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
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
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 questionand I am
sure we will come on to itis 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
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
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 discountedto
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
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
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
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
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
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.