Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 40-59)

25 MARCH 2004

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

  Q40 Norman Lamb: Are you all gradualists? Could I ask Kate Barker?

  Ms Barker: I am not sure that I would necessarily describe myself as a gradualist but I certainly do not subscribe to the view that surprises, not fully justified in terms of what we think is going to happen to inflation and the inflation target, would be the right way to proceed. You made the point in your question that if you do start to proceed in that way, there then start to be questions about credibility and what you are actually trying to do with monetary policy. I think the costs of going down that route therefore, in the long run, are very considerable. In terms of what is happening to the consumer at the moment, given the comments that have already been made about debt, I think that jolting the consumer too much might be a rather dangerous tactic.

  Q41 Norman Lamb: This is a bit of balancing act here?

  Ms Barker: It is indeed. After all, it is rather early to judge the full effect of the rises in interest rates that have taken place. It is certainly the case that one of the things that was on our minds, and the Governor has already talked about it, when we made the first rise in November was that because it was the first rise for some time, we might get an unexpectedly big short-term reaction. We did not get that. We certainly do not know at this stage what the full effect of the rises that we have put in place is. My view is that the right way to proceed is always to make changes in the interest rates that are justified by our views about the inflation target. At the moment, since we are not talking about a large overshoot of the target, that is an argument for the small changes we have made.

  Ms Lomax: We have not seen the need for large increases in interest rates. If you take an overview of the pressures on inflation, the case for it is not made. You can look at the balance of risk, but this is not just about controlling consumer behaviour. This is about taking an overview of the inflationary pressure across the whole of the economy. Perhaps the public debate focuses excessively on consumer spending and the housing market to the exclusion of other relevant considerations. That is the first point I would add to what people have said here. The second is on the question: is it right to surprise or not to surprise the market. If we have an open and transparent framework for monetary policy and we explain ourselves clearly and we are taking decisions on the basis of information which is available to everybody else, our actions should be pretty predictable. If we do things which are going to surprise the market, we should have a very good, clear reason for it. If you cannot answer the question "why are you surprising people in the markets?" in a clear and convincing way, then you should not do it. You are probably wrong.

  Q42 Norman Lamb: Sir Andrew, you do take something of a different view. You have talked specifically about your concerns about household debt. You have done a whole speech on it. You were described yesterday in The Financial Times as the "Bank hawk". You have talked in your speech about credible threats. I think that was the phrase that you used. You have a greater concern here, do you not, and you have consistently voted for rate increases. Why do you take that view?

  Sir Andrew Large: Are you wanting me to talk about gradualism or caution?

  Q43 Norman Lamb: Yes.

  Sir Andrew Large: I think you used the words yourself that it is a matter of balance between cause and effect. I think the other point that perhaps is worth drawing out is that, as the Governor said, there may be some element of distinction between surprise in relation to the direction of rates and surprise in relation to the timing, and so I think it is important to bear both things in mind.

  Q44 Norman Lamb: While I am with you, can I just put to you what the Chancellor said yesterday? He seemed to take, some might say, an almost complacent view of the risks that household debt could pose and did not seem to take any view of the credible threat that you talked about. He talked about debt servicing costs equalling 7%. I thought you were indicating it was nearer 10%. He says, "This is a reflection of the course of low interest rates but I do not think anyone, including the Deputy Governor, is suggesting that we should be returning to interest rates of the early Nineties". But you are saying that if interest rates continue in their current trend, we will get debt service costs similar to, if not equal to, those of the early Nineties, are you not?

  Sir Andrew Large: This is in relation to the rates in the marketplace, and so in that sense if debt levels rise also, as the Governor said, yes, that is the way that the arithmetic goes.

  Q45 Norman Lamb: So the Chancellor was wrong in discounting that?

  Sir Andrew Large: I do not think the Chancellor was wrong. I think the Chancellor was referring to the central case. I think he was also referring to figures that are quite recent rather than looking ahead. That was my interpretation of it.

  Q46 Norman Lamb: At what point in interest rates do we get to that point where the debt service levels are similar to the early Nineties?

  Sir Andrew Large: Depending on the assumptions that go into it, you are looking at two to three years ahead.

  Q47 Norman Lamb: So that is the crunch point, is it? That is the period that you would be most concerned about?

  Sir Andrew Large: Yes. Whether it is precisely two or three years, it is difficult to say, but perhaps I could just say this. Some people will describe others by birds' names, et cetera, but these decisions are very much a matter of balance and at the margin. The point that I have been trying to make is that I do see a possible risk, not a strong likelihood but a credible threat that, under those circumstances, looking ahead, there could be a downwards move in demand as a result of this that would make it difficult, or more difficult, for us to continue meeting the target that we have. So that is why, given that I see it as a credible threat, I take it into account.

  Q48 Chairman: Marian, would you like to comment?

  Ms Bell: I agree with a lot of what has been said, but I would just like to emphasize that our remit is to target inflation, not house prices, consumer debt or any particular source of demand, such as the consumer, so in our discussions the focus is very much on how these things would feed into inflation. I would certainly agree with the point of view that if you were to try and prick a bubble of any sort, the sort of interest rate changes that might be required to do that could do damage to the economy and lead to a failure to meet the remit in the short run. With regard to gradualism, that is what our forecast implies at the moment. We expect to under-shoot the new target for most of the next two years. If we did not see the kind of slow-down we are expecting, and if it looked as if we needed to do more, more quickly, more aggressively, on interest rates, then I am sure we would do that, and hopefully that would be well expressed and understood by the markets.

  Q49 Chairman: Rachel, you mentioned something about household debt but, given your views about the growth of household debt, why did you not join Sir Andrew in the past few months in voting for increases in interest rates?

  Ms Lomax: What views do you think I hold about household debt? I think I made that clear in a speech I gave in Bristol recently. I regard the build-up of debt as an issue which is one of the balance of risks that we look at. We do endlessly discuss some of the issues that we have been talking about this morning.

  Q50 Chairman: So you think it will take quite a long time to get back to the level of household debt we had in the Nineties? I am talking about the headlines that were put to Sir Andrew's speech the other day. How long do you think it will take us to get back to that, or do you not think we will get back to that?

  Ms Lomax: Andrew was talking about the levels of debt service, I think, the proportion of income that would be taken in servicing debts, assuming that the debt/income ratio goes on rising. I would think that what the press say and what Andrew said in his speech may be two separate things on one or two issues. I have read the speech a couple of times so I know what he was trying to say.

  Q51 Chairman: It is important for the market and the press to have an understanding of what the view of the MPC is. It is with that in mind that I am trying to get clarity at this point.

  Ms Lomax: Yes, and I am very happy to answer your questions. Can I go through it again? The point that Andrew was making, which, as you said, we had made in the minutes, and we have actually made in the inflation report a couple of times, I think, is that if the debt/income ratio goes on rising as borrowing catches up with the increase in the value of the housing stock, as the Governor explained, and as we think is likely to happen, and if interest rates rise in line with market expectations, you will see a rise in the proportion of income which has to be devoted to servicing and repaying debt. The question is, what impact will that have on consumer spending and what else will be going on in the economy at the same time, and through all that, what impact will that have on inflation? There are a lot of imponderables along the road to answering those questions, and I think the exercise we go through when we do the inflation report and when we take interest rate decisions is about weighing those risks at each stage. I would not say that just because income gearing rises over the next couple of years that it will necessarily cause problems either on a central case or on a balance of risk analysis which suggests we ought to be putting up interest rates now. But I do think these are issues we need to reflect on and set against the other risks that there are about, risks to do with the world economy, what is happening with the exchange rate and all the rest of it. This is not the only material source of risk at the moment.

  Q52  Chairman: Sir Andrew, just to finish this, if you had been writing the headline for the newspaper yesterday, I gather you would not have written that.

  Sir Andrew Large: I would not have written that headline.

  Q53  Chairman: What would your tabloid headline have been on your speech? What would you have said? To make it easy for the consumer, what would you have said, in half a dozen words? I will give you time to think about it.

  Sir Andrew Large: If you give me a little while, I will try to think one up. I am not a great headline writer.

  Q54  Chairman: Before you leave, you have to answer, Sir Andrew.

  Mr King: Can I just make one point? All this debate on debt is actually summarised at paragraph 14 of the Committee's March minutes. The key sentence, reading straight from the March minutes, is "The income gearing implied by current and prospective indebtedness, if interest rates followed the trajectory implied by market forward rates, would reach levels last seen in the early 1990s within two or three years. A key difference, however, was that this increase could be anticipated, as it was not the result of unexpected policy changes . . ."

  Chairman: That is not a snazzy news headline, is it?

  Q55  Mr Walter: I wonder if we could look for a moment at the international value of sterling. Sterling seems to have recovered most of the weaknesses of last year, with the trade-weighted index at around the 105 mark, which is roughly its five-year average. The dollar has been particularly weak. What do you attribute the current value of sterling to? Is it your monetary policy or is it somebody else's monetary policy?

  Mr King: I do not know. I do not think it is either our or other people's monetary policy, because we look quite carefully to see whether the changes in sterling in recent months—the last two months is when it has picked up again—occurred in the wake of changes in either actual or expected interest rates as revealed by the market yield curve. There is very little evidence that in fact the movements of sterling can be attributed to movements in the yield curve, so that is an explanation that we do not attach much weight to. In the March minutes we did go through various possible explanations for the rise in sterling, noting that sterling had risen against most other currencies, that the recent pick-up was not against one currency or another but against the generality of other currencies, and I am afraid that we could not come up with any convincing explanation, so I am afraid the answer is we do not know.

  Q56  Mr Walter: That is a fair enough answer. Can I move on to perhaps a more technical question, and that is the composition of the basket for the trade-weighted index. There has been quite a bit of comment recently suggesting that this is out-dated and that it needs revision. Do you have any views on that?

  Mr King: This is not a new issue. This has come up at regular intervals in the last ten years, I believe, and we do internally look at a broader exchange rate index as well as the narrow index. We would very much like to be able to move on from where we are because in order to construct the current effective exchange rate index, we use trade weights for other currencies, which are given to us by the IMF because they have the source of data for trade among countries, and it is very important that we look not just at trade directly between the UK and other countries, but at the impact of third party relationships, trade between the dollar and euro area, in order to calculate the true effective exchange rate index. This is not something that trade data available to the UK authorities is sufficient for. You do need a broader set of trade data, and their figures are certainly very much out of date. We have been talking to the IMF about whether it is possible for them to update their estimates, and I hope we will see progress in that direction. To offset that, we have, as I said, looked at our own index, both in the current narrow form but also in a broader form, expanding the number of countries to around 50. It is true that in the last couple of years that exchange rate measure has risen more than the narrow effective exchange rate index, and that is something that we can take into account in coming to our judgments. It is not true that that broader index is a better guide in the longer run, because one of the reasons why it has moved around a good deal is to do with the very sharp changes in currency values in emerging markets. Sometimes they are so large that you can be confident—and indeed, they have been followed by changes in inflation, so that big movements in that kind of index do not signal changes in competitiveness, because they are likely to be offset by inflationary consequences of the exchange rate changes themselves. We would very much like to find a way of updating the weight and expanding the coverage of the present index to include services, more countries and so on. We are thinking of ways of doing it. We do think it makes sense to try to do this in conjunction with the IMF, we are certainly working with them on that, and when we have something to produce or announce, we will do that and we will let you know.

  Q57  Mr Walter: In your February inflation report you said you were looking for a solid recovery in export growth in the near term. However, in the annexe to the March MPC minutes in the data that you use, you refer to the fact that total exports had risen in the fourth quarter by 1.8% whereas total imports had risen by 2.2% and then even adjusting for the effects of missing trader intra-community (MTIC) VAT fraud, export and import growth had been estimated at 1.95 and 2.4% respectively, so the proportions are roughly the same. Has the recent data on the trade deficit changed your views on export growth?

  Mr King: No, because I would not want to put very much weight on any single statistic, and certainly not in the trade area. They have been very volatile from quarter to quarter, they are often volatile from one half of the year to the next half of the year. And there have been major statistical problems to do with the recording of both exports and imports. We hope we are coming to the end of that, but I am far from confident that we have got to the end of that period of difficulty. I would not want to put a strong judgment just on the latest statistics—certainly not—and I am very unconfident on what the outlook is for the trade position. All I would do is refer back to what I said earlier, which is that the business surveys themselves appear much more buoyant about export prospects than they have really since the mid 1990s. It is quite a noticeable change. Whether that will feed through given the recent rise in the exchange rate remains to be seen. It is something we will watch carefully. It is extremely hard to measure these data accurately, and we have seen specific problems to do, as you have mentioned, with VAT fraud, but there is also the new method of recording statistics in Customs and Excise. Both of these have given quite different problems to the analysis of the trade data, and all that comes on top of the usual volatility. So I think it will be some time before we can be confident of how that picture is evolving. You talked earlier about the trade deficit and how it will move. We have seen very significant revisions a year or two down the road to the figures for trade and services, so again, one cannot be confident of what these data really mean at this stage.

  Q58  Mr Walter: The recent trade data have indicated that the depreciation of the dollar is causing some difficulty. Your regional agents indicated that exports to the US were only profitable below an exchange rate of $1.60-1.70. Does that cause you any concern?

  Mr King: Some say that. I do think that, compared with where we were a couple of years ago, the balance of exchange rates is one that people find much more acceptable than was the case before. Obviously, individuals who focus entirely on the dollar market or the euro area market will have views relating solely to the bilateral exchange rate, but there is no doubt that we were at an exchange rate against the euro that it was difficult to believe was likely to prove sustainable, and it has not proved sustainable: the exchange rate against the euro has come down quite significantly compared with where we were. Against the dollar, clearly, we have gone up. But in part that reflects the fact that the US economy has a very large current account deficit. For many years economists have been saying that the dollar would fall and it did not. But in the end it did, and it has fallen quite significantly over the past two years. Its effective exchange rate index is now 12% down, despite the recent recovery. Who knows where it will go in the future? However, I think this change in exchange rates has given us a better balance within the overall effective exchange rate index.

  Q59  Mr Walter: I want to move on and make a comparison. You have just mentioned the US current account deficit, which is causing a problem, and the US current account deficit of course is generally financed so long as foreign investors are prepared to buy dollars, particularly Asian central banks. We have been running a current account deficit since 1982, and it is becoming almost structural. Does that give you any concern, and do you believe that we also have the ability, like the United States, to finance that virtually ad infinitum?

  Mr King: I think there is a big difference in the scale of the current account deficits between the US and the UK. That, I think, is very relevant to the question of whether one can continue to finance it, because the scale of the US deficit was financed initially by large inward direct investment and inward portfolio equity investment, and there has been a change in the nature of their financing flows; it is much more short-term now, increasing short-term dollar-denominated assets, and obviously particularly increased holdings by Asian central banks. It is not obvious that that will go on indefinitely, so I think there is a much stronger case for supposing that there will be a change in the financial flows to the United States than in our case.


 
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