UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 1675

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

TREASURY COMMITTEE

BANK OF ENGLAND NOVEMBER 2011 INFLATION REPORT

MONDAY 28 NOVEMBER 2011

DR BEN BROADBENT, PAUL FISHER, SIR MERVYN KING

and DR MARTIN WEALE CBE

Evidence heard in Public

Questions 1 - 127

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Oral Evidence

Taken before the Treasury Committee

on Monday 28 November 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andrew Love

Mr Pat McFadden

Mr George Mudie

Jesse Norman

Teresa Pearce

Mr David Ruffley

John Thurso

Examination of Witnesses

Witnesses: Sir Mervyn King, Governor, Bank of England, Paul Fisher, Executive Director, Markets, Bank of England, Dr Ben Broadbent, and Dr Martin Weale CBE, external members of the Monetary Policy Committee, Bank of England, gave evidence.

Q1 Chair: Good afternoon, Governor. Good afternoon, other members of the MPC.

Sir Mervyn King: Good afternoon, Chairman.

Q2 Chair: Can I begin by asking you about growth in the eurozone? Everyone is now suggesting that growth is well down, and is going to remain well down on what it would otherwise be, both in terms of out-turn and prediction. What proportion of that do you estimate is caused by the eurozone crisis?

Sir Mervyn King: If you go back to the projections we made in August, obviously we do not make a point forecast; it is a fan chart. The whole of that distribution has been revised down-

Q3 Chair: Looking at the central rate.

Sir Mervyn King: For growth over the next 12 months: in the first year of our forecast, growth has been revised down across the board by over 1 percentage point. That is a very big reduction. I would say that the bulk of that can be attributed, directly or indirectly, to a changed perception about circumstances in the euro area: directly, through lower exports from the UK to the euro area; and indirectly, through lower asset prices and lower wealth-share prices have fallen and credit spreads are also higher, because the funding costs of our banks, as well as those in the euro area, have risen. If you put all those things together, the bulk of the downward revision can be attributed ultimately to news since August about what is happening in the euro area. There are some other sources of news-clearly there are signs of slowing in the world economy as a whole-but the bulk of it is the euro area.

Q4 Chair: When you say "the bulk", are you talking about 51% or 99%?

Sir Mervyn King: I am not going to give a precise percentage, but it is well over 51%-it is the bulk of it.

Q5 Chair: And looking forward?

Sir Mervyn King: Beyond the one-year horizon, we have not made significant changes to our growth rates in the forecast in the second and third years. They are largely unchanged. So we have a period of a soft patch over the first year, with weaker growth, but then we expect some bounce-back in the second and third years, as before.

Q6 Chair: So you are implying a resolution to the eurozone crisis, somehow?

Sir Mervyn King: No, we don’t know. Indeed, we were very careful to say that-

Q7 Chair: I have seen that in the text.

Sir Mervyn King: The extreme events associated with developments in the euro area are simply not in the fan chart; it is impossible to quantify them.

Q8 Chair: In making that assessment yourself, are you an optimist or a pessimist that the eurozone is going to get through this crisis without fragmentation?

Sir Mervyn King: Well, you have to define what optimism and pessimism mean in that context.

Q9 Chair: I have described it as fragmentation being on the pessimistic side.

Sir Mervyn King: That is something which we have not made a judgment on. It will depend on the politics in the euro area, which you are better placed to decide than we are.

Q10 Chair: Maybe I should ask an economic question to get the ball firmly back in your court. Do you think that the Greek economy can recover at current exchange rates?

Sir Mervyn King: Let me not base it on one economy. Let me make a more general statement, which is that underlying this problem is a crisis of current account imbalances. Germany and the Netherlands have very large trade surpluses. Many economies in the south, including Greece, have large trade deficits. The question is: how can they get back to a point when these can be financed and, ultimately, the debt serviced?

What we have seen is that the private sector, since the summer, has indicated pretty clearly that it does not want to finance these current account deficits. That has left Governments to finance the deficits-primarily the euro area Governments. Given the scale of the debts which have been built up to the rest of the world and some of the periphery countries, it is very hard to see how just making further loans to those countries will actually resolve the problem. During the transition period in which they regain competitiveness, which is clearly crucial to having any sustainable path for those countries-they have to find a way of regaining competitiveness-those current account deficits will need to be funded, I suspect, largely by transfers rather than by loans. What markets are looking for is a clear signal from other Governments in the euro area that they are willing to provide the transfers. This is a very old problem of current account surpluses and deficits. It is not a problem to do with fancy financial instruments or modern economics; this is as old as the hills.

Q11 Chair: In fixed-rate systems.

Sir Mervyn King: Yes.

Q12 Jesse Norman: This is a question for you, Governor, but by all means share it among the others if you like-it is really persisting on the issue of the eurozone. In the worst-case scenario, what would be the economic impact of a euro-area country default on the UK economy?

Sir Mervyn King: It is very hard to give a worst-case scenario from that. Many things could happen. An awful lot will depend on the politics of it. I am not sure whether it is terribly sensible to try to pretend to quantify the worst-case scenario.

What I would say more generally is that we are facing a situation in which some painful adjustments need to be made, both for creditors and debtor countries. Those adjustments will be necessary irrespective of how the euro-area crisis plays out, so there is no easy way out of this. Maybe others would like to comment, but I do not see much point in trying to speculate on the worst case. I suspect it is always possible to find things, as they pan out, that are even worse than you could imagine.

Q13 Jesse Norman: Quite so. In your scenario planning or modelling, do you look at the difference between a default inside and outside the eurozone?

Sir Mervyn King: As we said in the report, the more extreme events associated with developments in the euro area-I think sovereign defaults come under that category-are not things that we have tried to quantify, because they will depend, critically, on market responses to them, which will ultimately depend on whether people believe that the solution that is put forward is politically sustainable.

Q14 Jesse Norman: I guess I was asking about scenarios that have not necessarily been taken to the full level of quantification. I am thinking about the possible implications for growth, broadly conceived, inflation, and the stability of the banking system at those times.

Sir Mervyn King: As I said, there are some painful adjustments to be made whatever the scenario as the euro crisis develops. Therefore, the fact that very large potential credit losses have been built up prior to the crisis beginning means that there will have to be a rebalancing between both creditors and debtors. The idea that only debtors will pay the burden of this is mistaken; creditors will have to accept some of the burden, too. How that is shared, how it plays out, how serious it is, is almost impossible to know.

Q15 Jesse Norman: Would it be better for the UK for a euro-area default to be inside the euro rather than outside?

Sir Mervyn King: I do not want to make any statements to that effect, no. All I will say generally is that there are these painful adjustments to be made. It would be much better if they were made in an orderly rather than a disorderly way.

Q16 Jesse Norman: We are already seeing deleveraging across Europe in the commercial banks. How safe are the UK banks from the impact of that deleveraging on the British financial system and the potential real shock to further confidence?

Sir Mervyn King: The British banks are clearly much better capitalised than they were in 2007-08. Clearly, they are also better capitalised than many banks on the continent and in the euro area. When the European Banking Association published its estimates of the amount of capital that the European banks needed to obtain over the next six months, it allocated the numbers by country, and argued that many countries in the euro area required significant amounts of capital to be injected into their banks. It thought the appropriate number for the UK was zero, so it did not recommend that more capital be injected into the UK banking system.

Clearly, other things being equal, the more capital a banking system has, the better able it is to withstand shocks that come. None of us can really know the scale of shocks that might come from the euro area, and no banking system can withstand shocks that are sufficiently large, so there is certainly no room for complacency.

Q17 Jesse Norman: The report makes it clear that the UK banking system has become less safe over the last quarter, if you judge by CDS spokesmen.

Sir Mervyn King: Yes, over the last quarter, all banks have become less safe, because our banking system is exposed to the euro area-there is no question about it. The countries that matter, primarily, for UK banks are Spain and Italy, and exposure is not primarily to sovereign debt; exposure is to other banks in the euro area and also directly to the real economy in those countries.

Q18 Jesse Norman: But the market for bank funding has tightened considerably. There has been no term debt from any bank over the past three months. Bank funding has shortened in the money market significantly. How much concern is that causing you?

Sir Mervyn King: It is causing a great deal of concern. I think it is causing a great deal of concern to policy makers around the world. I regularly discuss it with my opposite numbers.

Q19 Chair: Just to be clear, you have said that things could get even worse than we can possibly imagine on the downside. Could they get better than we could possibly imagine?

Sir Mervyn King: Absolutely, they certainly could. The point I’m making is not that they will be worse. Far from it, but I don’t actually think there is a great deal of point pretending that we can quantify or even describe accurately how things will play out. If you go back to 2007, I remember that we had regular discussions at the IMF about how the imbalances would unwind in the world economy. Almost all our discussions concluded that they were likely to unwind with a significant fall of the US dollar. We did not conclude they were likely to unwind with an evident collapse of the banking system.

There are many things that could happen, if developments in the euro area get worse. I honestly do not think it makes much sense to pretend that we know precisely how this will play out. What we have to do is be ready and prepared, with contingency plans, and to ensure as far as possible that our banking system is as robust as possible to withstand whatever shocks come from the euro area, of whichever sort or origin.

Q20 Chair: I think you are inadvertently quoting "Star Wars" with your apocalyptic downside risk scenario. I don’t know in which role you are casting yourself.

Sir Mervyn King: I am not an expert on "Star Wars"; not as much as you are.

Q21 Chair: I had to get some clearance from my Clerk to be sure that remark was right. Jesse, you wanted to come back with a quick question.

Q22 Jesse Norman: Just to be clear, it cannot be helpful, can it, for there to be further delay in measures taken to resolve the euro crisis? It must be worsening outcomes when they eventually occur.

Sir Mervyn King: That is certainly true.

Q23 Jesse Norman: As it were, the earlier the better from your and the Bank’s point of view.

Sir Mervyn King: Yes, but it is important that they are convincing answers. It is all very easy for those of us not in the euro area to criticise countries that are. What they are trying to do is put together an agreement between separate sovereign nations about a way forward that is going to change radically the nature of their union. I don’t think any of us would be particularly enthusiastic to jump from one position to a radically different one in two or three days, but the market pressure is clearly there.

Q24 Mr Love: Governor, in your statement or report to the Treasury Committee you said that there were two key risks to the inflation outlook. On the one hand, there was the risk that a persistent marginal spare capacity and subdued wage growth would result in inflation moving below target. Clearly, that depends on the outlook for spare capacity, a very difficult thing to achieve. According to the inflation report, there are some misgivings about whether the Bank has got that correct. The business surveys do seem to suggest that there is not as much spare capacity. Why are you so confident that the Bank is right about the measure of spare capacity in the economy?

Sir Mervyn King: Well, we are not. We are very uncertain about how much spare capacity there is. You can look at it from two different viewpoints. One is that clearly there is spare capacity in the labour market; we see that with the higher levels of unemployment. How much spare capacity there is in firms is harder to judge. It may be that there is a very large amount of labour hoarding going on within firms at present, which would indicate that in total there was a great deal of spare capacity. On the other hand, the surveys do not support the view that there is a particularly large amount of spare capacity.

It is very difficult to judge. In the end, it comes down in part to a view about whether one thinks that the underlying growth of potential output-productivity growth-over the past four years has continued at the usual average historical rate, which is about 2% a year. That has been very stable for a long time-50 years or more. Or, whether that has, in these circumstances, fallen back and, for some reason that is not entirely easy to quantify, that productive potential has not risen in the past four years in the way that we would normally expect it to. If that were the case, that would be consistent with there being much less spare capacity than one might think, given the low growth rate of output over the past four years. There is enormous uncertainty. My colleagues will have other, different views. For me, there is enormous uncertainty.

Q25 Mr Love: I will come to them in a minute, but surely that then requires the Bank to do more research into both the output gap and this mysterious reduction in the improvement in productivity. Are you doing that?

Sir Mervyn King: We are indeed.

Q26 Mr Love: Much depends on this being the case, in terms of your strategy.

Sir Mervyn King: It does, and we are doing it, but I put enormous weight here on the information from our regional agents, who, between them, talk to more than 8,000 companies across the country. We have a chance to supplement that with our own visits, so we can ask questions ourselves, but I think that this is a case where just going directly to what is happening in companies may help us to understand what is happening, but it is a puzzle. These are unprecedented circumstances, so just to look at past data as a means of guessing what has happened is not terribly helpful in these circumstances, but we are trying our best to find out what is going on.

Q27 Mr Love: But the business surveys seem to be very clear. I do not know which one of you to ask-or other Members. Are there more concerns about whether the level of the output gap is-?

Chair: I think that Dr Broadbent wanted to come in.

Dr Broadbent: Do I? If you are asking me a question Chairman, I will be happy to answer it.

Chair: That was the impression I got, but if you do not want to, now is the time to withdraw, but I think you had something to say.

Mr Love: So I will ask Dr Broadbent.

Dr Broadbent: Thank you very much. Most of the time that I have been on the Committee, which has been only six months, has been spent talking about either the euro area or precisely the question you asked. It is not easy either to answer what the level of spare capacity is now-in fact, it is even harder to answer where it is going over the future, if we are not confident about the growth rate of productivity.

One thing I would point out is that, as the Governor said, in the labour market there are clear signs that there is a wide margin of spare capacity, and that is probably more than half the output gap. The other thing is that it is not actually the case across all business surveys that they say that there is not much spare capacity. It is mainly the case in manufacturing. Those surveys say that capacity use is around average. In services-a sector for which I would argue it is harder to gauge what spare capacity actually means-there is some indication of spare capacity, but we are undertaking quite a bit of work to try to understand what has gone on. I would say that it is not wholly exceptional to see slow productivity growth after financial crises, but I think that even relative to other severe banking crises, the experience of the UK over the past three or four years is exceptional, so there is clearly a puzzle.

Dr Weale: May I add some observations to that, please? I think that one has to be careful about how one interprets the surveys; for example, it is not clear to me how a boarded-up shop fills in a survey to say that it is a boarded-up shop that could reopen. Another possibility, which, based on the businesses I visit and talk to, I am sure is true to a greater or lesser extent, is that people are having to work much harder, at least in some activities, than they did before the crisis to do the same amount of business. If you are selling things as a business, and you have to go out to look for customers, that may be quite a lot more work than it used to be, and in that sense, productivity has indeed stagnated. Of course, if the economy were more buoyant, people might find that they could get on with what they wanted to be doing, which is providing services and not just selling them.

Q28 Mr Love: Let me go on to the second part of what you said about subdued wage growth. That is certainly the case at present.

Sir Mervyn King: It is indeed.

Q29 Mr Love: But the level of unemployment and long-term unemployment is increasing. There are a lot of young people out there who have never been in the market. As well as the usual attempts to catch up that may happen in future, there may be labour market constraints that will lead to wage inflation. Aren’t you at all concerned about that?

Sir Mervyn King: We do not see it as an immediate concern, and I think that it is fair to say that wage growth has been remarkably subdued for a considerable period. There is no doubt that as the experience of high unemployment continues, one of the problems about which all of us should be concerned is the rise in the underlying structural level of unemployment. It is important that the Government, as far as possible, take measures to reduce that rise in structural unemployment, such that, when demand recovers, employment can pick up.

What is clearly going on at present, I think, is a rebalancing of the economy, not just in terms of demand and output, but in terms of employment. We see some sectors of the economy shedding employment and other employers hiring. One of the things that struck us over the past year was that, well, employers are hiring labour, which is not normally what you would associate with a very large level of spare capacity. That is one reason why this has been such a difficult question to answer. The starting point for us is to say that total output is probably around 10% below where it would have been had the economy gone on growing at its completely acceptable pre-crisis trend. That is a massive shortfall of output relative to where you would have expected it to have been. Not all of that seems to be accounted for by observable spare capacity, but, equally, it is very hard to see why you would expect the productive potential of the economy simply to stop growing at all.

So that is the fundamental question that is driving our thoughts about the labour market. So far we see, and I think we would expect to see it continue, subdued wage growth. One of the factors that might have led wages to rise over the past year and that we were concerned about is the squeeze on real take-home pay. There has been a very sharp squeeze on real take-home pay, but next year, although that squeeze will not be reversed, there won’t be a further squeeze, which is one of the good pieces of news in the outlook. That should help to diminish the upward pressure from what is known as real wage resistance.

Q30 Mr Love: The other risk that you mentioned in your report to the Committee was inflation expectation rising. We have seen a consistent period of higher inflation than originally expected-it is 5% now, and we were at 5.2%. How do you think that will filter through in current circumstances to expectations and demand for higher wage settlements and to price increases?

Sir Mervyn King: It is too soon to be completely confident about it, but I think we can draw considerable comfort from the fact that all the indicators that you would normally look at to see signs of higher inflation expectations-be they nominal wage growth, expectations of inflation in financial markets on yields, gilts and other assets, or, indeed, direct survey measures of long-term inflation expectations-fail to show any significant pick-up. Clearly there has been a rise in short-term inflation expectations, but not only is that unsurprising, it is what you would expect because our own forecast has gone up and inflation has been high recently. I think that now people are beginning to realise that the factors that led inflation to rise over the past year or so are diminishing. Although there is no certainty about the future, I do not think it would be in most people’s central view that they expect a repetition of the rise in energy and food prices that we have seen in the past year, of the increase in VAT or of the sharp fall in sterling that we saw over three years ago.

Q31 Mr Love: It would be unkind of this Committee to remind the Bank of previous inflation forecasts and how, in the recent past, inflation has always been higher than expected. Does that cause you some concern? Is your credibility at stake?

Sir Mervyn King: No, it would not be unkind at all. It is a question that we look at and think about. The point I made to the Chairman earlier is that our forecasts are not point forecasts. The statement that we forecast inflation next year to be 2.8%, or whatever number you want to choose, is not coherent. The forecast is a probability distribution; it is a statement about the balance of risks. That is the only sense in which a forecast can be used. We have been able to explain why inflation was above the central view in our forecast by reference to the unexpected events that occurred and the events that other people did not expect to occur that were not in their central view either, mainly the rise in energy and food prices across the world and the increase in VAT.

I think we can account for past movements in inflation. All I would say at present-I think people do understand when we make the point to them-is that a reasonable person would not have in their central view another 35% rise in energy prices this year plus sharp increases in food prices. They would not have another rise in VAT and would not expect a further 25% fall in sterling. If these rather extreme events were not to occur, you would have to have a very rapid and significant upward surge of domestic inflationary pressure to prevent inflation from coming down. As you point out, with unemployment high and now beginning to rise, this does not seem to be a set of circumstances in which domestically generated inflation is likely to pick up.

Q32 Mr McFadden: I would like to ask you, Sir Mervyn, about the outlook for economic growth going forward. Tomorrow, we are going to have the autumn statement, and every time we have had a Government statement since the election, projections for growth seem to be reduced. We have had the OECD report today projecting a contraction in the next two quarters in the UK outlook. What is your view?

Sir Mervyn King: The view we have is the one we set out in the November inflation report, where we said that in the fourth quarter of this year and the first quarter of next, broadly speaking our central view is one of roughly flat output with growth close to zero. Thereafter, there will be some pick-up, but over the first year of the forecast, going through to autumn next year, we do not see rapid growth at all. We made the downward revision that the Chairman asked me about at the beginning. Thereafter, we see some return to more normal growth rates.

The point I would make is that over the last year or so, the factors that have been largely responsible for slower growth than was expected have been an unexpectedly strong squeeze on real take-home pay. We did not expect a year ago that energy prices worldwide would rise by 35%. There was a very significant squeeze on real take-home pay. I do not think it would be sensible to expect that to be repeated next year. Who knows what will happen? We cannot be certain, but I think the balance of risks is not towards a further squeeze on real take-home pay.

Consumption has been squeezed a long way already. It is 6% down on its peak level at the end of 2007. That is a pretty dramatic fall in household consumption. At some point, you would expect that it will have reached as low a level as households feel that they need to go in order to be able to start to see a small growth in consumption in the future. Total output in the economy is 4% below its peak, so consumption has fallen even further. The concerns that we have are less about domestic demand, because we expected that to be weak. We had expected that exports would pick up a good deal of the balance in terms of some stimulation in growth. We have seen that over the last year or so, but going forward I think we are concerned that problems in the euro area, unless quickly resolved, could lead to weaker outlooks for exports than we had expected earlier in the year, and that is one reason why we have downgraded the forecast for the coming year.

Q33 Mr McFadden: Do you then disagree with the OECD when they predict not flat, but actually contracting output over the next two quarters?

Sir Mervyn King: I have not seen the OECD document I am afraid. It came out this morning.

Mr McFadden: I find that hard to believe.

Sir Mervyn King: All I would say is that there is a balance of risks. We do not predict a number-whether it is up or down. We said in our report that the balance of risks was on the downside from our central projection. The central projection was for broadly flat output, but thereafter output beginning to pick up. What is important is not whether growth in the next six months is plus 0.2 or minus 0.2, but whether we appear to have a framework in which it is plausible that growth will pick up. That is not easy to put in place when the euro area finds it very difficult to have any plan for them that makes it easy for us to make judgments about the likely market for our exports. This is a time not to try to fine tune and alter the growth rates over the next one or two quarters, but rather to think about the next three, four or five years.

Q34 Mr McFadden: On that note, I would like to turn to Martin Weale and ask about the trend rate of growth. You have given a statement saying that there is no reason to expect growth below the historical trend in the future. That is a big assumption, is it not? It is a big assumption behind what the Bank does, and it is hugely important to the economy. Do you believe that, given what we have been through in the last three years or so, we can get back to historic trend rates of growth in the next couple of years?

Dr Weale: First of all, it is important to remember that even if we get back to historic trend rates of growth and we do not have any element of recovery, output will be a very long way below where one would have expected it to be in the absence of the crisis-possibly some 10 percentage points below. That is a movement that really has no historical parallel for Britain, so even if we get back to historic trend rates of growth, we will be quite a lot worse off than we would have been. Essentially, however, the basis behind what I said was, as the Governor said earlier, that we do not think the underlying factors that have supported trend growth in productivity over quite a long time-things like improving education, the standard of the labour force, research and development and the stimulus of importing new ideas from abroad-have fundamentally changed. We certainly know, as happened in Japan, that countries can have periods of rather poor productivity performance. I certainly would not say that sort of thing could not happen here, but I have no reason to believe that it is likely to happen.

Q35 Mr McFadden: So the message from the Bank to the country is not that we have to get used to lower growth for a long time to come.

Dr Weale: I do not have any reason to think that underlying growth will be lower for a long time to come. Again, I stress that as we have said repeatedly, the future is uncertain, and estimates and underlying trends are also uncertain, but there is no reason to think that underlying trend growth rates have deteriorated markedly.

Sir Mervyn King: In the long run, I am sure we can get back to historical growth rates, but I have no idea over what horizon, because I think that ultimately this is linked to the rebalancing of the world economy. What is going on in the euro area is an example of that, but it is not the only aspect; the trade surpluses in China and the deficit in the United States are other examples. Until those problems have been resolved, all countries are likely to face a period when there will be unexpected credit losses, and adjusting to that will be a rather painful and unpleasant episode. I do not know how long it will take but once it is over, I see no reason why we cannot get back to the long-run growth rates that we experienced in the past, which were stable for quite a long time.

Q36 Mr McFadden: Looking at the basic policy division between the Bank and the Government on this in the last couple of years, the Bank has been running a loose monetary policy and the Government, since the election, have been running a tight fiscal policy. That is not producing economic growth. We have had a year of pretty flat growth. What other weapons are in the locker, if the current twin division of responsibilities is not producing growth?

Sir Mervyn King: The idea of a combination of a tight fiscal and easy monetary policy would actually be a standard textbook response to the problems that we faced-a situation with a large fiscal deficit, a current account deficit, and the need to rebalance the economy. What has happened is that we are facing extraordinary headwinds from the rest of the world: first of all, in terms of the rise in energy and food prices, which brought about a squeeze on real take-home pay and dampened consumption more than we had expected, and secondly now, in terms of the problems within the euro area, which of course renewed concern about the health of not just the euro area banking system, but banking systems right around the industrialised world. That is why this is an issue that all my colleagues at central bank level take seriously and talk to each other about. It has raised the cost to banks of obtaining funding and hence, in turn, the cost of borrowing to companies and households. Those are enormous challenges and it will not be easy to get through this. There will need to be a significant amount of rationalisation of the debts and credits in the world before we finally emerge from the end of this period.

Q37 Mr McFadden: How much do the Bank and the MPC consider the human cost of all this when they come to their decisions? We have unemployment at a 17-year high. We have 1 million young unemployed people. In your former home town of Wolverhampton, which I represent, unemployment is more than 12% now; it is the 14th highest in the country. How much does that basic human cost of coping with this crisis come into the MPC’s decisions?

Sir Mervyn King: We are all very concerned about it; it is one reason why many of us have moved into this career and why we are interested in policy making. I think the best contribution that the Bank of England can make is by meeting our remit to bring inflation back to the target over the medium term, but we have been very careful over the past two to three years to say that our remit includes the requirement that we do not cause undesirable volatility in output. That is why, for some considerable time now, we have had to put up with the criticism that we permitted inflation rates of around 5%. We deliberately did not take action to bring the rate down quickly to 2%, because to do so would undoubtedly have meant falling money wages, rising unemployment and a deep recession. I do not think that that would have been desirable. I do not think that it would have been consistent with the remit that we were given and it is not the measure that we have actually taken.

In the long run, the right thing to do-it is what we are looking at every month-is to ensure that when looking two years or so ahead, we are on track to bring inflation down to the target. The reason why we have expanded our asset purchases is because, in our latest forecast, we felt that the balance of risk was that inflation might actually be below the target, thus justifying further monetary expansion, despite the current high level of inflation at 5%.

Q38 Chair: Just to be clear on those remarks about the broader economic effects, you are not, are you, making an implicit bid there for a change in your remit?

Sir Mervyn King: Certainly not.

Q39 Chair: You do not want it more towards, for example, the remit under which the Fed operates.

Sir Mervyn King: Absolutely not. We have a very clear remit, which is to hit the inflation target, but the remit clearly says that from time to time there will be shocks to inflation, like the shock from VAT or from energy prices last year, which mean that to meet the inflation target immediately would cause undesirable volatility of output and employment. It is therefore necessary to look further ahead, to when those temporary shocks drop out. If we had raised interest rates significantly, to ensure that inflation was 2% today, not only would that have caused far greater unemployment and loss of output, but we would now be confronted with the prospect of inflation being well below target and we would be in a position where we had rather little we could do about it.

Q40 Mr Ruffley: Governor, I want to ask about inflation forecasts. There is no need to repeat what you said to Andy Love about it being a distribution and so on. You were very good at the start of this decade; the average forecast error for inflation one year out between 2001 and 2004 was 0.1%. Between 2004 and 2007, it was 0.3%. From 2007 to 2010, it was 1.3%. In the last 12 months, from November last year compared with this month, it is 1.5% adrift. Excluding what you said before about the VAT increase, world commodity prices and the effect of the depreciation in sterling-taking those out of the equation-what do you think in the model has contributed to the worsening forecast performance?

Sir Mervyn King: Nothing, because if you take those factors out, there is nothing else to explain. I do not like the word "error" because no one can know what the future might hold. It is a technical term. The magnitude of those is entirely driven by shocks to the world and UK economy from outside. If you get very large and unexpected shocks, you will get very large "forecast errors".

Q41 Mr Ruffley: I just want to ask about the model. In reply to Mr Love earlier, I think you, Dr Broadbent, used the words that you as a bank were trying to understand what has gone on in relation to the output gap. How far is your reliance on the output gap responsible for these overshoots in inflation?

Sir Mervyn King: I do not think that it is. The overshoot in inflation is not because we have had an excessively buoyant economy growing rapidly and putting pressure on capacity.

Q42 Mr Ruffley: I mean overshooting the forecast.

Sir Mervyn King: Yes. If we had overestimated the amount of capacity in the economy, therefore the economy had grown sufficiently rapidly to press on capacity, pushing up domestically generated inflation, you would not have seen subdued wage inflation and you would not have seen rising unemployment. So I do not think it is domestically generated inflation; if anything, domestically generated inflation has probably been below where we thought it was going to be. It is the external factors that have pushed it up.

Q43 Mr Ruffley: So it is purely external.

Sir Mervyn King: There are other things that make life very difficult at present: the nature of the crisis, and the changes and disturbance to the banking system, which are unprecedented in UK banking history-to have several of our major banks in deep trouble, pushing up on credit spreads in the way that they have. That has made life extraordinarily difficult. There is no model that enables you to take that into account. These are judgments about how long the crisis will persist. One of the things that we failed to understand was how long it would take for conditions in banking markets to get back to anything remotely close to normal. In 2009, I think the central view was that by now funding conditions in banking markets would be better than they were then. In fact, if anything, they are worse. That is a surprise, and it is something that we have had to take into account, but it is one of the factors that has made life extremely difficult in assessing where the economy is going.

Q44 Mr Ruffley: What contribution to the overshoot in inflation do you think the first round of QE made?

Sir Mervyn King: Inflation would have been certainly a bit lower, and we discussed that in our quarterly bulletin article.

Q45 Chair: I think you had the figure 1% in there.

Sir Mervyn King: In terms of the scale of the amount of QE we did, the asset purchases we did and the £200 billion. But we did that because we thought that without that the risk to inflation was on the downside. When we made those decisions we did not know the scale of the energy price increase, the scale of the VAT increase and so on. Those are factors that come along, and we have to accept them. We decided, as I explained earlier, not to offset those when we saw them coming in, because to do so would have been very damaging to the real economy. They would also have made life more difficult for us in the medium term, because the balance of risks would have been that inflation would fall below target at a time when we would have been hard pressed to find more instruments to ensure that inflation would pick up.

Q46 Mr Ruffley: Could you list the factors that prompted the MPC to go for another round of QE?

Sir Mervyn King: I think it was the change in the outlook between August and now, which I have explained. You have seen the very sharp downward revision in the growth outlook, and although the growth rates in the second and third years have not changed very much, it means that the level of output that we are projecting-the whole distribution of the levels of output-is markedly below in our current view what it was in August, for all the reasons I have given connected with the euro area and the knock-on effect on credit conditions.

Q47 Andrea Leadsom: Dr Broadbent, if I sell you something for £1 and buy it back from you at £1.10, what is your financial position?

Dr Broadbent: It depends what has happened to the underlying value of the thing I have bought from you. I would not sell it to you at less than that. Can you be a bit more concrete?

Q48 Andrea Leadsom: No, it is simple maths. If I sell something to you at one price and buy it back from you at a higher price, have you made money?

Chair: In nominal terms, Dr Broadbent, just to define the question.

Dr Broadbent: Yes.

Q49 Andrea Leadsom: You have made money. So if I sell you £100-worth of gilts at £80, having bought them from you previously at £100, what is your position then?

Dr Broadbent: If you are asking about QE and the benefits to the Bank of England’s balance sheet-

Q50 Andrea Leadsom: Would you just answer? Have you made twenty quid?

Dr Broadbent: Yes, in a sense, but I am part of the Government as well, and if the Government is selling me-

Q51 Andrea Leadsom: This is my point: I am very keen to establish that if I buy something from you at £1 and sell it back to you at 80p, you have made 20p on the transaction and, therefore, in theory I have lost 20p on the transaction, because I have sold it to you for less than I bought it from you. Why, therefore, is the Governor right to say that in terms of unwinding the asset purchases there is no loss when it is being bought from the market originally and sold back to the market subsequently? The Governor says in his letter to the Chairman, "Any profit or loss arising from movements in the market price of the gilts held by the asset purchase facility would be offset by a loss or profit for the Government as issuer of the gilts." Why is that right?

Dr Broadbent: Because that is the party on the other side of the transaction, ultimately.

Q52 Andrea Leadsom: But it is not, is it? You have bought the gilts from the market; you have not bought them from the Treasury. Now you have sold them back to the market, potentially at a lower price-granted, potentially at a higher price.

Dr Broadbent: But then the value of the obligation, which is the Government’s obligation, has also fallen.

Q53 Andrea Leadsom: No, it hasn’t. The Government issued them at par-

Dr Broadbent: The price of the gilt is what you are suggesting has fallen, and that is the value of public sector debt. Let me make another point first of all: these transactions are not on the central bank’s balance sheet; they are off the balance sheet and indemnified by the Government. In that sense-beyond going into any deeper questions-the transactions have no impact on our balance sheet.

Q54 Andrea Leadsom: No, that is simply not true. If you bought the gilts off the Government, then I agree that it is a Government liability and it is a Bank asset, and if you subsequently sold them back to the Government, it is now flat; I completely agree. But if you buy them from the market at one price and then you sell them back to the market at another price, so that the person the other side of the trade makes a profit or a loss, you cannot possibly not have made the opposite side of the trade.

Dr Broadbent: But this goes on all the time. There might be a private sector organisation-let us say a pension fund or an insurance company-that buys a gilt at a certain price, and then the value of that gilt may rise or fall subsequently.

Q55 Andrea Leadsom: Absolutely, and that is how profits and losses are made.

Dr Broadbent: So leaving aside the Bank of England in this for the moment, who is on which side of the transaction in that case? Suppose a private sector investor buys a gilt and then interest rates fall, and that private sector entity has therefore made money in some sense from that transaction, who in that case has lost money? There is no Bank of England involvement.

Q56 Andrea Leadsom: The point is that on this occasion the Bank is that private investor. The Bank has bought gilts and will be selling gilts. Therefore, by definition, if the two prices are different, the Bank has either made a profit or a loss. I just simply cannot understand the Governor’s response to the question.

Sir Mervyn King: Shall I try to help you out, briefly, Mrs Leadsom?

Andrea Leadsom: Please do. Thank you, Governor.

Sir Mervyn King: There is a narrow point, which is accounting. My point was simply that if the central Government had the same accounting conventions as the asset purchase fund, mark to market, you would find, as I said in the letter, that the gain on one would be offset by the loss to another, because what is the asset to one party is a liability to another.

I do not think that is a terribly interesting question to ask. The really interesting question to ask about the asset purchases is what is the counterfactual if we had not made the asset purchases? I suspect your question is trying to tease that out. That is a very different question.

My point is-I will come back to this-that the measure of profit and loss on our asset purchase fund should be of no interest to anyone. At present, we happen to have a very large profit-a staggeringly large profit-in our fund. We do not regard that as a sign of great triumph or success. Ultimately, I hope we will get to the point when interest rates are back to more normal levels; that will be a sign of success for everybody, because it would be a symptom of a healthy economy. But if that were the case, the same mark to market accounting would show that the Government had a profit, because the value of its liabilities would have gone down, and we would have a loss, because the value of our assets would have gone down, so I do not think these mark to market accounting valuations tell you anything.

If you look at the public sector as a consolidated group, which you should, the mark to market profit to one is a loss to the other. The interesting question is what is the counterfactual? If we had not made these asset purchases, all the interest rates would be different.

Q57 Andrea Leadsom: Can I just make one point please, Governor? I have to disagree with you, because the market is standing in-between. I just plainly think you are wrong. I have talked to a number of people in the markets who also think that you are wrong.

Sir Mervyn King: Let me just refer you to the standard accounting practices of all banks and all financial institutions.

Q58 Andrea Leadsom: It is not about accounting; it is about the fact that if I sell you something more cheaply than I bought it from you, you have made a profit and therefore I have to have made a loss. It is not about the accounting; it is about the simple fact that unless you sell those gilts at the same price you paid for them, you have made a loss.

You can say to me now you are making a staggering profit. You said yourself to us, the last time you gave evidence, that your intention when you came to tighten the money supply was to raise interest rates to set the direction and then to unwind the asset purchases to push the yield curve up. Well the yield curve is going to go like that.

Sir Mervyn King: Yes, absolutely.

Q59 Andrea Leadsom: You have referred to a counterfactual. What I am trying to establish is that there is the potential for a whacking great loss to the taxpayer. There is that potential. I still believe that there is and I believe that your analysis of it is just wrong. Secondly, I then think-

Sir Mervyn King: Let’s just beg to differ on that. Let’s go back to the counterfactual, which is what would have happened to the British economy if we had carried out these asset purchases. That ought to be the test. Of course, that is exactly the same test that you would apply to a monetary policy move that involved interest rates. No member of this Committee has ever said to us, "Gosh, you’ve raised or lowered bank rate. That has changed the interest rate on Government securities, so of the people buying or selling them, some would have made losses and others would have made profits." You ask us the question: does this monetary policy move make sense from the point of view of the UK economy? That is the judgment that you should use when judging asset purchases, not whether the fund happens to make some accounting profit or loss.

Q60 Andrea Leadsom: What concerns me is that there is no forward assessment being done by the Bank on the unwinding of the quantitative easing. We are now in a position where the European Central Bank could be doing what you have been doing, and they are not doing that for various reasons, including the fact that they are concerned about the impact on domestic inflation in the eurozone. Yet we are taking the view in this country that QE is a free lunch and the Bank’s own assessment suggests that QE accounts for 1.5% on gross domestic product, which is basically all the growth in the economy since the financial crisis. There has been no assessment of the cost of unwinding it.

Sir Mervyn King: That is not true at all.

Q61 Chair: Come back once more on it, Governor, and then I’ll move on to Michael Fallon.

Sir Mervyn King: This is a positive lunch. Everybody is better off because of the actions that we have taken. If we ever get back to the point where the value in our portfolio of the gilts has gone down, I will regard this as a triumph because it means we will be back to a world with more normal levels of interest rates and hence more normal levels of growth, output and employment. Anything the Monetary Policy Committee can do to get us back to a world where the economy is sufficiently strong that market interest rates have risen so that they have confidence that people can earn real rates of interest-if we can raise bank rate; if we can get back to that more normal world-that is the moment when I will say that monetary policy has been successful. You may think, "Gosh, there is a terrible accounting loss." I will come back and say, "Mark to market for the public sector as a whole, it’s awash". Neither of those things will matter a bit to people out there in the real world and your voters. All they will care about is the health of the British economy.

Q62 Chair: Still you’ve got an indemnity.

Sir Mervyn King: Well, that makes the point, doesn’t it?

Q63 Chair: That depends. I think it makes a number of points.

Sir Mervyn King: Whatever the Government can make or lose on mark to market with the indemnity needs to be matched up with the mark to market assessment of its other liabilities.

Chair: Andrea is particularly keen to come back with one more quick rejoinder.

Q64 Andrea Leadsom: So are you saying then, Governor, that there is absolutely no cost to quantitative easing? It is absolutely a free, good thing and there is absolutely no downside and no risk from it whatever?

Sir Mervyn King: There are risks associated with any monetary policy move and those risks are associated with the fact that if we make misjudgments, inflation will either be too low or too high relative to the target. But that is the ultimate cost of this.

Q65 Michael Fallon: Shall we bring Paul Fisher off the bench and give him a chance? The Bank has done an assessment of the first round of quantitative easing and reports that there is "little evidence that effective new bank lending rates for households or firms fell significantly following QE purchases". Shouldn’t they?

Paul Fisher: Yes, well at the same time as we were doing QE, the financial sector tensions were emerging and credit spreads were widening. If we had not undertaken QE and pushed down risk-free rates, you would have seen even higher rates for businesses and individual borrowing. One of the focuses of a lot of studies on the impact of asset purchases is on the effect on interest rates. It is not the only channel. It is not the channel that I, myself, tend to focus on when explaining it to people. It is much more about getting a quantity of money out of the economy in order to increase nominal demand directly.

Q66 Michael Fallon: Yes, but when you came to take your decision to authorise the second round of QE did you not weigh at all the impact it was likely to have on new bank lending rates?

Paul Fisher: Bank lending is not one of the main channels I would use to describe the impact of asset purchases. The effect could actually be to push bank lending down. Let me give an example. If we put enough money out there on to investors’ balance sheets, they go off and buy corporate bonds; the corporates end up with more cash and they may choose to repay that bank lending as a result of that. So the effect on bank lending could go either way but you have already had a beneficial impact on the economy because the corporate is in a better place than it was before. So the effect on bank lending is not for me one of the main channels through which QE works. In fact, the whole point of asset purchases is to bypass the banking system and get money out into the economy proper, not just give it to banks.

Q67 Michael Fallon: The minutes of your meeting on 9-10 November say that there was a range of views among Committee members about the likely strength of the factors involved in assessing QE. What is that range of views?

Paul Fisher: The difference is of emphasis and nuance really, rather than wholesale difference of view. We all sign up to the broad picture of the way the economy works and the different channels. Some people place slightly more emphasis on some of those channels than others. The striking thing is the extent to which we agree, rather than the extent to which we disagree. I wouldn’t want to over-emphasise those disagreements.

Q68 Michael Fallon: But the minutes do. As I said, they say, "There remained a range of views about the likely strength of the different factors."

Paul Fisher: Yes, so some people think that they will have a slightly stronger effect than others.

Q69 Chair: It is a bit more than a range of nuances, isn’t it?

Paul Fisher: "Nuances" was a description of the various channels through which QE works. There is a range of views, but most people think QE will have some impact, and that that impact will be positive. We are arguing about relatively small differences about exactly what the strength is. That will be exactly the same of a change in interest rates. There will be a variety of views about the impact of interest rates on the economy in one moment in time. Some people think it would have a stronger effect than others. It is not really any different for asset purchases.

Q70 Michael Fallon: When you say "most people", are there members of the Committee who doubt the effectiveness of QE in boosting demand?

Paul Fisher: Other people would have to speak for themselves. I am not aware that anybody says it would have no impact.

Q71 Michael Fallon: Is there concern that the transmission mechanism of QE may not work this time in the same way it did last time?

Paul Fisher: The broad picture would have to be the same; the broad mechanisms would be the same. Of course, again when you change interest rates, it never has identical effects on the economy. It always depends on the circumstances in which you are doing it. The differences will be there. The same will be true here. We start from a much lower level of interest rates, for example. We start in relatively different financial conditions, and different financial markets. So, the effects will be slightly different, but in the broad picture I would expect the overall scale of it to be the same.

Q72 Michael Fallon: Were you surprised that the OECD this morning forecast that you might increase to £400 billion in the early part of 2012?

Paul Fisher: People who believe in crystal balls and point estimates are best avoided. I don’t know yet what the amount of QE we will end up doing will be. I didn’t know in the first round until we came to a stop, and we decided that 200 was the right number at which to stop. I feel much the same about this round. We have announced 75; we will do 75. If we think we need to do more, we can do more.

Q73 Michael Fallon: When will you assess the second round?

Paul Fisher: We are assessing the economic conditions as we go. We will not learn that much more about the impact of asset purchases over the three and a half to four months we are doing it, but we will learn about the economy, and about the development of the situation in the eurozone. We will be able to take a fresh look at the medium-term position, and then decide whether we need to do more. I said in an interview over the weekend that £75 billion for me was the smallest amount I was sure we would need to do, and then we could come back to it and see whether we wanted to do another round.

Q74 Michael Fallon: Would you come back to it before you had done the kind of assessment of the second round that you did of the first?

Paul Fisher: We will not learn that much about the impact of asset purchases over a short period of three or four months. It takes a year to 18 months to come through fully, but we will learn more about the economy, and we will have a new assessment of the medium-term outlook.

Q75 Michael Fallon: What do you say to the suggestion that essentially, because this is all so new, you are all flying slightly blind on this?

Paul Fisher: We are all making decisions under uncertainty. That is always true of monetary policy. It is particularly true now, because we are recovering from a recession the like of which we have not seen since the great depression; we have got a global financial crisis that we have never seen before; we have had this very unusual shift in productivity apparently, which we cannot explain from experience. We are in a situation we have not seen before in UK economic history, so of course there is huge uncertainty out there. Add on to that the sovereign debt crisis in Europe, and of course the uncertainty just becomes enormous. But we have to make decisions and we have to try to make the best decisions we can, given the balance of risks as we currently assess them, and get on and do that.

Q76 Michael Fallon: What makes you uncomfortable at the moment about going beyond £75 billion?

Paul Fisher: First, we have a certain period in which to buy those assets. The markets at the moment are not functioning fully, generally across a whole range of financial markets. I feel that we are going at about the right rate at which we can acquire assets. It is a question of just how far ahead you can see into the future. Nobody actually likes the asset purchases; it is not a normal policy instrument. If I thought we could get away with doing less, I would prefer that, but, nevertheless, I am quite prepared to do it if that is the option we have on the table. We will do whatever we think is necessary to meet our remit.

Q77 Chair: You said a moment ago, Mr Fisher, that we are going at about the right rate of purchasing these assets, but your minutes state: "The Committee noted that…market capacity made it difficult to increase the monthly rate of purchases substantially above what was already under way." So you cannot go any faster?

Paul Fisher: We could go faster. I think what we are doing now is about the right rate. The faster we go, the more risk there is that some of our operations do not quite deliver the amount of gilts we want to purchase. There is a certain capacity in the market to supply gilts, depending on how much risk the market makers are allowed to take, and we have to reflect that in the scale of our operations. Can we always go a bit faster? Yes, but the risk builds up of you having some disorderly operations, which I do not think we would particularly like to see.

Q78 Chair: It is not going to be easy to ramp this up, is it? You are saying so yourself that it is difficult to get these purchases away any faster than you are doing now.

Paul Fisher: We can then do some more.

Q79 Chair: Afterwards. Later.

Paul Fisher: Yes.

Q80 Chair: So it is the maximum current rate, and then you just carry on indefinitely?

Paul Fisher: I would not say that it is the maximum. I have always said to the Committee that, if they want to go faster, we can go faster, but it is more risky the faster you go.

Q81 Mark Garnier: May I carry on with this quantitative easing question? Clearly the MPC’s job is to keep inflation at a pre-defined rate. When you are in the markets making an asset purchase, what is your primary objective? Are you trying to pump money into the system to increase liquidity, or are you trying to control bond yields?

Paul Fisher: We are not trying to control liquidity as such; we are trying to increase the amount of money in the economy. That, for me, is the first purpose. One of the consequences of that is that it will push down the bond yields, which is just one of the channels through which QE works. QE forces people who get that money to go off and buy some other asset. Since QE2 started, if you like, we have bought about £35 billion of bonds. That is £35 billion in gilts that somebody is not holding but would have held, so they must be holding something else, which is the main way that asset purchases work. They then have to go and buy some other instrument that they would not have purchased, which will include things such as corporate bonds, equities and the sort of things that help to boost the economy.

Q82 Mark Garnier: They could hold on to their gilts until such time as your demand for them has pushed the yield even lower.

Paul Fisher: They could, and doubtless some people will choose the right time for them to sell the gilts, but we have actually successfully bought that many gilts.

Q83 Mark Garnier: Here is an important question: would you say that the current gilt yield is a reflection of the Government’s policy or of the activities of you guys in the bond market?

Paul Fisher: It is both.

Q84 Mark Garnier: Which is having more of an effect?

Paul Fisher: It is a bit early to say, given the estimate of how much gilt yields are being depressed as a result of the asset purchase programme.

Q85 Mark Garnier: So it is more likely to be general confidence?

Paul Fisher: It is a mix.

Q86 Mark Garnier: Okay. You will be pleased to hear that I am going to change the subject to consumer demand.

I would like to canvass opinions from each of you. In your report you talk quite a lot about recoveries after banking crises tending to be a lot slower than average. Given continuing weak growth in domestic consumption, how quickly do you think the recovery can occur?

Dr Broadbent: Over longer periods of time, I am not sure whether consumer confidence determines growth. The more important consideration if you are thinking about growth over two, three or four years is underlying productivity growth, which we discussed earlier. Having said that, as the Governor said, we have seen steep falls in consumption. Recently I would attribute a lot of that, certainly over the past year or two, to very weak real income growth, itself the result of hits to VAT and, more importantly, to energy prices and weak productivity. Looking ahead, that is one relatively bright aspect of the projections. As long as we do not get increases in those costs on the scale that we have seen over the last year or two-it is hard to see them on that scale-then real income growth, and consumption growth, too, will improve. Whether that means that growth in the economy overall improves to the same extent is much harder to say in the face of these other head winds. It is more likely that the troubles in the eurozone will show up in other areas of demand-exports, investment and so on-rather than in consumption. So I would not want to hang the fortunes of the economy entirely on household spending growth.

Paul Fisher: Household spending growth has been remarkably flat for a long time, and consumer confidence has been falling quite sharply. Consumer confidence, as best as we can see, does not contain very much extra information in itself. It embodies all of the other factors that are going on in the economy like unemployment, inflation and so on. So it is a good summary statistic sometimes, but it does not give us new information. We can all see various reasons why consumer confidence would have been weak, including the international financial crisis and the fact that we have fiscal consolidation going on.

Now, I think the most likely impact over the short run that will lead to recovery in consumption will be when inflation drops off next year. That should restore some notion of real income growth and make people start to feel a bit better off again. I am envisaging that consumption will stay flat for a while and will then come back, but, as Ben says, it is probably not the major medium-term driver of the economy. It is something that affects short-run dynamics.

Dr Weale: I would like to say that what has happened to consumption since the start of the crisis is essentially without precedent in the United Kingdom’s history. If you look at income not relative to where it was last year, but relative to where it was at the start of the crisis, it is at broadly the same level, but, as the Governor said earlier, consumption is something like five to six percentage points lower than it was at the start of the crisis. Obviously, things like investment have fallen a lot as well. They have fallen more in percentage terms, but it is the movement in consumption that is more unusual.

Now, there are a number of reasons why that might have happened. One might simply be that people concluded that they were living beyond their means before the crisis, and they found themselves hanged on an expectation of plenty. So that is one possibility. Another possibility is that they simply concluded-it is in some ways related-that future incomes are not going to grow in the way that they had hoped and therefore they need to be saving more. They may be more worried about unemployment than they were. They may finally have realised that old age is coming to more people and for longer than it used to and that some higher level of saving is needed.

I share the view that, as the pressure on prices fades away and real income starts to recover, it is likely that we will see some upward movement in consumption, but I would also like to make the point that if the economy is to follow a well balanced recovery, what that essentially means is that the extra missing demand has to be largely filled by components of demand other than consumption-essentially investment and net exports.

Q87 Mark Garnier: We are in quite a difficult place, because you note that Government consumption has accounted for almost half of growth, but that is unlikely to continue with the fiscal consolidation, and then we look at household consumption. I was just making a quick note earlier about the problems that the household consumer has. They have very limited access to credit. They have too much debt, so to a certain extent we are asking them to deleverage. The savings ratios are still relatively low-they have gone up and they have come down a little bit, but nevertheless they are still relatively low-so people do not have a huge amount of savings. People have very poor pension provisions, and they are living longer, so their reliance on pensions is going to be greater. There is very limited confidence, as you said. You have falling real incomes. To a certain extent, people are still working part-time jobs, rather than full-time jobs. Then, to a certain extent, we are trying to encourage people to spend more money in the high street in order to promote growth.

There really are some extraordinarily confusing messages going out to the consumer. What should we be saying to the consumer to try to encourage them to help participate in the economic recovery? Or is that just something that is too difficult?

Sir Mervyn King: To pretend that we should be giving messages to consumers is too much, and they can work it out for themselves. They can see in their daily lives all the factors that you have just mentioned. It is important to recognise that the position of different consumers varies a lot. As you said, the household sector is highly indebted and in aggregate I am sure that the total burden of debt will be run down, but of course within that, some households need to be able to borrow. Some householders would like to be able to enter home ownership, others who are at the other end of their lifetime would like to sell houses. It is hard to sell houses to people who cannot borrow in order to be on the other side of the market.

The general comment I would make is that before the crisis hit, it was very clear-this had been said in speeches for 10 years or more-that we had pushed up total UK consumption, both private and public together, to an unsustainable level. That was done for good reason-to ensure that full employment could persist when we had a trade deficit resulting from a high exchange rate and a strategy of trade surpluses on the part of many countries in Asia-but there we were with an unsustainable level of domestic demand. At some point, that had to adjust.

Many years earlier, the point had been made that the longer we left it to make that adjustment, the bigger the adjustment would turn out to be, but there was no easy way through this. Now, events have conspired to start to bring about that adjustment. It will not be easy or painless, but it is clearly under way in this country and there is a strategy for dealing with it. There is a strategy for ensuring that the alternative sources of demand that Martin mentioned, being particular exports, can work, because the exchange rate is 25% lower than it was. This is all part of the strategy to rebalance the economy.

It will be difficult, and it is not easy for us to give simple messages. As I have explained in speeches before, at present, the MPC faces an extraordinarily difficult balancing act-a paradox of policy. In the short run you may want to expand those bits of demand that you can influence, which is largely domestic demand, knowing that in the long run you need a higher savings ratio in the economy and demand will have to come from elsewhere. Hence, in the short run, we are tempted to do things that we know are the opposite of what we need to do in the long run. Therein lies the tension between how far we go in the short run-how many asset purchases we engage in-and how far we accept that this adjustment must be made and that it will be painful.

Q88 Mr Mudie: With the wholesale funding problems and European problems, is significant deleveraging taking place in the banks? If so, how is that affecting lending?

Sir Mervyn King: I think it is still going on, but it is not as bad here as it is now in the euro-area economy, where the view among my peers is that already the deleveraging of euro-area banks is leading to early signs of a credit crunch, with concerns that it will get worse. You can see that even for banks in this country, and indeed US banks, funding problems have worsened since August. I think someone mentioned that the funding market in medium-term funding has been closed. It is difficult for banks to get funding. The Financial Policy Committee will have more to say about that later this week. Undoubtedly, they are real problems that will begin to affect the cost of credit down the road.

Q89 Mr Mudie: Your October report on trends in lending showed that lending to businesses and small and medium-sized enterprises was slowing-going down. That was in the three months to August. Is it continuing as much as the banks, regional people-

Sir Mervyn King: A consistent picture has been that net lending to businesses has been falling. It is closer to being flat now, but it has still been falling; it is certainly not rising.

Q90 Mr Mudie: How does it affect Project Merlin if the banks for small businesses have reached agreement with the Government and you are monitoring lending and it is going down? They were here last week and they said how wonderfully well they were doing, although they would not give us any figures.

Sir Mervyn King: The targets that are used in the Merlin agreement-that is an agreement between the Government and the banks; it does not involve the Bank of England-are defined in terms of gross lending and facilities. In our report, we publish three numbers: the facilities number, which is the number on which Merlin is based, the gross lending number, which comes in through reports by banks to the Bank of England, and the net lending number, which also comes in. The net lending number is the number that is relevant to the availability of business finance and the finance that is available to support investment and growth.

Q91 Mr Mudie: For the ordinary lad on the street who is looking in on this, does that mean that small businesses are getting more money or less?

Sir Mervyn King: Less.

Q92 Mr Mudie: Does that worry you?

Sir Mervyn King: Yes.

Q93 Mr Mudie: Under the terms of the agreement, are they breaking it?

Sir Mervyn King: No, I do not think they are. As I said, the agreement was not defined in terms of net lending, which is the economically relevant definition.

Q94 Mr Mudie: So this Project Merlin is not as good as it sounds for the lads out on the field. Could you supply us with figures? We are trying to put down some markers. Since the business started with banks, we have never ever been able to pin them down and get them to agree certain lending targets. Even last week, they refused to-not refused to, some of them did not know, incredibly. They were short on figures. Could you supply the Committee with some figures that will let us continue to monitor, with yourself, what is happening?

Sir Mervyn King: We already published those numbers. The banks seem to pre-publish their own gross lending facility numbers and we publish, on an agreed timetable, the numbers that correspond to the Merlin definitions-the gross lending numbers and the net lending numbers of banks.

Q95 Mr Mudie: We couldn’t get from them, Governor, whether they had sat down after the agreement was settled and divided the targets between them. To your knowledge, can you tell the Committee whether there is an agreement between the banks for their individual targets?

Sir Mervyn King: I have no idea and, as I have said, we are not party to the agreement. That is a matter for Government and the banks. We are not involved in it.

Q96 Mr Mudie: But you are monitoring them.

Sir Mervyn King: No, we are publishing the numbers which are submitted to us.

Q97 Mr Mudie: So you do not know whether they are above or below.

Sir Mervyn King: All we can publish are the numbers that are submitted to us.

Q98 Mr Mudie: The bigger question that I asked them was about your financial stability report, where you publish a chart with the stock of UK banks’ lending. When I asked them how satisfied they were, I pointed out that half the lending went abroad and that by far the biggest part of their domestic lending went to other banks or financial corporations. The next part went to households and the smallest part-the smallest sector in the whole description-went to small businesses and medium enterprises. Now, if we are talking about rebalancing the economy, surely, Governor, that has got to change. You cannot rebalance the make-up of the economy without the investment being much different from what has gone in the past few years.

Sir Mervyn King: This is a point that has concerned us about the lending figures. It is why we have been worried about the position of the banks. The leverage of the banking system increased dramatically before the crisis. It has come down significantly since then. Much of that deleveraging has indeed been to reduce the lending to other parts of the financial sector. In the five years running up to the crisis, two thirds of the lending by banks was to other parts of the financial sector. A lot of that has been unwound. That is good, because it has not, in and of itself, led to a contraction of lending to the real economy.

With banks under such pressure to deleverage, however, it is not surprising that they have reduced all forms of lending. The reason why that is serious for the small and medium-sized enterprises is because they do not have many alternatives to the banking system. Bigger companies have gone round the banks. It is true that the average of the biggest industrial companies in Britain can now borrow more cheaply than the average of our six biggest banks. That is a striking fact. They are disintermediating the banking system by issuing corporate bonds and equity. Fortunately, those financial markets are working very efficiently, but SMEs are not in that position, and I think, as you point out, the rebalancing is very much focused on the "M" part of that-medium-sized enterprises-and future innovation and ideas are very much linked to the "S" part of it. The SME sector is very important.

The sums involved are not enormous here; we estimate the total stock of lending to SMEs to be somewhere between £100 billion and £150 billion, and the amount of net lending to the SME sector, which occurred at the peak of say 2006-07, was about £10 billion a year. Last year, it shrank by £5 billion. Clearly, the economy is not growing rapidly, so that £10 billion looks to be more than SMEs would want to be able to borrow, but to turn the thing round, it is going from minus 5 to plus 5-that is the rough order of magnitude. I am not trying to be precise in any sense. These sums are very small in comparison with the total balance sheets of banks.

Q99 Mr Mudie: That is right. I tried to get from them their total lending-individually-and their lending to small and medium enterprises, and I failed. Do you have a figure off the top of your head for their total lending? We could then see as a Committee how small a part of that lending is actually going to British industry.

Sir Mervyn King: As I said, through work done by the Department of business, we estimate the total stock of lending to SMEs to be somewhere between £100 billion and £150 billion.

Q100 Mr Mudie: But that is £150 billion out of what? What percentage of their total lending is that?

Sir Mervyn King: Well, it is hundreds of billions as a total balance sheet.

Q101 Mr Mudie: I am just getting an order to shut up. I have one last question: do you agree that if we are going to rebalance the economy seriously, the banks with the money have got to start thinking of readjusting their lending patterns to be more domestic and more targeted on that part of the economy that we all want to see grow?

Sir Mervyn King: We certainly need to see the banking system lending more to British non-financial companies, and within that, we need to see lending to SMEs. I do not think that the difficulty is that the banks are sitting down and being deliberately obstructive in not lending to SMEs. They are in the position where their own balance sheets are sufficiently weak that people are not willing to lend money to them at rates that make it easy to lend on.

Q102 Chair: I would like to ask a further question related to that: the banks complain-privately a great deal and publically somewhat-that this pressure on their balance sheets is exacerbated by the liquidity and capital requirements now being imposed on them by regulators, even though those are not due to be implemented for some years. Markets are imposing a discipline, as a result of the increased transparency requirements that have come with those capital and liquidity requirements. Do you think that the banks are justified in their concern about this?

Sir Mervyn King: No. I totally accept that this is clearly not the time to raise capital requirements, and they are not being raised. It has been announced that they will go up in years to come. The pressure on bank balance sheets now is coming, not from what the regulators are doing, but from the realisation in the market as to how risky the balance sheets of banks actually are. Before 2007, people who lent money to banks did so in a world of innocence where they thought it completely safe to lend, particularly to big banks, because they would always been repaid or bailed out, so they were willing to lend to banks at interest rates only a few base points above bank rate. Now, people realise how exposed the balance sheets of all banks around the world are to what is going on in the euro area.

Q103 Chair: Just to be clear, your view is that we should be pretty dismissive of these moans that we are getting from the banks-

Sir Mervyn King: I do not think that you should be-

Chair: On the specific issue that the regulators are generating problems for them.

Sir Mervyn King: Yes, I think that there is an issue about liquidity requirements and whether at present the liquidity regulation is coming in too quickly. That is something that we are discussing on the Financial Policy Committee and that I-

Q104 Chair: It is something that I have raised publically. You are concerned about the liquidity side.

Sir Mervyn King: Well, there is an issue to be discussed.

Q105 Chair: But not on the capital side?

Sir Mervyn King: Not on the capital side, where I think market pressure means that the banks that can reveal that they have strong balance sheets and a lot of capital will be able to obtain funding. I think that this is a world in which transparency about banks’ balance sheets will serve them very well. We have seen that in the euro area. If a bank can reveal that its exposures to self-evidently risky assets are lower than the market expected, then they will benefit from that.

Q106 Stewart Hosie: Governor, you said in the report that the high level of uncertainty about inflation and growth, and concern about tighter credit conditions, had had only a modest effect on investment so far. Why do you think that was?

Sir Mervyn King: Sorry, I missed the first part of the question.

Q107 Stewart Hosie: You said that the high level of uncertainty about inflation and growth, and concern about tighter credit conditions, had had only a modest effect on investment. Why do you think that the effect was only modest?

Sir Mervyn King: Actually, I am not sure that I do think it is only modest. Can we have the full quote, to get the context?

Q108 Stewart Hosie: It is in reference to chart 2.12; on page 26, the second paragraph: "reports from the Bank’s Agents suggest that investment intentions, although softening since the summer, still point to modest increases in capital spending over the coming year. The prospects for investment in the medium term are discussed", etc.

Sir Mervyn King: That is a statement about the absolute level of investment intentions, not the impact of uncertainty on it. That is true so far. Whether that persists, remains to be seen. But we are reporting there simply the views that the agents have come up with; in part I think this is because investment plans are revised at infrequent intervals, and the concern that came up in our discussion in the Committee was that around the year-end and the beginning of the year, many companies would review their investment intentions for next year, and then we would see the impact of recent uncertainty come through.

Q109 Stewart Hosie: I am glad you clarified that. I was quite surprised when I saw that, because from peak to trough on your chart 2.12, we are looking at something like a 20% fall, from around £36 billion to below £30 billion, then up a little recently. A 20% fall is a huge fall.

Sir Mervyn King: It is, although investment is very volatile. I don’t want to dismiss it-it is a large fall, no question about it.

Q110 Stewart Hosie: The question I have then is, can monetary policy on its own, assuming confidence returned, do enough to encourage growth in business investment, or is there a requirement for a change in fiscal policy as well?

Sir Mervyn King: Well, I am not going to comment on fiscal policy, because that is elsewhere. What I would say is this, that in a rebalancing position, there is a serious limit to how far domestic economic policy can proceed by trying to stimulate further domestic demand when the need is to shift from domestic demand to external demand. We had taken the appropriate measures to ensure that our policy was consistent with the fall in the exchange rate and that we did not allow that fall in the exchange rate to carry on. We have not seen increases in domestic cost inflation, which would erode the value of the depreciation in the exchange rate, so we have maintained low rates of increase of domestic cost, which will sharpen prices in the future. So we have taken actions to ensure that that rebalancing can occur, and we have been affected badly by an adverse development in the rest of the world, primarily the euro area but not exclusively-we are now seeing signs of slowing in Asia and the United States. The world has taken a turn for the worse in the past few months, and that is bound to affect what we can do. We cannot easily offset that.

Q111 Stewart Hosie: I appreciate that. Certainly there were huge shocks to the demand side, not least what we have seen in the eurozone. But the OECD forecasts for growth next year are still higher in the eurozone and the US than they are in the UK. On the supply side, if we have seen this huge peak-to-trough fall in business investment, is there anything that monetary policy can do-you cannot comment on fiscal policy-to encourage business investment, particularly in gross fixed capital formation, signalling that they are ready for when the external market picks up?

Sir Mervyn King: The contribution of monetary policy is to provide an environment in which interest rates will remain low. One way or another, we have done that. We are facing very low long-term interest rates. That is the one factor that will be supportive to investments. Having low long-term interest rates is a positive factor. But, in the end, what will matter is whether we can get to a point where people can see that the rest of world is returning to more stable conditions and our external picture is one where we would expect to pick up in net external demand to offset the inevitable slowing of domestic demand. That rebalancing will then take place, we will come through it and we will get back to more normal conditions. We are facing extraordinarily difficult conditions from overseas at precisely the point in our rebalancing where we need growth from overseas to make that rebalancing feasible.

Q112 Stewart Hosie: On that basis, given we are close to the zero band-we have been for some time and may well be for some time in the future-it seems inconceivable that the 8 to 11% business investment growth target laid out in the 2010 Budget for the whole of this Parliament can be met.

Sir Mervyn King: Well, there were forecasts. We will have to wait and see what happens. Clearly if investment falls very sharply, it can appear to grow quite rapidly in succeeding periods without ever getting back to the level that it was, so growth rates can rebound. But, as I say, we do not pin much weight on precise forecasts at all. All I would say is that there are two sets of conditions that are important. One is that, in terms of domestic policy, we have very low long-term interest rates which, all things being equal, are supportive to investment. We have got the basic conditions for a rebalancing in the UK economy, but we cannot pretend that we are immune to adverse movements in the rest of the world, particularly in Europe. One way or another, I would hope that there will be a resolution of some of the most serious problems in the euro area before long. I do not think it is possible to continue indefinitely with this degree of fragility. One way or another, something will happen. I would hope that, after that, we will move to a position where we can start to see how it will settle down.

Q113 Teresa Pearce: Governor, earlier you were talking about the higher level of inflation and external factors such as energy prices, commodity prices and that a reasonable person would not expect for that to be repeated. But, it is my understanding that a reasonable person did not expect it in the first place.

Sir Mervyn King: Absolutely.

Q114 Teresa Pearce: Is there anything that the Bank has done to improve its forecasting of such external events?

Sir Mervyn King: It is very difficult because many of these things are inherently unforecastable. We look at futures markets, where people buy and sell these instruments in the future. They are the best guess in financial markets as to where the prices will go. So our forecasts are conditioned not on off-the-wall hopes; they are conditioned on prices in financial markets that we can see for energy and food in the future. We take those as our conditioning assumption for the forecast. There are risks around either side and we can look at some of the derivative markets in these energy instruments and see whether the market is expecting that the risk is more on the upside than the downside, and we try to take that into account.

It is really very difficult. I have spent 20 years coming to this Committee in different forms and saying each time that forecasts are not spot the ball contests, where you know where it is going to be. It is not like that. All we can do is to assess the balance of risks. The only reason we do this-if I did not have to do it, I would never do it and I can assure you that when I leave the Bank, I will never make a forecast-is because it takes time between when we change our policy instruments and when it affects the economy. That time lag means that we have to look ahead, but we do so not in terms of pretending that we know what the future holds because no one does. We do it by looking at the balance of risks.

The judgment we made last year was one where, in the event, we were surprised that energy prices moved upwards much more than we had expected. Who knows what will happen over the next 12 months. The chances are that energy prices will not move by the exact amount that markets have in their central view, and the chances of that actually happening are close to zero. But, we do not know whether they will be surprising on the upside or the downside. That is the difficulty in making forecasts. It is very important for policy not to depend on the assumption that it is vital to make an accurate forecast in order to make good policy judgments. It is important to recognise that no one can make accurate forecasts of an unknowable future. The right thing to do with policy is to work out how you can think of a robust policy response that, given the balance of risks, means the economy is in the best position to withstand whatever shocks actually occur.

Q115 Teresa Pearce: So is a further possible energy price hike in your probability distribution going forward?

Sir Mervyn King: Yes, it is.

Q116 Teresa Pearce: There have been a number of mentions of wages having been flat for quite a long time, and they might inflate. If wages rise faster than currently forecast, what will happen to inflation, but also, with the number of people unemployed, what if that actually depresses wages? How would that affect both of your forecasts?

Sir Mervyn King: These things all interact. If money wages were to rise faster, other things being equal, that might actually push unemployment up, which would then be a dampening factor on wages further down. Let me give you one reason why money wages might rise faster. Let us suppose that, as was mentioned by Mr Love earlier, inflation expectations were to pick up, so that both employees and employers thought that it was sensible to grant a higher money wage increase, because they both thought inflation was likely to be higher. That would lead to a pick-up of inflation itself a little further down the road. That is one reason why we pay so much attention to inflation expectations, because they are the conditions-if they rise, they in fact provide the conditions in which inflation itself may subsequently pick up.

On the other hand, as you point out, if unemployment is to rise further-and we do not know what will happen-that will, other things being equal, be a dampening factor on wage inflation, provided that the level of structural unemployment does not rise at the same rate. It may well do, and that is the one thing we really want to avoid; having a higher structural level of unemployment, which does not dampen wage inflation, but merely adds to the long-term unemployed. These are the challenges we face.

Q117 Teresa Pearce: We have seen, I think it is fair to say, a shrinking of the public sector. The public sector is often a major purchaser of commodities and services. Has the committee made any estimation of the effect of the decrease of public sector purchasing power?

Sir Mervyn King: Certainly the impact of the published public spending plans is incorporated into our forecasts, and we take that into account when projecting levels of demand, output and inflation.

Q118 Teresa Pearce: So it is taken into account.

Sir Mervyn King: It is taken into account, yes.

Q119 Teresa Pearce: A final question: we talked earlier about consumer confidence, and from the people who live in my constituency who have no confidence at the moment and are having quiet crises with their weekly household budgets, if their income were to go up, I do not think they would actually spend that increase in income. I believe that they would try and pay down their debt or save it. Because of all the things, as you have said, that could not be forecast and are not in our recent experience, they are afraid to part with their money. Do you think that that is something that is replicated across the country, or is peculiar to my constituency?

Sir Mervyn King: No, we spend a great deal of time in our forecast rounds trying to work out the answer to this question. There is no doubt that, given the uncertainty at present, consumers may well be saying to themselves, "We have a certain amount of debt. We don’t know what the future holds. Should we build up a reserve of precautionary savings? It may be very low at present, but perhaps we should have something." Or will they say to themselves, "Look, consumption has fallen so much that if we do see an increase in our real take-home pay this will be an opportunity to increase spending somewhat"? Perhaps my colleagues would like to come in on this because we actually spent a lot of the time discussing this question in the forecast round.

Dr Weale: What I would expect is that you will find different people in different circumstances. There will be some who are keen to reduce their debt but I would make the point that although you have seen a reduction in overall household debt, that has come much more, not because people have been repaying their debt, but because other people have not been borrowing in the way that they used to. There have not, for example, been new mortgages extending. So if you look through that it does not look as though there has been a rush for people to pay down their debts. All our experience is that when people get an increase in their incomes then different people react in different ways depending on their circumstances and their situations. But I would be very surprised if none of any aggregate increase in income were spent. That would be something that would be extremely unusual relative to past experience.

Q120 Chair: Governor, while we are on costs and prices, in chapter 4 of the inflation report, you give your best estimate of the effects on the index of the falling out of VAT and petrol at 1.5 to 2 percentage points over the next 12 months. However, you do not do a similar calculation for non-energy import commodity prices. I wonder if you could provide that for us. I presume you would want to do it in two stages: what the value would be as it falls out were prices stable, and the additional value that could be attributed to the recent falls in metals and "softs". Would you be prepared to provide that to the Committee?

Sir Mervyn King: Yes, of course.

Q121 John Thurso: Dr Broadbent, how concerned should we be at the persistent sluggish growth of broad money?

Dr Broadbent: It is a reflection of the deleveraging-the shrinkage of the bank’s balance sheets-that has driven the recession and the slowdown, not just here but throughout the developed world. In that sense, we should be very concerned.

Q122 John Thurso: Is there more in it than that? Is it just an indicator of the fact that we have been deleveraging?

Dr Broadbent: I see it more as a contemporaneous indicator, if you like, of weakness in the economy, and something that necessarily forecasts nominal growth. Certainly, if you plot it against the nominal growth rate in the economy, that is roughly what you see over the last few years. That growth rate fell pretty sharply in 2008-09, and it has stuck there, roughly speaking, at zero in the last couple of years. It is a reflection, as much as anything else.

Q123 John Thurso: Would you not have expected QE to have had an impact?

Dr Broadbent: Well, we talked about it a little earlier. As Paul Fisher said, I am not sure that one would expect that in an environment in which the banks remain under pressure-their own funding remains under pressure. I do not think it was ever going to be the case that the main effect of QE was directly via the banking system. Instead, I think it has been operating largely via the decisions of the non-banks, from whom asset purchases are made, and what they subsequently do with the proceeds of gilt sales. I do not think one should look at broad money or broad credit growth for the effects of QE.

Q124 John Thurso: The argument has been put to me that it is something we should be concerned about, because it indicates that the measures we are taking are not actually working. I wonder if that is an argument that any of you recognise or are prepared to comment on.

Sir Mervyn King: Let me comment on that, and then perhaps Martin can. To me, the big picture is what matters here. I think the broad money numbers are a good example of a glass half-full and half-empty. The half-full picture is that, despite the fact that we have had an extraordinarily serious financial crisis, and we are still bang in the middle of it, broad money is still growing at a positive rate. In the great depression in the United States, it fell very sharply and led to enormous falls in output and employment. We are not in a position where it is falling, and I think that is a success of policy. It would have been worse had policy actions not been taken. If we had not done asset purchases, broad money would be much weaker than it is now.

The half-empty picture, of course, is that we are still deep in a financial crisis with weak output, and we are a long way from getting back to normal. When we do, as Ben says, broad money growth will return to more normal historical rates. So it is not as high as I would wish, but it is a lot higher than one might fear, given what is going on in the world.

Dr Weale: Could I add to that, please, that I do not see that broad money tells us very much that we did not know anyway? From my perspective, I think the main influence of our asset purchase programme is through its influence on long-term interest rates, and then the knock-on effects on other asset prices, on corporate bond rates, on equity prices and so on. Broad money is simply telling us that the economy is not terribly lively.

Q125 John Thurso: Governor, can I come back to the point that you were discussing with George Mudie, namely credit to SMEs? We had some of the banks in front of us recently, and they gave a picture of their being out there in the high street, wallets open, just waiting for people to come and ask for money. However, every time I meet businesses that are successful in my part of the world, which I do regularly-there are 40 or 50 that I meet regularly, in areas such as manufacturing, engineering and oil services-they all say that they cannot get money. They say either that it is far too expensive or that they cannot get it at all. The common complaint is that the human beings have gone out of the system and they are being judged by a matrix, not a human being. Why is there this complete disconnect between the commercial world and planet banker? How do we connect that up so that money starts to flow?

Sir Mervyn King: That is a very big question, which will not be answered easily. It is related to the proposals of the Vickers commission, which related to trying to ensure that some part of our banking system sees its mission in life-or indeed its passion in life-as being to serve what I will call ordinary retail household and business customers rather than engage in investment banking transactions. That is a question of what motivates management and what they really want to do.

There is an enormous contrast between how consumers have benefited from changes in the way supermarkets operate, where over 30 years there has been a transformation in the retail experience, and the transformation that probably has not happened in the experience in banking. In part that is because the way banking has gone, around the world, has been consolidation. The too-big-to-fail problem has meant that becoming very big was the best route to obtaining funding at the cheapest possible rate, which meant that you could then get an edge on your competitors and become even bigger. That world probably has come to an end now, irrespective of what Governments do. Markets have come to the realisation that they did not understand the risks that were being run in banking. What is important, therefore, is gradually to work towards what I would call a new model. It is not blaming people for what happened; it is the recognition that the style, nature and culture of investment banking are very different from what is required to be a successful retail bank.

Q126 John Thurso: Do you think it is possible actually to get funding for SMEs, which do not usually have access to equities-that is a big part of the problem-and therefore regard their bank finance in a way that a larger institution would probably be looking for equity? Is part of the problem that as long as banks are engaged with investment banking it will be so much more profitable across the average year that they will never pay proper regard to providing funding for SMEs?

Sir Mervyn King: As I say, the idea that investment banking will always be wildly profitable has now gone. It is not at present, and I suspect that there will be years when it is and years when it is not. The idea that indefinitely it will be, I think, will go. The real challenge for SMEs is a fundamental problem that any market economy faces: you have got the idea, and I have got the money; how do we put the two together? How can we ensure that I do not put my money at unnecessary risk but that you can obtain money for finance? The banking sector was set up partly to answer that question, but it requires people on the ground who can assess not only the merits of the idea and the innovation, but the character, personality and determination of the individual who will take responsibility for that business and hence the repayments, to decide whether it is worth risking depositors’ money by lending to that firm. That is something that needs local expertise and support, and it is a million miles away from the idea of assessing credit risks in terms of, "Here’s a score list. Please fill in a form and if you get 17 out of 20 you get the money; if you don’t, you don’t." You cannot easily do that for SME lending.

Q127 John Thurso: It sounds as though you and I are saying exactly the same thing, which is that if there is no human to make a judgment you get bad decisions, basically. What can the Government do to make the banks understand that putting humans back into banking is essential to the future growth of the economy?

Sir Mervyn King: I think that the proposals of the Vickers commission would go a long way towards creating an environment in which-I suspect that market development is pushing us in this direction anyway-people realise that the merits of putting the two together are a lot less than was thought. Once you move to a world where investment banking cannot guarantee that it can obtain cheap retail deposit funding guaranteed by Government to finance its investment banking balance sheet, it becomes much more a genuine economic question of whether banks will want to put the two aspects of banking so closely together.

Chair: Governor, thank you very much for coming before us this afternoon. It has been extremely interesting, and we have learned a lot about not only the inflation report, but a number of other topics. Thank you, too, to the other members of the MPC for being with us this afternoon. We are very grateful.

Prepared 30th November 2011