Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 20 - 39)



  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 that.
  (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 summer.
  (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 MPC.

  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 you—and this is to Mr Walton as well because you are both paid to look into the entrails of these types of things—are 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.

Mr Tyrie

  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.

Mr Plaskitt

  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 unsustainable.
  (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 ratio—and this is in the early part of this year—is 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 buyers—and I am sure you are right that there are a lot of speculative buyers in the market—are 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 that?
  (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 London—that was a 30 per cent rise according to this figure—that 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.

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