Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 40 - 59)



  40. You do not interpret that statement as a suggestion on the MPC's part that they are about to act in order to bring about a cooling?
  (Mr Bootle) No.
  (Mr Walton) It is the same way that, when the exchange rate is very high, the assumption is that the exchange rate is going to fall. It does not necessarily mean that is what happens. When house prices are up 18 per cent, it is more reasonable to think that house prices are probably going to moderate over the next year, than inflation is going to pick up.

Mr Tyrie

  41. I just want to finish off with a couple of more general questions, some of which touch on what Roger was saying only a moment ago—but if anyone else wants to answer, please do. I am looking at what David Clementi said about the property market. He said: "Even if the property market gets out of line, monetary policy adjustment is appropriate only to the extent that property developments risk the inflation target not being met". One could have added: "on a two to three year view", because that is what they always talk about when you ask about their time horizons and trying to work out where inflation is going to be. I am wondering, first of all, what views any of you have on the extent to which central banks should start to take account of asset price inflation generally? Secondly, is that really the only objective that we should be asking the central banks to achieve? Should we not also be asking them to look at the systemic risk inherent in asset price bubbles, which inevitably means they should take a longer view? I may go on to talk about Japan in a moment.
  (Mr Walton) I agree with the general proposition that you should only look at house prices to the extent it has a bearing on the overall picture two years ahead. I personally do not think you should suddenly start introducing additional targets for asset prices. It is very difficult, when you have only got the one area of interest rates, to say you are going to have to start targeting things other than overall inflation. Why stop at asset prices? Why not say you cannot allow investment to fall? You get into all manner of problems. That said, I was slightly surprised by David Clementi. While I think the general proposition is right, I think if you are the person in the Bank responsible for financial stability then if anyone is going to worry about the housing market it probably ought to be him. I thought that speech he gave was actually really very relaxed about the housing market; and that seems a little bit odd, given his dual role of being concerned about financial stability as well as his role of setting interest rates and GDP inflation target.

  42. That is the question I am asking you. Is there tension between those two? To what extent are the MPC taking account of it?
  (Professor Miles) My view is that they should take account of it because, going back to what happened in the late 1980s, the implications for the real economy of what happened in the housing market were very significant, in the sense that mortgage arrears and the problems in the housing market did, I am sure, have a knock-on impact on overall levels of demand. There would inevitably be real economic consequences to the wider economy and to general inflation pressures from a major downturn in the housing market. The Bank clearly cannot ignore something like that, and does not. The rules of the game are that they set interest rates to try to hit the inflation targets. I think his comments are really not a great deal more than reiteration of the role that the Bank has been given. It may be that the issues in the housing market should be addressed more by the FSA than by the Bank of England—that this is an issue for the lenders.

  43. There is this tripartite rather murky committee, between the FSA, the Treasury and the Bank of England, that meets to assess this systemic risk. What in a sense you are implying is that that group of people, led by the Government, if they believe there to be systemic risk inherent in asset prices, should re-examine the inflation target to see whether it should be altered to enable the MPC to take the appropriate action, to the extent that interest rates is the relevant instrument. Is that correct?
  (Professor Miles) That is possible. I think my view is that the appropriate action, if you really felt there was a major bubble emerging as a real threat to the solvency of a large part of the household sector, is that that might be most directly addressed by the FSA.

  44. Let us take one step back from solvency and talk about huge dislocation to the macroeconomic framework in the country, which is what we had in the late 1980s and early 1990s. In the old days we had the Treasury. They were in the frame for all of this. We knew who was responsible—it was the Chancellor's job to sort it out. It was very difficult to do, but it was his job to do. Now, of course, we have had this very gentle monetary run over the past five years and it has been pretty easy on the MPC. Frankly; any old fool could run an inflation strategy when there are strong deflationary pressures in the global economy and you have gentle growth everywhere. It is when you have got negative growth and huge inflationary or huge deflationary pressures that it gets difficult. When we have a deep recession we will find out whether we have got the thing right or not. What we need to know is, when that comes, who this time should be taking and integrating those decisions, and how should that be thought through? Do you think the structure is in place to enable that to be achieved? We have had the inklings, as you have said in your paper, of some of the conditions that amount to having an asset price bubble.
  (Mr Walton) The only problem with all this debate is, supposing we were to take Sushil's advice and interest rates were being set at 25 base points lower, okay the GDP growth rate would be stronger, inflation would be a little bit higher and house price inflation would be higher. The implication of this is, if you really want to sort out the housing market, you raise interest rates. At some point that may be appropriate, but if you are doing it just to stop the housing market when inflation is below target, when the economy has been stagnating for the last six months, I would have thought the MPC would be criticised, and rightly so.

  45. You are answering a different question. I am not saying the policy has been wrong; I am saying, starting from where we are now, do we have the structures to take the kinds of decisions that might be required if we were to have an asset price bubble, which everyone agrees would require action.
  (Mr Walton) The policy structure is not that much different really from the situation in the early 1990s. There was no government policy to bail out people in negative equity.

  46. With respect, it is very different. We have got an independent FSA, so the regulatory side of systemic risk has been removed from the Bank of England. We have the Bank of England no longer answerable to the Treasury for the setting of interest rates. We have a tripartite structure with divided responsibility on systemic risk. We have very different circumstances.
  (Mr Walton) My point is, even when you had it all controlled by the Chancellor that did not stop the house price boom in the late 1980s and subsequent very severe house price crash in the early 1990s. If the system had remained exactly the same there would have been no guarantee that you would have avoided the situation we are in.

  47. That is also a different question. I agree that what we had in the past might have been wrong. I was a strong supporter of Bank of England independence as early as the 1980s. What I am interested in knowing is how the structure we have got now will or should operate in order to tackle what could become a more serious problem if the asset price bubble turns out to be very serious. I do not think it will personally.
  (Professor Dow) The Inflation Report does have some material on financial stability, particularly in the housing market. I assume that is a route through which the work of the Bank and the FSA on financial stability should be fed through into the monetary policy decision. Clearly, they have adopted this mechanism.
  (Mr Walton) The last financial stability report from the Bank of England was warning that the housing market did look a bit worrying, and they were issuing warnings to lenders that they should be quite prudent in their lending, and that last report was about six months ago so we must be due another one shortly. I am presuming they will reiterate that.
  (Mr Bootle) I would not underestimate the power of talk—it can be overdone—but the Bank, to some extent, has got some of that power still. Indeed, you could almost interpret some of Mervyn King's apparent hawkishness in that regard as well by indicating that the future outlook is for higher interest rates. That should be putting some pressure on people in the housing market to understand that affordability is not going to remain quite what it is at the moment. On the question of the different framework and looking at asset prices more closely, I actually agree with an earlier remark that once you introduce asset prices it complicates the process of monetary policy. But it is not obvious to me that complicating it is necessarily wrong. The reason why people are so loath to contemplate complicating it is because of this extraordinary period of success over the last couple of years. The question is how durable that is. I happen to think we have been very lucky and that, in due course, we will experience a much greater divergence than that. I feel quite sure that, as and when we do, asset prices will play a huge role in that divergence. If you wanted to introduce asset prices and yet still preserve the fundamental framework, the aspect of it you really need to tackle is, I think, the two-year time horizon. If you believe that house prices in particular have got way out of line, you presumably think that the danger of moving forward is a return to the sort of thing that happened in the early 1990s, when consumer spending was very low and, therefore, there will be major downward pressures on the inflation rate. The nature of this will be that you could not predict exactly when that would happen. It seems to me you could, by working on that, make some reconciliation between attention to asset prices and keeping inflation as your central focus. You just have to be a bit fuzzier about the exact time horizons. That brings all sorts of complications. Because of the history of success of the last few years, I am sure it is not something to be contemplated now but, if we ever went through again a repeat of what happened in the early 1990s, my suspicion is, indeed I am pretty sure, the performance of asset prices, and particularly house prices, will be directly factored into the process.

  Mr Tyrie: I was trying to elicit some of the thinking now, rather than in a few years' time, but I will leave it there.

Mr Mudie

  48. I am not sure it is relevant to that last answer, but I understood you to start saying you felt housing prices were a problem. I switched over to David and I understood what you said in terms of the whole operation. You should not be damaging the whole operation, of inflation and interest rates, because of one sector—but the sector does seem to be overheating. What can you do? If you are all saying, in terms of the Monetary Policy Committee, they are quite right to stay calm about this and not to start tampering, because we have got overheating in one sector—say we are pulling out of the Monetary Policy Committee ambit—for example, if the Bank does not do it—should the Chancellor be doing it; should he be doing something, taking measures, and what measures would you suggest he takes? There is some worry out there of people not being about to get on board. The other thing is, if anything happens to interest rates and the bubble bursts, we have negative equity and so on with people losing their houses etc. Roger, do you want to respond?
  (Mr Bootle) I suppose there are various things that could be done—indeed the Chancellor has done a few of them, with increased stamp duty on a number of occasions, which ought to have helped directionally but does not appear to have had very much impact. I think the truth of the matter is, it goes back to what David was saying about the nature of these markets, that when you have got price rises of the sort of size you have had and you had a history of building up that sort of price rise and expectations that is going to continue, then the idea of paying 3 or 4 per cent stamp duty, or even more, gets easily swallowed. Theoretically, that is one thing that could be done. Surely something could be done on supply and finance with regard to lenders. There could in principle be regulations about lending behaviour. There could even be something with regard to the capital requirements of lenders against housing assets. There are a number of things which I guess theoretically could be done, but none of them, frankly, is very easy or appealing.

  49. Do you mean politically?
  (Mr Bootle) Not just that, I think in other respects too. We used to have a housing market which was very highly regulated and extremely inefficient. I think most people would agree that terrific improvements have been made, because the thing has become more deregulated and freer and more competitive. At the same time, of course, the problems with deregulated financial markets is that they do have a history of generating considerable instability. It is really trying to get the appropriate balance between those things.
  (Mr Walton) I think the notion of introducing regulation is going to be very difficult—in the sense that you could say, okay, all of these building societies on the high street cannot lend more than X times income, but people would just go on the internet and borrow from some special vehicle set up. The notion of being able to regulate in practical terms is really quite hard. The only point I keep making is that the manufacturing sector has been under-heating for the last several years, and people have asked the MPC to not raise interest rates on occasion in order to protect manufacturing; and the MPC's response has always been, "Well, we have to look at everything. We can't just focus on one sector of the economy". The housing market, frankly, is not that much different from this. It is one bit of the economy; it is an important bit. Certainly if we get into a situation where house prices fall then that is going to be quite damaging for consumer spending. It is going to be part of the pay-back of consumer spending, having grown at such a rapid rate for the last several years. At the end of the day, when the MPC has one target and one instrument, to expect them to be able to deal with all these different bits of the economy, which at any point in time merit special attention, is asking too much.

Mr Beard

  50. The MPC said in its minutes of May that continuing strength of consumption growth in this quarter would be "not unwelcome", but added that "the immediate issue, of whether UK consumption growth would ease as world demand recovered, or would need to be restrained by policy action, remained much as before". Given these sorts of messages, if retail sales are strong in the coming months, would you expect that to cause a rise in the interest rate?
  (Mr Walton) The answer is, yes, providing the bits of the economy which have been very depressed over the past year actually recover; and that, in turn, is going to be related to the strength of the global recovery. I personally think there is no question that if you get these other bits recovering, given this aim of trying to keep the economy overall growing at close to trend rates, then that must necessarily mean the consumer growth has to slow; and it either slows of its own accord or it slows because policy is tightened to bring growth down.

  51. What are the mechanisms by which you could slow it down?
  (Mr Walton) One obvious one is, people may just see that the housing market is over-extended and the housing market could start to slow.

  52. What about retail growth?
  (Mr Walton) With a lot of what has been going on in the housing market—because the supply of credit has been very free and cheap, there has been a lot of it and it has been very competitive—you have had people who have basically borrowed against the increased value of their houses and used that to finance consumer spending. One mechanism which could happen—although I do not think it will happen myself without higher interest rates—is people could just decide, "Well, actually, these housing markets look a bit top-heavy; we've borrowed perhaps more than we should have done; we should actually begin to pay back some of that". That, in turn, would take away some of the financing for consumer spending. That would be one of the self-regulatory mechanisms. My big question is: will that happen of its own accord, or do people need a signal that they should be doing this? The signal would come from higher interest rates

  53. What is your opinion?
  (Mr Walton) I think also that interest rates will need to rise in order to send that message to people; that finance will not remain as cheap as it has done for the last few months.
  (Mr Bootle) I largely agree with that, but there is one other possibility which is in the labour market. The labour market has been pretty tight now for some while; on some measures unemployment has started to rise a bit and in others really has not. It is possible if the economy remains weak over the next couple of quarters, I think, unemployment will rise, and that will of course tend to moderate retail sales. Frankly, I cannot be very confident about that happening, not least because of the uncertainty about the figures. The sort of thing that would lead you to think it is a real possibility is the idea that the economy has been at a standstill for six months. If that is correct, and if growth remains pretty weak over the next couple of quarters, then I would expect there to be definite consequences in the jobs market which will then lead to moderating retail sales.

  54. Could I move to the exchange rate. Again, in the MPC minutes in May it said: ". . . it was notable that the euro had strengthened against the dollar at a time when the US economy appeared to be growing more strongly and against a background of political uncertainties in the euro area. This suggested a possible change in market sentiment". Do you believe there is a change in market sentiment which is causing the euro to strengthen against the dollar?
  (Mr Walton) The euro is now quite some way off its low point, about 8 per cent or so above its low point against the US dollar. On a trade weighted basis it is up about 5 per cent from its low point. I think all the things you mentioned were true, but the other thing that has also happened is that this US recovery is a very import intensive recovery. We are seeing quite a bit of deterioration in the US balance of payments, from what is already a very large deficit. I think that is starting finally to have an impact on the dollar. I think the other thing is that investor confidence has been shaken in the US. As a result of things which are quite well known, there is a questioning of whether or not the kinds of returns that people have had on US investments are really as true as the stated profits numbers suggested. It is reflected in the US equity market. That was a magnet for capital to flow to the US during the second half of the 1990s. I think it is much less of a magnet now. I think the two things have helped to turn things around. On most measures the euro did look to be considerably undervalued versus the dollar, and it still does. The kind of correction we have seen is not actually that great really in the context of where the euro started from at the beginning of monetary union.

  55. You think that the fall in equity prices in the States is an indicator of diminishing confidence in the dollar?
  (Mr Walton) I think certainly you had a period, particularly during the technology boom and the whole new economy era, where there was a desire by investors to invest in the United States because of lot of these things that were going on in the US economy. Those things will probably come back but, at the same time, I think there has also been a questioning about accounting practices, and whether the return on capital they were thinking they were getting is really true. To the extent that that questioning is going on, that is just raising questions in investors' minds about whether or not the US is such an attractive place to invest in. At a time when you need an increasing amount of money each month to finance the current account deficit that can have an implication.

  56. What are the implications for sterling, do you believe?
  (Mr Walton) My own view is, the pound has traded very closely with the dollar for a number of years now, and if we are genuinely seeing the euro mount a recovery against the dollar, I think it will probably mount a recovery against sterling. What we tend to see is the pound not moving that much against the dollar.
  (Mr Bootle) I largely agree with what has been said, although I would stress it is very difficult, I think, to have firm views about exchange rate prospects and the euro has had a number of bouts of apparent recovery over the last couple of years, only to slip back again. It would not be beyond the realms of possibility to see the same thing happening again. Having said that, I would agree with David's remarks. I think there is evidence of a change of tone and attitude. In particular, what seems to have sunk in is the difficulties posed by the US current account. If you think that investment in the States is going to be pretty attractive then you have probably got to believe that the US economy has got to be reasonably strong and the recovery in corporate earnings has got to be reasonably strong. If that happens, if the economy is strong then the current account deficit is going to be even wider and the amount of capital that needs to be sucked in is going to be greater. If the US recovery, by contrast, is going to be weak, okay, the current account deficit is not going to be under the same pressure but it will still be at a high level, although not increasing very much. What are the prospects for investment returns? Not very good, is the answer. All along I think there has been a sense in which the weakness of the euro had something about it of a stock adjustment process. I have written a note for this Committee some while ago on this subject. That is to say, when the euro was formed there were lots of bullish views bandied about, about how investors would pile into the euro in substitution for the dollar—particularly in relation to Far Eastern central banks. Very few people paid attention to what was going to happen in the euro capital markets. By contrast, what has actually happened, is that those Asian central banks have been slow to adopt the euro as an alternative to the dollar. Meanwhile, because of the deepening of euro capital markets, there has been a great surge of borrowing in euros to invest in other currencies. There has been a stock adjustment process going on against the euro in world capital markets; at some point or other that is going to run its course and may now have run its course, in which case the fundamentals, which David addressed earlier on, are likely to come into play and the euro is likely to strengthen further. One quick comment on the exchanges, it seems to me that what happens to the pound you can depict in terms of where it falls within two extremes: in one extreme it sticks to the dollar, in which case it falls quite sharply against the euro; in the other it sticks to the euro, in which case it rises quite a lot against the dollar. To some extent where it is positioned on the spectrum will be influenced, I think, by perceptions about the question of euro entry and euro referenda etc. In many ways, the most favourable outcome for this country, which I think is actually a serious possibility, is that it behaves somewhere in between—such that it rises somewhat against the dollar and falls quite a lot against the euro. If that were to happen it would actually serve to alleviate many of the difficulties and imbalances that the MPC has had to grapple with over the last couple of years.

  57. If there were a fall in sterling, is the MPC capable of addressing that sudden impact of a very rapid rise in prices and fall in the value of sterling?
  (Professor Miles) I think it would be not unwelcome for the reasons that Roger has just said. It would allow us to re-balance. It would mean that interest rates could be increased, which would be helpful in terms of cooling the housing market, whilst growth was being re-balanced towards more demand for UK exports as sterling became cheaper. It would be particularly helpful to the manufacturing sector, which is still fairly weak. I think it would be rather a welcome event if sterling were to fall quite significantly.

  58. How significant is "significantly"?
  (Professor Miles) What have we seen—8 per cent so far this year? Estimates of where the long-run equilibrium level of sterling against the euro might be suggest that sterling may still be over-valued by as much as 15-20 per cent or so. So "significantly" might be seen in the context of those kinds of numbers. Not 3 or 4 per cent, but double figures perhaps.

  59. Do you believe, following Roger Bootle's comments, that if we do in the next 12 months, as is likely, move into a phase of campaigning openly about the euro, then that would further push sterling down in relation to the euro?
  (Professor Miles) That is certainly possible, Yes.

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