Examination of Witnesses (Questions 20-39)
25 MARCH 2004
MR MERVYN
KING, SIR
ANDREW LARGE,
MS RACHEL
LOMAX, MS
KATE BARKER
AND MS
MARIAN BELL
Q20 Mr Beard: What are the factors that
have led the MPC to revise its assumptions on the flexibility
of the UK labour market?
Mr King: I think over a number
of years we have seen much less upward pressure on wages and earnings
in the labour market, given the level of unemployment. I think
we have learnt, over the last six or seven years, that the changes
in the labour market that have taken place, over a long period
now, but also including the New Deal and others since 1997, have
enabled unemployment to fall without generating upward pressure
on earnings. How far this so-called natural rate of unemployment
is likely to fall is unclear. I think the Committee have taken
the view that since there has been some reduction in that rate
of unemployment in recent years, rather than assume that there
will not be any further reduction, we have assumed that in the
central case there could be a further small, but it is only a
small, reduction in the natural rate of unemployment over the
next few years. It does not make a significant difference to the
forecast but we felt that we should recognise that there have
been improvements in labour market performance and it would be
slightly strange in the central view to assume that there would
not be any further improvements at all. But they are not large.
Q21 Mr Beard: How much have these developments
added to your assumptions on the future growth potential of the
economy?
Mr King: That is the main reason
for the judgment, that there is a very small increase. Since there
was a change, we felt that we should record it, but it is not
quantitatively very large at all.
Q22 Mr Beard: Does the Bank have a view
on the possible effects of the EU enlargement on the labour market
of these sorts of issues?
Mr King: I think it is an imponderable
issue that could be of great importance because obviously when
you use terms like "the trend rate of growth" or "the
output gap", the assumption behind the use of those words
is that there is some clear constraint on the supply of labour
to the economy. To the extent that it is possible for new employees
to come into the economy easily and respond to a small increase
in the demand for labour, then actually it is much less obvious
that there is a constraint on the supply of labour within the
boundaries of the United Kingdom. That could have quite a significant
impact in terms of how rapidly the UK economy could grow, the
relationship between the rates of growth of demand in the short
run, and whether there was any upward pressure on earnings and
wages. So this is potentially an important issue, but I think
it is very difficult for us at this stage to judge quantitatively
how significant that will be. It is important because, as I said,
conceptually when you use words like "the trend rate of growth",
lying behind that is an assumption that there is a fixed growth
rate of labour supply. If that is not the case, then the whole
notion of a trend growth rate falls apart.
Q23 Mr Beard: Is the restraining factor
the actual quantity of the labour supply or is it the availability
of skills within the labour supply?
Mr King: The views that we hear
from businesses around the country, I think, are that what they
focus on at present is a shortage of skilled labour. Of course,
given that not all labour is likely to be skilled, that may be
a proxy for talking about shortage of labour as a whole, but what
employers talk about all the time when we speak to them is a shortage
of skills.
Q24 Mr Beard: What factors are behind
the rise in self-employment that you record on page 23? Is it
a preference amongst some workers for self-employment or does
it reflect a lack of employee job opportunities?
Mr King: I do not know, and I
think one has to be careful before drawing strong conclusions
from the latest numbers because the very latest numbers show the
opposite, which is that the number of employees has risen quite
markedly in the past quarter. It may well be just fluctuations
in the way the data are recorded. Certainly, when confronted with
the data, we could not think of a really convincing explanation
for this. The latest data, as I say, seem to undermine the observation
that the increase has in fact been in self-employment rather than
employment.
Q25 Mr Beard: But the drop in private
sector employees looks quite a big trend over the last three years.
Mr King: That is true, but there
has been an increase in the latest observation. I would hesitate
to draw strong conclusions about that observed switch to self-employment.
There may have been temporary factors, which are now unwinding,
tax factors and so on. I would rather wait and see more data.
As I say, this phenomenon has been reversed in the latest statistics.
Q26 Mr Heathcoat-Amory: Governor, you
have just made some very interesting comments about measurement
of spare capacity. You are clearly hoping for a different methodology
than that used by the Treasury. The difference you said might
be very significant indeed. This is of crucial importance at this
stage in the cycle because growth is unexpectedly high, particularly
for consumer spending. This is leading to debt. There is a very
high and obviously vulnerable property market. Do you have plans
to reconcile your model with that of the Treasury so that we can
at least get a kind of unity from official sources about the degree
of spare capacity that may exist?
Mr King: There are obviously a
lot of conversations taking place now in the context of the Atkinson
review. I do think that it is one of the issues that has become
more clearly understood because it has mattered in the last year
or two whereas before it did not really make much difference.
There is a clear understanding that there is no single measure
of GDP that answers all questions, and therefore you need to be
very careful about what the aim of the measurement is and then
from that will follow the correct way to measure the output in
the public sector. In terms of spare capacity, we have always
had a somewhat different methodology from the Treasury. The Treasury
look at data on output and draw lines from the top of one peak
to the next peak. We have a different approach, which tries to
ask the question: given the labour supply in the economy, given
the amount of capital in the economy, what is the potential output
that is capable of being produced? Changes in the composition
of output between investment and consumption will affect our view
about potential output in a way that would not necessarily hold
true of the Treasury. So there are rather different concepts.
I think that is one reason why it is important not to put too
much weight on small differences. In the last year or so, the
difference has not been small and it is important. There are conversations
taking place. I hope that we shall be able to get to a point when
it will be easier to answer this question.
Q27 Mr Heathcoat-Amory: I take it from
that then that you simply have a different view to the Treasury
at the present time about spare capacity. You are using a variety
of models but the Treasury are not tempted by your one and you
are not satisfied with their one. I take it therefore that you
think there are tightening capacity constraints. In your opening
statement you made the interesting observation that the rises
in interest rates so far should lead to some slowing of the pace
of expansion which should follow, indeed be highly conditional.
Then you observe that this itself will lead to greater imbalance
in the economy because of course it has already led to a strengthening
of sterling. We are already running an unprecedented balance of
payments deficit. Are we not facing a real problem here that,
in the absence of an activist fiscal policy—and officials
over the last few days in giving evidence to us have only referred
to the automatic stabilisers, that there is no appetite for fiscal
tightening—and so relying entirely on monetary policy, you
are faced with a very difficult situation of having to moderate
consumer demand in the light of very unexpected buoyancy with
sterling tightening, which will lead to a further accentuation
of the problem that you allude to in your opening statement? Can
you comment further on how you see this balance developing between
consumer demand and the rest of the economy in the light of your
comments?
Mr King: I think the situation
you describe is, in a sense, our job description. We are paid
to face these problems and to cope with them. I certainly would
not expect fiscal policy to be there to help us out. The job of
fiscal policy is to decide the total level of spending and the
total level of tax and within spending, what kinds of spending,
and within tax, what kinds of tax. All of that is subject to an
overall framework to achieve medium-term fiscal sustainability.
I think that is quite enough for fiscal policy. I think it is
down to monetary policy to try to ensure that we keep close to
the inflation target and thereby achieve stability in the economy
as a whole. In terms of whether we will get to a more balanced
position in the economy, I do think there are some positive signs.
Although we have not yet seen a slowing of consumer spending,
I do think there are good reasons for expecting that we will see
some slowing of consumer spending. There are good reasons for
supposing that income growth will not be as rapid or as buoyant
as it was in earlier years, and we are now seeing much more optimistic
business surveys, for both business investment and exports, than
for some years. That is a positive sign. Of course, the rate of
growth of government spending, which has been contributing to
the growth of output, is in turn planned to slow down. I do see
in prospect a good chance of a rebalancing of the economy. The
precise timing of it can never be certain, and nor can one be
sure: there are obviously risks on both sides. I think that rebalancing
is something we would find very welcome. There are more positive
signs, though, and I certainly would not claim that as yet we
have started to see the rebalancing. I think it is perfectly right
to point to the rise in the exchange rate in the last couple of
months as something which will defer that rebalancing.
Q28 Mr Heathcoat-Amory: You have just
said that export prospects and investments are comparatively good.
I am putting to you that this may be in the light of people not
anticipating the rise in interest rates that flows from your more
pessimistic assumption of capacity constraints and the different
output gap measured by you than that assessed by the Treasury.
You clearly take a different view of the output gap. You have
been taken by surprise, as has the Treasury, by the strength of
demand. Interest rate rises are therefore almost certain, particularly
as you have just said you are not relying on fiscal policy at
all, although the Red Book points out that in the late Nineties
a tighter fiscal policy did operate on demand. So that is excluded
from what you have just said. Maybe we are therefore facing a
problem in the real economy flowing from these interesting remarks
you have made about the lack of spare capacity.
Mr King: I think, with respect,
that is exaggerating it a little bit. Maybe technical methods
of calculation of the output gap between the Treasury and the
Bank are somewhat different. There have always been different
methods but it is interesting that the forecasts that flow from
that are very similar. The forecasts for output growth that the
Bank and the Treasury are making are really very similar over
the next two to three years, as are indeed the projections for
inflation. Whatever assumptions are being made about the output
gap, those do not flow through to different views about the outlook
for the economy. I think that is a very important point to take
on board. We have made our judgment: they have made theirs quite
independently. Their view for growth of output in the UK economy
is broadly similar to ours, as is indeed the path for inflation
which they say is implied by their forecast. In that sense, there
is not actually any significant difference, as far as I can see,
between the two views.
Q29 Mr Heathcoat-Amory: I am sorry, but
I heard you say earlier when you were describing your different
authorities that the difference could be significant.
Mr King: The difference in the
measure of the output gap may well be significant, but it does
not seem to follow through to the forecast. Our forecast has inflation
moving up towards the inflation target, as does the Treasury's,
and they have a growth of total output very similar to ours. There
are all kinds of technical methods of trying to measure the output
gap which give different answers, but, in the end, if you are
using the output gap to try to project inflation, you are going
to be constrained by the past relationships between output growth
and inflation. In the end, the forecasters will come up with rather
similar looking forecasts because there has not been any underlying
change in the relationship between output growth and inflation.
I can only explain our forecast. Our forecast is one in which
there is some upward underlying pressure on domestically-generated
inflation from the pressure of demand on supply capacity that
is moderated somewhat by the rise in sterling, and the net result
is that inflation picks up from 1.3% to about 2% in two years'
time. I am also much less confident than you are about where interest
rates will go. I am never confident of that and it is something
I prefer to take one month at a time.
Q30 Mr Walter: Governor, if I can go
on with this whole question of fiscal policy just for a second,
obviously we had the Budget last week. The Chancellor appeared
before this Committee yesterday. One or two commentators have
raised some concerns. I wanted to refer you briefly to the IMF's
Article IV report, which also came out this month. The Executive
Board assessment said that in noting the widening fiscal deficit,
including in structural terms over the last three years, the Directors
concurred that the fiscal deficit needs to decline in the period
ahead in order to observe the fiscal rules, strengthen fiscal
fundamentals and support monetary policy during cyclical upswing.
If one looks deeper into the report, and it is laced with various
phrases in the staff report, it talks about reducing the risk
of large and unexpected interest rate hikes that may prevent a
soft landing of consumption and the housing market. Given that,
what are the implications of the changes in fiscal policy, or
lack of changes in fiscal policy, announced in the Budget?
Mr King: I would have thought
that almost all of that could have been in the Budget speech itself
since there are declines in the deficit implied by the Budget
forecasts. Indeed, there is a clear recognition that over the
past 12 months the deficit that has corresponded to a particular
growth rate has turned out to be much larger than was expected.
There are many reasons for that. The Iraq war is one; unexpectedly
higher take-up of credits and spending is another; and weaker
tax revenues is a third. Those are the reasons why the deficit
has turned out to be larger than was expected when the Treasury
made its forecast at the time of last year's Budget. Looking ahead,
as I understand the projections, it is for deficits to come down,
and that is clear from the forecast, which I take to be central
projections in the Red Book.
Q31 Mr Walter: So you are entirely confident
with the fiscal projections which are in the Budget and you do
not think that those are going to place pressures on you?
Mr King: They are central projections
and I am never confident. The only thing you can say about central
projections is that they hardly ever materialise. We are pretty
confident that, whatever turns out to be the Budget deficit, it
will not be precisely the numbers that are in the Red Book. The
question is whether that is a reasonable central view. I think
this is something on which you are better placed than we are to
ask experts and commentators to engage in a debate. The Treasury's
technical judgment that lies behind that central view is that
the share of tax receipts in GDP will rise by 2 percentage points
over the next three years. That is clear from the Budget forecasts
in the Red Book. What I draw comfort from, I think, is the fact
that we have a clear set of fiscal rules because if it turns out
that over the next year or two revenue is not rising as a share
of GDP in the way that is in the central forecast in the Red Book,
then the Chancellor will have a choice between either failing
to meet the fiscal rules, which would be very damaging to the
credibility of fiscal policy, or making some adjustment in either
spending or taxes to meet them. I cannot forecast the future and
anyone who pretends to know precisely what the Budget deficit
will be is clearly wrong. These are central views. It is important
we have a good central judgment but no-one can pretend that these
are going to turn out to be necessarily accurate. What matters
is that we have a framework in place such that you will be in
a very strong position to say, "The forecast is not working
out as was expected in the central view. Do you now think that
some further adjustment is necessary?" There is a very clear
framework and Treasury has put itself on the line here in terms
of saying that these are the rules by which they wish to be judged.
I think that is what gives us comfort. It is very important to
us that those rules are met and that there is a framework to ensure
they will be met.
Q32 Mr Fallon: Governor, you distinguished
earlier on between fiscal and monetary policy, but two days before
your February meeting we had an intervention by the Government's
most senior economic adviser on interest rates. Is that the first
time since the Bank was made independent on monetary policy that
that has happened?
Mr King: I do not know. I cannot
recall another one but I cannot be entirely sure.
Q33 Mr Fallon: Have you had an apology
for that?
Mr King: No, I have not received
any communication on it, nor do I necessarily think I should have
or would have expected one.
Q34 Mr Fallon: Presumably you want to
preserve the independence of the Bank. Have you sought any reassurance
that you will not get an intervention like this again?
Mr King: We have not had any.
Ever since 1997, as I have said to the Committee before, there
has not been a single occasion when the Committee has been pressured
to make a decision or offered advice publicly or privately. The
comment that was made was merely to offer general support to the
MPC. The comment that I made at the press conference was that
any such remark made just before a meeting can obviously be misinterpreted
or exaggerated by the press. That is why we on this committee
have a strict purdah for the week of our meetings. I am invited
to speak at many conferences but I have said, "No, I will
not speak on monetary policy during the week of the decision"
and no-one on the committee does.
Q35 Mr Fallon: Do you think it is appropriate
that a Treasury Minister or very senior economic adviser equally
should comment just two days before a decision?
Mr King: It is entirely up to
them what they choose to do. I think there are merits in the purdah
system. Certainly we intend to pursue that.
Q36 Mr Fallon: You would have preferred
them to have been silent, would you?
Mr King: I am happy to leave it
to their judgment but I think they know what we do.
Q37 Norman Lamb: On the central issue
of the interest rate decision, I want to look at what appears
to be a debate between the gradualists and the shock troopers,
as they were, as to how one deals with consumer spending and seeking
to suppress that. Roger Bootle in a submission made the point
that the November rise appeared to have had little effect and
that early evidence was that the February rise was not encouraging
either. He then poses the question: "Would the MPC consider
a change of tactics? Has the MPC considered the idea that 0.25%
rises which are fully expected make little impact and hence may
have little effect? Under what circumstances would it be appropriate
to raise rates by 0.5%, or even 1%? Does the objective of promoting
credibility and transparency rule out raising rates when the markets
do not expect a rise?" I would be interested in your response
to that. I would also be interested in some other views about
this debate. By signalling explicitly a gradual approach, is there
a risk that the increases are so small that the consumers simply
ignore them?
Mr King: Let me start and then
pass it on to others for views. I think there are several different
aspects to the decision that you have wrapped up into the question.
One is what I will call the gradual approach, which we call the
more cautious approach, following the November rate increase.
Then there is a question of dealing with consumers. Then there
is a question of surprise. I think all three are rather different.
On the first, I think we were concerned, when we were contemplating
making the first rate increase for over four years, that there
could be a jolt to asset prices through financial markets. That
was the experience of the Federal Reserve in 1994, even though
they had tried to prepare the financial markets for an increase,
and that had quite a significant impact then on their long-term
interest rates. I think we were keen to avoid that. So we did
make a small move, and we explained it carefully and explained
that our view was that we were cautious in part because, given
the high debt levels, it was unclear. We were just genuinely uncertain
as to how consumers might react.
Q38 Norman Lamb: And they did not react?
Mr King: Well, so far we have
not seen any reaction but, after all, we have only got initial
data for the fourth quarter. They would have to be pretty quick
off the mark for a November rate increase to have a drastic effect
even on the fourth quarter's spending. So we were deliberately
cautious in thinking about the way we would adjust interest rates.
That was because we were uncertain about how interest rates would
feed through to the economy, given that it was the first rise
in four years. On the second one, on consumers, there is some
discussion in the minutes. We have put it almost as a devil's
advocate question on the table. No-one advocated raising interest
rates by a lot in order to jolt consumers, as you can see from
the votes of members. So no-one voted for that. But it was a devil's
advocate argument: was there a case for considering a large increase
in interest rates to jolt people out of their spending habits?
It was worth contemplating but I do not think anyone felt there
was real substance to this because it would mean basically saying
that households did not know what they were doing. I think, going
round the country, we find people are well aware of the fact that
interest rates have now gone up by 50 basis points and they take
that into account in their decisions. They are very conscious
of the debate on interest rates and the fact that they might go
further. The third one is surprise. Here I think we on the committee
have never been deflected from making a change in interest rates
that we felt would be appropriate, even if it were to surprise
markets. We did that a year ago, in February last year, when we
changed our view about the state of the world economy and people
were not anticipating that. It was only when they saw the Inflation
Report that they realised the connection between the decision
and our then judgment of the economy. But we do not set out to
surprise people. We see merit in not surprising people. We very
much want this debate to be one in which people look at the developments
in the world and in the British economy and say, "Well, given
what is happening in the economy, it is not surprising if rates
were either to rise or fall".
Q39 Norman Lamb: You reject the thesis,
as it were, that to surprise people might actually be a sensible
thing to do to change behaviour?
Mr King: I do not rule out that
there might be circumstances in which for a specific reason or
a specific type of behaviour that would be worth contemplating.
I suppose the sort of situation in which people have talked about
this is in the context of a rapid change in asset prices. Remember
that that has not been very successful. When Alan Greenspan did
his retrospective analysis of monetary policy in the United States
over the last ten years, his view was that the kind of jolt that
you would need to prevent a continuation, say, of an asset price
boom, would be such as to cause substantial falls in output and
spending and the effect would be worse that what you were trying
to offset. There may be circumstances in which that would be worth
considering, but I do not think anybody on the committee felt
that in the present circumstances there was a case for doing that.
The general proposition is that in principle I would prefer not
to surprise financial markets, but that does not mean to say that
the path of monetary policy will be altered because of the fact
that people do or do not expect changes. If we think a change
is appropriate, we will make it, whether or not people expect
it, but we would like to operate in such a way that our decisions
were predictable.
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