Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1-19)

25 MARCH 2004

MR MERVYN KING, SIR ANDREW LARGE, MS RACHEL LOMAX, MS KATE BARKER AND MS MARIAN BELL

  Q1 Chairman: Good morning, Governor, and welcome to the Committee's hearing. There is an historical note to this today in that your team comprises more female members than male members.

  Mr King: This is the first time this has ever happened in the 310 year history of the Bank, but not the last!

  Q2 Chairman: You did send us in advance an opening statement.

  Mr King: It is a short opening statement. As always, I am 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 November, and, in particular, to explain how monetary policy has responded to the new 2% target for CPI inflation. Growth of the British economy was above its historical average during the second half of last year, and looks set to remain strong in the first quarter of this. Consumer borrowing and spending have been rising faster than expected. Household consumption is now estimated to have grown by about 1% in each of the past three quarters, and a range of indicators—from retail sales, surveys of consumer confidence, unsecured lending and the housing market—suggest that this pace of growth has continued into the first quarter of 2004. Some slowing of this pace should follow in the wake of decelerating post-tax incomes and recent increases in interest rates. But the prospect of a more balanced expansion of demand will not have been helped by the 3% rise in sterling since the February Inflation Report. The effective exchange rate is now about 6% higher than when we last met with the Committee and is continuing to make life difficult for many exporters, as I learnt from my visits to the West Midlands and the North-West this year. When I last appeared before this Committee I noted that RPIX inflation had been above the 2.5% target for almost a year. Since then the Chancellor has written to me setting out a new remit in terms of a target for CPI inflation of 2%, confirming this in a further letter of 17 March following the recent budget. The new target will have few implications for monetary policy over the coming months, as I explained in a speech in Birmingham and as other members of the MPC have done in their speeches and interviews. CPI inflation is currently 1.3%, but, as described in the February Inflation Report, is expected to pick up over the next two years as a result of increasing pressure of demand on supply capacity, notwithstanding the rise in sterling. It is, of course, impossible to know the future and so our forecasts focus on risks and probabilities. At future meetings the MPC will be able to assess whether the data since February have altered the balance of risks to the inflation outlook. That is clearly a matter of economic judgment. But the MPC will continue to follow the principle of looking ahead and acting early in order to keep inflation on track to meet the inflation target in the medium term. Chairman, those are the remarks that I would like to make and now I and the other members of the MPC stand ready to answer your questions.

  Q3 Chairman: Thank you, Governor. Could I then focus first on your broad strategy assessment? In your Leicester speech, you highlighted the strong economic performance of the Nineties and said that the next decade was unlikely to be as good and optimistic. Six months later, you have produced a very upbeat forecast for the UK economy with growth above 3% for two consecutive years. What are the main factors behind this renewed optimism?

  Mr King: I think I would distinguish between two points. One is the central projection for growth of the economy as a whole which, as you say, in our February Report was certainly fairly strong, in that it was at or above trend right through the forecast period. I think that is because we have seen some upward revisions to the data, particularly for consumption, so that, as I said in my opening remarks, we now have estimates of consumption growth of 1% for each of the last three quarters. The slow-down in consumer spending that we had expected to see, and indeed thought we had started to see last year, no longer appears to have yet begun. We do still see a rebalancing in prospect. I think the central projection is still based on a view that, with consumer spending buoyant in the short term. Although likely to slow down. The prospects for exports and investment brighter than for some time and Government spending still adding to overall demand, we would expect to see robust growth over the forecast period. The comments in the Leicester speech were directed primarily at the risks around that and whether we could expect to see such stability of output growth and inflation as we have in the past decade. I think we still feel that there is plenty of scope for surprises in both directions, which means that we may see more volatility over the next five to ten years than we have in the past decade.

  Q4 Chairman: What factors have led household consumption to be stronger than you expected at the time of both the August and the November Inflation Reports?

  Mr King: I think there are two factors. Obviously they are interrelated, so the underlying cause is difficult to detect. The most important, I think, was that we did not anticipate that household disposable income would grow as rapidly as it did last year. There was a slowing in post-tax income from employment. That we had expected, and indeed if you look at the data for the end of last year, the rise in average earnings was actually below the increase in the Taxes and Prices Index, so that real take-home pay from employment income was certainly not growing fast last year. But there was a substantial boost to disposable incomes from tax credits of various kinds—transfer of income from Government to the household sector. That growth of incomes is likely to be a one-off, so we would not expect to see a further boost to that during the course of the coming year. But we were surprised, I think, by how buoyant disposable incomes were. And, of course, house price inflation has turned out to be higher than we had expected, that gives households more opportunity to borrow against the equity in their housing. Of course, the buoyancy of the housing market may well reflect the same factors which determine the buoyancy of consumption. I do not want to argue that one necessarily caused the other, but they reflect similar factors.

  Q5 Chairman: On the issue of consumer spending and household disposable income, Sir Andrew, debt problems loom large, according to you in your speech in Wales this week. What were you trying to say there? I looked at your speech and you said there "in particular the possibility that the potential vulnerability stemming from the higher debt levels does in fact crystallise at some point and trigger a sharp demand slow-down that could have an adverse impact on monetary stability and make it more difficult to meet the inflation target over time". Given that you have voted for an increase in interest rates, certainly in the months from October to February, is this not a weak way of saying that we have to ensure that we have interest rate rises now and in the future?

  Sir Andrew Large: No, Chairman, that is not what I was trying to say. What I was trying to say in that speech really was that there is a central case which is quite consistent and on which all the data point to the central case we have in our forecast that the Governor was outlining but that, as debt levels rise, there is a vulnerability. Beyond certain levels, increasing numbers of people would find that they had difficulty in debt repayments and that could give rise, at a certain stage, to changes in demand and the possible downward movement in demand. I tried to make it quite clear that this was not the central case. It is a risk and, as debt levels rise, it is a risk that I do, at the margin, take into account when we make our monthly decisions. I am certainly not trying to suggest that under all circumstances interest rates have to rise. On the contrary, this last month, as you may see, I voted with everybody else on the Committee for interest rates to stay at the level they were because the data seemed to me last month to require that. As the Governor mentioned, sterling has been a factor in our thinking and sterling certainly was a factor in our thinking last month.

  Q6 Chairman: I think the press have interpreted that as you saying, and here is a headline, "The Bank Chief warns of return to debt levels of the 1990s".

  Sir Andrew Large: I noticed that. It is difficult when one is trying to make a point about potential risks rather than about what one thinks is actually going to happen.

  Q7 Chairman: Is there a case for plain English here?

  Sir Andrew Large: I think there is a case for plain English, yes. That is what I have tried to say in the speech.

  Q8 Chairman: I think you could work on that quite a bit yet actually, if that is the case. Let me try to take this a bit further with you. You spoke of the fact that if, as you expect, debt continues to grow faster than income as a result of turnover in the housing market and an interest rate rise is expected by the markets, income gearing is likely to pick up towards the peak last seen in 1990. You said that but, given your projections, how long will this take to occur?

  Sir Andrew Large: If I could just point out, that statement was in the minutes of the March meeting of the MPC. I was really repeating something that had already been said.

  Q9 Chairman: How long do you think it will take to occur, then?

  Sir Andrew Large: It depends, of course, what happens to interest rates, but if interest rates do rise in the manner that the market is predicting, and if you take into account repayments that are necessary on debt, quite apart from the servicing costs of interest payments, then over a two to three year period that is what would happen.

  Q10 Chairman: The Governor in his statements over the past few months seemed to be quite relaxed about the issue of debt. I have heard you on a few occasions, Governor, and now you yourself, Sir Andrew, seeming to give a different impression. The public are mixed up.

  Mr King: I am never relaxed about anything, Chairman! I think the point is that the figures that were given in the March minutes show that over the next three years, if debt were to continue to rise in the way that it has been—and there is a good reason to suppose that it would because the stock of debt is catching up with the value of the housing stock—and if interest rates were, as Sir Andrew said, to rise in line with the market yield curve, then the ratio of interest payments plus principal repayments would get back to the levels of the early 1990s over the next three years. But, and here is the very big difference between that situation and now, we can predict it now, and in the households themselves that are making the decisions. They themselves might well imagine that there will be a small increase in interest rates. They themselves understand how much debt they are taking on. This is a predictable rise in the ratio of debt repayments to income whereas in the late 1980s and early 1990s the big rise in the debt repayments and service ratios was the result of unexpected rises in interest rates, a doubling of interest rates. I think, to the extent that each household individually knows how much mortgage debt it is taking on, understands that they are expected to repay it (which they are repaying—the default ratio on mortgages is the lowest for a generation) then there is no reason to suppose that this increase in debt is in fact likely to lead to a large jolt in consumer spending, but it will help to slow down the growth rate of consumer spending.

  Q11 Chairman: When you were here previously, Governor, we did mention the issue of the data on household debts. There is a dearth of that information. You were undertaking a study of that.

  Mr King: Yes, and we published that.

  Q12 Chairman: Are we are talking about 10% of households that could find themselves in a serious situation if things turned adversely?

  Mr King: That is 10% of households with unsecured borrowing, particularly credit card borrowing. I think the point we made was that there is undoubtedly a small group of households that could find themselves in quite serious difficulty in repaying unsecured credit card debt if there were to be a further rise in interest rates to match the predictions of the market yield curve. But that group is not large enough to make a significant difference to the outlook for the macro economy as a whole. It is a problem, very much so, for those families concerned.

  Q13 Chairman: Sir Andrew alluded to the issue of income gearing implied by current and prospective indebtedness. That was in your previous MPC minutes. What forecasts has the Bank undertaken of prospective debt burden and will that be published in the next Inflation Report? In other words, will these figures be regularly placed in the Inflation Report?

  Mr King: Certainly there is our view about the aggregate position of debts to incomes and of debt relative to house prices, because that is a key part of our judgment about the outlook for the economy. The survey we carried out of individual household debt was commissioned from an outside agency, and that is not something we would do every quarter, but we will look at it from time to time.

  Q14 Mr Beard: Could you expand on the comments you made in the Inflation Report press conference when you said: "the official GDP data may not be the best guide to the balance between demand and supply in the economy as a whole" and then went on to say that "a measure of total demand for resources has risen significantly more than official GDP in both of the past two years, with implications for the degree of spare capacity?

  Mr King: The official measures of GDP have been using as the contribution of public sector output to growth of the economy as a whole an estimate of real growth based on using a deflator, a sort of estimate of the price increase in the public sector, of a very high magnitude. The implied price increase looks extremely high and it is real growth that looks rather low. That is in part because the ONS in recent years have made a very laudable attempt to switch away from measuring public sector output in terms of the inputs into the public sector and has tried to measure the outputs. That is not an easy task. In some respects, for example, measuring the output of schools in terms of the number of pupils who leave school, you immediately come across the anomaly that if you put teachers into schools, productivity goes down and the deflator goes up; there is no increase in output at all. As you know, Professor Atkinson has been appointed to conduct a review into the best way of measuring the outputs of the public sector. For many important purposes that is an extremely urgent task. If we want to know what the output of the public sector is and if resources are being used efficiently, then these measures are clearly crucial. But, and I think this is the most important point, it cannot be the case that a single statistic on GDP is the answer to every question. There is a different question one could ask, which is: what is the pressure of resources going into the public sector on total demand on resources in the economy? Resources that are used in the public sector are obviously not available for use elsewhere in the private sector. In trying to gauge what is the pressure of spending in the public sector of resources in the economy as a whole, trying to measure the degree of spare capacity in the economy, then what one has to do is to ask the question: what is the opportunity cost of the resources that are being used in the public sector? People who are employed in the public sector, whether they are being employed productively or not, are not available for use in the private sector. From that perspective, actually the old measure, looking at inputs into the public sector, may well be a better guide to trying to get a feel for how much spare capacity there is in the economy as a whole. The point I was making was: if you have two very different questions—one, what is actually being produced by the public sector and, two, what are the spare resources in the economy as a whole—you do not necessarily use the same measure of GDP. In the last year or two that has mattered because these questions would give different answers. The current official estimates of real output in the public sector are not providing a very good guide to how much spare capacity there is in the economy.

  Q15 Mr Beard: What figure should we look at to assess total demand for resources?

  Mr King: There are many ways of doing it. The ONS have not published a figure based on the way they used to do it, which was looking at inputs into the public sector rather than outputs. I think the order of magnitude of the difference between the two is anywhere between 1 and 1.5%. These are quite big figures in assessing the degree of spare capacity in the economy as a whole. That is why when we look at spare capacity in the economy, we prefer not to look at a single measure based on a so-called output gap but to look at the labour market and what we think the pressures are there, and surveys of spare capacity in individual industries and so on, to try to get an overall view.

  Q16 Mr Beard: What are the implications of your comments on the use of GDP-based estimates of the output gap that have been used in the Budget for public finance projections?

  Mr King: I think it raises the question about the switch to trying to estimate the output of the public sector in terms of what its real outputs are rather that the inputs. That may be a very sensible thing to do if you are trying to gauge what the public sector is producing, but it may not be the right answer to a different question, which is: what is the output gap? You have a different deflator technically.

  Q17 Mr Beard: Is the implication also that you do not think the output gap is as big as is being estimated in the Budget?

  Mr King: The Treasury have a different method of measuring the output gap and it is not easily comparable with the Bank. I think the Bank takes the view that obviously there is not a lot of spare capacity around but I think these are different concepts; they are not strictly comparable.

  Q18 Mr Beard: The IMF believes that the UK economy will be above trend by mid-2004. Given the rising inflationary pressures in your projections, is that close to the assumption that the Bank is making?

  Mr King: We do not have a precise figure for it because it is very hard to know what the trend is, even what current output is. The figures are being revised all the time. We have not even seen a first estimate yet for the first quarter. So that is really a central view. We have—and it is clear from our February Inflation Report,—that we do think there will be some underlying upward pressure on inflation in the economy from the pressure of increased demand on supply capacity. That will be offset to some extent by the impact of the higher exchange rate that we have seen in recent months, but nevertheless it is not a large pick-up in inflation from 1.3% to around 2% at the two-year horizon, but it is in that direction and it is because we think there will be a pressure of demand on resources.

  Q19 Mr Beard: Marian Bell, in November you voted against the rate rise, in part because you were optimistic about the extent of potential supply and spare capacity. Are you still as optimistic?

  Ms Bell: I am, and in fact some of my views I think are now embodied in the committee's central projection, but other things have also changed. Most significantly we have had a stronger growth performance and we are expecting an acceleration going into this year. So we are looking at a much stronger growth forecast now than we were in November, and that has offset the impact of the rather better assessment of supply.


 
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