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.
| 
