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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 1326
HOUSE OF COMMONS
TAKEN BEFORE THE
Bank of England May 2011 Inflation Report
Tuesday 28 June 2011
Sir Mervyn King, Paul Tucker, Spencer Dale, Dr Adam Posen and Professor David Miles
Evidence heard in Public Questions 1 - 48
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Taken before the Treasury Committee
on Tuesday 28 June 2011
Mr Andrew Tyrie (Chair)
Mr George Mudie
Mr David Ruffley
Examination of Witnesses
Witnesses: Sir Mervyn King, Governor, Bank of England, Paul Tucker, Deputy Governor, Financial Stability, Bank of England, Spencer Dale, Chief Economist, Bank of England, Dr Adam Posen, External Member, Monetary Policy Committee, Bank of England, and Professor David Miles, External Member, Monetary Policy Committee, Bank of England, gave evidence.
Q1 Chair: Governor, thank you very much for coming before us today. I think we can go straight into questions.
Sir Mervyn King: Yes. Given that the Mansion House speech was two weeks ago and the minutes came out last week, I don’t think there is any need to update you through an opening statement.
Chair: We feel statements are only really needed where there is some market reason for them.
Sir Mervyn King: There may be at times.
Chair: We have had that discussion before. I would like to begin by asking you about sovereign risk and what probability you ascribe to the risk of a Greek default.
Sir Mervyn King: I personally don’t ascribe a risk to Greek default. That is not for me to do. Some calculations that we published last week in our latest Financial Stability Report, based on a number of assumptions that may not hold, suggested that the market ascribes a probability of 80% to some aspect of default, depending on how big a default it was. But it is not for me to say or judge and, indeed, I think the more important thing is to try and tackle the underlying problems than speculate about whether there will or will not be a default.
Q2 Chair: But in order to make an assessment of the effect on the UK economy, you have to also make a judgement about those sovereign risks, don’t you?
Sir Mervyn King: We certainly have to make a judgement about the impact of those sovereign risks and what would happen if there were to be a default, but it is less helpful at this stage to worry too much about the finer points of whether the probability is 85%, 70% or some other number.
Q3 Chair: In other words, although you are not second-guessing the markets, you are, for the purpose of the work you have done on this, taking the market judgement as your base camp?
Sir Mervyn King: No, what we are doing is to say that there is sufficient concern in the market about the possibility of a default for us to think carefully about contingency plans and the consequences of this event.
Q4 Chair: You have done that. It is clear that you have given quite a bit of thought to this, and that is set out on pages 18 and 19 of your Financial Stability Report. In your press conference, first of all, you make it clear that you think that this is a solvency crisis and not a liquidity crisis, and if it is a solvency crisis, you then go on to say that there are only two routes out of this. One is forgiveness or gifts and the other is a step improvement in the relative competitiveness of the economy concerned; in this case, Greece. If the only routes out are one of those two, what do you think is the most likely?
Sir Mervyn King: That is a political judgement, and I wouldn’t want to stray on to that terrain. It is not for me to second-guess what people would like to do. All I would say is that I think this problem goes much wider than just the euro area. One of the problems in the build-up to the financial crisis was the continuing pattern of trade surpluses and trade deficits, which, as a matter of arithmetic, means that some countries were continuing to borrow from other countries on a continuing and substantial scale, and what the crisis revealed-as indeed had been said many times before the crisis hit-was that this was unsustainable and could not carry on. So if it is unsustainable the question is how you make the adjustment. All countries are in that position. The United States has to make an adjustment and we have to make an adjustment. We have made the adjustment in terms of a fall in the nominal exchange rate, which has improved the competitiveness of UK industry such that we can now rebalance our economy and, one way or another, that same process of adjustment has to take place in all countries that were running substantial current account deficits and had built up significant stocks of net external debt.
Q5 Chair: When you talk about a mechanism for improving competitiveness, you are talking about devaluation, aren’t you?
Sir Mervyn King: No. Ireland has pursued a different strategy, which is to reduce domestic wages and prices in order to become more competitive. They have had some success in following that strategy, but of course it has the side effect that if you have fixed nominal debt, external debt which is denominated in foreign currency-or at least in a currency, in their case euros-and they reduce the euro value of their domestic wages and prices, the real burden of the debt increases. So what they gain on the swings, to some extent they lose on the roundabouts. But each country has to work out for itself the best way of trying to deal with the economic logic that if you have a very large net external debt and you want to continue to service that debt, the only way to do it is to run trade surpluses. That is the economic logic. It has applied over many periods in history and it applies now, it applies to us, but it particularly applies in the euro area and it is up to them to find a way through it.
The point of my remarks on Friday was to say that, whereas providing liquidity support may buy time to put in place a long-term strategy under which this competitiveness can be regained, so far the time that has been bought by the provision of liquidity has not really been used to put in place programmes that will guarantee a significant improvement in competitiveness.
Q6 Chair: Your replies did not give the impression that you think buying more time is useful; indeed, you add the words "may be useful". You are not advocating buying more time now, are you, Governor?
Sir Mervyn King: It is not for me to suggest what should be done. What I am pointing out is that buying time is not sufficient. That time has to be used.
Q7 Chair: Is it in the UK’s interest that more time be bought?
Sir Mervyn King: That is not for me to say. That is for the Government to say.
Chair: That ball will be very much in your court if instability becomes a crisis.
Sir Mervyn King: It will indeed, and I think we all have an interest in trying to find a way through it. Buying time appears attractive very often, because the immediate crisis appears to go away. People get to bed earlier, they relax more, but in fact, if the underlying problems have not changed, the crisis comes back in an even more severe form, and that has been the case right through the past 18 months in trying to deal with Greece, Portugal and Ireland, and indeed in the problems for the euro area as a whole, which is why I say that there are dangers in just buying time, because if you forget the problem and say, "Well, thank goodness that has gone away for a few weeks" that can be a very dangerous attitude of mind.
Q8 Chair: You are giving very full and interesting replies to these questions, and I understand your reticence in certain aspects of your replies. You have also said that uncertainty is a major-perhaps the major-cause of problems at the moment in the markets in this area; it is not knowing exactly where the risk is, including where the risk is for the UK economy. With that in mind, coming back to my first question to you, don’t you think that one way of reducing uncertainty is for the major public institutions to be more forthright about what risk rating they ascribe to sovereign default?
Sir Mervyn King: I certainly think that, in the present circumstances, more transparency about sovereign exposures would help, certainly, yes, and I think the willingness to be transparent about that might help to give more confidence. Of course, it will also reveal some of the interlinkages, and I don’t want to pretend that there is any easy solution from the position that we are now in.
Q9 Chair: So while you haven’t been prepared to give me your probability of default risk for Greece, you think that it might be helpful for the eurozone to do so?
Sir Mervyn King: No, I don’t think there is any point speculating on probabilities of default. Where there is value is in trying to ensure that financial institutions and governments are very open about their exposures to other countries, both sovereign banks and private non-financial sector exposures, and I think that can do a great deal to help financial markets evaluate where the risks are. I think financial markets have to make their own judgement as to what the political outcome of this process will be, because in large part it is a political process. If there is a credit default event or there is a sovereign failure, then that will be a political judgement and a political decision. I don’t think it is easy to decide that on purely economic grounds. What can be done is to be transparent about the facts, as we are now, the exposures, and then financial institutions can make their judgement.
Q10 Jesse Norman: Governor, what contingency plans have you put in place against a Greek default?
Sir Mervyn King: Against?
Jesse Norman: A Greek default.
Sir Mervyn King: I am not going to go into details about the contingency plan discussions that we have had with the Government, but what I would say is, if you look at the provisions for liquidity insurance that we have put in place for our own banking system, they are radically different from the ones that were in existence in the summer of 2007, when the financial crisis began. We learnt from that experience, and we have put in place now special auctions for liquidity, which we can introduce immediately if we need to. They are held at regular timetables now but we could hold them tomorrow if we had to. These auctions-I think it is a first in the world-they have been very carefully designed so that banks can bid against either narrow or broader collateral, and that gives us a signal about the potential degree of liquidity strains, and there is the discount window facility, which is a new facility against which we lend against almost any collateral but with increasing haircuts as that collateral becomes riskier.
It is also the case that the FSA, working with ourselves, are looking very carefully at the exposures of all UK financial institutions. What I would say-and I think this is the concern that no one can do very much about-is that the economic logic that I explained about countries with large amounts of net external debt, and the need to convert trade deficits into trade surpluses in order to be able to service that net external debt, applies to a number of countries and not just Greece. If, as their crisis evolves and develops, financial markets came to the view that these problems had not been tackled, there was no long-run plan for dealing with the need to regain competitiveness in these other countries, then of course the crisis could not only spread, but it would lead people to speculate, "Well, okay, here is a UK bank, which we are told has rather little exposure to Greece and we can see that, but we don’t necessarily know all the exposures of the French and German banks to which the UK banks are themselves exposed". So trying to work out these other links is very hard to judge.
As I said on Friday, even knowing the mechanical links-a matrix of interconnections between banks-does not guarantee that there can’t be a sudden loss of confidence in which those who fund banks decide to step back and say, "Look, we have no idea which European bank is exposed really to which other European bank, therefore we will just stop funding European banks". I think US banks and other national banks could be drawn in in those circumstances. I am not saying that is the most likely event, but it is the sort of circumstance that we ought to be concerned about and try and find a way of dealing with it.
As we saw in the crisis with banks themselves, in 2007, 2008, of course everyone involved, the management, the shareholders of banks desperately wanted to believe that this was a liquidity problem, but it wasn’t. It was a problem of excessive debt, excessive leverage, and in the end, the only solution that worked was not one of providing liquidity. Yes, we had to provide it to buy time, but what worked was the recapitalisation of the banks to put in more capital to make the underlying problems manageable. It took two goes to do that but it was done, and I think that is the big lesson, which is, if you ignore the underlying problems and just pretend this is a matter of liquidity provision, in fact the underlying problems may just go on getting worse before you get around to dealing with it. There is no alternative ultimately for dealing with the fundamental problems.
Q11 Jesse Norman: Thank you for that very full answer. How serious is the issue of our indebtedness due to public sector pensions in this country?
Sir Mervyn King: That is a completely different question, and I think one of the things that we have learnt from the euro area crisis is that the fundamental problem there is one of external indebtedness. That is not relevant to the question of pension provision in the UK.
Jesse Norman: I have changed the subject, sorry.
Sir Mervyn King: Yes, you are changing the subject. I think, in trying to assess the state of the public finances, one should look at not just the current payments, and the current deficits, but future liabilities. Of course that has to be judged in the context not just of future liabilities, whether it be pensions, PFI projects or any other kind of liability, but also assets. So you have to make a projection of potential tax revenues and growth of the economy and the age distribution. Now, there is a broad band of work, and indeed the Treasury published some work on this-it is called intergenerational accounting-in trying to produce numbers. The difficulty with all of that work, as you can imagine, is that the numbers are incredibly sensitive to small changes in judgement about growth of population, pension provision and so on. So I think we certainly ought to look at the public finances in the context of these long-term developments, and one of the great contributions that your Committee can make is to ensure that each time the annual Budget is discussed, it is discussed in addition with the context of what is the long-run outlook for public finances, not just the deficit over the next two or three years.
Q12 Jesse Norman: Thank you. Obviously, it seems to me on the public sector pension side, there is no compensating asset, it is merely a liability, is that not right, and would it not be quantified to some degree in the-
Sir Mervyn King: If it is an unfunded pension scheme, yes.
Jesse Norman: Yes, which most of these are.
Sir Mervyn King: Not all, but most of the ones applying to general Government are.
Jesse Norman: Have you made an estimate within the Bank of the scale of this indebtedness?
Sir Mervyn King: No. That is the Treasury’s responsibility. They have done work on this and I know they have talked to outside experts in this intergenerational accounting. I suggest you talk to them about it.
Q13 Jesse Norman: How far did you consider, if it all, and how sensitive are your judgements about inflation and interest rate levels to the possibility of foreclosures in the housing market?
Sir Mervyn King: Clearly we look at this, because it could affect consumer spending and one of the weaker items of aggregate demand at present is consumer spending. In large part, this is reflecting the inevitable adjustment over the next few years from domestic demand to net external demand. It is our way of dealing with this problem of the trade deficits that accumulated. So we expect to see relatively weak consumer spending.
All I would say is that, at present, what is quite interesting is that we have seen a 15% fall in house prices; it has come back a bit, house prices are broadly flat at present. Activity is certainly very weak, but the number of mortgage arrears and the number of repossessions is way down on anything that we saw in early 1990s. Of course a moment’s reflection suggests that the answer to that is that whereas, in the late 1980s, early 1990s, interest rates doubled to 15%, they have now gone in the opposite direction, so that someone who is still in a job is, if anything, finding it easier to service the mortgage than they were before the crisis hit. So that is one reason why the problem of repossessions and arrears is much lower than it was now.
I know there is some concern among some people that if interest rates were to rise, then the problem would become very great, but I think that can be exaggerated. The reason we would raise interest rates, certainly back to the levels they were at, would be in the context of a much stronger economy, which you would imagine would have unemployment, if anything, falling rather than rising, and in those circumstances there would be some offsetting factors. It should also be the case-and I think this is very important-that the interest rates that borrowers themselves face would not rise as sharply as the increase in bank rate. After all, when we cut bank rate, bank rate fell by much more than the actual interest rates that borrowers were paying fell. The spreads between the rates that banks were charging to their borrowers and bank rate went up a great deal, and I think that along the path of an increase in bank rate, which inevitably will come at some point from where we are now back to more normal levels, significantly higher than they are now, that is going to be accompanied-you would expect it to be accompanied-by a process in which the spread between the rates that banks charge their borrowers and bank rate would not go back to the very low levels that they were, but would undoubtedly narrow.
Q14 Jesse Norman: I question that answer in one regard, which is that you seem to be tying changes in the interest rates to the MPC to growth in the economy, rather than to inflation, because you have just described interest rates as going with growth and therefore not necessarily disconcerting homeowners. Is that really true? The second question would be that seems to imply a rather long-term approach, in which interest rates are going to stay rather low for a while, since the economy is undoubtedly going to be slow for a while.
Sir Mervyn King: No, I am sorry if I misspoke. The factors that determine the path of interest rates are of course the path of inflation, but unless there were to be a rise in inflation expectations, which was uncorrelated with any pick-up in economic growth, then I think the statement that I made would be true. We would normally expect that the circumstances in which inflation expectations would pick up would be ones in which people felt there was a tighter labour market and that it was more likely that domestic prices would be put up. What we see at present is an unusual combination, and a very unattractive one, in which domestic wages and prices are not really rising, but the prices that are reflecting the cost of goods imported from overseas, or tax changes, energy prices from the rest of the world, utility prices, are leading there to be a significant wedge between what you can think of as domestically generated inflation and the level of CPI.
Q15 Michael Fallon: Mr Dale, when is inflation going to move back to 2%?
Spencer Dale: I think that is very difficult to judge, given the significant uncertainty surrounding the inflation outlook. The projection in the May Inflation Report was that we expect inflation to come back closer to target in around two to three years, and I think that remains my central view.
Q16 Michael Fallon: Two to three years. I see. Have you seen the Centre for Policy Studies’ report showing that in the 12 quarterly Inflation Reports from August 2007, the average forecast for inflation a year ahead by you was 1.9%, but the actual was 3.2%? That is an average error of 1.3%. Why should we believe you this time?
Spencer Dale: I haven’t seen that actual report, but the fact that inflation has surprised us I am perfectly well aware of. Looking back over the last few years, there are two main issues I think where we’ve been surprised and why inflation has turned out stronger than we expected. The first was the degree of pass-through from the low exchange rate into retail prices has surprised us. I wrote a speech explaining the nature in which we were surprised and how we have learnt from that surprise that we expect greater pass-through going forward.
The second aspect is that oil and other commodity prices have all increased very substantially relative to what we expected, so the prices of oil, food and metal prices have all increased by between 30% and 45% over the past year. I don’t know any forecasters of financial markets that expected that increase, and that accounts very substantially for the stronger than expected inflation over the past year.
Q17 Michael Fallon: How long can you keep looking through current inflation and still maintain forecasting credibility?
Spencer Dale: I think the key issue for us is we have to explain, if inflation turns out to be stronger than we expected, why we think that is the case and what lessons we should learn from that; then secondly, provide a good rationale, an explanation for why we think inflation will gradually moderate, and it is very much along the lines the Governor was just suggesting. We think much of the strength of inflation is driven by temporary factors, factors which only have a temporary effect on inflation, either emanating from the rest of the world, particularly in terms of commodity prices or the increase in VAT, and that domestically generated inflation-most obviously in terms of wages-remains quite low. So as those price level effects wear off from inflation, you would expect inflation to moderate towards the level of domestically-generated inflation.
Q18 Michael Fallon: David Miles, in the last Quarterly Bulletin, the Bank says, "There is little evidence that inflation expectations have become significantly de-anchored, and few signs that they have affected prices or wage-setting behaviour". Do you agree with that?
Professor David Miles: I do. I think if you look at the surveys-and we look at a lot of surveys on the MPC of household expectations of inflation-over the near term, the next year, they have moved up quite sharply. Of course, that pretty much matches our own best guess as to what inflation will do over the next year or so, but I think the more important ones are, what do people think about where inflation will be two, three, four years down the road? There the story is a slightly different one, and my reading of the surveys-and they point in slightly different directions-is that expectations three, four years down the road are not very different now from the average over the period 1997 to 2007 where, on the whole, inflation was pretty close to the target. I don’t look at those surveys and say, "Here is a clear sign that people have lost faith that inflation will ever come back to the target level".
Michael Fallon: But your own chart in the last Inflation Report, chart 4.8, shows that for two years ahead, household expectations are running at twice your forecast.
Professor David Miles: Yes. Inflation over the next two years starting from now, I think on our own forecasts, our own best guess as to what we think will happen, for much of that period we ourselves think the most likely outcome is that inflation will stay rather substantially above the target level. So I think what the household expectations are doing is in a sense reflecting the information that we process ourselves, and the view isn’t that different from our own internal judgements.
Q19 Michael Fallon: How do we reconcile these two things: the bulletin saying there is little evidence of significant de-anchoring, and the Inflation Report showing that household expectations are twice yours?
Professor David Miles: I am not sure that they are twice ours. They-
Michael Fallon: Yes, they are. That is what chart 4.8 at page 36 shows; two years ahead, household expectations are twice yours.
Professor David Miles: Sorry, which chart are we looking at again, please?
Michael Fallon: 4.8.
Professor David Miles: These are the changes. Looking at this chart, these are the changes in expectations. I am not sure we are looking at the level of expectations of what households believe inflation will be over that period, but I think that the key thing here is, is there evidence that, looking further down the road, households clearly believe that inflation will not come back to the target level at any time? There is a risk of course but I don’t think there is clear evidence yet that that is the case.
Michael Fallon: Mr Posen, do you see any evidence?
Dr Adam Posen: I would take very much the same tack that my colleagues Spencer and David did, but I would put it a little more forcefully. The household expectations measures are signs of concern and experience by households. They matter, but they are not a good forecast for what is going to happen. When we speak about inflation expectations being de-anchored, we are talking about things like exchange rates and gilt markets, which have not responded in any way, then when there has been new information, they act as though, "Oh that means things are flying out of control". For example, last month, following the minutes, the estimate in the markets of when this Committee would raise rates moved more than six months further into the future. That had no meaningful effect on sterling or gilt prices. I believe this relates to what Spencer and the Governor have previously said. Our job is not to blindly hit the target. Our job is to explain and justify why we are taking the approach we are, and people in markets and people in professional forecasting have broadly understood what we are doing. They may not approve of it all, but they broadly understand why we are doing it.
The final point I would make, sir, is that-and again, this picks up on something I believe David was just saying-the issue isn’t just what people report in a survey. You could ask on a survey about pensions, as Mr Norman raised, and they will tell you all kinds of things that may or may not be accurate. The issue is, are they able to then demand wages that are out of whack with the growth in productivity, and there is absolutely no sign of that in the UK economy right now.
Q20 Michael Fallon: You are pretty dismissive of household views, aren’t you? I mean, how do we-
Dr Adam Posen: No, I am quite dismissive of household forecasts. I am not dismissive of household concerns.
Michael Fallon: Okay. But if your own forecast over the last three years has been out on average by 1.3% every time, forecasting inflation a year ahead, why should we be so dismissive of households that expect it to be higher than you do?
Dr Adam Posen: You will see that households were off by more than we were in the past. Secondly, I think Spencer mentioned two of the reasons why our forecasts were not accurate, but I think we are overlooking two others. The first is the VAT increase that came through automatically as part of CPI inflation, and for obvious political and legal reasons we don’t put a VAT into our forecast ahead of an election. So part of the reason our forecast was too low was because it was not our place, ahead of the election and the decisions by the current Government, to say, "Oh inflation is going to be up 1.5% because they are going to raise VAT by 2.5 points and they are going to raise indirect taxes". So I think we did have an error-I completely agree with Spencer-and as I said to the Members of this Committee last time I appeared, we got it completely wrong on the exchange rates. We are accountable for that, we got that wrong, we should be held accountable for that, but I do not believe the full magnitude of the literal subtraction you are doing, sir, represents what happened, because of the VAT increase.
Q21 Mr Mudie: Adam, I think we are going to overwork you, you are getting another question. The June minutes suggest a member of the committee was asking for an immediate expansion of the committee’s programme of asset purchases, quantitative easing. I toyed with the delightful thought it might be the Governor, but I settled on you. Was this you, and why are you particularly continuing to press for quantitative easing?
Dr Adam Posen: Thank you for the question. I appreciate the opportunity to explain my views. It was indeed me who voted that, and I believe the minutes are out so there is no secret that it was me. That is a consistent pattern I have been voting for some time. Again, as Mr Fallon raises, my forecasts may be wrong but if the previous question had been to me about what I expect inflation to be a year from now, I expect it to be below target. Again, there will be a spread of things around it, events in the euro area; the kind of confidence shock the Governor spoke about could wipe all this out and make it moot.
As I said in a speech last night, I and my colleagues on the committee have made a judgement call about energy prices, that they are likely not to go up at the continuous rate that they did in the first part of this year. If we are wrong about that, even I, the über dove, would have to raise rates. That said, on the assumption that energy prices largely, on average, only go up a little and the assumption that-God forbid-something terrible happens in the euro area, my belief is that inflation will be well below target by this time next year, and two years out.
This goes to the three issues that I raised the last time I was before the Committee that seem to have been borne out by events: first, that consumption would be weaker than was in the MPC’s modal forecast, in part due to the fiscal contraction, and part due to the savings issues the Governor has raised, and consumption has indeed been weak; second, that wage increases would be weak. Workers would be unable to get back in real wages what they have been losing in inflation and other things. That again has turned out to be the case. Third-and this is probably my point of biggest difference with some of my colleagues on the committee, and in the spirit of what I said to Mr Fallon-I do not believe that long-term inflation expectations in the financial markets or in wage-setting are moving in response to the previous misses, because we have done a reasonable job of explaining them and reasonable people would understand why inflation has been where it has been. They are not automatically saying, "Oh they missed the target, so therefore I should make the bad forecast and assume they are going to inflate everything away". That would be a false forecast.
So if you put those three things together, I expect consumption to be even weaker than is already in the IR; I expect wage growth to be weaker than is already in the committee forecast, and I do not expect any meaningful drift upwards in inflation expectations that translate into exchange movements or interest rate movements. Then it seems to me that the policy is insufficiently stimulative and we should be doing more.
Q22 Mr Mudie: Governor, you might want to comment on that, but don’t you think there is an additional reason, which is a social reason? I am looking at what is driving the economy at the moment, and it seems to be that we are all waiting for the banks to recapitalise and then we can get back to some sort of normal life, but in that time, people are going through a very hard time. Would not a bit of quantitative easing-and I think finessed, if possible, so that the receiving banks take it on the basis that they will deal with small businesses and households better than they are at the moment-go some way to increasing demand and maybe bringing a bit of growth?
Sir Mervyn King: Obviously our task is to meet the remits set by you in Parliament, and that remit does allow for us not to try to bring inflation back to the target immediately if that would lead to undesirable volatility of output, and I think most of us on the committee have taken the view that to tighten policy now would be to risk that. I share qualitatively much of what Adam says. Obviously, the precise quantitative mapping of that into policy decisions, I voted for no change, I haven’t voted for an increase in asset purchases. But I think the differences among members of the committee are easy to exaggerate. After all, the differences range only from whether interest rates should rise by a quarter of a percentage point now to whether there should be an extra £50 billion of asset purchases. I think these are differences that reasonable people can clearly come to believe in, but it is within the broad context of a position in which inflation is clearly uncomfortably high, and this is representing-and it is a symptom, it is not a cause-a symptom of a very substantial squeeze on real living standards.
I am definitely concerned by the factors that you mention, which is the squeeze on real living standards. I don’t believe it is easy to do much about that. This is the way in which we as a country are adjusting to the consequences of the financial crisis and the macro-economic rebalancing that is necessary to get through that process. It is going to be an uncomfortable period. There is no doubt about that. Our task clearly is to set bank rate on a path that we think will bring inflation back to the target in a reasonable time horizon, and I think all of us on the committee have signed up to that, and that is what we are trying to do. But inevitably, reasonable people can disagree about what that policy should be from month to month.
Q23 Mr Mudie: I just take the words you say, though, about there is not much you can do about it, but a bit of quantitative easing is a little that if it fed through to the economy and helped ordinary people get a better standard of living or even maintain their standard of living, it would be something. What is the economic reason for not doing it?
Sir Mervyn King: I think it would-albeit in very much more difficult circumstances than most in the past-be another example where we would be accused of having taken the easy option and hence made more difficult the ability to get low inflation in the medium term.
The reason why most of us have voted for no change in bank rates so far is that, as Adam said, we have not seen signs that the current high level of inflation is feeding through to second round effects on domestic wages and prices. If we were to see that, then I think we would be concerned that our ability to meet the inflation target in the medium term might require a much more severe policy further down the road, and there is no reason why we should want to do that. We should take action now. But we don’t see that at present and that is why a majority on the committee voted for no change at present.
Q24 Mr Mudie: For what it is worth, I think the committee were-not brave-very sensible to withstand the hysteria that went on about raising interest rates to deal with what were external matters. I am raising that I think that was the right decision on interest rates, but the lack of action on quantitative easing when we have this low growth, and in fact no growth over the last six months, is worrying.
Can I raise another question? You are here dealing with the Inflation Report, but you brought another very important report out, the Financial Stability Report, and that was the first report under the Financial Policy Committee in the new setup, and there are some important recommendations in here, very important. The first thing is, do you not think it would be a good idea to start, as soon as possible, the type of hearing we have for the Monetary Policy Committee on inflation with the Financial Policy Committee on financial stability? There are broad-ranging recommendations in here that I would love to get stuck into more than the stagnant world that is inflation at the moment.
Sir Mervyn King: The answer to your question is yes.
Q25 Mr Mudie: Wonderful. Let me just have a first go at it, just a first go, just one question. I was delighted with the-
Sir Mervyn King: We only have two members of the MPC here. We stand ready to answer your questions at any time.
Mr Mudie: No, that is very helpful; I hope it is taken up by the Committee, because I think it very important we get in at the beginning with you. But one of the important things, one of your recommendations, recommendation 4, on interconnectedness and derivatives and so on, your recommendation is to the FSA-I think I will read it to you-"To monitor closely". That seems to carry over the sort of behaviour pre-crisis, where we are putting things on record and we are monitoring, and so on. Is there an unspoken view or is there anything stopping the Financial Policy Committee, while the FSA are monitoring and investigating it, from starting their thoughts and starting to warn the market that you are concerned about this, there are dangers in the growth of this and if it gets too far the Financial Policy Committee would be prepared to take action?
Sir Mervyn King: Yes, I agree with you on that, and I hope that the report itself will constitute a warning, which carries much more weight than the Bank of England’s warning could before the crisis because we had no involvement in any process that could do anything about it. The FPC clearly does. If the legislation that is proposed to set up the FPC is passed by Parliament, then FPC would have the statutory powers to direct the FSA-the then PRA, it would be-to take various actions, and also the FCA, and that is important. At present, we don’t have those powers and we can’t do it, but I do think that what matters more than anything else is that the ability of the FPC as a body, with external members, knowing that it will have statutory powers, should carry sufficient weight that participants in financial markets will listen very carefully to what we say.
Q26 Andrea Leadsom: Good morning. I would like to go back very quickly to a comment you just made, Governor, which is that the difference between members of the committee is tiny, it is about 0.25% increase versus a bit more QE. But would you not agree that it might be tiny in numerical terms, but the enormous significance of the direction of travel is very market sensitive and incredibly important? Would you just comment on that?
Sir Mervyn King: I certainly take the point that when we are at a turning point for policy the market is concerned about the direction of travel, but I think that the big picture is one where the challenges facing the committee are agreed and understood by everyone on the committee. I don’t think there is any real debate about that. The right debate, and it is the one which we should always have, is precisely what we do at this stage, and there is a range of views from, "I don’t think that we should engage in more stimulation now", to the view of others-including Spencer-that we should now start the process of tightening somewhat. Both of these views have very good arguments in favour of them. It is a difficult balance, and no doubt at some point we shall do one or other of those actions. But the future will tell us that. It is the evolution of the economy, how the data unfolds that will tell us which to go. I think at this stage, what is helpful in terms of the debate is that we can alert everyone in the market to what the arguments are, and I think that is the most important thing. Everyone in the market has their own view as to where the economy will go, but what we want to do is to point out to them in our judgement what the balance of risks is to inflation, looking further, 18 months, two years ahead. That is our job and I think the debate on the committee helps to bring that out.
Q27 Andrea Leadsom: Thank you. In the last minutes, the external members, Adam Posen and David Miles, note that, "The fiscal challenges in the euro-area periphery highlighted the potential for further adverse shocks to demand. For some of these members, it was possible that further asset purchases might become warranted if the downside risks to medium-term inflation materialised". Could you both set out your views specifically on that point?
Professor David Miles: Maybe I will just quickly say something about that. I think there are a whole range of risks to demand and output in the UK. One of the big ones at the moment, as we have already discussed this morning, is what is happening in the peripheral areas of the eurozone. Who knows how that will play out, but clearly there is a possibility it plays out badly and has a negative knock-on impact on demand in the UK. My own view is that if that were to happen, or indeed if some of the other risks to demand and output in the UK were to materialise, that would make it much more likely that I would vote for further asset purchases, because we would want to offset that, because I think if we did not do that the path of likely future inflation would move down, because unemployment would be greater, slack in the economy would be greater, and I think it would be appropriate to respond to that by having more expansion in monetary policy. That is not what I think the most likely outcome is but it is certainly a possibility.
Q28 Andrea Leadsom: Can you give us the benefit of your views on what are the biggest adverse shocks, because obviously the eurozone is a very important potential adverse shock. You said that there are others. Can you tell us what they are?
Professor David Miles: I think the degree of confidence among households in the UK about their economic future is extremely fragile. My best guess-the thing I think is most likely-is that output will start growing from here, that unemployment will not rise significantly and may stay more or less flat and ultimately may come down a bit. But it is perfectly reasonable for people to worry about much worse outcomes than that, and that has the potential to be self-fulfilling. If people become even more nervous about the future, they may decide to spend even less, the household savings rate rises, the level of demand falls and what is currently a soft patch turns into a more extended period of weak activity.
Q29 Andrea Leadsom: But that wouldn’t be a shock, so there are not specific shocks you are concerned about, for example, another commodity price shock-another enormous instability would be perhaps a default in the eurozone-there are no potential domestic shocks that you are worrying about at the moment?
Professor David Miles: I think there is a potential for one of the shocks you just mentioned to play a serious role, but it could go either way. I think commodity prices falls into the category of things that would happen to the UK. They are beyond our control, but they would have substantial knock-on impacts, and who knows how that might play out. Just in the last week we have seen oil prices fall 10% or more, and who knows where they will be three or four months down the road, but that has the potential to have a big impact, both on near term inflation but also on disposable income and demand.
Q30 Andrea Leadsom: Are you considering the impacts of industrial action, for example, on the level of demand and confidence in the UK economy?
Professor David Miles: It is not so easy to see a strong link between industrial action, which in the short term largely looks like it will be in the public sector, and the overall level of demand. I think it is quite difficult to trace through significant channels there.
Andrea Leadsom: Mr Posen, would you comment?
Dr Adam Posen: I will try to be brief. Thank you, Ms Leadsom. I essentially begin with what the Governor said. We are agreed on most of the channels and the mechanisms of how the economy works, so my mean expectation is a step down from some of the others and then my explanation of what the shocks would do is very similar to theirs. It just starts off from a less good place. To me, there are three major shocks. Obviously, the first is the euro area. The primary effect of that would be through trade and demand because, as the Prime Minister has pointed out, we still trade more with Ireland than we do with all the BRICs combined. Critically, the issue is the financial market shocks, the potential for lock-up of liquidity and withdrawal of banking the Governor mentioned, and which the report of the other committee came out with last week.
Q31 Andrea Leadsom: Sorry to interrupt you but, on that specific point, do you think that the Bank of England now has the remedy in place? Do you think that the potential for another crisis of liquidity, a complete sort of drying up of liquidity, is possible to happen again or do you think that there are systems in place to deal with it?
Dr Adam Posen: I am fully confident that the system we now have in place to provide emergency liquidity is a huge improvement over what existed prior to 2007-08. I am also fully confident- thanks in part to my colleagues, the Governor and Deputy Governor Tucker and their colleagues in the financial stability side-that they have done more to track, reveal, force recognition of the most vulnerable banking aspects of the UK in this area. It is not my place to judge but, just as a fan, I fully support what they have done and I fully support the call for transparency.
It remains-and this leads back to a point Mr Mudie was raising that I just wanted to go back to-that the small and medium enterprise sector in the UK is particularly vulnerable to banking crises. That is true in every advanced economy because it is banks that do most of the lending on secured loans and relationship banking for small business. They have very few alternatives. When banks contract, banks then only do very gilt-edged-if you’ll excuse the expression-lending. We are already seeing some of that. It has not been sufficiently bad to keep the GDP numbers on investment from being decent, but I share Mr Mudie’s concern and I have spoken about this in the past.
If there were to be a financial problem in the euro area or, say, through the US banks, which the Governor rightly raised, that would probably reduce liquidity for small and medium enterprises in this country, and that is serious about employment, that is serious about investment, and that is serious about inflation. It is very difficult to imagine, all else equal, inflation going up fast in that environment.
Q32 Andrea Leadsom: One last question to turn this argument on its head slightly. In the event that the next direction of travel was in fact to tighten, are you considering the net effect of raising interest rates versus reversing QE, because, for example, obviously if you were to raise interest rates by 0.25% and then start to reverse QE, you would have the impact of a tightening without the knock-on effect for mortgage owners. Does the Bank take into account the impact of raising base rates on home owners specifically?
Sir Mervyn King: Our remit from you in Parliament is to take account of its impact on inflation, and that is what we will do. We had a committee discussion on this, and we said that our instinct would be that we would start by raising bank rate and then move to discuss the speed at which we would want to reverse the asset purchases. The reason why we would start with bank rate is because we feel it would be sensible, with asset purchases, to unwind that programme through a programme of sales over a number of months. That is better done in the context of a period in which the committee felt that it was pretty confident that it would want to engage in some tightening over a three and six-month period. I think it is very hard to find yourself in that position before you have made the first move. So I think that we would make the first move on bank rate and then we would debate among ourselves the relative merits of unwinding asset purchases, versus further increases in bank rate. That of course is a hypothetical question. It is one that the committee will return to when it finds itself in that position.
Q33 Mark Garnier: David Miles, you spoke at the Home Builders Federation policy conference in March, talking about the housing market and the mortgage market. You talked about a transition in the housing market from one equilibrium to another. Two parts to the question: how long do you think that will take and how do you see the new equilibrium in the future?
Professor David Miles: I think the transition is from a world in which mortgage pricing and the availability of mortgage was at unsustainable levels-I am talking about 2005, 2006 and 2007, before the financial crisis really hit us-a transition from that world to something that is more sustainable. In that more sustainable world, I expect that the spread between mortgage rates and bank rates on new mortgages will be a bit higher, and the deposit that people need to raise before they enter the market will also be a bit higher. On the transition, I think that means that the number of first-time buyers falls very, very sharply. That is what we are in right at the moment. I did a rather simplistic "back of the envelope" calculation, described in that speech, which suggested that the transition might last four or five years or so. I think it is very hard to be precise about that. If four or five years is of the right order of magnitude, and you thought that that transition got under way once the crisis had reached its worst point at the end of 2008, one might be looking for 2012-13 transactions to be moving back to a more normal level. I think it is that kind of timescale. I don’t think one can predict to the nearest quarter when things, in terms of transactions and mortgage lending, might move back to more normal levels, but I suspect it will happen some time over the next few years.
Q34 Mark Garnier: If you are talking about the mortgage market going back to a more traditional level, say 10 or 15 years ago, before the bubble was created, does it not follow then that the housing market will go back to a similar sort of level? I was thinking specifically of the average house price versus the average wage, which on a long-term basis has been around 4½ times, and I think went to around 8½ times during the bubble, and is still quite high. Do you think that means we are going to have a long-term correction of the housing market alongside the-
Professor David Miles: Yes. I am sceptical as to whether one would expect the level of house prices relative to people’s incomes to return to some average from the past, partly because a couple of things have changed. Firstly, on average, we have become richer through time, and the supply of land in the UK is fixed. Therefore, you would expect real house prices to move up, maybe even relative to people’s incomes. Secondly, the level of long-term real interest rates for many years now has been substantially lower than was the case in the 1950s, 1960s, 1970s and 1980s. Those things will have an impact on the long-run ratio between house prices and people’s incomes.
I think one thing we should expect-and we have seen it already-is that the level of owner/occupation in the UK might move back down to a slightly lower level than we had a few years ago, and I don’t see that as a harmful or bad thing. It will mean we have a slightly bigger rented sector but that is not a sign that the market isn’t working properly.
Q35 Mark Garnier: Can I just finally turn to something you mentioned a bit earlier in Ms Leadsom’s questions. You said households’ view of their own economic outlook is fragile. To what extent do you think households, as a result of this long period of low interest rates, are now a lot more sensitive to interest rates? Again, with your answer, I am looking for two things. One is, first of all, in numeric terms, what is their sensitivity in terms of, if interest rates go up have you calculated the numeric impact? I think also, very importantly, is their knowledge of their sensitivity, their understanding of interest rates and what it means if interest rates start going up in terms of their day-to-day living standards?
Professor David Miles: It is certainly true that the total amount of household debt in the UK, relative to the size of the economy, is significantly larger than it was 10, 20 years ago. Although it has moved down a little bit relative to income, more recently, it is still a much higher level than was true in the 1970s and 1980s. That in itself would suggest that the sensitivity to a change in interest rates, mortgage rates in particular, will be a little bit higher. I am not so pessimistic about the risks that arrears and repossessions move up very sharply as interest rates move up a bit. Part of the reason for that is that there has been very little net new mortgage lending in the last few years. What that means is that the vast majority of people, with a mortgage right now in the UK, had that mortgage more than three or four years ago, and therefore were used to an environment in which their mortgage rate might have been 5% or 6% and therefore materially higher than it is today.
Q36 John Mann: I wrote and I asked quite a few questions last year suggesting that, using the barometer of Retford High Street, in small towns, as this year went on, we would see significant brands exiting the high street and we would see small traders either going under or throwing in the towel. That seems to be happening. Indeed, just today we see the news with Thorntons, which is one of precisely those brands that I anticipated would retrench out of many high streets. Mr Dale, you are the Chief Economist, do you think this process is going to continue in the small towns across the country throughout the rest of this year?
Spencer Dale: I think the broad pattern that consumption will remain weak may well continue. What we have seen in the past couple of years are very sharp falls in consumption, and I think that has possibly contributed to some particular retail stores going out of business. I don’t expect to see further significant falls in consumption, but the fact that we may see very weak consumption growth over the next year or so I do think is likely, for the reasons that the Governor and others have outlined.
Q37 John Mann: One of the consequences of this-and the reason I suggested the second half of this year was because of the impact of public sector job losses, but also of job movements from small towns to larger centres, which is also going on-is of course there is a knock-on effect. When it comes to the small trader, the small business, and you are looking at quantitative easing again potentially, Governor, what is the downside for small businesses if you went for the QE?
Sir Mervyn King: The arguments for and against QE for our view would have to be not to do with particular sectors of the economy, whether it is small businesses or home owners, but to do with the outlook for inflation, and that is the basis on which we have to make that judgement. One of the things that is going on at present is a significant deleveraging, a contraction of bank balance sheets. The sectors that are suffering most from that-as Adam referred to earlier on-are those parts of the economy that don’t find it easy to raise finance by issuing equities or bonds on the market but rely on banks. That is very much the SME sector. Lending to businesses by banks is still falling. That is not an environment in which it is easy for small businesses to operate, and clearly that is a concern for the long-run health of that small business sector. I said to this Committee before I thought there were only two ways through that: one was to either use the ability of Government-owned banks to lend to SMEs or to wait until the banking sector got back to health, would begin to lend again, and to encourage more competition in the banking sectors. Governments of both parties have gone for that second option.
Q38 John Mann: What about the impact if the US follows the same approach? Is that going to have an impact on whether you would determine further quantitative easing?
Sir Mervyn King: No. I regard quantitative easing as a perfectly conventional monetary policy tool. It was used and debated at great length in the 1980s. This is nothing new. It had a different name then. It was called "over-funding" and "under-funding". This is something that we can do. I think it is of particular relevance when interest rates are extremely low, but nevertheless it can be used at any point. We will do this entirely on our judgement about the outlook for the UK inflation.
Q39 John Mann: But the US is doing the same thing. Isn’t there a potential impact on world commodity prices, and isn’t this going to again disproportionately impact against SMEs who don’t have those options through bonds or equity?
Sir Mervyn King: Overall policy is bound to be concerned with the objectives of each country, that is to do with inflation, and if we feel that there is a threat to inflation caused by easing policy, then we won’t do it. But you are right to say that the process of adjustment from the pre-crisis position to the new equilibrium we need to get to is one, which in that transition, makes life particularly difficult for those firms and sectors of the economy that depend on finance from banks.
Q40 John Mann: A final question, perhaps for the external members. It does seem to me that there are policies now having a disproportionate impact on SMEs, as opposed to the rest of the business sector, and that SMEs are getting trapped-especially the small SMEs, such as the sole traders-in a situation with increasing inflation that they are not going to get out of in many instances, and that we could even see a restructuring of the whole economy based on that that could be to our long-term detriment, and I wondered what you thought about the position. Are SMEs being overlooked too much in what we are doing?
Dr Adam Posen: As I think you are aware, Mr Mann, I, David Miles and the Governor have all spoken out in the past about this issue, so at least I certainly share your concerns, and I am just back from visits to the Potteries, to Aberdeen, to North Wales and Bangor. I have visited groups of small businesses several times over the last couple of months, and the concerns about funding as well as about inflation are very real. I think going beyond what the Governor says, though, about our need, in line with the remit we have been set to focus on the economy as a whole, I would additionally point out that no matter what the policy would be, in a time of higher inflation or a time of contraction, SMEs will always suffer more. It is like in a sense if the flu is coming around-and I don’t mean to be patronising the SMEs-if you have children, they are inherently more vulnerable than adults. SMEs, especially the smallest ones, especially retail-oriented ones, are going to inherently be more vulnerable than other companies, because of this dependence on external finance that is harder to get.
That is why I fully support what the Governor has said and some of the things the Independent Commission on Banking has said. As I was saying just yesterday in Aberdeen at the Institute of Directors and then at the Chamber of Commerce, we need more competition in the banking sector in the UK; we need more Government programmes, to the extent that we cannot rapidly get up competition for lending and provision of finance from Government in the UK economy, and that is not something that our interest rate policy can affect one way or the other without doing great harm to the rest of the economy.
The final thing I would say is you mentioned the idea that maybe we are having a long-term restructuring. Clearly there is something changing in the high streets, so when last summer I was in Caithness, there is a huge Tesco right up there, just a few miles east of John O’Groates, and obviously the Wick high street isn’t doing very well if there’s a huge Tesco; and you have Carrefour in France and you have Walmart in the US. There is a reason things are going that way. People seem to prefer that. If the Parliament of the UK, or planning commissions at a local level, decide they want to stand against that, that is their right, but that is a kind of long-term cross-national force of people’s preferences. There is absolutely nothing I think the monetary policy can or should be doing about it.
Professor David Miles: I will come back very briefly on one thing. As Adam said, I think the difficult thing for smaller companies is that their options to finance themselves are so much narrower than a larger company. A larger company can issue in the bond market, in the equity market. A larger company probably typically has relationships with maybe three or four banks, so if one of them decides to pull out, there may be one or two others to go to. Smaller companies are simply not in that position. Usually they have dealt with one bank. It may be the case that you have a smaller company that dealt with maybe an Irish bank that has decided more or less to pull out of the UK. That is a very difficult position to be left in, and I think it takes time for those companies, if they can, to form relationships with other banks that may be in a better position to lend to them. I would say that I have noticed a slight improvement in the tone of this discussion. Certainly a year ago and definitely 18 months ago, in travelling around the country and talking to smaller businesses, this was the number one issue they wanted to talk about, namely, the availability of finance, the difficulty of getting bank finance. I think it has dropped down the list a little bit, but what has come to the top of the list is what has happened to their costs, and in particular commodity prices, in energy and gas and metals; you name the commodity, they have gone up a huge amount. That is a real problem.
Q41 John Thurso: David Miles, in your report to us, you make a very interesting point that we have touched on a little bit before, which is the low level of spreads between bank rates, and the rates that banks charge when lending to households and firms remains substantially higher than before the recession. In fact, chart 1.9 reflects that very graphically. So a quarter point or a half point increase in the bank rate it would be hoped would be absorbed in that, so it wouldn’t have much impact. So how big a rate rise would be required to have an impact on inflation expectations going forward?
Professor David Miles: There are a lot of different channels, as I know you appreciate, through which monetary policy can work. Some of them are the impact on the cost of mortgages and debt to households, but there can be effects on gilt yields, on the interest rates that corporates pay when they issue money in the bond market. There may be knock-on impacts on asset prices as well. So there is a range of different channels, only one of which is-although a very important one-what is the impact on the cost of, say, mortgage debt?
I think it is likely that, at a point at which bank rate goes up from this extraordinarily low level, that won’t be reflected one-for-one in mortgage rates. I would be surprised if it wasn’t reflected to some extent: in other words, I would expect the spread between bank rate and average mortgage rate on new loans to come down somewhat, but not to fall by the full amount of whatever the increase in bank rate is. I think it is a bit tricky to work out in advance and try and quantify that, but I think we should expect there to be a less than one-for-one increase in mortgage rates when bank rate does go up.
Q42 John Thurso: Is it not the case that to a certain extent the committee is between a rock and a hard place, because if you wanted to use an increase in rates to achieve any measurable dampening of inflation going forward, you would have to stick it up by 2%, or something, to achieve anything? I mean, a quarter or a half is just going to get lost in the wash. Therefore, given the enormous shock that a decision like that would have on the economy, it is unthinkable, and therefore you have a tool you can’t use?
Professor David Miles: I wouldn’t say it was a tool we could not use. I would agree with you that if all we did, at the point where a majority decides this is the right strategy, were to increase interest rates by 25 basis points and people thought that was the end of the story, the impact of that in itself might be rather small. It is much more likely that people will see a path and a progression of monetary policy beginning with an initial tightening in policy, but more likely than not followed by movements in interest rates down the road, and I think it is the totality of the impact of all that that would likely be non-trivial.
John Thurso: The point I am trying to get is that at the moment you are faced with a much more complex decision than possibly in the sunny days of the past, where you could up it a bit to get an effect or down it a bit to get an effect, whereas this is a much more complex picture, and a simple up and down is a much more complex decision than it might have been three or four years ago.
Professor David Miles: I very much agree with that. I think it is a more complicated picture, because many of these mechanisms that looked relatively stable between, say, 1997 and 2007 have moved in ways that it is difficult to quantify now. So I agree with you, it is more difficult.
Q43 John Thurso: Can I quickly come to you, Adam Posen-and thank you for the plug for Tesco in Wick-and your speech in Aberdeen and banking. I note two things. One is that in aggregate the corporate sector has been running a substantial financial surplus.
Dr Adam Posen: Yes.
John Thurso: So the corporate sector has quite a lot of cash and it is hanging on to it and not doing anything. On the other hand, the banks seem to be struggling at best, failing at worst, to get anywhere near delivering on Merlin. So to what extent is the banking structure the problem, and your suggestion of creating a much wider and more competitive banking centre essential for growth?
Dr Adam Posen: Thank you, and thank you for the plug for my speech in Aberdeen. I think this is absolutely essential for growth for both the short and the long term in the UK. As everybody in this room is aware, the issue of funding domestic investment and domestic industry in the UK is one that has been talked about since the late 19th century and the Macmillan Commission in the ’20s. But the point is this is real. It is not just people talking about, "Oh the City". You look at the data. Genuinely the domestic bond market, the domestic banking market, the domestic commercial paper market has been underdeveloped in the UK, even at the same time that the City of London continues to provide fantastic financial services globally. You can’t easily trace and say, "Okay, therefore investment level ongoing is lower in the UK than in other places" although it is, and this probably has something to do with that. In the short term, for many of the reasons my colleagues have mentioned-and you are well aware, and in line with what Mr Mann was saying-the situation has only gotten worse.
When you say corporations are sitting on cash on their balance sheets, it is in part, for some of them-and I think I would argue many of them-a self-defence, that they feel they are not going to have access to credit, or the criteria to be used for them any time they want to go get credit will involve a much higher fee or a much longer delay, and so they feel they have to hold more cash on their balance sheet to self-protect and self-finance. The fact that we have corporations that on average in the UK, and to a very broad range, are in better financial shape and have been paying down debt, as the Governor says-if you look at our M4 number, that is because companies and people are paying down debt-are still not able to access credit is very disturbing.
Just to bring the point home. David was mentioning how there are concerns about inflation, but one of the things that I keep hearing from small business as well is concerns essentially about variations on trade credit, on debtor days, on how long it takes them to get payment, on big companies, and not to pick on Tesco but say any grocer, major supermarket chain pushing back on agricultural people, agricultural producers-I have heard this every place I go-pushing down on margins. You put all this together, some of that is unavoidable, but a lot of that would be avoidable, if there were more opportunities for financing for these companies, banks were forced to meet good terms and the buyers from these small companies did not have so much financial leverage over them. So I think this is a fundamental thing. I think there are steps this Committee, the House of Commons, this Government should be considering.
Q44 John Thurso: What steps should we be considering? Sorry, I have probably overstepped the mark on time.
Dr Adam Posen: No. Again, and just to be clear, this is not in my remit on the MPC. This is just my opinion; having a reasonably educated but individual opinion. First thing, in line with what the commission has said and other people-including the Governor-have said, I think you need to have more than four main high street banks in this country. I think you need to have fewer banks that have such a huge share of lending. There is obviously a transitions issue, particularly with Lloyds-HBOS, considering the mortgage issues that the Bank of England report raised last week, but when we, the British people, when you, the Government, responding for the British people, execute the sale of these shares, it is fine to talk about getting the highest price and it is fine to talk about making sure everybody has a share. I would urge that you consider the structure; one of the criteria you use for how you re-privatise these banks is how you change the structure of the banking industry in the UK.
Q45 John Thurso: Just so I get that straight, what you are suggesting is that the best public good may be in using this absolutely unique one-off possibility through state ownership of a large chunk of banking to restructure it to the advantage of the consumer?
Dr Adam Posen: Yes. You put that better than I did. And to the advantage of small and medium enterprise, and therefore to employment and investment in this economy. It might cost you-penny-wise, pound-foolish-something in terms of the immediate benefits to the Treasury. If you break up an oligopolistic system, the dominant players may be worth less to the stock market because there is no competition. But in terms of-as you correctly put it, I believe-the public good, the greater good of the UK economy, over time the benefits would be much greater, and since we have seen when there are banks, like Virgin Bank or other banks, that talk about coming into the market but don’t seem to be able to come into the market and grow quickly, there are obviously some barriers to entry there and barriers to growth of alternatives. So it seems to me-as you put it, I agree-a unique opportunity to take things that are brick and mortar, personnel and franchise that already exist, and sell them off in a different way.
Chair: Paul Tucker, you haven’t had much of an outing this morning so far and-
Paul Tucker: I was wondering when to chip in.
Chair: -before we finish, we would like to give you something to get your teeth into.
Sir Mervyn King: He will be playing in the second half.
Q46 Chair: Yes, he is going to be much more active in the second half anyway, but why don’t I offer you an opportunity to comment on the Bank for International Settlements’ view that we should all be raising rates?
Paul Tucker: I certainly don’t think it should be just cast aside. About an hour ago, Michael Fallon asked about inflation being between 4% and 5%. This is distinctly uncomfortable. In fact, I had been thinking of chipping in because I am concerned that you, and the people listening, could gain the impression that this is a committee that is uniformly drifting in the direction of thinking more stimulus may be needed. More stimulus may be needed. Bad things can happen, and if bad things happen that don’t threaten an upward drift in inflation, then maybe we will have to provide further stimulus, but for me the threshold for that would be high. I am one of those who-from the backend of last year-have worried about the possibility of an upward drift in inflation expectations. I accept the balance of the comments made by my colleagues that so far those risks have not crystallised, although the evidence is mixed. But the longer that inflation remains so high, the more likely it is that when we say, "Oh it is one-off factor. It is another one-off factor" people in this country will think, "They use the sentence, ‘It is a one-off factor or a one-off event’ in a completely different way from anyone normal’" and-
Q47 Chair: BIS is suggesting, though, that we normalise monetary policy now, aren’t they?
Paul Tucker: You can see my votes have been that I have not voted for that. The economy has turned out softer this year than I would have expected. My own position has been that we should start to withdraw the monetary stimulus once we have securely achieved what I call escape velocity; growing at a pace that starts to absorb the slack in the economy. The economy has been weaker than we expected and that has not happened. We now face another risk though. The longer that the weakness persists, the more likely it is that the supply capacity of the economy will get eroded, which in plainer terms means that long-term unemployment increases, people leave the workforce, investment remains weak and capital gets scrapped.
We could find ourselves in circumstances where the upward pressures on inflation don’t come from strong growth, but come from an erosion of supply, and it is for that reason-going back to John Thurso’s question-that I do think this is a peculiarly difficult moment to make policy. Yes, the transmission mechanism of our instruments is more complicated than usual, but I don’t think that is the big thing. The big thing is that the forces buffeting this economy frankly are all over the place, making it very difficult to predict what is going on.
The only thing that we must absolutely remain determined about, in those circumstances, is that people don’t lose faith in us and our determination to keep inflation coming down. We are not happy that inflation has been so much higher than our target, of course we are not. This has made life much more difficult for the country and much more difficult for us in underlining our credibility, and that is what we will remain focused on.
Q48 Chair: Adam Posen, we have just heard Paul Tucker say that the BIS view should not be dismissed, but you did dismiss it in Aberdeen pretty vigorously, did you not? In fact, you described it as nonsense. Do you have anything you want to add to what you have just heard?
Dr Adam Posen: Yes. It is nonsense. Let me make a quick statement about why it is general nonsense and then explain why I take a different tack than my colleague, Paul, does. In general terms, what the BIS said in its annual report was mistaken in three senses. First, they argued that there is a general issue of running out of "room to grow throughout the world economy". That is possibly true of China and a couple of other overheating emerging markets who have made the mistake of maintaining a peg to the dollar when it is inappropriate for them. There is no evidence of that kind of overheating any place else; possibly Germany. There is a little bit of an uptake in wages there, but nowhere else in the euro area.
The second thing that they do that is crazy or nonsense is that the one contribution intellectually of the BIS in the past decade was they emphasised the fact that we can’t ignore when there is large amounts of credit growth. The large amounts of credit growth that are uncontrolled can lead to very bad outcomes. That is why it is quite strange to me to have the BIS now calling for a tightening of monetary policy when-as we were just discussing-here in the UK, and in most other Western economies, there is basically zero credit growth. So the BIS is standing itself on the head and saying, "Despite the thing that we told you is the main reason, besides inflation, you should worry about raising rates not being the case right now, we want you to raise rates". That is why it is nonsense.
The third reason why it is an issue-and this is one place where I am very much an outlier on the committee and in other places-is I object to the very concept of normalisation of interest rates. There are certain things like, say, Nationwide and other building societies who have certain kinds of long-term contracts for whom near-zero nominal interest rates are important, but in general there is nothing normal about a high or a low interest rate. The only question is, is it appropriate for the economy at that time? They are infected with this idea that something terrible happens just because we are setting interest rates at a given level.
So where I differ from Paul Tucker on the UK-and this goes back to my response to Mr Fallon, which may indeed be unpersuasive, and he may find Mr Tucker’s response much more persuasive-I see no sign that people in markets, people in economic decision places, people who are paid or put their own money on the table, are losing faith in the credibility of the Bank of England, because they get basic economics, they get the explanations we have given. They know we were wrong about the exchange rate, but they know we were largely right about the rest of it. Therefore, we are not seeing-and this is what I presented in Aberdeen last night-any evidence of upward creep in market-determined interest rates, any evidence of upward creep in wages, of unit labour costs. If you compare this to the 1970s and 1980s, it looks nothing like that. So therefore, I don’t see any reason to act in that direction.
Chair: You have been forced to sit opposite Montagu Norman, you tell us. Who would you prefer to have in front of you, Mervyn King?
Dr Adam Posen: I do have Mervyn King in front of me, and that is always an inspiration.
Chair: As a more permanent reminder?
Dr Adam Posen: Oh John Maynard Keynes.
Chair: That is a very helpful contribution. David Miles, you have been scribbling away heavily there, which suggests that you may have a contribution to make to this debate about the BIS.
Professor David Miles: I have not read in detail what the BIS said. If they were saying that monetary policy should be tightened right now, then I am in exactly the same place as Paul. My voting record is what it is. I don’t think that that is where we should be. If they were saying that interest rates at this current extremely low level were unsustainable and shouldn’t be left here for evermore, then I think that is a statement of the close to the blindingly obvious, which very few of us would disagree with.
I should say I strongly agree with what Paul said a moment ago, which is that the centrality of the inflation target and the importance of us maintaining-as I think we have to done to date, although there are risks-people’s faith that we will bring inflation back to the target. That is absolutely crucial. I think Paul is right to point out that there are risks. The longer that inflation stays above target, there are risks that that credibility may get eroded, but I don’t think that’s where we are right now.
Chair: Thank you very much for coming to give evidence to us this morning. We will take a five-minute break and then resume on the accountability aspects.