Examination of Witnesses (Questions 140
THURSDAY 13 JUNE 2002
140. A question for Mr King on the euro. Are
any of the five economic tests being met at the moment?
(Mr King) I do not know. We are not carrying out an
141. So the Bank is not doing any monitoring
of the five economic tests of any kind at all?
(Mr King) It clearly monitors the European economy
because that is relevant to our remit, but our remit does not
include an assessment of the tests.
142. Does not the possibility of the tests being
met within the next 12 months have any influence on the setting
of monetary policy, informing the thoughts and judgements, albeit
indirectly, of MPC members?
(Mr King) Not in itself. Where it is relevant, of
course, is in affecting market expectations, and that may affect
the yield curve, asset prices, the exchange rate. Those things
obviously are highly relevant to us and we take them into account,
and indeed, when we think about why the exchange rate may have
changed, it is important to us to try to understand why. Trying
to understand market reactions to this is important to us but
it is not in terms of carrying out an appraisal ourselves.
143. You do not even do an informal assessment
internally when you are looking at all the things you have just
described, yield curves and the rest of it? You do not come to
any preliminary view as to whether or not the meeting of the tests
is unlikely or very unlikely or quite likely. You do not make
any of those judgements. You are saying it is not part of the
Bank's working at all.
(Mr King) That is correct.
144. So I can take it from that that you do
not have any discussions with HM Treasury about the five economic
tests in any way at all.
(Mr King) No.
145. If and when the tests are published, if
you fundamentally disagreed with the conclusions, is it something
on which the Bank is also going to remain silent?
(Sir Edward George) I have said publicly that if we
were summoned by a proper body to give our opinion, we would do
that to the best of our ability.
Mr Tyrie: I am sure that is something
for the Chairman to discuss with the rest of us, but for my part
I think we would like to see you.
146. I want to come back to something which
you said which I want to be clear about. You said that if there
were to be a change in the pattern of the exchange rates so that
the pound sterling fell against the euro but rose against the
dollar, you would regard that as being a neutral position, if
those numbers worked out, that would not necessarily trigger any
fears of an exchange rate effect on inflation.
(Sir Edward George) What feeds into the prospect for
inflation is essentially the effective exchange rate, which is
a measure, a weighted measure, against all currencies. So yes,
you can envisage a circumstance in which it weakened against the
euro but strengthened against the dollar, and that was absolutely
offsetting allowing for the weights, so the effective exchange
rate would not change at all. That is not what has been happening
in the recent period. In the recent period the euro has strengthened
and we have tended to stay more closely with the dollar, so that
our effective exchange rate has fallen by more than we factored
into the Inflation Report, and that as a matter of arithmetic
will imply an upward pressure on the inflation forecast from where
we were. Of course, that could change, but it does depend upon
the pattern that this thing takes, not the movement of sterling
against any bilateral currency.
147. Just to be clear, you are operating with
a concept of an effective exchange rate against the dollar zone
as well as the euro zone, and other currencies, and therefore
a straight read-off of the pound falling against the euro meaning
an increase in interest rates does not necessarily apply if the
effective exchange rate, as you put it, remains reasonably stable.
(Sir Edward George) That is right, but you have to
bear in mind that the euro zone is a big weight in the effective
rate index, so that is why the rate against the euro zone is relatively
important, but it is the effective rate index which matters.
148. I wanted to touch on the speech Mr King
made in April about the monetary policy challenges in the UK.
The whole thrust of that speech seems to be that you are expecting
a significant re-balancing of economic policy in the UK in the
next few years, which would be a lower exchange rate and a less
buoyant domestic sector. You talk about the need to restore domestic
demand growth to sustainable levels. Given that we have had a
very buoyant consumer sector in the housing market over the last
few years, how much do you think we are going to have to reduce
the growth of domestic demand and consumer demand over the next
few years in order that that will play its part in the re-balancing
that you anticipate?
(Mr King) As a question of where the growth rates
might go over the medium term and how rapidly that adjustment
takes place, broadly speaking, final domestic demand has been
growing at more than twice the growth rate of output of the economy.
Net trade has been making a substantial continuing negative contribution
to output growth, so that overall the economy has been growing
reasonably close to trend, slightly above it, so that unemployment
has come down. It is hard to see how in the future it is possible
for that negative contribution from net trade to unwind and to
make room for the provision of better public services without
the growth of private sector final demand coming down to a little
bit less than the growth rate of output. It looks as if, broadly
speaking, the growth rate of private sector final demand over
a number of years will have to halve compared with the average
over the past four or five years. The issue for policy of course
is whether that is likely to come about of its own accord, and
to a significant extent it may; we have already seen that in investment;
where business investment had been very strong for four or five
years, business investment has now been extremely weak for the
last year. So in that sector the adjustment has already occurred.
The big picture is that those growth rates of private sector final
demand that we saw in the past five years will not be able to
continue at that level, but that unfortunately does not answer
the question of over what time horizon this adjustment will occur,
and that, of course, is the tricky one which is relevant to policy.
149. Do you think that means that, compared
with the last few years, in which we have had very buoyant consumer
demand, as you say, we are likely to see consumer demand for a
period of years growing under the trend rate of growth of the
(Mr King) I think certainly much less buoyant, and
much closer to the growth rate of output, and possibly even a
bit below it on average over a number of years, but that is generally
just the arithmetic of trying to square the circle between a reduction
in the contribution from net trade, which has been negative, and
the need to make room for more resources to go into the public
sector. How that comes about and over what timescale is very hard
to judge, but over a number of years, yes, I think one would expect
to see a much lower growth rate of private consumption than we
have seen in recent years.
150. So we are going to get a better environment
for industry and a less good market for the consumer and housing
sector over the next few years.
(Mr King) I think it depends on which part of industry
you look at. Obviously that part of industry that has been producing
to meet domestic consumption may find that the growth of their
markets will be slower, and those people producing for the overseas
sector may find it easierit has certainly been extremely
difficult in recent yearsand that is, of course, part of
the re-balancing that we would hope to see occur.
151. Returning to some earlier questions in
this section, Mr King said that at the moment you do not see assessment
of the five economic tests as part of your remit, but my colleague
Mr Tyrie has encouraged you into saying that you would be willing
to make such an assessment if you were asked by an established
body, such as the Treasury Select Committee. Is that a correct
interpretation? Are you offering yourself as a sort of brains
trust for any question that we might ask?
(Sir Edward George) No. You can ask us for our opinion
on things, which we come and give you as freely as we can, and
if you thought it would be useful for us to give you our opinion
on the Chancellor's assessment, I think I could be thrown into
the Tower of London if we refused!
152. But you would agree that you would not
want to give an off-the-cuff opinion; you would have to make an
independent assessment yourself of the state of the tests in order
to give a qualified opinion.
(Sir Edward George) I would have to review the assessment
as published by the Treasury.
153. Governor, the impact of the Budget. You
said in your Inflation Report, page 43, that the cumulative growth
over the next two years is likely to be somewhat faster than assumed
three months ago, principally reflecting the overall stimulus
from the Budget changes and a slightly stronger picture for global
demand, but the Budget itself in paragraph 261 indicated that
there would be a small tightening in the fiscal stance in 2002-03
and in the year 2003-04. Why therefore do you cite the Budget
as being a principal reason for higher growth than you expected
in February over the two-year projection period?
(Sir Edward George) It is the pattern. Basically,
if the government is spending more and it is recouping the cost
of that expenditure from the private sector, the private sector
will fund some of that from savings, or it will not fund it all
out of reduced spending. That will tend to add to total demand
and growth to that extent. The other factor is that the propensity
to import from government spending is lower than the propensity
to import from the private sector, and therefore the impact of
demand on the UK economy will be somewhat larger, and those factors
together, we think, means that there will be a net expansionary
effect even from the broadly balanced Budget.
154. On National Insurance contributions, one
of our witnesses this week, David Walton, said that he personally
thought that the MPC made a little too much of the increases in
National Insurance contributions given that they do not kick in
for another year, and a lot can happen over the course of the
next year. How much of the effect of the higher National Insurance
contributions on inflation is included in the central projection
(Sir Edward George) We agree that the National Insurance
contribution issue does not kick in until next year and what I
think we discussed at great length was what is going to be the
process. In the long run, we assume that the impact will actually
fall on a rather slower rate of growth over time in nominal earnings,
and indeed real earnings, so that it will fall on to the employees,
both the employee increase and the employer increase, but that
could come about in a number of different ways. The employees
might demand higher wages to compensate certainly for their increased
National Insurance contribution, and that would mean that earnings
grow faster than before the change in the National Insurance contributions.
On the other hand, you could have resistance on the part of employers
to that process. Employers, if they were adversely impacted either
by the wage demands or simply by the contribution that they have
to make to increased National Insurance charges, they could try
to recoup it through higher prices. We really do not have much
of a read on how that process is likely to occur. Depending on
how it occurred, it could obviously have a larger or smaller impact
on inflation, so we had to make assumptions about that which we
built into the forecast and they come through next year. Obviously
we will be doing as much analysis and research as we can to try
and harden up those assumptions.
155. What feedback are you getting privately
from your agents in the different regions on the matter?
(Sir Edward George) Well, I think on the whole, it
does vary of course, the view I think we are getting from employers
generally, though it is not consistent across the piece, is that
competition is so tough that they could not possibly hope to recover
this from raising prices which means that they will either have
to accept it as a reduction in profits or they will have to be
tougher in recouping it from employees, either in the form of
a slower rate of wage increases than they would have otherwise
or in the form of reduced employment. I think on the whole that
is the sense that we are getting from a lot of contacts, and indeed
I think the reaction from some of the trade associations has been
in that direction.
156. Just on this point. You say in the Minutes
that "Households might reduce consumption in anticipation
of the additional tax burden, before the tax changes took effect".
Is that speculation or is that measurable where previous increases
of this kind have been in the pipeline a year ahead or is there
evidence already of that?
(Sir Edward George) I do not think we have got any
kind of hard evidence of that sort of effect. It is unusual to
have this increase announced early and this far ahead. We really
do not have much indication. It would be a rational response if
employeesleaving aside the impact it could have on pay
negotiationseither felt that they were going to have pay
this higher tax themselves, therefore, their income would be reduced
or feared that the effect would be to impact employers in the
direction of reducing labour.
157. When would you expect to see that response
start to appear?
(Sir Edward George) In 2003 after it happens.
158. Not before?
(Sir Edward George) We will be monitoring the expenditure
numbers. Our assessment of what is happening to consumption, we
will be looking to see if there is any evidence of this happening.
159. What I meant was if people did reduce household
consumption in anticipation of that, when would they start doing
(Sir Edward George) I suppose if they know that it
is going to happen now, if it is definitely going to happen then
any time from now on. You could see it reflected in the pay bargaining
process in anticipation too so we will be looking for that. Honestly,
we are not in a position where we can say any of these things
are definitely going to happen. We just have to think about what
is the nature of the process and monitor the incoming data which
we will be doing from now on to see if we can detect any directions.