Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 60-79)

20 NOVEMBER 2003


  Q60  Mr Fallon: It just puzzles me why you said that on 18 September, "We've got to start explaining this"?

  Mr King: I am sorry, maybe I misspoke, in terms of starting a process which was not yet appropriate. We will start explaining it once that decision is announced, and we know now that indeed it will be announced on 10 December.

  Q61  Mr Fallon: Yes, I understand that, but the difficulty surely for commentators and those who say these things is that you yourself, in the Inflation Report, note that the approaching switch, if it does take place, may well have raised inflation expectations already, and that is an undesirable development, is it not?

  Mr King: I do not think it will have raised inflation expectations. The broad picture remains as we have said before when asked about this issue at several points during the year, which is that, looking ahead two years, we think the basic picture is that the likely difference between the two measures of inflation, RPIX and HICP, is around half a percentage point, and nothing really has changed our view about that. I do not think we can get in the position of giving a precise view of how we are going to model something until we know exactly what it is that we have to model, and then we can explain to people what the change in the target means, what its consequences are for monetary policy. As I said, the big picture, I think, in terms of explaining, is less to the commentators—I think the commentators know full well as much about the difference between the two measures as we do. It is going to be explaining to people at large why it is that inflation is presently above target and then suddenly it will appear below target, and yet from our point of view we do not see that as having any major significance for monetary policy. That is going to be the challenge to us, to explain why it is that, despite the fact that you move just like that from being above target to below target. Nevertheless, it does not have any implications for monetary policy, because looking ahead the difference between the two measures, which is at present very large, at 1.3 percentage points, will come down to something around half a percentage point. That is the challenge which is for us to explain, what this means for monetary policy if that change is introduced in due course. I think it is not a sensible background to start the effort to explain, as you are trying to explain something that at this stage is only hypothetical. I do assure you that if and when it is not hypothetical but a real announcement, then we will start to explain, and between the announcement and our February Inflation Report there will be a number of opportunities that all members of the Committee will have to explain the issue and what it means for policy.

  Q62  Mr Fallon: Does that mean, between 10 December and the February Inflation Report, there will be speeches, or, in fact, now you know the date, will you be ready to publish projections of HICP immediately after 10 December?

  Mr King: No, I do not think we shall be in a position to publish projections, because that would be a projection of what we believe will be the outlook for inflation and we make those projections only once every three months. I do not think it makes sense for us to go through another entire forecasting round, because what matters here is the big picture, and the big picture is what is the outlook for inflation relative to the target and that is something that sensibly we update only every three months. That projection will be available in February. I repeat what I have said before and what other members of the Committee have said throughout this year that, as far as we can see, in present circumstances, the likely difference, the central view, of the gap between RPIX and HICP inflation looking two years ahead is around half a percentage point. Beyond that it may well be bigger, because the long-term, historical difference between them is between 0.7 and 0.8 percentage points and that will depend very much on how the technical differences between the two indices evolve. I think a very important factor in this, what I would like to see myself when the decision is made, is that the body which should explain the technical difference between the two measures is the Office of National Statistics. I think it would be appropriate to hear from them about how the two measures are constructed, because they construct the measures, they are the guardians of these two measures of inflation and I think the appropriate body to speak first on what is the difference between the two measures and whether that difference will be likely to change over time, in fact, is the ONS.

  Q63  Mr Fallon: Have you been in discussion with them about that? Will they lead the debate?

  Mr King: They are not going to lead the policy debate, clearly, but I do think that they will explain clearly to us all what the difference is between their calculations of these different measures, yes.

  Q64  Mr Fallon: The other important point in December, of course, is your own Monetary Policy Committee meeting. That is very close to this potential announcement. Would you expect, or prefer, to be told privately what the announcement is a week before the rest of the world?

  Mr King: No, I would not. I do not like being in the position of having confidential information that the rest of the world does not have. I think that is not a good position to be in, and I think it would not be helpful to us to be told privately that we were going to be given a change in the target, unless we were told at the same time to ignore that for the purpose of the meeting. The best way to do that is not to tell us.

  Q65  Mr Fallon: You could be voting blind?

  Mr King: That is fine. As I said, I think looking ahead two years it does not make very much difference to monetary policy. We do not know what that announcement is and I think this is not a major consideration for policy. What I think would be wrong would be for us to be making a decision on a basis which people did not themselves know about. It is important that the basis on which we make decisions is understood clearly by you and the outside world when we make them. I think it would not be helpful for us to be briefed on that before 10 December.

  Q66  Angela Eagle: If possible, I want to take you back to what seems to be a pretty optimistic scenario of gradually increasing trends of growth and recovery in some of the economies worldwide, which even Stephen Nickell had to admit, he said, was out there. It was almost as if he was disappointed that it was out there, but it is out there. Perhaps there is a little cloud that might cheer Stephen up. I wonder what your view is of the current institutional stand-off that is going on in the eurozone with respect to the Stability and Growth Pact, which is creating uncertainties as the stand-off between France and Germany and the Commission is going ahead, and it is creating uncertainties as to targets and the institutional arrangements for the euro? How do you see this impacting on the potential for growth in what is, after all, our largest market?

  Mr King: I am delighted to hear that Steve has become a true central banker and he knows that to every silver lining is attached a cloud. You point to the uncertainties about the operation of the Stability and Growth Pact, and I think clearly there are great uncertainties as to how it affects the medium term. I think it is fair to say that it is not easy to know how it is operating at present. I think, in the short run, it is very easy to see how it is operating, which is that it is not stopping countries allowing their budget deficits to rise when the cycle means there is a downturn in the economy, and that can be only supportive of growth in the short run. They will need a stability and growth pact in the medium term to make a success of the monetary union, and no doubt there are many discussions going on, in some of which we participate, as to how best to construct a medium-term picture for a stability and growth pact. I do not think there is any reason to suppose that at this stage it is being operated in a way which is forcing down growth of the European economy.

  Q67  Angela Eagle: That is interesting; so you are fairly optimistic that there is time to get the institutional structure into a more sensible place without disrupting the natural growth of the economies that is beginning to be indicated by the signals? You seem fairly optimistic?

  Mr King: There is certainly time to do it. That is not the same thing as saying that it will be done.

  Q68  John Mann: I have two questions on labour market issues. I note in your Inflation Report, in the section on "Labour market tightness", you refer to indicators of employment and unemployment. Do you not think that your approach is rather outdated and that really what you need to be looking at is some kind of indicator of the propensity to flexibility?

  Mr King: I do not think it is outdated in the sense of trying to get a feel for the balance between demand and supply. Certainly I accept that, in order to form judgments about the labour market as a whole and the likely evolution of trends in wage costs and total unit labour costs, you have to form a judgment about the degree of flexibility and what that means for movements in unemployment, and so on. I think that is a clear part of our judgment. I do not think that it is outdated—or that to think about the balance between demand and supply in the labour market is the wrong way of thinking about it. We have seen in the last two years or so that we have had a picture in which employment has still continued to grow, hours worked may have fallen back a bit, but unemployment has been really rock solid for two years with no change at all in the rate of unemployment. Earnings growth also has been very steady. That looks a position in which in the last two years or so there has been a reasonable balance between demand and supply, and I do not think that is a silly way to think about it. As I say, I do accept that flexibility and understanding how the labour market behaves and the fact that it may change over time is a key part of our work.

  Q69  John Mann: Certainly they have come down, in real terms, have they not, I think quite significantly, in terms of rather pessimistic anticipations of what would happen with employment?

  Mr King: Anybody who pretends to have perfect foresight and to know what will happen is foolish. There have been developments in the labour market, I think. In terms of the measures taken to improve flexibility, they have been taken over the last 20 years or so and the effects have become evident in the last ten years in which the rate of unemployment which is possible to run the economy without seeing inflationary pressures has come down, and that is something to be welcomed. It was very hard to know at the beginning of that process. I think it was possible to argue that it would lower the rate of unemployment at which the economy could be run, but it was very difficult to know by how much and what the quantitative effect would be.

  Q70  John Mann: With respect, my question is should you not be looking to see whether some kind of indicator of the propensity to flexibility can be created, in order to make future predictions more accurate?

  Mr King: I am not sure if I understand really propensity to flexibility. I think a measure of the degree of flexibility and how far wages respond to changes in the balance of demand and supply, that is something that we try to look at, and Steve is the expert not me. We do try to look at those things. The propensity to flexibility suggests almost there is something that you can observe and measure which predicts how future reforms will operate or how labour markets will evolve, and that is difficult to judge. I do not think, even if you could find it, it would supersede the need to form a judgment now about today's balance between demand and supply in the labour market.

  Professor Nickell: I think that is very fair. At the moment, the situation we are at is that if you talk to most business people they will tell you that there are quite large areas of the labour market where they find it hard to get people. That suggests, in some sense, the labour market is quite tight. On the other hand, they will say also they do not expect serious upward pressure on wages, and therefore one might think perhaps the labour market is not quite as tight as they are telling us it is, but getting further than that is quite difficult. We are in a situation where we have to look at these things all the time, because if the labour market got tighter, as measured by, say, the level of unemployment, and so on, we are not quite sure at the moment the extent to which that would impact on pay. That is yet another reason for operating cautiously, which I think we do in a variety of ways. I think otherwise what the Governor said is completely fair.

  Mr Lambert: I take your point. Personally, I have been surprised by how subdued earnings growth has been over the last months, given what has happened to take-home pay and given the position in the labour market. That is something that has been a matter of interest. As we go round the country talking to people, which we do a lot, you hear very different stories from different sectors and different regions about what that all adds up to. As Steve says, I think all we can do, at the moment anyway, is look on a monthly basis and try to form judgments about whether the trends are changing, and that is what we are doing.

  Q71  John Mann: My second question was, considering the high levels of employment that we have got in the UK at the moment, is the UK overrigid in impairing the supply of labour through inward migration? If it is, is this going to start to create underlying inflationary pressures?

  Mr King: Whether there are inflationary pressures is a matter of the balance between the supply in the economy and our policy, we can react to any changes in supply. The question of immigration policy is a national policy which may have economic aspects to it, which goes way beyond it, and that is not for us to comment on whether immigration policy is or is not too rigid, that is for you.

  Q72  Chairman: You are strictly non-political, Governor?

  Mr King: Sorry, I did not mean to answer the question, I was just posing it.

  Chairman: It is an issue we have raised before.

  Q73  Mr Cousins: I suppose, inevitably, I have got to put these questions to you, Governor, because you referred to some of the statistical fog having been dissipated. I wonder if you could tell us which bits of the statistical fog you consider have not been dissipated?

  Mr King: Can I start by saying which bits have been dissipated, which I hope will make it a bit clearer what is left.

  Q74  Mr Cousins: Let us have the boring bits first and the entertaining bits later then, it will give us something to look forward to?

  Mr King: Clearly, what we were faced with when we came to you last was that we felt, on the very latest estimates for growth in the first half of this year, there was a real inconsistency between the official data on GDP growth and what we saw from the surveys and the anecdotes. One of the things which has been clarified is that the data for the first half of this year have been revised up. What we were concerned with also was the implications of the problems in measuring trade data accurately and what that meant for the growth of demand and output in the past. We have seen a series of revisions. They are more definitive estimates of demand and output growth over the past five years, and the ONS has been able to take on board much of the information it has got now on the pattern of trade, so now we have a consistent series on the growth rates of demand and output. There are still uncertainties, I think, about some aspects of the trade data. The export data for certain quarters are not entirely easy to understand. It is not yet obvious whether the problems in the recording of exports have been fully clarified, and, of course, for the very recent quarters, it is still possible that there may be significant revisions. I do think the ONS deserves credit for one important change that has not attracted very much attention, for the good reason that it is boring, in your word, which is that it has not had any really significant impact on our view of the outlook, which is that we have now switched in the UK to chain-linking of the National Accounts. Which means that in the way in which different components of demand are added together and are weighted together—using more up-to-date weights than they were—we have moved to international best practice. This is quite a major change. We were unsure whether that would lead to quite significant changes in the picture for demand and output, and it did not. I think this has been the dog that did not bark and I think the ONS does deserve real credit for introducing this change, in the way it went very smoothly, has brought us up to best practice and has been very successful. There do remain uncertainties still, inevitably, I think, about what the picture for demand and output means, for whether the underlying growth rate in the economy has altered or not. As I said earlier, we do not see any evidence for that, but equally it would be extremely difficult to deny that there has been such a pick-up. I think it is very hard to detect these sorts of changes. Maybe it is to borrow a phrase which I think Charlie Bean used in an earlier session. Some of the statistical fog has lifted and what is left is a certain amount of analytical fog, which is, how do we interpret some of these revisions to demand and output, what does it mean for our views about growth in the UK economy and the rate at which it can expand sustainably? That is something which will take even longer to sort out, I think, and there never will be a point or a date when we know the answer to that, it is part of the ongoing process. In that sense, I think some of the fog indeed has lifted.

  Q75  Mr Cousins: Taking up a point you made earlier, which is that you consider the first preparatory work for the translation of the present inflation target into the European harmonised form would lie with ONS, you said that here this morning. I think we would both accept, and I want to be careful about what I say myself, I do not want to imply any denigration of the work of ONS at all, I recognise the difficulties that they have had, but they have been through a very rocky period in terms of public presentation. Do you have some anxieties about that, because, fairly or unfairly, their public credibility has been damaged?

  Mr King: If it has been damaged unfairly then I think I would like to take the opportunity to repeat what I have just said, which is, there are many stories which have not attracted publicity for which they deserve great credit. I am not going to comment on the other stories, that you and others in this Committee rightly have asked questions about, what happened to the data, and it is right that you should do so. There are stories, and I think the switch to chain-linking of the national accounts was one, that, within the Bank, the economic staff in the Bank were saying to us, "This is a very big change, it's an important and very valuable change. It's good that the UK is making it, it could have significant implications for how we see the economy." That change went extremely well, sufficiently well that no-one outside really noticed it, and I think they deserve credit for that, and I think it is worth putting that on the record. In terms of inflation measures, I think there are three steps in this. First, the decision clearly is one for the Treasury and they will need to explain what the decision is and why they have taken that decision. Secondly, I think at some point it is appropriate for the ONS, because they are the guardians, they collect and publish these data, it would be sensible for all of us to hear from the ONS about precisely how they calculate these measures and what in their view the differences are between the two measures. Thirdly, and an ongoing process, is one in which the Monetary Policy Committee, all nine members of the MPC, will need to explain, particularly as we go around the UK, what the change in the measure means, whether it is significant for monetary policy and how policy is being set now in terms of the new target.

  Q76  Mr Cousins: I am grateful to you for that. The one area that you have referred to already where the recent revisions in data have produced a dramatic impact is in the area of trade, and it is so dramatic that you have drawn attention to it in the Inflation Report, quite properly, in which the lines are completely divergent as a result of the revision. Do you think that indicates simply a data preparation problem, or does it give to us an indication that there is an underlying problem about the size of the trade deficit and how to finance it?

  Mr King: I think the particular data problems that have given rise to this difficulty, that certainly have exacerbated it, are the discovery of VAT-related fraud and the problems Customs and Excise had in recording export figures correctly. I think it is always difficult to know how to calculate the trade figures in the absence of an even greater burden of regulation on businesses. In the old days you could perhaps stand at the docks and look at the exports, sort of measure them, but now so many exports are in the form where you can only try to record the values. I think it is extremely difficult and we try to get better information. For example, we know we have very poor information on capital account flows between countries, and they are the counterpart to current account flows and would provide a very useful check. But without imposing foreign exchange control, which I have not heard many people argue for, it is very difficult to know how you would ever estimate these flows accurately. There are difficulties in retaining data which will always be there, and they will be particularly important at times when you get large and growing current account deficits. I do not think that this has been a major problem in setting policy, because the big picture story for us has been that the rise in the exchange rate led to a position in which quite deliberately we allowed this imbalance in the economy to grow, in order to make sure that the economy could continue to grow and that inflation would stay close to the target. The imbalances in the UK, whatever they are, are significantly less, markedly less, than in the United States, so I do not think it has been a major problem for policy. There is no doubt that, in trying to gauge the development of the economy during the course of a year, one of the lessons from this is that since we cannot expect—and it is no good blaming the ONS, they are the messenger not the source of the problem here—to get terribly accurate quarterly data on movements in the trade account, so we should not put too much weight on the latest number for the growth of GDP. I think, those people who feel that "Oh, the GDP number has changed from 0.2 to 0.3, this is a really important change," that is very, very foolish. It is important not to put too much weight on the latest number, and that is a responsibility not of the ONS, not of anyone else but us. We are the people who make judgments about how much weight to put on these numbers and it is very important that we do not put too much weight on the latest number.

  Q77  Mr Ruffley: Governor, could I ask about house prices and the house price bubble. I was just looking at the revised remit that the Chancellor gave you in April 2003 for your Committee: "(a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty's Government, including its objectives for growth and employment . . . The Government's central economic policy objective is to achieve high and stable levels of growth and employment . . ." Is not the house price bubble threatening the second part of that remit, and can you be doing more to tackle the house price bubble?

  Mr King: I think there is no doubt that one of the major challenges to monetary policy in many countries in the last five to ten years has been how to deal with asset price movements. I think I would say two things. I do not think this is an easy problem and I do not think there is any magic solution to it, but I do think that the inflation target framework is still the right one to examine that problem. I think it is the case that there may be circumstances in which the Committee could say to itself, because of the movement in asset prices that threatens future adjustments to demand, and hence inflation, that maybe we would err on the side of thinking carefully about the risks to inflation beyond the normal two-year forecast horizon, and if we felt those risks were sufficiently large that might affect policy today. The remit does not tell us to hit the inflation target two years ahead but says that we should be looking at the inflation target at all horizons. If we felt that the movement of asset prices was likely to threaten large movements in inflation away from target further ahead, that is something we could sensibly take into account, and we have been very conscious of that in the last few years. The second thing I think is that house prices are not the only asset that we have had to think carefully about in this context. If we had thought only about house prices then it is true that we might have said to ourselves, "Well, should we raise interest rates sooner and by more, in order to slow down the rate of increase in house prices?" Instead we could have looked at share prices, and there would have been a period in which we might have been thinking of raising interest rates a bit sooner, but then lowering them a bit faster and a bit more than we did, in fact, because of movements in share prices. If we had looked at the exchange rate then, in fact, we had the opposite message from house prices. We might have been looking for quite a long period at whether we should have held interest rates even lower. I do not pretend that the movements in asset prices do not create difficulties for monetary policy, I think it has been the big conceptual problem facing monetary policy, but I do not think it has been a problem because we had an inflation target. I think whatever monetary policy framework we had, that problem will have been there. I think that it is the inflation target framework I still find the most helpful framework in which to think about that problem and to deal with it. I think that in the UK context it is not just one asset that we have had to think about, it is several assets, and the messages from each of these asset markets are very different. I know that is not a simple answer, but I do not think it is a simple problem to which there is a simple answer. I do think that this is something we have thought about a great deal and I am sure that we will carry on thinking about if asset prices behave in a way that, to us, raises the prospect or the possibility of a significant correction further ahead.

  Q78  Mr Ruffley: I want to pay specific attention to house price inflation, because that would seem to have more of a pass-through effect than equity prices or an equity bubble. In the immediate circumstances, that would appear to be the case, so let us stick on house prices. Am I right in saying that, from the first part of your answer, it is conceivable you will be paying more attention in the next few months to house price inflation when you are setting interest rates?

  Mr King: No, that is not the case. Just as a footnote, let me say I am not sure if I accept the premise that house prices have more of a pass-through, and I think the exchange rate is particularly important, and even equity prices, if you look at the debates that were occurring when share prices were going up about the impact of the equity market on consumption.

  Q79  Mr Ruffley: I mean at the moment?

  Mr King: I thought you were making a general point, I am sorry. At the moment, in terms of house prices, what we are thinking carefully about is what that means for consumer spending, but we are not giving independent weight for house prices, we are looking at what all of this means for the outlook for inflation in the future, for the short run, the medium term and indeed further ahead. One of the things that we will be asking ourselves is whether we think it is house prices or the growth of debt, or indeed the prospective growth of incomes, that means there is a possibility that there could be sharp movements in consumer spending or demand, and hence impacting on inflation. That is the prism through which we will examine it. It will not be an independent view, but when we form our judgment about inflation, we also have to look at house prices. House prices are relevant not just because of the immediate impact on spending but because of the risks to the inflation target further ahead as well, but it is through the inflation rate that we look at this.

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