Examination of Witnesses (Questions 20
TUESDAY 11 JUNE 2002
20. Will and should?
(Mr Bootle) Yes, the same answer really for both with
a major caveat about the housing market which we have not yet
spoken about but I hope we will at some stage or other and I will
not beat up on it now, but I do have some central concerns about
(Professor Miles) I am also worried about the housing
market and, in answer to the question as to when interest rates
should rise, my feeling is soon, within a few months. Obviously
it depends on what numbers we see for retail sales. If nothing
unexpected happens there but the housing market carries on in
the way it is, I think that interest rates need to go up pretty
quickly. As regards the question as to when they will go up, again
it will of course depend on the news we get on what is happening
in the economy. In the absence of anything unanticipated, I would
expect that rates might ease up a little towards the end of the
(Professor Dow) My feeling is that interest rates
should not go up in the near term. Obviously a lot depends on
the evidence that comes in and things are very much at a knife
edge still and have been at a knife edge month after month, and
that might well continue particularly in terms of developments
in the housing market.
(Mr Walton) I tend to the Governor's view that as
the world economy recovers and that leads to a pick-up in those
parts of the UK economy which are very depressed, then consumer
spending growth has to slow and my view would tend to be that
it is not going to slow sufficiently without some help from policy.
So, I would expect interest rates to go up in the next few months.
Formally, we have a view that they will go up around the time
of the November inflation report, but I think that the recent
depreciation in sterling has probably brought forward the time
when it will rise.
21. May I ask in particular David and Mr Bootle
about the significance of the comments that Mervyn King made in
his inflation report press conference when he said that the MPC
had decided then to keep policy on hold but that it stands ready
to counter the build in inflationary pressures as and when they
emerge. Some people regarded that as being hawkish and as a bias
towards tightening policy that you get in the US. Who writes the
comments that Mervyn King makes at the time of the inflation report?
Are those representative of the views of the MPC or do those represent
Mervyn King ...?
(Mr Bootle) You will have to ask Mervyn King who writes
his actual comments. As I understand it, the overview of the inflation
report is something which is signed off by all Members of the
22. Does that statement represent the policy
of the MPC or does it represent Mervyn King's statement?
(Mr Bootle) You cannot say that the Committee stands
ready to act to contain any developing inflationary pressures
further ahead is the view of one Member of the MPC because, if
it were the view of just one Member, even if it were the Governor
or the Deputy Governor, I do not think it would be his own view.
23. Do you think it has any policy significance?
(Mr Bootle) It is significant in the sense that that
sentence could have been omitted or they could have a sentence
which said that the Committee
24. Do you think it suggests that they are close
to increasing interest rates?
(Mr Bootle) I think it suggests that they have a presumption
that at some point in the next few months, interest rates are
going to rise.
25. Do you think it is odd at all, when you
look at the comments Mervyn King has made in his commentary in
the inflation report, if you look at what he says in those three
pages, that virtually everything is about the risks to inflation?
It is all that the growth is quite strong, it is all looking quite
good ahead. It is almost then as if, at the end, someone has come
along with some Tippex and brushed out the part where it says,
"We are going to increase interest rates" and put, "We
are going to keep them on hold but we have a bias towards tightening
them" because the tone of that is quite different from the
summing-up of the MPC minutes where you have an initial view of
some people that interest rates should maybe go up and then you
have other people who clearly do not want them to. Is there an
imbalance between these two papers?
(Mr Bootle) I think this is an issue that has been
under-explored since the formation of the MPC. We have had various
discussions and bits of information about the process of the writing
of the inflation report and the conduct of MPC meetings. I do
not think I can recall any effective discussion as to what preparation,
what agreement or what methods of agreement there are running
up to the press conference. I happen to know that some MPC Members
have on occasion been somewhat surprised, as it were, by the tone
taken at MPC press conferences.
26. Do you think they were surprised by this
particular conference or not?
(Mr Bootle) I think is it possible that they were
and what also I think is worthy of remark is the contrast in tone
between the Deputy Governor's remarks at this press conference
and what other Bank spokesmen have been saying over the previous
few months because the thrust of their remarks, including the
very explicit speech by the Governor, was to tell the money market
that they were being much too pessimistic about interest rates,
which I thought was an extraordinary development. When I heard
Mervyn King's remarks at the press conference, I must admit that
they seemed to me to be rather out of kilter with the remarks
that were made by several Bank spokesmen in the preceding months.
Having said all that, it must be said that we are talking nuances
now and even I think that interest rates have to go up at some
point or other. It is no surprise, bearing in mind how low they
are now, that the Bank should think at some point or other that
they should go up. The contrast I think is really rather about
when and by how much and there were several Bank spokesmen in
the months before this report saying, "You have it wrong;
you are being much too pessimistic" and then the tone of
this press conference
27. Would you agree that, if you look through
what Mervyn King has said at the press conference, virtually every
comment he has made about the outlook is about higher inflation
and growth being quite solid? If you look at the summing-up of
the MPC report, it said that some Members felt that rates should
be going up and then it said that there were six arguments for
not increasing interest rates. There does seem to be an imbalance
between these two documents.
(Mr Bootle) Yes, that is right.
28. Can I just ask youand this is to
Mr Walton as well because you are both paid to look into the entrails
of these types of thingsare you surprised at the May MPC
meeting, we have paragraph 31 saying that some Members felt that
the latest inflation projection report could justify an increase
in interest rates, they were worried about sterling falling and
they were worried about the Budget, but nobody actually voted
to increase interest rates at that meeting? Do you think that
the voting of the MPC Members actually is reflecting at the moment
what they think should happen to interest rates?
(Mr Bootle) I think they are in a very difficult position
in that the logic of the forecast, their growth forecast, ought
to be pushing them towards higher interest rates at some point
or other. The logic of the imbalances of the economy, the fact
that we now have public spending rising quite a lot and we have
perhaps the world economy recovering so that exports will be picking
up as well points towards the need to moderate consumer spending,
and yet the situation now is not, I think, commanding immediate
action because inflation rate is still below target. Even the
Bank forecasts it to remain below target for most of the next
two years and the history of the last six months, according to
the ONS, is that there has been no growth in the economy at all.
So, to move from that position to immediate action on interest
rates is pretty strong.
29. Do you think that Mervyn King or other Members
of the MPC would like to increase interest rates now?
(Mr Bootle) It is difficult to answer that because
the history is that he did not vote to raise interest rates at
the last meeting. I suspect that he and some other Members of
the Committee would like to raise interest rates in the next couple
of months and the issue really is about whether they should be
raised in the next couple of months and by how much or whether
they should be raised, let us say, depending on events, in six
months or seven months' time.
(Mr Walton) I think the key is one of the things that
Mr Bootle just said, which is that inflation is projected to remain
below target for most of the next two years and then it rises
at the end of the period and that is quite often a feature of
the Bank's inflation forecasts, but what it does mean is that
there is no pressing need today necessarily to tighten policy
because although interest rates have their maximum effect over
two years, they clearly have effects over shorter periods as well.
However, if things start to pan out in the way the MPC expects,
ie if the economy does recover strongly, then there will be a
point at which interest rates will need to be increased and I
think that is what is being signalled in this inflation report,
that if growth does actually pick up to an above trend rate and
if there looks to be the prospect that that is going to be sustained
for several quarters, then the MPC will probably need to do something
about it. Indeed, if you look at the MPC's behaviour in the past,
they have been very sensitive to the actual growth performance
of the economy. Whenever the first estimate of GDP growth has
been more than 3 per cent annualised quarter on quarter, the MPC
has always tightened policy at the ver first opportunity. So,
I think this inflation report is portraying the same kind of behaviour
that the MPC has conducted over the lifetime of its existence.
I do not think there is any inconsistency particularly with the
Governor sending the message earlier in the year that the markets
were too aggressive in the way they were pricing in interest rate
rises because the markets have been pricing in a quite substantial
rise in interest rates, much more than any city economist is forecasting.
So, there is no necessary contradiction in saying that markets
are too pessimistic with the situation we may be in where interest
rates do actually rise somewhat over the course of the next 12
months or so.
30. Can I ask you to comment on a sort of mischievous
conclusion from these various views. The mischievous conclusion
that you might draw is that the Bank staff, people like Mervyn
King, think that the evidence is stacking up for an increase in
interest rates and that it should be happening pretty soon and
they write the inflation reports and they write the commentary
at the inflation report press conference and everything and that
is largely reflecting their view. However, a number of the MPC
Members are feeling uneasy about doing this particularly as we
have had two quarters of low growth; so they have not been prepared
to actually vote with the logic of what the Bank staff are telling
them and perhaps, if I could add a last bit of extreme mischieviousness,
Mr King does not want particularly to stand out as an inflation
hiking hawker in a minority at a time when the Government are
considering who the next Governor of the Bank of England should
be. Would you like to comment on that, Mr Bootle?
(Mr Bootle) I am not
Mr Laws: I do not think there is anyone
from the Bank here.
31. I am sure there is!
(Mr Bootle) I find it very difficult to judge whether
there is anything in that idea at all!
(Mr Walton) I think this is clearly a question you
should put to Mervyn King when he comes before you. I would only
say that Mervyn King's track record is that he has never been
afraid to vote for a rate hike and be in a minority and I frankly
doubt whether he is so Machiavellian that he is going to change
his behaviour just because of a job.
Chairman: We will move on to the household
sector and imbalances.
32. A number of you have said that you are worried
about the housing market. What exactly are you worried about?
(Mr Bootle) There are a number of ways of judging
whether and when and by how much the housing market is stretched
or over-valued. The essence of the debate at the moment, I think,
is whether you pay more attention to how affordable houses are
in terms of mortgage interest payments in relation to income or
whether you pay more attention to how high house prices are in
relation to earnings, the house price earnings ratio and, for
a whole variety of reasons, I think the latter should command
more attention. First of all because the affordability ratio does
not distinguish between real and nominal interest rates. Secondly
because affordability may be low now but in some ways it begs
the question because interest rates go up and it will not be affordable
any more. If you look at measures of value as given by house price
earnings ratio, they are beginning now to look extremely worrying
by comparison with previous key periods in the past. The most
widely watched measure is the Nationwide measure and it is not
far short of the level reached at the end of the Lawson boom at
the end of the 1980s. There are other measures which are even
more alarming. The Department of Transport, Local Government and
the Regions produces a measure of house prices which is constructed
slightly differently and, if you use that to construct a measure
of the house price earnings ratio, you reach the conclusion that
we are almost at the level of house prices in relation to earnings
that was reached at the peak of the Lawson boom and in London
the figures are even higher than they were at the end of the Lawson
boom. Some people will say "This is a completely different
situation". These ratios should not get you really worried
because the economy is so different, interest rates are so low,
et cetera. I have heard all this before. The fact of the matter
is that the house price earnings ratio has a fantastic record
of forecasting major movements in the housing market both up and
down and it is now indicating quite clearly that valuations are
(Professor Miles) I agree very much with that but
maybe I can give you some numbers here. These are all numbers
that Sushil Wadhwani presents in his very interesting paper. According
to the DTLR, the house price to average growth earnings ratioand
this is in the early part of this yearis 22 per cent above
the average over the last 20 years. So, house prices are 22 per
cent higher relative to earnings than on average they have been
since 1982. That was at the end of the first quarter, since when
we have probably had at least another 5 per cent or 6 per cent
house price inflation. Just coming back to the point that Mr Bootle
was making about houses looking affordable if you only look at
interest payments relative to household earnings, that is true
but of course is reflects the fact that we have historically very
low interest rates. There is again a nice chart on page 5 of the
Bank inflation report which shows various measures of income gearing,
that is interest payments relative to household earnings. The
green line there is interest payments on debt relative to household
earnings and that does not look dramatically worrying, it is 9.5
per cent almost 10 per cent, probably about the average for the
last 15 or 20 years, but interest rates are 4 per cent. Supposing
they were to move to 6 per cent some time in the next two or three
years, not entirely implausible. That could double. So, that would
take that ratio from 10 per cent to almost 20 per cent. That strikes
me as extremely worrying.
(Mr Walton) The only thing I would add is that you
cannot really have it both ways. It was not so long ago that people
were criticising the MPC for raising interest rates just because
of house price inflation in the South-East and damaging the manufacturing
base. If the MPC had been raising interest rates now just because
of house price inflation, I am sure that would have raised some
consternation amongst some quarters because they would say they
are not looking at the wider economy. The point I would make is
that house prices are an important indicator of consumer demand.
We know that consumer spending is very strong as reflected in
house price inflation. At some point when you need consumer spending
growth to be weaker and if interest rates are raised in order
to achieve that, that will also have a knock-on effect in the
housing market and that will be part of the process in getting
consumer spending growth to slow. Arguably, given how much debt
people have, it means that interest rates will not need to go
up as much as perhaps historically they have needed to go up in
order to slow consumer spending because these effects on the housing
market may be seen somewhat sooner than has been the case in the
past. It seems to me that it would be wrong to focus exclusively
on house prices. House prices are an indicator along with many
things, like the exchange rate and like anything else, that the
MPC has to take into account as part of a balanced assessment
of the outlook for growth and inflation and if it is the case
that because house prices are now rising in high double digits
that is leading to the risk that growth will be too rapid, that
inflation pressures will build too much in the economy, then the
obvious conclusion is that interest rates will go up at some point
in order to check those things ease off, but this should never
be a policy directed exclusively at house prices.
33. Is there not some element of self-regulation
in the housing market? If, as you say, the ratio to earnings is
getting up to this historically very high level, is that not the
point at which the consumer takes control of this market and,
if they reach unaffordability, people stop buying and then the
prices start to slow down? By definition, if they are becoming
unaffordable, people are not going to buy.
(Professor Miles) They might seem affordable at current
interest rates. It is when interest rates move up, if they were
to move up even by relatively small amounts like 1 per cent or
2 per cent some time in the next four years, let us say, that
would change the position dramatically. If householders were farsighted,
forward-looking and considered the potential future burden of
mortgages as opposed to simply looking at how much the interest
payments right now relative to their current earnings, if people
were forward looking, I think there is a lot of force in the logic
of your argument. My own feeling is that the history of the housing
market in the UK suggests that people are not particularly forward-looking;
they look at what interest rates are right now, they look at what
has happened to house price inflation over the last year or so
and in a sense they are backward looking rather than forward looking.
That is why I think there is a tendency for this market to have
great instability. I think that is really what happened in the
UK in the late 1980s and it happened in earlier periods. To be
honest, I do not see any reason why it will not happen again.
I do remember clearly that after the very sharp increase in interest
rates in the early 1990s with house prices falling, and an enormous
increase in mortgage arrears people were then saying, "People
have now learned their lesson. We will not see double digit house
price inflation in the UK. Things will now be very different."
That was spectactularly wrong.
34. Why is the UK housing market so volatile?
It seems like any other housing market.
(Professor Miles) I am not sure that it is unlike
other housing markets. Housing markets do seem to be volatile
in lots of countries. There was dramatic boom and bust in housing
markets in many Scandinavian countries in the early 1990s. They
were just a few years behind the UK in terms of their very volatile
cycles. I think it is a characteristic of housing markets in general
and the key feature is that housing markets are not like the market
for baked beans . If demand for baked beans goes up, the supply
of baked beans is going to increase pretty quickly. That is not
going to happen in the housing market. So, you have this market
with a long-lived asset that is very valuable, the supply is more
or less fixed in the short run, so swings in demand with a fixed
supply are going to cause the price to be very volatile.
(Professor Dow) Just to add to that, I think a particular
circumstance at the moment is that alternative locations of investment
are not particularly attractive and there is a speculative element
to demand on the housing market and in many ways it would actually
be helpful to have more disaggregated data to indicate the situation
in the buy to rent market which is highly speculative and which
may indeed be turning round for market driven reasons. Also, while
I agree the debt to earnings ratio, the figures are very aggregative
and it would be interesting to see a decomposition not least because
the growth experience in different parts of the economy is different
and therefore the rate at which the housing market is going to
turn round is going to be different and how that relates to earnings
is going to be different.
35. Presumably the speculative buyersand
I am sure you are right that there are a lot of speculative buyers
in the marketare forward looking because their sole purpose
of getting into it is to say, "Can I make some money out
of this?" and if their judgment is, "I think it is coming
towards the end anyway", then they are not going to go in
and I wonder whether that would be a bit of self-regulation in
the housing market.
(Mr Walton) I think you are asking a lot of individuals.
You could have said that about the technology boom in the stock
market. Clearly that is right providing you get out at the right
time, but the housing market is not the most liquid of markets
to suddenly get out of at the right time. You have had a situation
where real interest rates in the housing market have been very
negative. If you are borrowing at 6 per cent but house prices
are rising in double digits, that is quite an attractive proposition
for speculators in the housing market and indeed house prices
could probably fall a bit before that ceases to be the case. Also,
the other point is that it is not just a demand question as a
supply question here which is that banks and building societies
should also be taking a view as to whether or not these low interest
rates are sustainable in deciding whether or not to lend money
and presumably to sustain these very high house price earnings
ratios, there must have been some easing of lending criteria by
the suppliers for the finance when mortgages, as a percentage
of the value of property, as a percentage of income, must have
increased quite a bit I would have thought over the past couple
of years. So, it is not just the demand side, it is also a supply
and credit side as well.
36. How do you interpret chart 1.18 on page
9 of the inflation report, which looks at the regional spread
of movement in house prices? The red bars show quite a regional
distortion, but the green bars a year later suggest that it starts
to equal itself out a little. The hot spots have actually cooled
and the cooler spots have warmed up a little. How do you interpret
(Mr Walton) I would hazard two explanations. One is
that, if you look historically, the London housing market has
typically led the housing market in the rest of the country and
you can see that has been true in this episode as well. The rest
of the country is beginning to catch up. The second thing is,
as Sheila mentioned, the financial markets have not been performing
very well, and the financial services industry as a result as
suffered. I think that has taken away some of the frothiness from
the London housing market. Whereas the rest of the country, which
has less dependence on financial services as an industry, has
actually continued to do quite well.
37. Does that not show a bit of self-correction?
That the hot spots have gone too far?
(Professor Miles) Relatively, yes, but absolutely,
no. The hot spot in 2000 is Londonthat was a 30 per cent
rise according to this figurethat has cooled, but it has
cooled to 15 per cent.
38. In one year.
(Mr Walton) Still 15 per cent.
(Professor Miles) 15 per cent is pretty warm!
(Professor Dow) The spread of average house prices
between the regions is a factor of 2½-3 times.
(Mr Bootle) On this point about self-correction, I
take a slightly different view from David. It seems to me that
in principle he must be right, at some stage or other there has
to be self-correction, otherwise this could go on forever. The
question is: at what point is there self-correction? Is it at
a rational point? There I have to agree with David, that the evidence
is that, no, it is not; that people extrapolate the recent past
when thinking about future rates of increase and they drive prices
to unsustainable levels; and, therefore, without some outside
event, the market generates very volatile behaviour. I wonder
if I could just comment on an earlier remark of David Walton's
that the MPC's job is not to regulate the housing market but to
concentrate on inflation. I absolutely agree with that but, it
seems to me, this is an incidence of a hard case, of something
really difficult for the MPC in thinking about policy, because
the housing market necessarily has been tremendously important
as a governing force, as well as an expression of factors operating
in the British economy. The weakness of the housing market in
the early 1990s was absolutely fundamental to the problems of
this economy. Let us suppose that what the MPC thought it could
see in the housing market, developing over the next six months
or so, was something like a repeat of that, which I personally
do not think is beyond the realms of possibility: should that
not impinge upon the way the MPC sets policy? I do not think there
is an easy answer to this. It seems to me, it has got to think
about what the implications are of a housing market crash for
inflation and economic activity as we proceed, not just for the
next six months, year or two years but going further. The danger,
I think, has to be that if the rates of increase of house prices
carry on for a long while then something like that becomes a definite
possibility. One thing I think to bear in mind is that, it is
by no means the case that all asset markets move together. I think
it is quite noticeable that in the late 1980s the asset boom turned
to bust, first of all, in the equity market in 1987, and the housing
market did not turn until late 1988, the beginning of 1989. There
are a number of other occasions where that also was the case.
This ties up with comments by Sheila Dow and other people, suggesting
that one of the reasons why houses are regarded as such a good
buy is the lack of attraction in other markets. That almost compounds
the problem. People fleeing poor performing asset markets generate
another bubble in another market because they cannot put up with
the poor performance of the conventional market.
39. The MPC expect house price inflation to
fall over the next two years. Why have they helped themselves
to that assumption? Do they think there is some mechanism at work,
or do they anticipate that it is their intervention that
will be causing it?
(Mr Bootle) I think it is your self-correcting process.
A number of outside commentators, dare I say, myself included,
have expressed the hope that the market would moderate of its
own accord. They believe that as house prices get higher and higher
in relation to earnings this thing is self-regulating.