Select Committee on Treasury Minutes of Evidence


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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