Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 20-39)

20 NOVEMBER 2003  


  Q20  Mr Beard: Are you all of the view that the concept of the neutral rate is baloney? That is more or less the answer, is it?

  Professor Dow: Apart from anything else, it is conditional upon which rate of inflation you are talking about, for a starter. It is statistical.

  Q21  Mr Beard: We are talking about the RPIX here?

  Professor Dow: Yes, which clearly is going to be very important for future decisions.

  Q22  Mr Beard: Most outside commentators in the market see the November rate rise as the start of a sustained upswing in the interest rate cycle. Do you think the markets are right to price in a 5% rate, 18 months out, and how do you think that the consumer and housing market will do, if we see 5% base rates by the end of 2004?

  Professor Dow: It may be that, because these expectations have been given a lot of publicity in the media, that in itself is impacting on the perception of households about their financial position, and that in itself might help to curb excessive borrowing and keep things stable. Having said that, given the uncertainties surrounding the forecasts, which I think are larger than are implied by even some sort of fan chart, I would be loathe to make such a prediction that that kind of rate would be appropriate over that time frame also.

  Mr Bootle: I think that the market probably is overestimating the level of interest rates. It does have a record, over many, many years, of doing that, by the way, that is to say, of not adjusting fully to the  change of inflationary conditions and overestimating the level of interest rates that is going to be necessary. It does all depend in my view on the reaction of the housing market and consumer borrowers. If modest rises do not bring a significant reigning back in the rate of growth of borrowing and the increase in house prices then, even within the inflation targeting framework, and after a switch to HICP, if that is going to happen, I think the Bank will have to consider pushing up interest rates until they do get a reaction.

  Q23  Mr Fallon: Could we turn to the paragraphs on bond yields in the Inflation Report. Roger Bootle, if inflation expectations have risen quite sharply, as they appear to have done since the summer, does not that mean the MPC's credibility, in fact, is a little more damaged now than it was perhaps a year or two years ago?

  Mr Bootle: I do not think so, not to a notable degree. The increase in inflationary expectation, such as it is, is pretty small. If you compare the movements in bond yields over the last several months with what we have been used to over the last 10 or 15 years, this is just a totally different kettle of fish. Indeed, comparing the movements in bond yields in Britain with the movements in bond yields in the United States, for instance, ours have been comparatively minor. I would not say that the credibility of the MPC is at risk.

  Q24  Mr Fallon: The Bank itself attributes some of the rise to expectations of the changeover from RPI to HICP. Do any of you think the debate there has undermined some of the MPC's anti-inflation credentials?

  Ms Rosewell: Not at present, no. It will depend entirely upon what actually happens to that target, when and how and at what it is set, after all, which we do not know, and then how they respond to that.

  Q25  Mr Fallon: Were you surprised that this Report itself did not discuss the changeover and some of the more technical aspects that needed to be aired before the changeover itself?

  Ms Rosewell: I would have been more surprised if it had discussed those. I am sure that discussion is going on, but I am not surprised that it is not published in this Report.

  Q26  Mr Fallon: You do not think it would have been useful if the Bank had published HICP projections alongside its RPIX projections, given we are going to move?

  Ms Rosewell: I think, if they had tried to do that, that is the kind of thing which would have confused markets and had the potential to undermine credibility. The time to do that is when you know what that target is going to be. I think it would be useful if there were separate research reports being published on the relationship between these measures over history and how they have been moving together and that was published by the Bank.

  Q27  Mr Fallon: It means, if there has been no airing of this in the November Report, if the target is switched in the next couple of weeks, everybody then has to wait until the February Report to see the Bank's HICP projections. Is there not some disadvantage in that?

  Professor Pissarides: Hopefully, the ad hoc projections will come out. I think it is important to know what the Bank thinks about HICP when it has made it the official target, but I agree entirely that it would not have been appropriate to have it in the Report now, because it is going to be the Treasury's decision as well. I hope and expect that there is a lot of background discussion, technical discussion, between the Treasury and the Bank as to exactly what the targets should be and the advantages of switching over to HICP. Until the switch is actually made, I agree with Bridget, it would be better for the Bank not to have them both running side by side.

  Q28  Mr Fallon: The Governor said himself, did he not, back in September, they had a lot of explaining to do about this change, there was an awful lot of presentational work to do? Would you not have expected them to start debating this, if you did not want to see it in the Report, would you not have expected to see more speeches by MPC members on it, more technical papers published, and so on?

  Professor Pissarides: We would expect them probably to have had discussion and be having this discussion now at the Bank, but make it public when we know more about the timing of the switch and the new target. Inevitably, questions are going to arise about the target and should it be 0.8, or should it be 1.5, and what are the implications, and then you get into speculation about policy before that policy has been agreed.

  Ms Rosewell: Certainly I would expect to have a lot of publications and presentations when such a switch is made and around that switch.

  Mr Bootle: I will dissent on this. I would have expected some sort of treatment of the HICP issue in this Report, or at least an acknowledgement of the change and a broad discussion of how it might affect policy. The Inflation Report was written as though the change was not going to take place, and that I find absolutely extraordinary, I have to say. We have just had an interest rate rise predicated on the idea that inflation is going to be above the target, or in danger of being above the target, on one particular definition, and all of that may be changed radically if the target is set at a particular level. Not to have treated that at all does seem to me to be absolutely bizarre.

  Q29  Mr Fallon: Could that mean, in fact, that the switch might be delayed or deferred?

  Mr Bootle: There is a strong rumour in the markets exactly to that effect, that Gordon Brown is going to make a statement announcing that we are going to move to the HICP definition but it is not going to be enacted now. Given that the markets are speculating about that, I think the argument that there would have been speculation if the Bank had treated this head on is quite weak, frankly, and already there is considerable uncertainty about exactly what is happening.

  Professor Dow: I think it would have been particularly helpful, in fact, if they had updated the table they had in the May Report, which showed the breakdown of the difference between the two measures. At least people would have up-to-date information on which to base their expectations about the relationship between the two and what that would imply for monetary policy.

  Q30  Mr Fallon: Two of you would have expected some treatment of this issue in the November Report?

  Professor Dow: Yes.

  Mr Bootle: Yes.

  Q31  Mr Ruffley: Can I ask Roger Bootle about asset levels and house prices. The remit that the MPC has got obviously is in relation to the price level but also to securing high and stable levels of growth in employment. I just wonder what you thought about the second bit, whether or not the MPC was paying sufficient attention to that, given that it seems to downplay the bursting or deflating of asset bubbles?

  Mr Bootle: I think, sotto voce, the MPC has been paying more attention to that gradually as the years have gone by, although the presentation of what it is doing obviously is still very much in terms of hitting the inflation target. Indeed, with regard to asset price bubbles, I think you could readily express a policy of trying to avoid the worst of a bubble, in terms of hitting the inflation target over a longer period. As I said in my note to you, I do think this is becoming a serious issue now. As long as the Bank, of course, thinks that inflation, whatever definition, is threatening to move above the target in the foreseeable future, and it is worried about the house price boom, then policy is not subject to any sort of dilemma, both factors are pointing in the same direction. I think the really interesting issue is what would happen, let us say, if they adopted HICP and a certain inflation target, and on the basis of that target there was not really any reasonable prospect in the foreseeable future of inflation exceeding the target, and yet house prices were continuing to rise and rise and rise at unsustainable rates, what would policy be then? This seems to me to be the gathering issue around monetary policy.

  Q32  Mr Ruffley: Do you think the MPC should be talking down asset levels in any way, sort of ex-cathedra statements? Are they doing enough, do you think?

  Mr Bootle: As things stand, it is not part of their brief, and I think this is the interesting question, how they interpret their brief in relation to asset levels, and how they think they ought to behave, as and when there is a conflict, which at the moment there is not, according to their forecasts, between what a narrow interpretation of inflation targeting would have them do and what an attempt to control the bubble would have them do.

  Q33  Mr Ruffley: There could be a divergence, there could be a need for a change in their emphasis?

  Mr Bootle: Yes, I think that is right.

  Q34  Mr Ruffley: Do the markets share that view, do you think?

  Mr Bootle: I do not think the markets, dare I say it, think very much about that issue. I think, for the time being, they are locked into the inflation targeting approach, they do not see necessarily there is a problem.

  Q35  Mr Ruffley: In the minutes for the MPC for July there is an argument that the sum of the 25 base point cap was unlikely to cause house prices to re-accelerate. Is it the case that a Ô% base rate rise equally will have no effect on house prices, Roger?

  Mr Bootle: I think that is the danger. We are dealing here very much in the realms of psychology. I agree with Bridget's point that a quarter point matters an awful lot more now than it did, given its lower levels of interest rates and from these much higher levels of debt. Clearly, the Bank does not want to overdo it, but we always argue that monetary policy, to be fully effective, must carry people's hearts and minds. A quarter point which leads on to the expectation of more quarter points, by the way, could end up being more effective than a Ö% increase, to which I referred before, which causes people to conclude that is the end of the rate rises. The Bank has to play the psychological and expectations game.

  Q36  Mr Ruffley: In the Bank of England model, what do you think the effect on the housing market and housing prices would be of a rise in base rates by next September to 5%, which is what the money markets are kind of pricing in? Five per cent in a year's time, what does that do to house prices, do you think?

  Mr Bootle: The Bank has already got the forecast, I think, still that house price increases come down to zero within two years.

  Q37  Mr Ruffley: I just wondered what your take on it is?

  Mr Bootle: That would be on unchanged interest rates, I imagine, conventionally. Therefore, on the basis of an increase of interest rates to 5%, you would have to imagine that the Bank's model would give you house price falls.

  Q38  Norman Lamb: Really just following up on that last point. If it went up to 5%, that would be something like a 40% increase in interest rates from the 3.5 level. What is the extent of your concern about the potential impact on the housing market and consumer behaviour if it gets to that level? Will it be a smooth levelling-out, or could it be a more dramatic reaction?

  Mr Bootle: Although there are serious grounds for concern, I think the point to emphasise is that conditions are nothing like what they were at the end of the eighties or the beginning of the nineties, either in general macroeconomic terms or indeed in relation to the housing market. Loan to value ratios, the absolute level of interest rates, the putative level of repossessions, all these things are very, very different levels. I think there could be an increase in interest rates which prompted a consumer response without prompting, as it were, mass distress. People would be able to pay their mortgages still, by and large, and in today's labour market conditions I do not think you would find the mass repossessions and the negative equity stopping many people from moving, and all that stuff, that we had in the early nineties, I think it would be radically different from then.

  Q39  Norman Lamb: Roger Bootle, you said earlier that you thought there was a case for a Ö% rise in order to shock people, that was the word you used, into a change of behaviour, and you did not think that the Ô% had any real impact on behaviour. Bridget Rosewell, you indicated that you were concerned a shock could have disastrous consequences, essentially. Those are two very different interpretations of the situation we face and it rather indicates that we are walking a tightrope. Do you have any further thoughts on the dilemma facing the Monetary Policy Committee, given that you are painting two very different pictures of what could happen?

  Ms Rosewell: I think there are more things than just the housing market. It is not just a tightrope in the context of how fast the rate of increase in house prices is appropriate and levels of debt for consumers, it is also a tightrope in the context of the rest of the economy. We are talking about it as if we are trying to set interest rates just in order to manage the housing market, but that is not the case. Actually what we are trying to do is set interest rates to maintain a high level of employment and keep inflation within the target range.

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