report was written was my concern with risks to the downside, especially coming from the credit market. I guess from your earlier question, having seen what has happened in the US is that activity will drop dramatically and that would be something I do not want to see. My concern is that it is appropriate to take out some insurance and get ahead of the curve in the sense that the arguments made on the upside were that, but it seems to me those arguments apply on the downside too, so my concern would be one should make sure one is ahead of the curve so that later one is not in a position where something horrible happens, I do not want that to occur. My risks are to the downside and I have concerns that something horrible might come and I do not want that to happen. Mr King: Chairman, four excellent answers on which I could not possibly improve! The biggest risk facing the Committee, I think, is that the germ which has affected Rachel spreads to the whole Committee and when it meets in exactly two weeks from today it will have no voice at all! Q69 Chairman: Governor, you are back to see us next month and we will have a wider look at issues, so I look forward to that. Rachel, I hope we did not stretch your voice too much this morning. Ms Lomax: Thank you very much indeed. Q70 Chairman: Dr Sentance, we are seeing you immediately. Dr Sentance: I will stay behind! Chairman: Thank you very much. |