Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 43-59)

20 NOVEMBER 2003


  Q43  Chairman: Can I open the meeting, Governor, by welcoming you and your colleagues to this session. Starting with Professor Nickell, could you identify yourselves formally, please, for the shorthand-writer?

  Professor Nickell: Stephen Nickell.

  Sir Andrew Large: I am Andrew Large.

  Mr King: Mervyn King.

  Mr Tucker: Paul Tucker.

  Mr Lambert: Richard Lambert.

  Q44  Chairman: All members of the MPC. Thank you. Governor, I think you want to make a quick opening statement?

  Mr King: A short opening statement, if I may, Chairman. I am very grateful for this opportunity to explain the reasons for the Monetary Policy Committee's decisions on interest rates since we last appeared before you in September, and, of course, in particular, the reasons for the rise in interest rates at our November meeting. In most of the industrialised world, demand and output, as expected, are responding to the exceptional supportive stance of monetary and fiscal policy in recent years. In the UK, estimates of demand and output have been revised up, and some of the statistical fog has dissipated. Following a weak first quarter, output has grown at around its historical average and inflation has been above the 2.5% target for almost a year. Consumer spending has decelerated markedly to growth rates averaging just over Ö% a quarter for the past year, from around 1% a quarter over the previous five years, but neither consumer spending nor the housing market have slowed as much as the Committee expected, and the growth of secured and unsecured credit continues at high rates. Last week, in its November Inflation Report, the MPC published projections for output growth and inflation conditional on official interest rates remaining at their current level of 3.75% throughout the two-year forecast period. The central projection is one of growth around or a little above its historical average throughout the forecast period. Overall, this outlook is somewhat stronger than in August. Although some of the temporary factors pushing up RPIX inflation are expected to unwind in the coming months, the central projection for inflation is that it remains around the target through the forecast period, picking up at the two-year horizon as underlying inflationary pressures build. The Committee sees moderate growth of consumer spending and slowing in house price inflation as the most likely outcome, but obviously there are enormous uncertainties surrounding that outlook. In particular, the Committee is mindful of the risks to domestic demand and inflation resulting from the high level to which household debt has risen. Its best assessment is that the position of households in aggregate is not as fragile as some have suggested, but the Committee is aware of the need to understand better how that debt is distributed among households and hence the scale of those risks. In the Committee's view, the risks to the central projection for inflation are broadly balanced. Inflation is expected to remain close to the target, but continuing, steady growth—at home and abroad—and diminishing spare capacity are likely to mean that underlying inflationary pressures will build gradually. As a result, the Monetary Policy Committee judged that the first interest rate rise for almost four years was necessary to keep inflation on track to meet the target. Chairman, those are the remarks that I would like to make this morning, and I and the other members of the Committee stand ready to answer your questions.

  Q45  Chairman: Thank you very much, Governor, for that opening statement. Could I start by focusing on your broad, strategic assessment, the one you made in your Leicester speech, which highlighted that the strong economic performance of the 1990s had eroded most of the spare capacity of the economy. You highlighted also the dangers posed to inflationary pressures by diminishing spare capacity, in your opening comments at the Inflation Report press conference. Therefore, is the MPC operating now against a basic background which requires it to act quickly to constrain UK growth if at any point growth looks like rebounding back above trend?

  Mr King: I do not think it is a question of trying to target growth, but it is a question of the Committee, I think, as before, always looking forward and being ready to take action on interest rates when it is felt to be necessary. The message I was trying to give in the Leicester speech was that we have been through a decade in which gradually we managed to use up the spare capacity and in which supply side reforms brought down the normal level of unemployment. That was a period in which living standards were able to rise faster probably than they would be able to normally, because of the sharp increase in the terms of trade of around 10% since sterling started to rise in the mid 1990s, and it is very unlikely that there will be a repetition of that increase in the terms of trade. I am not suggesting that the terms of trade will unwind necessarily. I think, a repetition of that sharp increase in the terms of trade—which enabled real wages and household consumer spending to rise at above trend rates, without any substantial financial imbalance in the economy and without undue upward pressure on employers' costs, and hence inflation—is not likely to repeat itself. It is a slightly more normal, if you like, but slightly more difficult position than the one in which the Committee operated over the past five years or so.

  Q46  Chairman: What does the Bank estimate the trend growth rate to be currently, in the UK?

  Mr King: It is hard to judge, and I think the recent revisions to national accounts data make it more difficult to judge still. For some time we have felt that around 2Ö% is not a bad estimate, that is close to the historical average. Of course, there are arguments to suggest that perhaps changes in investment and IT might lead to there being some increase in that, but it is not easy to detect that in the data. The upward revisions to the National Accounts really raised the estimate of growth in 1999 and 2000. I think it is a good question to ask, how should one react to the upward revision of growth in those two years? I do not think it is obvious that one would infer, from an increase in the estimated growth rate in just those two years, that there has been a rise in the trend growth rate. I think this is a question, obviously, to which the Committee will wish to pay a good deal of attention in the future.

  Q47  Chairman: On the issue of spare capacity, it has been suggested that the euro economies and Japan have spare capacity, and when their economies rebound that could be used up. What implications will that have for US growth over the next few years? Do you think, as a result of that, if these economies rebound, that the US growth will be weaker by international standards than we have become used to?

  Mr King: I do not think the question of whether the European or Japanese economies will grow faster in the next few years has any direct implications as such for the US. Indeed, I think that faster growth in those economies would help the position of the imbalances in the US economy, particularly the large current account deficit, and it would help the US economy see those deficits unwind somewhat, as one would expect they would do, within the medium term. I do not think it would have any negative signal for US growth, indeed, I think actually it would ease the position for the US.

  Q48  Chairman: Could it have any negative effect on UK growth?

  Mr King: No. Again, I think it would lead to a somewhat better world climate. To a much lesser extent than the United States, we have also suffered from a position in which we have managed to grow at around trend growth rates for quite a long time, during a period in which the world economy has been slowing quite rapidly. It is now starting to pick up from that. I think a recovery to historically more normal growth rates in the euro area and Japan can be good for not only the world economy and the US but also for the UK.

  Q49  Chairman: Could I ask what factors have led household consumption to be stronger than you expected at the time of the August Inflation Report?

  Mr King: I do not think it is easy to give a definitive answer on that, at this stage. Clearly, it is a conjunction of factors and you could point to the housing market as one explanation for why mortgage equity was withdrawn and spending has continued to be buoyant. Equally, one can argue that, in fact, the key question is what is driving both of them, and that both consumption and the housing market simultaneously have been stronger than we thought. There has been a slowing in the growth of real wages. This is the first time for some considerable period in which the average growth of take-home pay in real terms actually has been negative. That is, real take-home pay has fallen in the last few months compared with the year before, and I think we had expected that the growth rate of consumer spending would slow. Of course, it has slowed quite significantly compared with the growth rates of the past five years, but perhaps not quite as much as we had expected. That may be because households have responded to the low level of interest rates, it may be because they can detect, looking ahead, that perhaps the climate is more optimistic. Certainly, consensus views about the world economy have become more optimistic in the last three months. There are many factors and it is hard to pin down what is the factor that has driven it. Whatever it is, it has been a little stronger than we expected, though I think we should not lose sight of the fact that the growth rate of household consumer spending is a good deal lower than it was over the past five years.

  Q50  Chairman: I know that you have expressed concern about the number of highly indebted households with little or no liquid assets, and you have expressed the need to have more information on that, and I believe you are commissioning an independent study on that. What implications could that have for the economy with these individual households, ex post, as it will be?

  Mr King: It is not easy to judge, but I think if you look back to the early 1990s it is not easy to understand why consumption was so depressed without looking at the distributional effects. That is that, where over a million households suffered from negative equity, they cut back their spending more sharply than they might have done had the fall in average incomes and real pay been spread evenly over that population. If so I think the total fall in consumer spending would have been less than we saw in the early 1990s. If there are significant balance-sheets effects focused on a small group in the population, that can have a disproportionate effect on total consumer spending, which will be of relevance to the Committee. We do not think we are in that position now. Even if house prices were to fall, we do not think we would go back to the number of households facing negative equity. It would require a very dramatic fall in house prices for that to be the case, so the negative equity situation looks considerably better than it was in the early 1990s. On the other hand, because the debt burden has increased, there is a minority of households facing fairly high income gearing, and they are more vulnerable, and so we decided we would like to know more about it. I remember, when we came to you in September, you asked whether we would repeat our survey on mortgage equity withdrawal, and the impact of that on household spending. We did go away and consider that, and we decided that we would not carry out our own survey on that because there is a survey being conducted by the Office of the Deputy Prime Minister, the Survey of English Housing. They will be publishing some results at the beginning of next year which will contain answers to the same kinds of questions that we asked about mortgage equity withdrawal: what it was financing, and so on. So we did not feel there was a need for us to replicate our earlier survey on that, and the British Household Panel Survey is producing data also. What we did decide to do, however, was look at the unsecured debt position, and the British Household Panel Survey produces information on secured debt and the distribution of that across households. The latest data that we have from the British Household Panel Survey concerned the year 2000. There had not been any trend increase in the number of households reporting themselves that they felt they had serious debt problems. We commissioned a small survey earlier this year, in the spring of this year, which we hope to be able to publish by the end of the year, which updates the numbers to 2003. The broad conclusion is that, again, there does not seem to have been any trend increase in the number of households reporting that they face serious debt problems. This is only a survey, it is not a large survey, and, of course, the problem can be very severe for a minority of households, and it is one that we wish to keep on top of because of its implications for total spending. That is our particular concern. Obviously, for the families themselves, there are potentially very serious repercussions if they get into debt difficulties. Our remit that we have been given is to worry about the macro implications of that, and there could be such implications if it affected their spending significantly.

  Q51  Mr Beard: The November Inflation Report shows your estimate of further slippage in the euro growth rate, but last week there were more upbeat economic data coming out from France and Germany. Do you think that this presages the light but long-awaited recovery in the eurozone, and do you expect UK export performance to improve before there is a substantial improvement in economic performance in Europe?

  Mr King: There is no doubt that the position in the euro area economy is of absolutely crucial importance because it accounts for more than half of our trade in goods and services, so it is very significant from that point of view. I think it is too early to judge whether the figures we have seen, the first estimates for output growth in the third quarter, really will be the sign of the upturn. It is part of our central projection. Our central projection is that during the course of next year the euro area economy will return to around trend growth rates, and I think the survey evidence suggests that is a reasonable, central view. The survey estimates are becoming more and more optimistic over the last few months. The figures to which you referred are the first sign in the official data. One needs to be cautious still because, as we know here, the first estimates can be revised easily, in either direction, and it will be too much to put a lot of weight on that one latest number, but it is supportive of the view that is embodied in our central projection that we would expect to see an upturn in the euro area.

  Q52  Mr Beard: Sir Andrew, in a speech you gave on Monday at the National Liberal Club, you referred to the Financial Services Action Plan and gave a warning about the concerns that are arising about the pace at which this is being introduced. I know this reflects many comments in the financial services industry. You went on to say: "We need to achieve so much so quickly and warn against people taking their eye off the ball in the process of instituting these changes." Is this likely to have an impact on the economic performance of the eurozone?

  Sir Andrew Large: When I said people should not take their eye off the ball, really I was thinking particularly of the UK. I think that the concerns about the Financial Services Action Plan and the speed with which it is being introduced are more to do with potential financial stability than they are for the immediate prognosis for demand and output within the eurozone or, for that matter, the UK. That was really what I had in mind.

  Q53  Mr Beard: Thank you. The Bank has voiced doubts about the sustainability of the United States recovery. Do you think the financial markets are becoming complacent about the world growth prospects: whoever wishes to answer?

  Mr King: Let us share it around then. How about Professor Nickell? Always a considered view.

  Professor Nickell: I do not think the financial markets are particularly complacent on this matter. It is always hard for me to detect whether they are complacent or not, however, I should say. My view is that the US recovery benefited greatly from the tax cut, of course, in the immediate past, so it seems very unlikely that US growth in subsequent quarters, after the tremendous burst in the third quarter, is going to continue at an extremely high rate. However, I think that there are certain factors going on in the United States, notably the very high level of productivity growth, rising profitability, rising investment, which suggest that a relatively high growth rate will be sustained in the United States for some time. My guess is that these real forces will tend to dominate. They could be disturbed by some financial crisis generated by the huge current account deficit, but my guess would be that the most likely outcome is that the United States will grow quite strongly for some time.

  Q54  Mr Beard: How confident are you in general that the external demand will recover enough to maintain the momentum of the United Kingdom's economy and also allow some rebalancing in the economy?

  Professor Nickell: I have to admit that the picture one is beginning to get, namely the strength in the United States, the recent, one has to say, welcome news from the eurozone, that the eurozone economy is starting to get back at least towards trend, the patchy but by and large relatively optimistic news from Japan, and certainly from non-Japan Asia, all these things to me add up to a recovery in the world economy being more likely than not, and that will be a tremendous help to the rebalancing of the UK economy. I think the most likely outcome is reasonably positive on that score. Of course, there are always risks, but that is the most likely outcome.

  Q55  Mr Beard: Does the Monetary Policy Committee generally share that view?

  Mr Tucker: I think that the two key pieces of data that have come out of the States over the last two months have been on the labour market and on business investment. If you go back a few months, the big question there was would households restrain their spending, which had been strong for a while, before business recommenced investment? The reason there was that concern was that unemployment was continuing to go up quite markedly. From August, the data from the labour market have been encouraging. In particular employment has risen, while they have revised up some of the employment data too. Going back to an earlier question about financial markets, I think that had quite a big effect on financial markets' perception of the risks in the States. Separately, for both Q2 and Q3, business investment came in quite strongly and, I think, again, financial markets took encouragement from that, as did I. The reason is that, although you cannot rely on it absolutely, it is the first strong sense we have that the atmosphere of nervousness and risk aversion that has been fairly pervasive in the US business community over the past few years has started to pass. You asked, Mr Beard, whether that meant that financial markets are now overoptimistic about US recovery, and I guess there is a risk of that. I think the one thing that would suggest perhaps there is still a kind of tempering thing there is that—really the point that Steve made—with the current account deficit continuing to be pretty big, the dollar has gradually glided down and had there been strong bullishness in financial markets about the US, a kind of "no risk" scenario, I am not sure that would have happened.

  Q56  Mr Beard: With this relatively fragile, global economic recovery, how important do you think it is to avoid tension over trade tariffs between major blocks, such as is emerging now over steel?

  Mr King: Extremely important, but it is not just a cyclical problem, it is not just that it is now. One of the sources of greater prosperity through the whole post-second world war period has been the growth of trade, involving many countries around the world. I think the concern that all of us must share is not just the signs of tension about trade among developed countries but also the breakdown of the trade talks in Cancun. If you put those two things together, I think that is a concern, and clearly the people involved are working extremely hard to make progress, and I think we would only encourage them, they have a very difficult task. The big picture here is that one of the sources of our prosperity has been the growth of trade, and anything that would endanger that, whether that be tensions about trade between our closest trading partners in the industrialised world or, indeed, failure to make progress in the trade talks with the developing world, either of those would cast question-marks about the longer-term growth and prosperity, and it is very, very important that we make progress on that.

  Q57  Mr Fallon: Governor, when you appeared last, we discussed the switch to HICP inflation, and you accepted the importance of the presentational side of this and said you needed to do some explaining. You said, I quote: "This morning is part of that process." It seems also to have been the end of that process. Why have you been silent since then, why has the Bank been silent on this?

  Mr King: I do not think we have been silent. I think the position is one in which we know now exactly the date on which the Chancellor will announce his decision, and I think until he announces his decision it is very hard for us to explain something It would be wrong for us to explain his decision. The first part of the process is that the Treasury must explain what the decision is, and we do not know what that is, and why that decision has been made. And once that has been done—that part of the process is out of the way—then certainly we will go to great lengths to explain the consequences of that decision for our work and the prospects for inflation. Until we know what that decision is, and if and when there will be a change in the inflation target, it is very hard for us to know what to say.

  Q58  Mr Fallon: There could have been some more technical explanation of how it is going to be modelled, whether your forecasting techniques will be the same for HICP as RPIX. On the website, I think, there have been only two MPC speeches since 18 September and neither of them touches on HICP?

  Mr King: I think it is important to give explanations which are clear when there is something to explain. The world is not short of speeches and I do not wish to add to a world of unnecessary speeches. When we know the target then I promise you that we will explain frequently and often what there is to explain, but I think to try to explain clearly and simply to people what a change in the target might mean when we do not know what that change in the target is, or even whether it will take place, would be slightly presumptuous on our part and actually would not aid the clarity of the process. I think it is sensible to wait now. It is a matter of only days really until 10 December when we will know the decision and the outcome and then we will know what it is we will have to explain.

  Q59  Mr Fallon: That rather implies that you think it is possible the switch itself could be deferred?

  Mr King: I have no idea. The Chancellor will announce his decision. I simply do not want to anticipate his decision. It is right and proper that it is his decision, but I do not know what that decision is.

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