Examination of Witnesses (Questions 60-79)
RT HON SIR EDWARD GEORGE, MR MERVYN KING, MR CHRISTOPHER ALLSOPP, MR CHARLES BEAN AND PROFESSOR STEPHEN NICKELL
THURSDAY 28 FEBRUARY 2002
60. We can take it then from your comments and Kate Barker's in The Financial Times this morning that you are on side with her and against the consensus in the financial markets that the next move in interest rates will be upwards?
(Mr Allsopp) Of course, it follows on what I was saying that I am not in line with what the financial markets are expecting in terms of interest rate changes. I would hasten to say that we can all be wrong. The news tomorrow might be quite different, and if the news tomorrow suggests that inflationary pressure is higher or demand is stronger or the US recovery is likely to be stronger and less delayed, some of the risks of the downside go away and I, like everybody else on the MPC, would be expected to change my mindand you ought to be able to predict how I would change my mind.
61. Presently you hold the minority view on the MPC.
(Mr Allsopp) Yes.
62. Governor, you were very optimistic, quite optimisticwell optimistic . . .
(Sir Edward George) Cautiously optimistic. I am never more than cautiously optimistic.
63. We would expect no less of a central bank governor, except perhaps Alan Greenspan. You were taking a cautiously optimistic view of the course of the international outlook and the prospects for the international economy, but in fact, in the summary of the arguments which members of the MPC heard at their last session, there was a remark about concerns about the Enron fall-out, the just announced Allied Irish bank losses and from Japan of somewhat greater financial fragility in terms of asset prices and so on. Do I see from that that in no sense are you taking American recovery for granted?
(Sir Edward George) Yes, we do. Whenever I talk about it I use the word "tentative signs" and that is precisely the terms that Alan used yesterday. I do not think it is written in stone that we are going to see its recovery. My best expectation is that we will see this recovery. There are always risks on the upside and the downside.
64. So you would regard some of the press comment about Mr Greenspan's comments yesterday as perhaps over-selling optimism?
(Sir Edward George) Interestingly enough, I honestly have not studied the press in general today, but what press I have read gave me the impression that perhaps they were on the cautious side. If you actually look at the numbers in what he said of growth during the course of this year of 2.5-3 per cent, I think some of the suggestions were that he was more cautious than perhaps those numbers suggest.
65. The Guardian yesterday had a rather alarming article about the prospects in Japan, foreseeing the possibility that Japan could be moving towards a 1930s-type depression. If that were to occur, what would be the impact on the world economic situation and to what extent have you foreseen any of this sort of risk in the analysis that was presented?
(Sir Edward George) I have not read the Guardian article and it sounds rather extreme. Typically, there is a black and white dimension to this, and I would not have a view if you are talking about a 1930s-type result in Japan. What I think we do see in Japan is rather discouraging over the next couple of years, in the sense that they clearly have a very weak economy now. The focus in Japan is on addressing some of the supply side weaknesses, which they have suffered with for some time and which are reflected in the bad loans; the non-performing loans on the balance sheets of the banking system. They produced a counter-deflation policy yesterday, which again, I am afraid, I have not had a chance to look at in any great depth, but they have been focussing on the supply side issue, and they need to; it has to be addressed. But Japan also has a demand side weakness, and the two things are connected in the sense that if they address the supply side weaknesses, if they try to get banks to foreclose on some of the non-performing loans rather than simply carrying them forward, that could adversely affect the demand side in Japan by causing unemployment to rise faster, to generate uncertainty and lack of confidence in the consumer sector in particular, in which case the Japanese economy will go through a sustained period of weakness before it benefits from the changes that they make on the supply side. I think that that is an analysis which many people in Japan also recognise. So it is not a tremendously encouraging prospect in the next year or two. You ask what impact that picture would have on the world economy: it depends whereabouts in the world you are. It would obviously be a significantly depressing experience in Asia, but the impact on Europe and the UK will be relatively modest, and that is factored into the forecast that we put in the Inflation Report.
66. Mr King, first of all, does the MPC set any store by ready reckoners for the relationship between interest rate movements and the effect of interest rate movements as opposed to exchange rate movements on monetary conditions? The old adage used to be a four per cent move in the exchange rate would roughly be equivalent to a one per cent interest rate change.
(Mr King) I speak for myself, and I think it is also true of our collective discussions, that the Committee puts no store by these ready reckoners. The reason is quite simple. It goes back to the point that Chris made earlier, which is that the impact of a change in the exchange rate on the economy and on inflation depends very much on the circumstances in which that change occurs and why the exchange rate altered. One can think of different scenarios in which a given change in the exchange rate might have very different implications for inflation. It is fundamentally misconceived to equate a change in the exchange rate with a change in UK domestic monetary conditions. The exchange rate can change for all sorts of reasons, including developments overseas, which are unrelated to UK monetary conditions. The implications for inflation would obviously not be the same, hence I think ready reckoners are fundamentally misconceived, and from that point of view ought not to play any role in the setting of policy, and they do not. What we do is to ask the question: given that the exchange rate has moved, what implications does that have? Instead of a ready reckoner, we would say it is our projection for inflation which replaces a ready reckoner.
67. Do you agree with what Mr Allsopp said a moment ago, and I think the Governor said in evidence on Tuesday, that you cannot take exchange rate changes into account in working out where you should set policy until the exchange rate change happens?
(Mr King) I do not think I would exclude the risks to the exchange rate altogether from my judgment on policy. If you knew that the exchange rate day to day would either remain constant or would fall by, say, 10 per cent, it clearly might well make considerable sense to exclude the risks in your policy judgement. You would have no chance to take it into account until it did fall by 10 per cent, and then you could factor in your response, but that is not the only risk to the exchange rate. The exchange rate could drift down steadily over a period. If you think it is likely to move down over a two to three-year period, if you look at it month to month, it could be some considerable time before you woke up to the fact that it had actually moved to a considerably lower level, and then it might be too late to respond. So I think it is sensible to take some of the risks to the exchange rate into account. It is a very difficult judgment to know how much. This goes back to the question, as the Governor said and Chris emphasized, that there cannot be a mechanical link between the central projection and the policy decision, because, as I mentioned earlier, the central projection may be marginally below the target but actually the expectation of inflation, taking the risks into account, is actually above the target, and I think those risks are relevant to the policy decision.
68. What you are doing there is second-guessing the market to some degree. The market is by definition a reflection of a view of a symmetrical position. There are as many people in the market at the moment thinking sterling will go up as thinking sterling will go down, by definition. You are saying you think the balance of probabilities may not lie where the market thinks it lies.
(Mr King) I do not think it is second-guessing the market, because the market too expects that the exchange rate is more likely to go down than up, whether you look at option prices or whether you actually look at interest rate differentials. Interest rate differentials would not be there if we felt the exchange rate was almost certain to remain the same. So I think it is not second-guessing the market. The relevant issue is, given that most of us on the Committee think that there are some medium term downside risks to the sterling/euro exchange rate, the question is what is the appropriate policy response to that? There is no simple answer to that question.
69. The reason I am asking is because you said in answer to a question, when you issued the Inflation Report in the press conference, that the potential downside risk to the exchange rate is the main cause for the upside skew in the inflation forecast. So this is not just one issue you are taking into account. You are now justifying the upward skew in the inflation forecast primarily by reference to a view about where you think the exchange rate will go. Yet at the same time others on the MPC, including the Governor, are telling us that we should not take exchange rates into account until those movements have happened.
(Mr King) There are two separate questions. First, what is the inflation outlook? Second, what are all the risks that might affect inflation? That is what the fan chart is designed to illustrate, and the Committee felt that there were downside risks in the medium term to the exchange rate which created upside risks to inflation. One of the pieces of evidence for that is what has happened to profitability on the tradeable side of the economy. Those risks were agreed collectively to be relevant to the outlook for inflation, and that explains why there is an upside risk. Given that there is an upside risk, the question is what is the appropriate policy response? As I said earlier, and I think Chris indicated, if you ignored the risk altogether, you could say to yourself there is a prima facie case for considering a small reduction in interest rates. If you took all the risks into account, there is a prima facie case for raising interest rates, because the expected inflation rate in that projection is as far above the target as the central projection is below it. You may well not, for the reasons Chris gave, want to take all the risks into accountthat would seem quite sensiblein which case no change would be a perfectly reasonable judgment to take. So I think it is important to distinguish between the outlook for inflation, which is captured in the fan chart, and the policy judgment from that fan chart, which cannot be a mechanical one just from the central projection or indeed either from the mean or any other part of that distribution. It must take all the aspects of the risks into account.
70. It does seem to me there is a difference of view on the MPC about the role the exchange rate should play in monetary policy. If I may say so, there is extremely little information about the role of the exchange rate in the overall conduct of the Monetary Policy Committee in the inflation outlook.
(Sir Edward George) Could I intervene at that stage, because I do think that the distinction that is being drawn is not a proper reflection. It is very clear that in the central projection we make an absolutely standard assumption. We have changed it at times in the past, but there are two possible views about what standard assumption you make. One is that the exchange rate is a random walk; you have really no idea, in which case that would mean the exchange rate remained flat, and the other is that it declines in line with the interest rate differential for the reasons that Mervyn touched upon. We just draw a line between those two possibilities and that is what determines what is going to happen to the exchange rate in the central projection. Then we have discussion about the risks around that assumption, that conventional assumption. That is the way in which it is taken into account in the forecast. In the policy discussion your views about the likelihood of this risk materialising, of course, the change in the exchange rate which you observe, is factored in; that is arithmetic, but differences of view on the Committee about the likelihood of that risk materialising are bound to influence their individual judgments. I think that is true of everybody on the Committee, and I think that is the basis of the approach. The extent to which you think that this is likely to happen, and likely to happen in the near term rather than something that would happen over time, may very well affect you at the margin in your policy conclusion. But the approach is exactly the same. I do not know how we can explain to you more than that the way in which the exchange rate does enter into the forecast and into the policy judgment.
71. I understand what you are telling me. I am trying to get to the bottom of whether you have in fact a coherent position. A moment ago I was told that it is justifiable to deviate from what the spot currency market thinks is the central projection for the exchange rate on the grounds that forward markets take a view, in this case that the euro may rise and sterling may fall. In which case, is that what justifies, as you put it earlier, your suggestion that the upward drift in the inflation projection is derived from a possible higher euro and lower sterling rate?
(Mr King) There are two quite different things here. The central projection and the risks. The central projection moves up slightly towards the two-year horizon. That is not based on a view about the risks to the exchange rate. The risk in the central projection, which explains why the mean is above the most likely outcome, is because the Committee has taken a judgment that there are downside risks to the exchange rate against the euro and hence upside risks to inflation at that two-year horizon, and the policy response to that is a quite separate question. Those risks are by no means absent from the foreign exchange market. You would have to look at the prices the options market, and there does seem to be evidence that people think the exchange rate is more likely to fall than rise against the euro, but the magnitude of that is very hard to judge.
72. You are looking at those forward markets as a means by which to justify the view on the upward skew in the inflation rate.
(Mr King) I think "justify" is too strong a word. We have to make our own judgment. It is our judgment in the fan chart, not that of others, but it is a judgment that is perfectly consistent with market judgments.
73. One last question related to what David was asking. It is a purely factual question. If and when the Government do respond and provide an assessment of the five economic tests, will the Bank offer a view about that judgment?
(Sir Edward George) If this Committee or the equivalent Committee in the House of Lords asks us, we will do our best to give you our opinion.
74. But you are not intending to produce an opinion, a formal opinion as the institution most affected by any decisions that may be taken?
(Sir Edward George) No. The tests are tests which the Government has set, which the Treasury is undertaking. We are contributing information, but the decision will be taken, and the judgments and assessments will be made by the Treasury and the Chancellor.
75. Could I ask Professor Nickell would a fall in consumer spending which led to a depreciation in sterling necessarily lead to inflation, or could it be that the fall in consumer spending would cut demand-pull for inflationary pressures and so absorb the cost-push inflationary pressures of the fall in the exchange rate?
(Professor Nickell) That is possible.
76. Is it likely?
(Professor Nickell) My view on this would be that if you have a fall in the exchange rate, obviously that has an immediate effect on the prices of some goods in an upward direction, but there are a lot of other prices of imported goods, and their response would depend on the judgment of the firms who are producing the goods, and, as you pointed out, if there were simultaneously a fall in UK consumer demand, that would undoubtedly moderate the inflationary consequences of an exchange rate fall.
77. So we could look to a painless drop in the value of the exchange rate?
(Professor Nickell) I am not sure how painless it would be. If the consumer demand that occurred simultaneously fell too rapidly, that could be a negative. Of course, the fall in the exchange rate would be of assistance to our exporters. The response would take a bit of time and if domestic demand fell too rapidly in the interim, the economy could have a bit of a downward dip for a period.
78. Would a fall in the exchange rate address the imbalances that have been talked about in the economy?
(Professor Nickell) It would certainly assist the tradeable sector of the economy, which is the sector under severe pressure at the moment. That is one imbalance which would certainly lessen if the exchange rate were to fall, yes.
79. What in your estimation would be the necessary rate between the euro and the pound which would achieve that state of affairs?
(Professor Nickell) To be quite honest, I do not have much idea. The issue really, I suppose, is how far you want to go in boosting the tradeable sector. I would say, if I may speak in terms of the old deutschemark rate, since that is the one I am used to thinking in terms of, if the sterling rate fell to three or somewhat below that, that would certainly be very helpful. I know that some of those in the manufacturing sector would argue that the exchange rate should fall a lot further than that, but in my view for the overall health of manufacturing, I think a relatively modest fall in the exchange rate would be enough.