House of COMMONS
MINUTES OF EVIDENCE
THE MAY 2008 INFLATION REPORT
THURSday 26 JUNE 2008
MR MERVYN KING, SIR JOHN GIEVE, MR PAUL TUCKER,
PROFESSOR TIM BESLEY AND MS KATE BARKER
USE OF THE TRANSCRIPT
Taken before the Treasury Committee
on Thursday 26 June 2008
John McFall, in the Chair
Mr Graham Brady
Mr Philip Dunne
Mr Michael Fallon
Mr Andrew Love
Mr Mark Todd
Witnesses: Mr Mervyn King, Governor, Bank of England, Sir John Gieve, Deputy Governor, Bank of England, Mr Paul Tucker, Executive Director, Bank of England, Professor Tim Besley, External Member, Monetary Policy Committee, and Ms Kate Barker, External Member, Monetary Policy Committee, gave evidence.
Q54 Chairman: Welcome to you and your colleagues to today's 2008 Inflation Report. Would you like to introduce your colleagues for the shorthand writer - and I believe you have an opening statement?
Mr King: Thank you, Chairman. Good morning to the members of the Committee. On my right is Professor Tim Besley, one of the External Members of the MPC; and to his right another External Member, Kate Barker; on my left, Sir John Gieve, Deputy Governor for Financial Stability; and on his left is Mr Paul Tucker, Executive Director for Markets. If I may, Chairman, I should like to make a short opening statement. Last week we received the news that inflation rose to 3.3% in May. Much has been written and said since then, not least by me in my open letter to the Chancellor and in my speech at the Mansion House, so I do not therefore want to add to the description of the economic challenge we face, but I would like to highlight briefly three key elements of the economic outlook. First, inflation is likely to rise further this year. Oil prices are now as high in real terms as they were in the 1970s. Wholesale gas prices have risen very sharply, and sterling has depreciated, pushing up the prices of imported goods. Over the rest of the year, the impact of these changes will continue to pass through the supply chain to household bills and consumer prices. The Monetary Policy Committee's current judgment is that inflation is likely to rise to above 4% before the end of the year, although this projection is very sensitive to the path of domestic gas and electricity prices. Second, the immediate cause of the rise in inflation we are seeing now is a change in the prices of food and energy relative to other prices. This will push up the overall level of prices but it cannot, by itself, produce sustained inflation unless we allow other prices and wages to rise at a faster rate. The MPC is focused on preventing that, so although inflation is rising now, we will ensure that it falls back to the 2% target. Third, there are indications that expectations of inflation have risen; so we believe that a slow-down in the economy is needed this year to ensure inflation returns to the target. Business surveys indicate that the economy is slowing, and the squeeze on real incomes resulting from higher food, energy and import prices means that growth is likely to remain weak this year. Therefore, the MPC continues to face, as it has over the past ten months, a balancing act. The economic slowdown will need to be sufficient to ensure that inflation does not persist above the target. But at the same time, we need to avoid a slow-down that is so pronounced that it would pull inflation down not just to but below the target. Chairman, I am grateful for the opportunity to make these brief remarks. I, and other members of the MPC here today, stand ready to answer your questions.
Q55 Chairman: Thank you very much, Governor, for that statement. Can I focus on your comments about inflation projections that have been very sensitive to the path of domestic gas and electricity prices! You seem confident and it has certainly been conveyed in the media that current inflation is temporary, caused by rising commodity prices; but given the fact that fuel prices in particular are a key component of all manufacturers' costs, why should we not expect fuel and commodity price inflation to spread to other goods?
Mr King: We would expect the increase in commodity prices generally to pass right through, and that is not just the direct effect, as you point out, on petrol prices or prices of heating fuel or gas prices; it affects all manufacturers' costs to a greater or lesser extent, depending on the sector, and we would expect that to pass through; but it is still the passing through one-off shock to the price level of those commodities. That cannot produce sustained inflation unless the prices of other gods and services and other components and other costs, in large part of course pay, also pick up from their present levels. If that does not happen, then the inflation rise will be temporary and it will fall back next year. The task of the committee is to ensure that the rate of increase of other costs feeding through to final prices does not pick up and is consistent with inflation falling back to the 2% target.
Q56 Chairman: Paul tucker, in a speech in April, you said that, "Only by underpinning the credibility of the nominal anchor provided by the MPC's commitment to the inflation target will we maintain the scope to cushion the real economy from the effects of the stresses in the international financial system." How credible is the 2% anchor? I say that mindful that people are experiencing the rapidly rising costs of living, but the MPC seems to be quite relaxed about that. Is the inflation genie out of the bottle?
Mr Tucker: I do not think it is yet. That is partly because of vigilance on the part of the committee. One of the things that has been encouraging in some respects over the past six weeks or so is that as robust inflation numbers have come out, financial markets have appreciated, and that means that monetary policy will have to be somewhat tighter than otherwise. That underlines that they understand that we have an inflation target, not a growth target; whilst being mindful of the implications for the slow-down of the economy on the medium term projection for growth. The point I was making in the speech is that if we were to allow the inflation genie out of the bottle, then we would end up aggravating the slow-down at some point because we would have to tighten monetary policy to put the genie back in the bottle; and all the experience of the past shows that that is quite a difficult and quite a horrid thing to do. It is absolutely vital we maintain credibility. If I can add one other thing, near-term inflation expectations have plainly gone up because of the rising oil and food prices that you describe. I would say that so far we can take a degree of encouragement from measures, such as they are, of medium-term inflation expectations; but we cannot be complacent about it and we really do have to underline our determination to deliver inflation back to the target.
Q57 Chairman: On the issue of determination, Sir John, in a speech you made last Thursday, you said: "The next year is not going to be comfortable for anyone and we already hear calls to change the system, the target and our focus on inflation." But the new framework was designed for difficult times as well as for plain sailing, and given the public debate that has already been generated about the remit of the MPC, why is it important that we should not change the MPC's objectives at this point?
Sir John Gieve: The ten years we have had have entrenched the belief that the MPC will bring inflation back to target - it has been up, it has been down but it has come back to target. I think it would be very dangerous now to start trying to change the goalposts because that would feed directly through into expectations. Suppose you said, "Let us raise the number a little" - I think that would be self-defeating in a way. It would not ease the task of controlling the economy, but it would feed straight through to expectations. More generally, I spoke in that speech about the consensus that has existed really ever since we left the ERM on the need to focus on inflation through monetary policy. I think that was based on twenty years' hard experience, and I hope we do not forget that.
Q58 Chairman: Can I interpret that as being a loud and unbending message from the Monetary Policy Committee that any talk of changing the framework is absolute nonsense at this stage?
Sir John Gieve: Well, it is an unbending message from me.
Q59 Chairman: Could you put it more eloquently, Governor?
Mr King: I will put it as firmly. As far as we are concerned, it would be simply very silly. The reason is just straightforward. You do not change the dilemma that the committee is facing now by making some announcement or writing a piece of paper saying the target is a different number. We are facing a situation with rising inflation and falling growth. It is very important that we get back to price stability defined as our target as soon as we can, and we have made it clear that it would not be sensible to try to bring inflation back to target within the next six months because that would mean a need for an extremely deep recession, and that would be silly. We are bringing inflation back to target over our normal two-year horizon. To change the target now would not resolve that dilemma in any way; what it would do, as John said, is to make people think that we were less likely to be committed to meet the target, and it would almost certainly thereby mean that we would need a bigger slowdown, a sharper more prolonged slowdown in activity, in order to bring inflation back to the target; thereby, as John said, being wholly self-defeating. We are certainly not relaxed in any way. We are monitoring extremely carefully what is happening in the economy, particularly inflation expectations and the movement in other costs that feed through to final prices. We are absolutely determined to bring inflation back to the 2% target. That is the single-minded objective of the Monetary Policy Committee.
Q60 Chairman: Kate, do you welcome the fact that house prices are now falling, and was the market due a correction?
Ms Barker: I do not particularly welcome the fact that house prices are falling at the moment, given the reasons for the decline. The decline in house prices has been produced by more expensive credit and less availability of credit; it has not really had the effect of making - which is I take it the point of your question - housing more affordable for many first-time buyers; in fact, if anything, it is less affordable. At the same time we see rents rising. This is not a situation of the more affordable housing that I have been looking for wearing other hats.
Q61 Chairman: Professor Besley, how will the MPC ensure that inflation expectations are firmly anchored, given the rising costs that we see daily and weekly?
Professor Besley: It is a combination of two things. One is to give a persuasive commentary on what is going on in the economy, to make people understand that we are trying to balance these two sets of risks that we have laid out, and that we are going to set policy according to the balance of those risks so that people can appreciate that we are in a situation where it is necessary to do that. Commentary at this time is extremely important. Equally, if it becomes necessary to turn words into action, taking the appropriate action and explaining the reasons for that action is the second part of what we will be trying to do. By a combination of those two things we should be able to get people to believe that the framework will deliver, and only a temporary increase in inflation; and that should be sufficient to bring expectations down too.
Q62 Mr Fallon: Governor, your letter to the Chancellor contains the rather dismal admission that there will now be a sequence of open letters over the next year or so. You are paid to keep inflation under control, not to write letters! That is right, is it not?
Mr King: I rather enjoy writing letters, Mr Fallon. What I have just explained to you is that to try to bring inflation down within a few months merely to avoid writing a letter is neither our target, nor would it be sensible for the UK economy.
Q63 Mr Fallon: But in announcing the collective letters in fact you are telling us you cannot get inflation back on target for at least a year.
Mr King: When there is a sharp increase in the price of any particular commodity that pushes up measured inflation, it stays in the index for 12 months. Even if there were absolutely no underlying inflationary pressure, it takes 12 months to drop out of the index. It would not be sensible to overreact to that and to say: "Gosh, it is in the index for 12 months; I do not like writing letters; therefore let us turn the economy into a deep recession merely to avoid putting the stamp on the envelope!" Writing letters is not the target. Writing letters is part of our ability, as Tim explained, for us to explain to people why it is that measured inflation has gone up and why, in our judgment, that would be a temporary phenomenon. You may not be convinced by the explanation; but our job, as Tim said, is to give persuasive explanations. It certainly is not our job to avoid writing letters.
Q64 Mr Fallon: But writing letters for more than a year - is that not an admission of failure?
Mr King: We do not know whether it will be more than a year or not; let us come back and see whether it is. That will depend on the factors. Whether the explanation we give is persuasive will depend on the circumstances that generated the need for the letter.
Q65 Mr Fallon: Let us take your very first letter 14 months ago. You said: "The committee must ensure that inflation expectations are anchored on the 2% target. It is important to prevent that anchor from dragging." In fact your own inflation survey shows that in May most people believed that prices had risen by 4.9% over the last year, and expect them to rise by 4.3% over the next 12 months; indeed, 37% of people expect inflation to be over 5%. In terms of inflation expectations, you have lost the plot, have you not?
Mr King: No. It would be perfectly sensible for people to believe that inflation will be high over the next 12 months. We did. That is what we have been explaining to you. What matters is whether they believe we can bring it back. The data on those inflation expectations I do not pretend are entirely sanguine, but nor are they anywhere near as bad as the numbers that you have quoted. There has been some movement, but nowhere near as significant. It would indeed be perfectly sensible for people to believe that inflation will be high in the short run but will then come back. Those are the basic messages from the inflation expectations data. We are certainly not complacent about that and we will take whatever measures are necessary to ensure that inflation comes back.
Q66 Mr Fallon: When you told us a year and three months ago that it was important to prevent the anchor from dragging, the anchor has dragged, has it not?
Mr King: No, I do not think it has. Moreover -----
Q67 Mr Fallon: I am sorry to interrupt you, Governor, but if people believe inflation is well over 4% and it is supposed to be at 2%, how can the anchor not have dragged?
Mr King: Because it does not matter what the immediate forecast over 12 months is; as long as people believe that looking beyond that inflation will come back. The same was true then. We said to you and to the world at large that inflation was over 3% when we wrote that first letter, but that it would come back to target. It did come back to target. We have done it once, and I believe we can do it again.
Q68 Mr Brady: Governor, in May it was reported that you were keen to see how the Chancellor would make the rise in personal tax allowances consistent with his fiscal rules. Last week we heard from Roger Bootle, who told us that the sums involved were tiny. Why are you more concerned than he is?
Mr King: I am not sure there is any inconsistency. The figure that was announced, the 2.7 billion is about 0.2 percentage points of GDP; and that is relatively small. In itself it will not have a marked impact on activity or inflation. The point about the fiscal rules is to look at the longer-term impact of that and what follows from how the Chancellor will follow through on that measure and how far it will persist and what that means for the level of debt and the golden rule. Those are things that the Chancellor will tell us about in the autumn and in the budget next spring.
Q69 Mr Brady: But it is your view that even that relatively small change is sufficient that it needs to be addressed!
Mr King: No, I think what has to happen is that we will see in the autumn and the spring how the Chancellor intends to extend or continue this particular measure and what all that means for the fiscal outlook. We are concerned not with a particular measure as such but the adherence to the fiscal rules in general. That is the important aspect. It is the overall position of fiscal policy; and that is something that the Chancellor will return to in the pre-budget report and again in the budget next spring.
Q70 Mr Brady: We also heard last week from Professor Muscatelli who told us that if growth slows to 1.5% then taxes would need to be raised by between £7-10 billion or expenditure cut by that amount, simply to maintain the status quo in fiscal terms.
Mr King: We are not the experts in producing the numbers on this - other people are. The whole point of the fiscal framework is that if growth slows in a period when growth is well below trend, that will obviously have an impact on tax revenues. It is not sensible to respond to that by simply raising other taxes. That is the virtue of looking at this over the cycle as a whole. The idea behind that is clearly the right one. How you implement it, people have different views on; but the idea that you should look at the fiscal position over the cycle is clearly the sensible way to approach it.
Q71 Mr Brady: Without committing to those particular figures, you share the thrust of his argument that was being -----
Mr King: No. It seems to me that you have to assess the fiscal position as a whole, both in terms of the level of debt and what the deficit looks like adjusting for the level of activity relative to trend; and then you see how far the prospective deficits link to the target deficit - here the golden rule: borrow only to invest - and the level of debt as a share of GDP. I am not going to speculate on what those numbers are, but that is the framework as a whole, and the numbers as they evolve should be judged against that framework. That is exactly how the Chancellor does it when he presents the pre-budget reports and the budget.
Q72 Mr Brady: Can I move on to exchange rates: what factors, in your view, explain the weakening of the pound against the dollar and the euro?
Mr King: I think the major explanation behind the movement in sterling since last summer, which is now about 12 per cent in effective terms below where it was, is the re-balancing of the UK economy, which is clearly now happening. That is something we talked about for a long time. The trade deficit has risen to an uncomfortably high level; domestic demand needed to slow, and we needed to see an increase in net exports. We are beginning to see both of those developments occurring. It is very hard to see how that can be sustained without a change in the effective exchange rate of sterling against other currencies. We have seen that, and it has been almost a step-change. It is impossible to forecast what will happen to exchange rates, but it is consistent with the re-balancing. It is a much smaller version of the developments we have seen in the United States. The difficulties that everybody sees in exchange rates among the developed economies are not because exchange rates move among developed economies but because a very important part of the world economy has decided to peg their exchange rates to only one of the exchange rates, namely the US dollar. That has caused difficulties, and in current circumstances it is leading that part of the world economy to have a much more expansionary monetary policy than would be desirable. I have no doubt that that is one of the factors that has lain behind some of the upward pressure on commodity prices, in addition to issues to do with the balance between demand and supply.
Q73 Mr Brady: Does nervousness about structural changes taking place in the UK banking sector have a role in depressing the value of sterling?
Mr King: I do not know. I think it is impossible to judge. I see no obvious reason why that should be the case. There have been problems in the banking sector in the main developed economies and the main financial centres. I see no reason why that would have led to a significant change in exchange rates among those economies. Indeed, you can see that the fall in the dollar, which has been much more pronounced than the fall in sterling, clearly preceded the financial crisis.
Q74 Mr Brady: When we heard from Bronwyn Curtis last week, she expressed concerns about the speed of the pound's decline. Do you share her desire to see gradual movements rather rapid movements?
Mr King: I think after eleven years on the MPC, I have given up hoping or trying to do anything about asset prices: they move where they want to, and that is particularly true of exchange rates. The important thing is what we can influence is our own domestic policy, monetary and fiscal. That is why it is very important to have stable and credible frameworks for policy and then other people in the Western world can judge what they think of the outlook for our economy and set exchange rates accordingly. I would not have thought the movements in the last 12 months exhibited enormously rapid signs of change. Sometimes these prices move quickly for a period and then do not move. What we have really seen is a step-change of 10% or a bit more than that of the effective exchange rate of sterling - as you point out, largely against the euro, because that is about 60% of the trade-weighted basket, so that is the major influence. I think that is reflected in adjustment that was a necessary part of the re-balancing. It would be very hard to imagine how the re-balancing could occur without the same change in the effective exchange rate.
Q75 Chairman: Kate, Morgan Stanley recently forecast that 2 million home-owners could be at risk of negative equity if house prices fell by 20% before 2010. Is the housing market shortly going to resemble that of the early 1990s?
Ms Barker: I am glad you have asked me another question about housing, because it gives me an opportunity to add something I ought to add to the point I made earlier in regard to house prices falling. I should have said that while in the short term I do not think it is particularly good news, there is one sense in which I think it might be helpful, which is that prior to these declines I think there probably was some element of speculation in the housing market, particularly with regard to buy-to-let, and a removal of the erroneous belief that house prices will only ever rise sharply in real terms is, I think, potentially a beneficial factor. Do I think it is going to be like the 1990s? I think conditions are different to the 1990s. One of the chief reasons that we saw such a big correction in the housing market in the 1990s and so much related pain was the fact that we had a much sharper slow-down in the economy as a whole and a much greater rise in unemployment than at the moment people are expecting and judge to be likely. In one sense, the housing market adjustment is more severe than the 1990s because it looks as though the fall in housing construction this year may be on a scale that it took almost six years to achieve in the 1990s.
Q76 Chairman: Tim, one of our expert witnesses said that we have two new phenomena to factor in: the credit crunch and a very large buy-to-let sector, as has been mentioned by Kate. How much weight do you attach to the buy-to-let sector in your voting considerations?
Professor Besley: There are two very different takes on that, and trying to weigh those up is quite difficult. One is to say that we have an element in the market that potentially will take a long-term view of their investments, and that could impart greater stability. The potential for people to wish to unload those investments in a declining market is probably quite limited, and there is no reason therefore to think that absent that happening we will see something that will contribute towards the instability in that market. On the other hand, that has been an important part of the market that has been driving the market recently. I think it is unlikely we will observe a significant interest by buy-to-let investors for some while; and therefore in terms of looking forward to a recovery in the housing market - whenever that happens at the end of this adjustment process - it is not clear that buy-to-let investors will be tempted back into the market very quickly.
Q77 Chairman: Paul, to what extent has the housing market turnover been hampered by a shortage of secured household credit?
Mr Tucker: I think it is, and quantifying that is almost impossible as well but qualitatively it is. It goes broader than that. A point we have been making for some while now is that in terms of the outlook for consumption, it is not just the credit crunch; it is also the rise in energy prices, which is hitting real take-home pay. Of course, the two are related because as people's disposable incomes fall, in other circumstances they would probably borrow a little bit more in order to sustain their consumption; and that has become a lot more difficult because of the adverse shift in the supply of credit. It is mostly via secured credit, and most credit to households is secured on their houses, so this is almost certainly a downside risk to the outlook.
Q78 Chairman: What shape do you think the market will be in, in the next 12 to 24 months?
Mr Tucker: I think that if I look out three or four years, there will be quite a change in the mortgage market. Probably less of it will be broked and probably the market will be a little bit more concentrated amongst big diversified banks. I think the path to that position is uncertain and I do not know how long that will take. One of the lessons, not just in the UK - by no means just in the UK but internationally - is that it is better to be diversified both in the Bank's asset portfolio and in its liability portfolio.
Q79 Chairman: Sir John, mortgage rates advertised by banks and building societies have risen sharply against Bank rate and government bond yields. Does this imply that the monetary transmission mechanism is impaired?
Sir John Gieve: No, I do not think it does imply it is impaired, but it means it has changed. Obviously, we have to take account of the mark-up and spreads over bank rate in deciding how tight conditions are in the household centre. The spreads have increased. If we had not decreased the bank rate, obviously that would have been tighter still; so in that sense the decisions still feed through.
Q80 Chairman: Governor, if you were to sum up how you think the housing market will be in the next 12 to 24 months, what message do you have publicly here?
Mr King: It is very difficult to know. There are different aspects to the housing market. On prices, it is very, very hard to judge. As Kate said, we could see big movements, but no-one knows and there is no point pretending anyone can know that. It is worth still remembering that in other aspects of the housing market, the situation is very different from the early 1990s. At the end of the first quarter of this year the proportion of households with mortgages that were more than three months in arrears was just over 1%; in the 1990s that reached over 6%; so there is a very significant difference. The level of possessions is still well below half the levels they reached in the 1990s. In that sense it is very different. That is in part because the ability to continue financing a mortgage depends on two key factors: big changes in interest rates, which change the cost of financing relative to the cost you have taken on. There have not been big changes. There have been changes and some increase, but it is relatively marginal still. We have not seen enormous shifts in unemployment or income prospects either. That is one important respect that Kate referred to in which the situation is very different from the 1990s. On the other hand, the levels that house prices reached were not entirely easy to rationalise, and none of us can really know where house prices will go. We are going through a period of adjustment now in which because any prospective purchaser cannot judge the likely level of house prices and where they will settle, it would be a very natural response to pull back and wait until the market has reached a new equilibrium before coming in; so I think we are likely to see a period of extremely weak activity, which will gradually then recover. Paul referred to a very important factor in all this, which is the supply of finance from banks. The reason why that is difficult to judge is that the financial crisis has moved into a very different period and phase now. In the first few months the concern and focus was on the immediate liquidity problems. I think that is largely behind us. That does not mean to say that the problems in the financial sector are behind us - far from it; it does mean that we are beginning to see now a significant unwinding of the size of the balance sheets particularly of the large financial institutions. It is the great unwinding - what the Americans would call the de-leveraging. This is proceeding at a rate that was perhaps larger and faster than people initially realised when the crisis struck. It is almost as if the extraordinary expansion of balance sheets of banks and other financial institutions in the last five to ten years, built largely on financial engineering, is all going, if not quite into reverse, very substantially run down. That adjustment process makes it very difficult for banks to consider expanding their balance sheets in other directions. It will be an adjustment process not just for the housing market but also for the banking sector. It is very hard to know how long that will take. There will always be, for institutions that do not feel the need to contract their balance sheet, opportunities now to make money by lending in the housing market. At some point we will see other institutions come back in to lend into the housing market. The time over which these adjustments will take place is almost impossible to predict. It is important that we monitor what is happening very carefully, through our contacts which John and Paul organise on our financial stability and market side, and through monitoring economic data, so that we can follow what is happening, although we do not pretend to be able to predict the time path of this.
Q81 Chairman: Tim, the "Big D", as it has been referred to - is that something we have to worry about in the next few years?
Professor Besley: By the "Big D" you mean?
Q82 Chairman: De-leveraging.
Professor Besley: Sorry, yes: I am not, obviously, fully familiar with all the shorthand! That is the major part of the adjustment that has to work through the financial system. At the moment, as has been said, we are part way through phase 1. The question is - and it is very difficult to judge - where things will eventually settle. A number of the comments that have been made suggest - that will have implications for the level of house prices ultimately because it does depend very significantly on access to mortgage finance. Until we know where the market will settle, it will be very difficult to make a judgment about where prices will end up.
Q83 Mr Todd: Can I turn to the points made about the balance sheets and the clearing-out of balance sheets that is going on at the moment? You implied it is moving rather faster than you had thought. Can you update what the inflation report says on that?
Mr King: I do not think it is moving faster in the sense of something that happened in recent weeks. We are seeing that all the major financial institutions are going to go a lot further than might have been expected initially. In the first few months there was a feeling of a liquidity problem - "As long as we can acquire sufficient liquid assets, we will be all right". As I said, I do not think liquidity is the source of concerns now, although problems may show up in terms of liquidity down the road. It is much more now that people are taking a structural look. They are realising that a number of the markets in complex financial situations are unlikely to re‑open, a simple example being the mortgage-backed security market. The form in which those instruments were sold - they would need to be modified at least in order to provide the right incentives, and in many other instruments it is very unlikely that they will reappear. This extraordinary expansion of balance sheets in the last five years is unwinding, and banks will have to make up their own minds as to how far they want to go. I think it was Stephen Green of HSBC who pointed to the need to re-balance the focus of banking away perhaps from trading activity and more towards the provision of services with customers at the other end.
Q84 Mr Todd: Has the special liquidity scheme contributed to this process?
Mr King: The existence of it has clearly meant that banks and other institutions contemplating dealing with a bank would know that that bank would have access to the special liquidity scheme, and that has meant that their concerns about potential liquidity problems have been eased. It has undoubtedly contributed a -----
Q85 Mr Todd: It is a safety net that has practically been used relatively little.
Mr King: Well, it has been used, and in due course you will see the extent to which it has been used; but I want to urge an understanding that this is not the only aspect of what is going on in the financial sector. That is the explanation, I think, of why the spreads in the LIBOR market and other spreads have not come down as far as some would have wished because those spreads are reflecting not just liquidity aspects but more general concerns.
Q86 Mr Todd: Paul, you made an interesting speech in April. I have sent someone out to find the meaning of one word you used! You referred to the banking system simply as not being structured routinely to insulate new business from the legacy of past mistakes. In fact, you then went on to say funding and capital are fungible, which I must admit I did not immediately -----
Mr Tucker: Liquid(?)
Q87 Mr Todd: I assumed it meant that, but it is a nice new word to learn. To what extent do you think this shock will make the banking system look harder because, to be honest, there is an illogicality, which is that new business remains attractive, based on the realities presented to you, and should not be affected by a process of clearing out your past mistakes. To some extent the market, as the Governor hinted, will deal with that in that there will be businesses that identify opportunities and will be able to move faster than those clearing their balance sheets. What is your perception?
Mr Tucker: If I could first add, as a supplementary to what the Governor said in a previous question, we will probably get our best read on credit conditions when our next credit conditions survey comes out, which is due in a few weeks' time. The key question then will be whether banks say that they have tightened credit conditions more or less than they said three months ago they were expecting to over that three-month period, so that will give you the hardest information we have on that. The issue you raise is quite a challenge for the banking industry compared with, say, the reinsurance industry. The reinsurance industry, not uniformly but to quite an extent, will set up separate vehicles, whether it be in a Lloyd's where it is a vehicle over time or in Bermuda where it is a vehicle for a particular vintage of business. If they write duff business and the prices adjust, they can set up a new vehicle and take opportunities that they currently see. Banking is different; they carry the legacy assets on their books. As the Governor says, that means that any adjustment in the banking sector is fairly long and drawn out. Do I think the banking industry will restructure itself in some profound way to make itself a bit more like the insurance industry? I doubt it, frankly. I think that banking is different in quite a deep respect. I do think it means that the lesson, if you like, is that the biggest bankers will have their legacy portfolios on their balance sheet and it means they have to be careful about the business they write because it will be with them tomorrow and the day after tomorrow. One of the great lessons from this episode is that even when you think you have distributed risk to some of your clients, it can come back to you either contractually or to protect against reputational risk.
Q88 Mr Todd: What do you think the medium-term position will be on LIBOR, the relationship between that and the base rate? Has there been an adjustment in that, which we will have to get used to?
Mr Tucker: Judging from the financial markets themselves, they are predicting for the dollar, the euro and sterling that the spread, the difference between LIBOR and policy rate will settle around 40 basis points, which is considerably above where it was before this whole episode began. I do not know whether 40 will prove to the right number or not; but it does seem to me to be plausible that it will be a higher number. I also think that what will happen in financial markets is that in degree there will be slightly less reliance on LIBOR as the benchmark interest rate product. We will probably see a growth in activity in products related to expectations of our policy rate and the Fed's policy rate and the ECB's policy rate. I do not think for one moment though that that will squeeze out LIBOR from financial markets. We, and fellow central banks, have taken quite a close interest in the work that BBA has been doing to buttress the governance around the LIBOR process.
Q89 Mr Todd: Can I turn to the growth projections for next year, where we certainly have had more Cassandra voices than the ones presented in your report, where you are assuming a substantial recovery in growth in 2009. Have you had reason to reconsider those projections?
Mr King: I am sure we shall look at them again when we turn to our next forecast round, and we will tell you about them then.
Q90 Mr Todd: Right!
Mr King: The committee makes these projections every three months. It is not a sensible idea to -----
Q91 Mr Todd: Second-guess it in between!
Mr King: Once you start to make forecasts every day and whether it has changed since yesterday, you slip into this process of making no adjustments.
Q92 Mr Todd: Let me instead put some of the things that might make one think that your projection will move downwards! One is that perhaps we will see a slower rate of global growth, partly fuelled by higher inflation levels in some of the developing economies. That might be one basis for that, although one might balance that with the expectation that food price inflation will fall as a result, because that appears to be directly related to the rapid growth within the developing world. That would be one of the areas of possible doubt and potential for revision downwards.
Mr King: Keep going because this is giving us an excellent agenda for our next meeting! You make some good points, and we will consider them.
Mr Todd: There has been a reasonable amount of expectation that the Government's own growth forecasts may be over-optimistic for the UK. It has already been touched on ----
Chairman: Is there a question coming?
Q93 Mr Todd: Well, he is not answering and being very careful not to comment on it! The likelihood of increased government borrowing, which may also knock through into your decision-making on interest rates are among the factors that must be borne in mind. You would accept that, too, I imagine!
Mr King: All of these points are perfectly reasonable points. How far they will actually map through to change - remember we always stress the risks around the central projection. We do not put a great deal of store on the central projection. The chance of it coming through is close to zero, as I always say. There are significant risks and we will just see how they play out.
Q94 Mr Todd: But the risks are surely to the downside!
Mr King: We said that in our report. It is always psychologically very easy to think of downside risks. There are also upside risks. It is easy to forget that. If it were the case that all the risks were on the downside, you would be moving the central projection down as well because there would not be anything above it! There are risks on the upside.
Q95 Mr Todd: Can you give an example to cheer us all up?
Mr King: The US economy may not do anywhere near as badly as most of the Cassandras have been assuming it was doing. The European economy may not slow down as much. The Asian economies may turn out to be a bit more robust. We just do not know. It is only sensible to recognise that there is great uncertainty. I am not arguing that the balance of risk lies on the upside, but I am merely point out that there are risks in both directions, as we have always seen in the past. The big difference between the way we approach it and the way many of the commentators approach it is that the commentators focus only on the central projection; but we do not. The balance of risk is crucial and we are very conscious of that. That is why we try to monitor the risks and look at this month by month.
Q96 John Thurso: Governor, can I return briefly to the answers you gave regarding your predilection for letter writing? I fully accept the answers you gave and completely understand the explanation as to why the target should not move. The Fed has two responsibilities, one being of employment within a sustainable economy - and you have one objective, which is basically inflation. In obliging you to write a series of letters, are we not missing the other side of the equation of responsibility in this matter, which is that the Chancellor should respond to you? You are being asked to take a judgment about when it is or is not sensible to have the depth of a recession, which in a way is not strictly part of your remit. It obviously is part, but it is not actually in the statute. Should there not be a response to you on these points that you raise in your letters?
Mr King: I think if the Chancellor were unhappy with the explanation that we gave in the letter, then he would write back and say that. Remember that in the letter we have to set out over what time horizon we would expect to bring inflation back to the target. If the Chancellor were to feel that we should be bringing inflation back to the target more quickly, then he could say that in his letter; but so far, in the two letters that have been written, the Chancellor has not been dissatisfied with the explanation or the strategy that we set out for responding to the problem. You are quite right that the Chancellor has the opportunity in that letter to say that.
Q97 John Thurso: So the lack of response is basically saying that the Treasury agrees and the Chancellor agrees with the strategy you have set out in your letter!
Mr King: I presume so because in broad terms they have the opportunity to say, "Your remit is to keep inflation at 2% at all times; and if you say that you expect to allow inflation to persist above the target for 18 months to two years before it comes back to the target, we think that is not good enough and you should bring it back more quickly" they have the opportunity to say that.
Q98 John Thurso: Thank you for that. Sir John, can I ask you about the two monoline insurers in the States that have been downgraded from AAA, and that it is anticipated that banks will be obliged to take further write-downs? Do you think that this poses a risk to wider financial stability?
Sir John Gieve: We have been worried about monolines for some months and I think they still do present a risk, and certainly some banks that have relied heavily on their insurance. The one positive, I would say, is that this has drawn out now over several months, so I think most of their market counterparties have had time to set in place plans for dealing with that. I remember there was a great deal of worry around January, and I think if a monoline had failed in January - one of the big ones - that would have really rocked the system. We are now six months on, and I think people should be in a better position to handle them.
Q99 John Thurso: Governor, you talked, in answer to other questions, about the growth of the Bank's balance sheet through financial engineering and its re-balancing, de-leveraging. It seems to me that the banks are responding to the crisis they largely created by doing what they always do, which is punishing their good customers with higher credit; but there is also the fact that the scarcity of credit will slow down considerably the ability to invest in R&D and innovative businesses which impact on the future growth of the economy. Is that something that you have given thought to, and do you see that as a risk for future growth?
Mr King: Certainly we have given thought to the ability of the banking system to finance investment in general. We have not focused on particular types of investment, but investment in general. That will affect not only the expenditure on investment but also, as a result, the growth of productive capacity of the economy, which would otherwise have been enhanced by more investment. That is one of the consequences of the credit crunch. It is extremely difficult to make quantitative judgments as to how big that impact will be, and that is why we put a lot of weight on business surveys and indeed our own surveys through our agents as to what firms are telling us. We will be focusing very much on the impact of the credit crunch, not just on consumption and borrowing for house purchase, but also on investment.
Q100 John Thurso: You highlighted food prices in your statement and in the report. The Ernst &Young ITEM Club recently issued a paper in which they claimed the UK was more exposed to rising world food prices than its peers because of its trade deficit in food. Do you think that is an accurate analysis, and what impact do you think it might have?
Mr King: Again, I think it is very hard, in part because the data in this area are not necessarily entirely accurate. There is an offset to that phenomenon that was pointed out, which is that if you look at the official data, it appears to suggest that our expenditure on food is a smaller share of overall household spending than in other European countries. Whether that is true or not I do not know. There are some oddities in the apparent pattern of expenditure on food that are not entirely easy to explain, suggesting that data may not necessarily be completely comparable. I would have thought that in the end food prices, because there is trade in food, will tend to be equalised across countries in many kinds of food anyway, particularly in so far as related to the fact that we import food and therefore that it would be unlikely that that would have a major impact. I just do not know. The impact of higher food prices is big enough in itself here so let us worry about that: I am less concerned about whether the effect is bigger or smaller than elsewhere. I am more concerned about the fact that it is big here.
Q101 John Thurso: Do you think the fact that more than half the food consumed in this country is not consumed in the home and therefore comes through effectively the hospitality businesses or food-makers in one way or another has not been sufficiently taken into account in looking at food consumption figures? Traditionally we think food, and we think of people buying it to take home and cook and eat; whereas 50% plus of food is in restaurants and sandwich bars and all sorts of other places.
Mr King: Certainly the Office for National Statistics is very conscious of all that and collects data both for food consumed at home and outside; but the difficulty must be - although I am no expert on this - that what you obtain data on relatively easy are expenditures, not quantities. It cannot be easy, I imagine, to divide expenditure on food outside the home into those components which are purchase of the food component versus the service component that goes into the creation and serving of a meal, and the financing of the premises on which you choose to eat it. This is not an area in which I have any particular expertise. I would have thought you have a lot more than I do!
Q102 John Thurso: As it was my old businesses I am probably riding a big horse! I think the point that it comes down to is whether food prices and to a certain extent energy prices should be given as much weight as we do give them in our measure of core inflation; or whether we should find some way of re-balancing, which is the logical place if you look at what the ITEM Club said that you arrive at.
Mr King: What I disagree with in terms of the idea of promoting core inflation is that whatever measure you use does not change the reality of the dilemma we face at present. If the Monetary Policy Committee were to say to people, "We have decided that actually the amount you really spend on food is a bit less than the official statistics say and we are going to ignore that", people would look with incredulity at us because they can see now what the real position is. Whatever measure we use now makes no difference to the real situation they are in. The dilemma is out there and we have to confront the dilemma. I do not think that pretending that in some sense we should put less weight on one measure of inflation than another helps a lot. The way we deal with this problem is, as I have said before, is to look ahead. We are not trying to say that inflation must be brought back to target immediately; we are trying to look at where inflation will be two years from now. One of the reasons for not putting all your eggs in the basket of core inflation is that not only is core inflation not something that anyone actually pays, but it is not necessarily a good predictor of where headline inflation will be two years from now. Other prices and wages may change in response to particular movements in energy and food prices. Just stripping those out to get a core inflation measure is not necessarily a good guide to what underlying inflation is. There are two good reasons for not using core inflation measures, and a better reason for saying, "This is the best measure of headline inflation we have got; it includes everything you spent your money on, and it will move up in the short run, but we believe it will come down, looking further ahead." That explanation is probably better than simply saying, "Here is a different measure that is not moving up as much."
Q103 Mr Dunne: Governor, in your Mansion House speech you referred to reductions in disposable incomes looking forward. How much of this is due to tax rises above inflation?
Mr King: This year there will be a temporary pause in living standard increases on average - and I stress "on average" because it is will be very different for different families and people. That is almost entirely down to the increases in energy prices and food prices.
Q104 Mr Dunne: Do you monitor the impact of tax rises on household consumption?
Mr King: Yes, part of our judgment in the forecast process is to look at what fraction of household incomes are taken in tax. That is an important part in the construction of our judgment about where real disposable incomes will go, and hence consumer spending.
Q105 Mr Dunne: Although you have identified in your statement energy and food prices as the two primary components -----
Mr King: This year.
Q106 Mr Dunne: Where do you rank tax as a feature in changes in household -----
Mr King: It depends on the period you look at. If you look back over the last three to four years, tax increases have played a part in the observation that the growth of real disposable incomes has been below that of growth in the economy as a whole. There has been some squeeze in real take-home pay. It has not gone down but it has just grown a bit more slowly than the growth rate of productivity over a long period. Looking ahead, this judgment as to the size of the average tax rate on households is not our judgment; it comes from the Budget Red Book. There is a further small increase projected in the next few years. There has been an increase in the past three or four years, and there is projected to be a small increase in the next few years.
Q107 Mr Dunne: You have identified energy prices and we have touched on a couple of points today. Professor Besley, do you agree with the Governor's assessment about oil prices because in April you wrote an article where the correlation between oil price inflation and general inflation you said did not really exist. Is this over a long period of time or is it a timing issue rather than a disagreement with the Governor?
Professor Besley: It is certainly not a disagreement. The point I was trying to make there was that if you look over a longer period and you exclude two very significant episodes, 1973 and 1979 - and we do not have enough information to what extent we would want to exclude the current episode - but my guess is you would want to - there is basically no correlation between inflation and oil prices. The reason is oil price fluctuations relative to other price changes are pretty small, so in terms of what was driving inflation in that period, it was not a significant driver. The real point I was trying to make, and one that I want to reiterate here, is a point about inflation persistence. There is no reason to believe that oil price changes have led in any way to persistent changes in inflation; and therefore by and large over the kind of range of fluctuation we have seen over a longer period it has not been the story as to what has driven inflation over anything like the medium term. The only way in which current oil price increases could have a permanent impact is if there are responses in other prices and wages, as we have already said.
Q108 Mr Dunne: Governor, do you see, therefore, oil prices adjusting to allow you to anticipate inflation coming down in 12 months or so? Are you making predictions about what will happen to the oil price?
Mr King: I do not think we are in a position to make better predictions than the market as a whole. We take as our central view what is embodied in the futures price, which is and has been for some time flat from where the spot price is. Of course, the spot price has moved around and so, by implication, has the expected future price. This is one of the great uncertainties and I think we do not pretend to be able to forecast that. We have to react to the changes that we see. Tim's view is absolutely right: the message is that difficult though it is for us to deal with this much larger variation in CPI inflation than we have seen through the previous ten or eleven years of the MPC's existence, it is up to us to make sure that this is a temporary impact of CPI inflation. As Tim said, over a longer period the lesson of history is that it is only temporary if the monetary policy response is appropriate.
Q109 Mr Dunne: Do you think the recent rapid increase is mostly down to restrictions in the current supply and the ability to bring new supply on stream, or increases in demand, or down to speculation?
Mr King: I do not like the attempt to distinguish the cause of an increase in the oil price or indeed any asset price between demand and supply on the one hand and speculation on the other, because as soon as you get into the futures market demand is, by definition, a speculative demand and it depends on what people think will happen to oil prices in the future. I do not think that is a terribly helpful distinction. The information we have makes it difficult to determine how far the oil price is moving in response to changes in demand or changes in supply. It is clearly the case that the bulk of the increase in recent years has reflected a sharp increase in demand because of the expansion of China and India and other Asian economies, relative to what looks like a relatively fixed supply. You would expect in the longer run that that increase in price, if it were expected to persist, would bring forth greater supply, and we will see whether that happens. You would also expect the higher price would start to diminish demand, and we are seeing that. In other words, that very high oil price contains within itself the seeds of its own destruction with the increase in supply and diminution of demand. We are beginning to see that. I am no expert on the oil market and I do not pretend to predict, and I do not think the financial markets have been very good at predicting. We will have to see what comes out of it. What is important from our point of view is that we monitor and understand what we can about it, and then accept policy accordingly to ensure that these shocks coming from the rest of the world are only temporary shocks to our inflation rate. I will say just one other thing. It is true, as I tried to allude to earlier, that some of the increase in the nominal price of oil is reflecting a situation in the world as a whole where monetary policy looks on average a little lax. I think the concern we should have - this is a concern that is not the responsibility of any one country but should be a concern to the international system as a whole - not just the IMF but the G7 and all of us involved in international discussions. We talked for a long time about the imbalances in the world economy and we did so in an environment where they were still relatively benign. We talked about the unwinding of the imbalances and what that might do. What we are seeing, which was not fully anticipated, is that the imbalances are now unwinding in a way that is not just possibly leading to a sharp slowing of the world economy, as Mr Todd suggested, but also higher inflation. The linking of the exchange rates of the countries in the Far East to the dollar at a time when the dollar interest rate has been cut very sharply for very good reasons in the United States - that level is not appropriate to those countries. The exchange rate has come down in a way that has led to an expansionary monetary policy. Right up until last August everyone was worried about too much liquidity in the world economy. Then we went through six months where everyone said there was no liquidity at all and that central banks had better start providing it. Now we are back in a position where people are nervous about extra liquidity in the world economy. The biggest challenge for the world economy as a whole is not the oil price as such - I think there are mechanisms that will lead eventually to an equilibrating between demand and supply - but it is trying to ensure a monetary policy framework for the world as a whole that does not build into it an excess inflationary impetus. That is a challenge, and in the short run that can make life difficult for countries that are really committed to keeping inflation down. It certainly does not stop us in the medium term from determining our own inflationary fate but it can make life awkward in the short term.
Q110 Mr Dunne: What you have said is very revealing, and it suggests to me that perhaps the Prime Minister and the Chancellor have been tilting at the wrong target when they rode off to Opec on their charger, which has been likened by one of the commentators to fighting with a toy plastic sword against the indomitable forces of nature. Actually, I think you are suggesting that it is not the current oil price that is causing the problem; it is the exchange rate imbalances with the major oil-producing countries and major consumers, which is ultimately driving the process.
Mr King: I think these factors, which distort the way in which monetary policy is set in the world, and which have produced very significant shifts in real income between different parts of the world economy are the major factors that we should be thinking of in trying to analyse the challenges facing the world economy. It is important that we try to do what we can to increase supply of oil.
Mr Dunne: The measures after last weekend resulted in an increase in the price rather than the supply.
Q111 Mr Love: Was the response to your letter to the Chancellor of last week - widely characterised as dove-ish - what you expected?
Mr King: I do not think some of the comments made about the letter were expected or indeed an accurate reflection of the letter. I think what they reflected more was the fixed view which some people had in mind before the letter appeared - it was the framework from which they were showing it. One of the things we found slightly puzzling in recent months was that as recently as May the market seemed to be pricing in two or three cuts in interest rates over the next few months; and then it suddenly swung round in a month to expecting two or three rises in interest rates. That seemed to me a rather sharp reaction to the data. I think ours was a more balanced response. I do not think we thought the letter was - or it certainly was not intended to be "dove-ish"; it was intended to be a balanced statement of the outlook, with risks on both sides, which we spelt out very clearly. We thought about the letter carefully. The whole committee discussed it and we sent it off, so we were slightly surprised by some of the headlines - but then we should not be really because, frankly, some of the headlines bear little relationship to even the stories beneath them, let along the events that generated the story!
Q112 Mr Love: Since, as politicians know only too well, perceptions rather than reality are pressures upon us, do you think there is any need for further explanation to ensure the correct interpretation?
Mr King: Well, we live in a world of reality not perception. I will leave the perceptions to you. What is important for us is that we continuously explain what we think the reality to be. We cannot just sit in our little corner in the Bank and ignore what people think - expectations matter; but I do not think we should go out and try to rebut or change a particular story. Our task is, on a regular timetable which we have with the minutes and speeches and so on, to continually explain what the Committee's view is. I think over time, if there are misconceptions they will be corrected by the steady continuous explanation that we will make.
Q113 Mr Love: Because this is a particular time of sensitivity between growth and inflation and how you balance the needs of the economy, does that make the importance of getting the forecast inflation rate going forward more important than it would normally be; and how confident are you that you are doing that?
Mr King: It certainly makes it important that the judgments we make are as well informed as possible and that we explain what those judgments are. The problem is that even simple things like the timing of any further pick-up in inflation is almost impossible for us to judge easily, particularly at a time when it is so dependent on particular decisions by the utilities setting gas and electricity prices. You have no means of knowing precisely when they are going to do that. It is difficult to make these judgments. The most important thing is that we explain as clearly as possible what we know and what we do not know, and then leave it to others to form their own judgment. That is all we can do - be as clear as possible. That means thinking carefully about communications, but not overdoing it. We do not want too much noise. I do not want people to think the MPC says one thing today, uses a different word on Wednesday and a different word on Thursday. That is noise and confuses the communications. It is having regular, consistent but not everyday communication about our message so that people can understand what we think.
Q114 Mr Love: There has been quite a lot of commentary in the media, and you are being urged by many to put up interest rates as a signal of inflationary expectations. Indeed, we were told last week that higher interest rates "shows a seriousness and credibility about fighting inflation". How do you respond to that argument that is going on at the present time?
Mr King: I think the best way to be serious and credible about fighting inflation is to set out clearly what we think to be the likely path of inflation over the next two years and to set our policy accordingly. It is only a month or so since people were saying if we were serious about the health of the British economy we should cut interest rates by a vast amount and follow the Americans. Within a month some of the same people said: "Gosh, the problem clearly is not growth, it is inflation; why do you not raise interest rates to demonstrate?" This is not what we should be doing. This is not serious. Being serious about it is being absolutely serious that we are targeting inflation and not growth, and being quite clear about what we think our judgments are on the likely path of inflation, with all the risks - upside and downside - and then carefully setting out a judgment. Quite reasonable people disagree about the precise level of interest rates. We have always said that, and it is true now too. You can have a perfectly reasonable disagreement about precisely what to do with interest rates, and all we can do is make our best judgment and stick with it, and look at it again next month and take one month at a time and explain very clearly the reasons for our decisions. That, I think, is being serious about it: it is not making gestures in either direction.
Q115 Mr Love: Professor Besley, are you particularly concerned about inflationary pressure and how do you respond to the suggestion that is being made that there are likely to be second-round effects from the current temporary inflation that we are experiencing?
Professor Besley: I am concerned about inflation expectations. I think one should be in the process of inflation targeting. I think the best way to address that issue is by having a clear and persuasive account of what is going on and showing people what it is that is driving policy and what will drive policy in relation to things that may or may not happen in the economy. I spent two days on a regional visit talking to businesses about the challenges they face, and it is very interesting to see a broader take on inflation expectations on the ground. People are thinking hard about the implications and challenges in the economy. What we can engage with them on in these meetings, which are extremely useful, is not the detail of where things are going - up, down or sideways - there is a large amount of uncertainty, and it is a matter of understanding the issues and challenges and trying to see that we are addressing those on a month-by-month basis, rather than trying to think we confront inflationary expectations by telling people where inflation is going. It is more about making people understand the forces that shape that. Through a variety of means, whether on a very micro level, talking to specific individuals out on regional visits, or speeches or whatever, they are extremely important in giving a clear message.
Q116 Mr Love: I know you would not be drawn by Mr Todd in terms of growth rates going forward, but would it be accurate to characterise the current view of the Monetary Policy Committee that you are concerned enough about the slow-down in the economy that you think any movement in interest rates would not be helpful at the present time; and on the basis of the slow-down you are confident that inflation will come back over a period of time to the level that you are looking for?
Mr King: I feel you are trying to put words into my mouth, Mr Love!
Q117 Mr Love: We are always trying to do that!
Mr King: I am confident that we will bring inflation back to the target, but I cannot tell you what level of interest rates we will need to set to achieve that. I promise you that we will do our very best to set bank rates at whatever level is needed in order to bring inflation back to the target, but I do not know what that is.
Q118 Jim Cousins: Sir John, one of your team said this morning that it was psychologically easier to deal with downside risks, but in your own written presentation you gave to the Committee it seemed to me that your consideration of the outlook for the economy was very finely balanced between upside and downside risks, and there was a considerable stress on the downside risks to inflation and the risks to growth in the economy at the present time. Would that be a fair understanding of what you were trying to say?
Sir John Gieve: Yes, I think it is finely balanced. In setting interest rates, I approach this under three headings. First, there is the effect that an interest rate change has on domestic demand, that works through over a period of about two years and increases, depresses or reduces the growth rate of domestic demand. Secondly, there is a short-term market reaction, you are making a decision which may surprise markets, may change markets or may change asset prices. Thirdly, there is a semaphore involved here, ie in affecting the public's expectations of how the committee behaves and how far they can trust it. At the moment I think the fundamentals, if you like, the longer term, the two-year horizon is quite finely balanced and there are risks that the downturn will be greater than is necessary to bring inflation back to 2% over two years. Clearly, in the last two months the shorter-term considerations when we announced very marked increases in our forecast in inflation have tended to push the other way. Even on the longer term of course we do not know how commodity prices are going to behave over the next year and if they continue to get higher or stay at these current levels, there is the inflation risk.
Q119 Jim Cousins: In your written remarks to the Committee you did refer very clearly to the evidence of slowing investment and the reduction in employment growth. Will it not be particularly difficult to convince workers to contain their reactions to increases in their cost of living, their food and fuel costs particularly, against a background in which they already feel that investment and employment prospects are getting worse for them?
Sir John Gieve: What matters for the economy is what settlements are made for pay and prices.
Q120 Jim Cousins: I am asking you to consider how workers would view that situation, on the one hand, as you put very clearly to us, faced with a reduction in employment prospects, a squeeze on growth, and an increase in their own living costs? I am here using the term "worker" in a more general way, you will appreciate.
Sir John Gieve: Yes. In my experience, when workers are worried about their employment prospects they press less hard for pay increases if they think that is going to put their employer in more difficulties.
Q121 Jim Cousins: Yes, and so the impact on their living standards will be greater still and the impact on demand in the economy will be greater still and that will compound the downside risks to the economy, will it not?
Sir John Gieve: I think that is re-stating the downside risk. We are expecting a slowdown in activity. Over a period I would expect that to put a downward pressure on inflation and that is part of what is necessary to bring it back to 2%. The extra risk that I would be most aware of is through the effect of the credit squeeze, if you like, through the banking system and how much an impact that will have on investment and, secondly, the impact of the housing market slowdown on consumption, where again there is no necessary read across because there are winners and losers from a reduction in house prices but where I think you can see that movements in house prices and housing activity could have an effect on consumer confidence and a wider effect on the economy.
Q122 Jim Cousins: Thank you for that. Professor Besley, your own approach set out to the Committee in your written statement seemed to me to be a little different in tone, it was very clearly saying to workers that they must take the hit in their living standards.
Professor Besley: Certainly I do not view myself as being in the business of lecturing anyone about these issues. I think, and again I will draw on the experience I have had in the last couple of days talking to businesses in the process of negotiating wages, it is clear as we go through the next few months there are some very difficult negotiations that will take place because workers are very realistic and aware of the current situation in the economy and so are the people who run businesses. I feel fairly strongly that as long as that realism prevails, and I think it will, then there will be the kinds of absorption of some of these costs into wages that mean it will not result in longer-term inflation and, therefore, require more activism in policy going forward.
Q123 Jim Cousins: In your written statement to us you make it clear that you do not feel that monetary policy should prevent the real adjustments in living standards that are taking place at the present moment from occurring, those are of course downward shifts in living standards, and then you go on to say: "we will need to convince wage and price setters through word and deed that the increases in inflation that we foresee will only be temporary". That is a clear signal of your view that the living standards of workers are falling and you expect and almost require them to fall further and you do not expect monetary policy to do anything to alleviate that.
Professor Besley: Let me say a couple of things in response to that. One, I do not particularly like using the term "workers" here. It is all of us, it is all of us around this table, it is all people who are exposed to higher food and energy prices.
Q124 Jim Cousins: That is the sense in which I am using the term "worker", I am not using it in the old fashioned way.
Professor Besley: I prefer to say, "We have to adjust our living standards", meaning all of us.
Q125 Jim Cousins: We are all New Labour now!
Professor Besley: Let us be clear. Again there are a lot of people talking about the 1970s and other historic periods. One of the mistakes that we can make collectively is to believe that somehow by bidding up wages we can insulate ourselves from what are global phenomena, rising energy and food prices. Clearly, if we do that, that is a self-defeating process which comes through in higher inflation and wages will not end up being higher because the prices of all goods will be higher and that will be self-defeating. My reference is really to trying to say, "We have to avoid that process". The reality is that oil is at, whatever it is today, $136 a barrel, that will be have to be absorbed into our living standards and we will have to make adjustments around that. Some of those adjustments will have to occur immediately, hopefully they will be less painful in the medium term as people respond by changing their lifestyles to higher energy prices. This is just a pure reality check on where we are and I do not see that any way in which we could set monetary policy can avoid those real living standard adjustments and I think if we get into the business of trying to claim otherwise, we will be misleading people about what the role of monetary policy can be. Equally, in the medium term the economy will pay in the sense that inflation will be higher and it will be necessary for the monetary action to be taken later. It is better for this to be anticipated and for people to understand now this is a necessary part of the adjustment they have to face.
Q126 Jim Cousins: It seems fairly clear from that we are facing in the immediate period a reduction in the living standards of workers and that those bargaining on behalf of workers and the workers themselves are in a very difficult situation. As Governor of the Bank of England and Head of the Central Bank, what can you do to restrain the compensation packages in the City which will provoke, in a setting in which living standards are under pressure, a very strong reaction if people perceive that there is a part of society that is not sharing in those difficulties?
Mr King: I think I would rather use the phrase "a pause" in the growth of our living standards. I do not think we are talking here about something which is imposing absolute falls in living standards necessarily but on average roughly I would say for this year the impact of the rise in energy and food prices means, as Tim said, altogether as a country we will see a pause in the growth of our living standards. Normally the growth in productivity in the economy, which on average has been 2% a year, has meant that our living standards have been able to rise. The first thing I would point out is that what we are seeing this year, this pause, is the opposite side of the coin to the same forces that generated significantly increased living standards between the mid-1990s and about 2003-04, when living standards were rising about one percentage point a year faster than they would have done had we not benefited from the advent of China and India into the global economy. It is a pause for one year which is an offset to some extent to the very significant rise in living standards which the same ultimate cause generated. I think once we get through this period, then once again we will see the benefits of openness in trade which the UK more than any other economy has benefited from, that is the key thing. This is a one-year pause, that is what I would say. The second thing is that I have never commented on any individual pay settlement or group of pay settlements; as Tim said, it is not our role to do that. I have commented quite separately on the structure of remuneration in some large financial institutions, that does not seem to me to be the same as commenting on the level of remuneration. There are many groups in society which either get paid a lot more or a lot less and I do not want to get involved in that, it is not for the Central Bank. As Tim suggested, and he put it extremely clearly and I am not going to repeat it because he did it better than I did, essentially we are all in this together and the reality, explaining the challenges facing the UK economy as a whole, is our best role. In my role as governor I try to do that, to spell out what we see to be the challenges facing the UK as a whole.
Q127 Jim Cousins: Governor, the last time you appeared in front of the Committee on 29 April you referred very clearly to small, medium-sized companies whose managers and employees were paid: "far less than people in the City". Those were your words. On the same occasion you also referred to banks having "designed compensation packages which provide incentives that are not in the long-run interests of the banks". Do you not think it is very important that you follow through on that with, to use Professor Besley's formulation, clear words and deeds that will assist wage bargainers, and those they bargain for, in not having a perception that there are parts of the economy and people in those parts of the economy who are not sharing in the general difficulties of living standards that everyone else experiences? You drew attention to those very things yourself when you last came here on 29 April.
Mr King: Yes, but I did not do so in the context of a temporary pause in the growth of living standards, I did so in the context of trying to point out that the best hope for, if you like, reducing what you feel clearly is a provocative size of remuneration - I have not used that phrase or said that was the case - what I was concerned with was the incentives which produced excessive risk-taking. It is the structure, the design, of the remuneration packages not the level, which led in my judgment to some excessive risk-taking. The best way of dealing with that is for banks themselves to realise that it is not in their own long-run interest to do it. I think you are beginning to see after recent experience that the banks themselves are collectively understanding the design of some of those remuneration packages did lead to excessive risk-taking and, therefore, collectively they will start to move towards somewhat different designs of remuneration packages in the interest of the shareholders of those companies.
Q128 Jim Cousins: Governor, I think you are rather understating the force of the words you used when you appeared in front of us on 29 April when you said: "when so many young people when contemplating careers look at the compensation packages available in the City and think that these dominate almost any other kind of career". Those are your words.
Mr King: Yes, they are.
Q129 Jim Cousins: Surely you can see that wage bargainers and those they are bargaining for will read those words, and indeed they were widely reported in the newspaper so they had every opportunity of reading them, and they will feel a sense of difficulty about their own situation where their own living standards are declining?
Mr King: I do not think the issue about the relative level of compensation among different alternative employments for graduates coming out of university in the long term is relevant to how you explain the reasons behind a temporary pause in the growth of living standards for one year. I think they are quite separate issues.
Q130 Chairman: Governor, you seem to be suggesting that the danger of shielding the economy from increased oil prices and, in fact, other commodity prices is that such shielding can only be temporary and may have an adverse effect. Is that the message we should be taking back to our constituents?
Mr King: That is certainly true. I think the most important thing is that there is no magic bullet that will protect the UK or all of us from higher oil and food prices imposed on us by the rest of the world. As Tim said, it is better that we face up to that now and recognise that fact rather than pretend to ourselves we can avoid it and start to push up prices in the hope we can avoid this burden because the cost of reducing inflation once it has stayed above the target for a period will be a very prolonged and deep slowdown in activity. That is a much more costly process than we need to go through, that is the lesson of the past. Facing up to this reality now gives us the best chance not only of bringing inflation back to the target quickly but also of resuming growth.
Q131 Chairman: I take it that is no dovish comment.
Mr King: It is not meant to be a dovish comment, it is meant to be an objective comment on our position.
Q132 Chairman: The June minutes show that the MPC
considered all options available to it, cutting, maintaining and raising
interest rates. Did any of you on the
panel advocate raising rates and, if so, what persuaded you at the end of the
day against voting in such a way?
Professor Besley: At every meeting I say I consider all three options, so there is not much news in that per se. As you know, I did not vote for the cut in April and I certainly contemplated the case for an increase in subsequent meetings. As ever, when I cast my vote I make my best judgment about where the economy is going and which factors are most relevant to that. I still felt I wanted more time to consider the medium-term implications of what we have seen recently and it takes a while to process that outlook. I did not feel ready to vote for an increase at that meeting and I certainly felt, as has already been mentioned, given the yield curve had moved significantly, that it may have given an unwelcome steer to make such a judgment at that meeting but there were a variety of factors, it was not just one factor. I just did not feel that on the balance of risk, although they have changed, I think, to the upside for inflation, they merited a rate increase at that time.
Q133 Chairman: Maybe I could ask each member for a short answer on this. The MPC appears to be in a wait and see mode at the moment. What information will you be looking for to convince you of the need for a change in the base rate? Kate?
Ms Barker: You did not ask me this question, perhaps because you had an assumption about the answer. I too considered the case for a rate rise at the last meeting and I think it would have been odd not to consider the case for a rate rise from a position of holding the previous month, given the very large change in the short-term inflation prospects we face. Of course, that does not necessarily mean there is a medium-term change and that has already been very well discussed. Why did I not vote for one? My reasons are very similar to the ones Tim has given, there had been a considerable tightening in market expectations, to some extent of course that delivered some tightening to the economy. In addition to that, when we met we only very recently had quite a big rise in the oil prices, there was considerable uncertainty about the short-term path of energy prices, and I felt we could pause and consider what would happen. As to what we are looking at over the next few months, of course we will be continuing to look at the effect of the fallout from the credit crunch, how that is affecting the housing market, how it is feeding through to consumer spending and, particularly, how it is feeding through to employment. On the other side, we will be looking at inflation expectations and, in particular, a view of likely changes in wage behaviour for the reasons that have also just been very lengthily explored.
Professor Besley: I would only add to that, what we have been seeing from the pricing surveys and particularly recent output prices from businesses has not been particularly supportive of the near-term prospects for inflation, I have certainly been monitoring those carefully, but I think it would be very hard to say that there is some very simple mapping from one data series into a decision like this. The very difficulty in describing what we do is we have to weigh across a variety of steers we get from different things, but certainly the big issue is, are we going to avoid the kind of second round increases in prices and wages. If I felt at any point that looked in jeopardy, that would be the kind of signal which would certainly send me towards wanting to vote for an increase.
Q134 Chairman: Sir John?
Sir John Gieve: I agree with both of those. I did consider an interest rate increase but rejected it at this point. I think I will be looking, first of all, at price setting and wage setting behaviour, is there any sign of that changing? On the other side it is a question of is the slowdown that we are expecting actually happening because, looking backwards, we see some surprisingly strong consumption figures, for example very recently, so the question I have there is, is our previous judgment of what we have done enough to bring about a slowdown in the economy actually producing the goods?
Mr Tucker: I also explored the case without advocating the case for a tightening. Very important to me over the coming months will be the nominal indicators, money growth, nominal demand, long-term bond yields and, as Kate said, nominal earnings growth. I think the labour market is going to be crucial to this. The other thing will be commodity prices themselves. The greatest hazard I think we could encounter is that the oil price continues to rise and we say, "This is a temporary rise in inflation", and temporary gets extended and people in the real world say, "What do these people on the MPC mean by 'temporary'? It seems to be rather extended". We cannot control the oil price and so we just have to stick to our guns in explaining what is going on. The other thing, and the Governor has emphasised this, is what goes on in the emerging market world is going to be tremendously important. The global imbalances have driven part of the problems we have and they remain a cloud over the Western economies. It makes it likely that we will end up with tighter monetary policy than otherwise, that growth would be slower than otherwise, the pressure on the banking system would be greater than otherwise. When I say "us" I mean not just the UK but the rest of Western Europe and Member States and I really do think that could be a quite hazard over the next two years and a complication for UK monetary policy.
Q135 Chairman: Governor, last word to you. What reality check are you leaving the Committee with this morning?
Mr King: As you can tell, my colleagues are eloquent and persuasive, so at the meeting all I had to do was listen to them and it was pretty obvious what I should do. They have summarised exactly what data we will need to look at. It is a question of what is happening to the other costs and prices in the economy, but I would echo what Paul said about oil prices, a continued rise in oil prices or food prices makes it that much more difficult to argue that it is simply a shift in relative prices and if it was feeding through to inflation for a longer period we will to have to take action. Looking at what is going on to the other costs and prices is the key to it and I think Kate, Tim, John and Paul have summarised very accurately what we will be looking at and we look forward to coming back to seeing you to report on that.
Q136 Chairman: Could I thank you and your colleagues for your presentation this morning.
Mr King: Thank you.