Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1-19)

8 JUNE 2004


  Q1 Chairman: Good morning and welcome. Would you mind introducing yourselves for the benefit of the record?

  Mr Walton: David Walton, Chief European Economist Goldman Sachs.

  Professor Miles: David Miles, Professor of Finance, Imperial College, London.

  Mr Bootle: Roger Bootle, Managing Director of Capital Economics.

  Q2 Chairman: Thank you very much. We intend to spend around an hour with our first set of witnesses and we have quite a lot of questions and brief answers to come. We will try and direct our questions at one of you so that we can end on time and cover all of the ground. As the MPC meeting begins tomorrow is it time for the first Bank rate increase since February 2000?

  Mr Walton: I think it is. I think the precise timing from month to month does not matter too much. I think the situation we face in the UK is one in which the economy is growing faster than trend, there is not that much slack and further tightening is appropriate over the course of the next few months, so the MPC might as well get a move on and move it this week.

  Q3 Chairman: The MPC's forecast for the profile of GDP growth is for growth being stronger in the near term due to higher household spending but significantly weaker going out towards 2005-06 due to weaker consumption and investment. Do you agree with that, David?

  Professor Miles: It seems to me quite a sensible profile, as indeed is the profile for inflation. In fact, on the basis of those profiles the case for changing interest rates is really not a very strong one. If one looks at the inflation forecasts for example, the central expectation is that inflation stays under 2% for nearly all of the next two years and just about gets back to the target of 2%, in fact very slightly above it, two years from now. If one just looked at that picture, focusing on the overall inflationary situation and the level of demand in the economy, the case for a rise in interest rates is less than compelling. I think the big question—and I am sure we will come on to it—is the situation in the housing market and that is the central issue for the Bank at the moment.

  Q4 Chairman: Roger, recent data on the trade deficit, retail sales and the housing market seem to suggest little rebalancing in the economy. The MPC's projections are forecasting higher but more unbalanced growth in the near term. When are we going to see the long awaited rebalancing of economic growth and maybe have the house price crash that you have been predicting for the past couple of years?

  Mr Bootle: I do not think it is possible for the MPC to control the degree of rebalancing. What that really requires is a much weaker exchange rate combined with a further revival of world demand. My guess is that it is going to take a significant weakening of the housing market to bring about the circumstances which can lead to a significant rebalancing. A significant period of weakness in the housing market will lead on to much lower interest rates and that, in turn, could well undermine the pound and that would bring about the rebalancing.

  Q5 Chairman: What about housing?

  Mr Bootle: I think the Bank is in a very difficult position. It is going to take something of a shock to change the mood of the housing market. Whether that shock is back to back increases or a ½% increase is debatable, but I think it needs something.

  Q6 Chairman: Do you agree with the MPC that the spare capacity will be eroded quickly and the economy will be above trend throughout most of the forecast period, leading to a steep pick up in inflation towards the end of the forecast period?

  Mr Walton: I do not think there is that much spare capacity in the economy. You can see this most evidently in the labour market where unemployment has fallen to new lows. It never really rose during the downturn in contrast to many other countries and so the MPC was very successful in having a much smoother business cycle. Now that we are into the up-swing quite firmly we are seeing unemployment hitting new lows and employment growth is very strong. In the first quarter the Labour Force Survey suggested that employment was growing at about a 2 ½ % annualised rate; you have to go back to the late 1980s to find employment growing quicker than that. We are starting to see wage pressures increase very gradually both in terms of non-bonus earnings and once you add bonuses in you are seeing a really quite rapid earnings growth, so I think you are seeing signs that the economy is beginning to move a little bit above trend. I think the economy will continue to grow quite strongly because this year the world is probably going to record the fastest growth since 1988 and that is going to be good for those bits of the economy which were very depressed, namely investment and exports, while income is going to be supported by what is going on in the labour market. Yes, I think all of that is consistent with inflation rising. I am not sure it is a dramatic rise, it is a rise from 1 ¼ % up to just over 2%, but that is not enormous in the grand scheme of things.

  Q7 Mr Beard: If the cycle is going to be foreshortened in this sort of way, what are the implications for the Government meeting the golden rule?

  Mr Walton: It is a combination of the lagged effect of strong economic activity which is still to be fully felt on taxes. Certainly, if you look at the Treasury's own rules of thumb, you would expect to see taxes rise as a share of GDP as a result of the fact that the economy this year is going to be growing by over 3% and quite probably next year it will be growing at a faster trend as well. So those things will help to increase taxes. I think it is going to be a close call as to whether or not the golden rule is going to be met over future years.

  Q8 Mr Beard: Even with this shorter cycle?

  Mr Walton: I think so. I do not think there is a black hole in the public finances at all. Whether we are just either side of meeting the golden rule is a bit more debatable and at some point that may need some corrective measures. There is no need to panic on public finances at the moment.

  Q9 Mr Fallon: Roger, it seems to be conventional wisdom that we are now in for a period of short increases and in your paper to us you clearly believe that is wrong, you think that is likely to be ineffective. You suggest that one larger uplift might well mean that the peak interest rate would end up being lower. Is that right?

  Mr Bootle: Broadly speaking, yes. When you say "wrong", I would distinguish between a forecast of what is going to happen and a comment on what should happen. I rather suspect we are in for a period of continued short increases, but that is not what I would be voting for were I on the committee. The point is all about how you affect the psychology of the housing market. The position at the moment is one in which people are facing a history where house prices have risen at very rapid rates and they still are rising at very rapid rates. If they put that history and that current experience against an extra ¼ % on interest rates I think they are liable to think, "What difference on earth does it make? This is an asset that is going up 15 or 20% a year, so why worry that rates are going up by another ¼%?" Moreover, indeed these fully discounted—to use Mervyn King's word—"boring" changes in monetary policy barely make the headlines. What I am saying in this paper is that I think what monetary policy needs to do is to act on the psychology of people and that demands giving people some sort of shock. Fortunately, in today's circumstances, given that we have had these Ô% moves now for some considerable time, a shock may mean as little as a ½% increase in interest rates, but if I were on the committee I would vote for that in order to deliver some sort of psychological effect in the market.

  Q10 Mr Fallon: Is it not the growth of debt accumulation that really is the real argument for that kind of shock approach or certainly for abandoning a more gradualist approach to raising interest rates?

  Professor Miles: I think there is something to be said for that and I agree with what Roger said about the situation in the housing market and the need to drive home the message that increases in house prices at the current rate are self-evidently unsustainable and people buying in the expectation that things will carry on like this are making a very big mistake. On the debt issue, I think there is a danger in just looking at the aggregate numbers. Clearly there has been a lot in press about the fact that we are about to go through a trillion pounds of debt. But what really matters here is, more than just the aggregate numbers, is the distribution of debt across the household sector. There the story is a bit more complicated than just the headline numbers showing tremendously rapid growth in aggregate debt, because the distribution of debt is somewhat more equal and somewhat less worrying than it was, say, at the end of the 1980s. Then there had also been a massive build up in debt and the affordability of debt for households that had very recently borrowed became more stretched than is likely now in an environment where rates might be going up but probably not by all that much. I think the debt situation is a symptom of what is happening in the housing market. I would say that the housing market is really where the action is and there the Bank is in a very difficult situation. You almost feel you would not want to start from here but here is where we are.

  Q11 Mr Fallon: I want to be clear whether you agree with Roger that the gradualist approach is likely to give us a higher peak in interest rates in the end?

  Professor Miles: The danger with a situation where many households may continue to believe that house prices may rise at double digit rates into the future is that that in itself will become the back end of the bubble which will drive prices up even further above a sustainable level. If that happens then when the adjustment comes, as I think it will come, it will then generate a fall in house prices back to a more sustainable level which will be even more dramatic than if you could reduce the rate of increasing prices now. I am not quite sure that I see the problem as being that ultimately down the line interest rates would have to be a lot higher if you do not increase them now. I think the problem in not acting now is that house prices will be driven even further above a sustainable level and when the adjustment comes it can cause problems, particularly for households that may have borrowed three or four times their income recently, and maybe 80-90% of the value of a house. If house prices then fall sharply they are going to be in a position of negative equity. To me that is the real issue in the housing market.

  Q12 Mr Fallon: David Walton, do you agree with your colleagues on that?

  Mr Walton: I do. One point David made that I would like to stress is that it is not debt that is the issue, it is the housing market. If people entering the housing market now are as leveraged as people who have gone before then the fact that house prices have doubled over the last five years or so, according to the Halifax index, means that mortgage debt is going to double once all of the housing stock has turned over. If you wanted to slow down the rapid rate of growth of debt at the moment you would need to do something very dramatic to the housing market because these natural dynamics are going to continue for quite a long time. It takes about ten years for the housing stock to roll over. The key thing is not so much what is happening on the debt side but the fact that house prices do look somewhat over-extended. As to whether you need the shock therapy of raising rates aggressively in one go or you just have a sequence of moving quite frequently, my own view is that it probably does not matter which you do. It is the case that monetary policy has been a bit too loose and it needs to be tighter and that is really why I think you should have another increase in interest rates this week following on from the rate increase that we saw in May.

  Q13 Mr Fallon: Finally, Roger, there was something else in your paper which I just wanted to ask you about. You spoke about the increasing prominence given by the Bank to the chart to forecast future CPI inflation based on market interest rates and you suggested this was almost an attempt to start managing market expectations. Do you think they are doing that?

  Mr Bootle: I think there is a definite trend along those lines, yes. A number of remarks by MPC members have been along those lines. If you make a statement along the lines that it may well be that interest rates have got to rise somewhat faster than the market is currently expecting then I think you should expect the result that the market is going to say, "Hold on a minute, maybe we got it wrong and we should expect faster rates of increase," and the Bank must be fully aware of that when it makes those statements.

  Q14 Mr Beard: You have all spoken as though the Monetary Policy Committee should take into account these rises in house prices and increases in consumer debt, but the central terms of reference of the Monetary Policy Committee are to control inflation, pure and simple. They do not have a remit to be controlling house prices and debt, so why should they branch out and start basing their decisions on either of these questions?

  Mr Walton: I think that is absolutely right. The MPC is not targeting the housing market specifically, nor is it seeking to burst the housing bubble. What it is trying to do is to keep inflation overall at the 2% target and by and large the way to achieve that is to keep the economy overall growing at somewhere close to a trend rate of around 2 ½%. In the second half of last year the economy was growing at a 3 ½ % annualised rate. It appears, based on the official numbers, if you believe those, the economy did slow to a 2½% rate. I think there are good reasons not to believe those numbers, mainly the survey evidence. It is more like the economy is continuing to grow at a 3 ½% or so pace, if not faster and it is that that you need to control. Where the housing market comes in is really in the fact that those bits of the economy that were extremely depressed during the downturn are now starting to recover, government spending is also growing quite strongly and so what you need is consumer spending to grow less rapidly in order to make room for the recovery in these other bits of the economy. At the same time we are seeing income growth per household doing well with the labour market improving and with wages picking up. So effectively what you need to do is you need to encourage people to save more, which is most easily done through a combination of raising rates and through some hit to wealth and the hit to wealth is going to come most easily through some decline in house prices, that is where the housing market to my mind fits into this; it is how do you get the consumer to make room for the recovery that is taking place elsewhere in the economy?

  Professor Miles: The MPC does not just have an inflation objective, pure and simple, they have a target for inflation. Right at the beginning of the Inflation Report it says: "Subject to that"—ie subject to trying to keep inflation at round about 2%—"the MPC is also required to support the Government's objective of maintaining a high and stable growth in employment." So I think there is a case for the MPC paying attention to a potential build up of a huge disequilibrium in the housing market even if that enormous increase in house prices might have no implications for inflation at all because of this other part of the objectives of the MPC. You might say that monetary policy should be directed overwhelmingly at controlling inflation and we need to look for something else to control a problem in the housing market, but then the question is what else is there? The world we have in the UK, with people overwhelmingly borrowing at variable interest rates, is one where the short-term interest rate, the policy lever of the Central Bank, also happens to be the most powerful and obvious policy lever for controlling house price inflation.

  Mr Bootle: I very much agree with David, but I would go a step further. It is true that the MPC is not charged with targeting the housing market, but you could easily fit special concern about the housing market into the inflation targeting regime even without the qualification that David has just made. I would say that an economy will not be able to sustain house price inflation of 15 or 20% a year for many years without causing some major disruption to the economy overall, including to the inflation rate, both upside and downside. If you want to achieve broad stability of the inflation rate at the target level as well as the point that David has made then I think you would be paying special attention to the housing market. It seems to me to be rather odd that the Committee devotes this enormous amount of attention to working out whether the inflation rate is going to be 1.9, 2%, 2.1 or whatever in two years' time, something about which no one can know and yet staring them in the face is a massive bubble in the biggest asset market of the lot which historically has had enormous consequences for the whole of the economy. I do not think that can be lightly dismissed. I would say that what you should do is pay attention to the thing that is right in front of you which you absolutely know cannot be sustainable on any reasonable basis.

  Q15 Mr Plaskitt: The Governor said in his press conference when introducing the inflation report that the current high level of oil prices represented a key risk to the near term outlook. Mr Walton, what is the risk and how big is it in your view?

  Mr Walton: I think we have to ask ourselves why oil prices are so high. I think it is very different to the situation we faced three or four years ago when we saw oil prices last rise quite sharply and that is the fact that the world economy is growing so rapidly. So the world economy this year is probably going to grow at the fastest pace that we have seen for 16 years and I think a lot of what is happening in the oil and other commodity markets is that they struggle to keep up with an acceleration in activity of that kind of pace. So this is as much a demand shock for the global economy as anything else. The appropriate response to that is that global monetary policy conditions ought to be tighter. Sometimes you can have a situation where if oil prices go up that represents some kind of deflationary shock that may curb growth. It would be a good thing in this environment if global growth were a bit weaker. So that mechanism should be allowed to work and I think it probably needs a little bit of a helping hand through global monetary policy tightening being somewhat faster than we have seen and I think we will get that most probably with the US Federal Reserve beginning to raise interest rates later this month and other central banks also tightening policy as we go through the course of the next few months.

  Q16 Mr Plaskitt: In your view how real and sustainable is the current price level? There is a lot of analysis of the price which shows that there is a considerable speculative element in it at the moment which comes out in due course. If you look at futures oil trends, it suggests this is a temporary spike giving way to a more moderate but slightly higher level than we had two or three years ago. Is that the right interpretation?

  Mr Walton: Forecasting oil prices is probably harder than forecasting anything else; they do tend to be pretty volatile. I think there probably is some speculative activity and that again to my mind is a symptom of relatively easy global monetary conditions. The estimates that we have at Goldman Sachs for where we think the sustainable dollar oil price is is somewhere around the high twenties for a barrel of oil. I think the problem in a lot of commodity markets is that there has not been much investment over the past decade or more in new production capacity and that is true in oil, not so much necessarily in the production of crude oil, but certainly in terms of refining capacity that is true and it is certainly true in agricultural markets and a lot of metals markets. If you suddenly get the world economy growing very rapidly then it does become quite difficult.

  Q17 Mr Plaskitt: How big is the impact of all of this on the end consumer? If you look at the media you will find all sorts of hysterical comments about the price at the pump of fuel, but the reality is that two years ago a litre of unleaded was 75 pence. If you put on top of that two years of price inflation, it should now be about 78 pence and it is 82 pence. Is this a big deal? It is just a few pence more.

  Mr Walton: It is certainly true that the percentage increase in oil prices this time round is a lot less than the percentage increase we saw back in 2000 or thereabouts and to the extent that it is that change which matters and it is less significant at the moment than perhaps it was in the past—

  Q18 Mr Plaskitt: So when the Governor is talking about risks to the outlook, he is not talking about the inflationary impact of higher fuel prices at the pump, you think he is talking about the global economy and the effect of a sustained period of higher oil prices on slowing down the recovery, is that what he is pointing at?

  Mr Walton: He may have several things in mind, but certainly one thing he probably has got in mind is that if oil prices were to rise further then at some point that could cause a sharper than desirable slow down in activity, but I do not think we are yet at that point.

  Q19 Mr Plaskitt: To what extent does a higher oil price do the job of the MPC for you? Does it act like another bit of tightening of monetary policy which, after all, takes money out of people's pockets, does it not?

  Mr Walton: It does, but I do not think we have yet seen a sufficiently large rise for that to do the job globally. There is very little that the MPC can do in isolation in that regard. You certainly would not want the MPC to be taking on the burden of slowing down demand in the UK sufficient to bring oil prices down. This is very much a global phenomenon, it certainly will help to slow growth a bit, but it is not going to damage economic activity that much when the economy has already got so much momentum.

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