Examination of Witnesses (Questions 20-39)|
8 JUNE 2004
Q20 Mr Plaskitt: Professor Miles, what
is the impact of the rise in oil price from the point of view
of the Treasury? What bits of good news does it bring and what
bits of bad news does it bring in terms of public finances and
Professor Miles: It brings in
a bit more revenue. The down side is that it means a slight increase
in inflation and it is a slight dampener on growth. I think the
down side is far less than it has been in the past just because
the structure of the UK economy now is very different from 20
or 30 years ago. The sectors of the economy that were really big
users of oil as an input are so much less important now than they
were in the past, and the corollary of that is that the impact
of a given increase in oil prices on the general level of prices
and on increases in costs for the production sector is just a
lot less than it was in the past. I am struck by a picture in
the inflation report on page 34 which shows how the price of Brent
oil has increased relative to the Bank of England's projected
path, which is just based on futures, over the last few months.
There has been a non-trivial increase in oil prices over the last
few months. If you look at what impact that has had on their changing
view of where inflation might be or GDP growth, it is hard to
Q21 Mr Plaskitt: So is there any reason
in your mind as to why the Chancellor should reconsider his proposed
additional duty in the Autumn?
Professor Miles: Personally speaking,
no. I would strongly be against a decision to reconsider the very
sensible strategy on the long-term future of fuel taxes. I would
be very against postponing that due to temporary gyrations in
Q22 Mr Beard: How much is this present
rise of oil prices due to a transient concern for the tensions
in the Middle East and how much of it is likely to persist because
of the increased demand from India and China and some of the other
Mr Bootle: I do not think anyone
absolutely knows the answer to that. There are a number of reasons
for believing that the current high level of oil prices is unlikely
to last. Although there is great stress at the moment on the increased
demand from China and that is undoubtedly putting up the pressure
on prices, in my view not enough stress is being placed on the
very large increases potentially in supply, including from the
Caspian Basin region. The history of the oil market, as I think
David said earlier on, is that the price is very volatile. The
very fact of increasing the price stimulates further supply and
of course tends to cut back on demand. I think there is a fair
old chance that short of a substantial supply upset in the Middle
East the price would in due course decline.
Q23 Mr Beard: What is the typical consumer's
response to higher petrol prices?
Mr Walton: I think it is the case
that demand for petrol is fairly inelastic, so if prices go up
you can cut back on your motoring activities a little bit, but
in general what you have to do is you have to pay the higher fuel
prices and then, for any given income that you have got, you presumably
have to cut back elsewhere, or if you think this is just a temporary
spike in oil prices presumably you dip into your savings to maintain
consumption. There will be some hit to consumer spending growth,
but I think you have to view this in the context of the economy
growing very rapidly and anything that can help it to slow down
economic activity is probably quite desirable.
Q24 Mr Beard: How much do you think it
will slow it down a bit?
Mr Walton: If you take the impact
on inflation, you are probably going to see about a Ö% boost
or so to inflation.
Q25 Mr Beard: What about growth?
Mr Walton: If you have about a
½% boost to inflation, as a first order of approximation
that is probably going to take ½% off household disposable
income and so about ½% off consumption which means, if you
allow for multipliers and so on, you could conceivably take about
a ½% off GDP growth in the UK, it is that order of magnitude.
It would still leave the economy growing above trend.
Q26 Mr Beard: The May minutes of the
MPC say that "The implications for monetary policy of higher
oil and commodity prices depended on whether inflation expectations
overall remained well anchored." How do you interpret that?
Professor Miles: I think what
that means is that if there were to be an increase in oil and
commodity prices which triggered a big increase in expected inflation
and which then showed up in pressure on wage settlements the Bank
would view that very differently from the same increase in oil
and commodity prices which then did not trigger a second round
impact on wage settlements. What the Bank would be very keen to
do would be to signal, perhaps through changing interest rates,
that if people's expectations of inflation were to pick up they
would not be fulfilled because they would then tighten monetary
policy in a way that stopped inflation rising. In a sense what
they would want to do is knock on the head any second round impact
of commodity oil price rises, but if there did not look to be
any second round impacts then the situation would be very different
and they would be less likely to respond by tightening monetary
Q27 Mr Beard: Do you not think that is
a rather indirect way of putting it if you want to have that impact?
Professor Miles: Maybe you could
make the point in a more straightforward way, but I think that
is what the main point was.
Q28 Mr Beard: Is there any evidence that
stronger oil and commodity prices are beginning to feed through
into higher wage demands and increase producer prices?
Professor Miles: I do not see
it very strongly. In terms of the wage settlements, if you strip
out the bonus elements, which are very seasonal and are very strong
in the latest quarter, and look at the basic wage settlements
without the bonus element then they are still running at levels
which are quite consistent with inflation staying very low. Personally,
I cannot see any strong indications at the moment that recent
rises in oil prices are feeding through to wage pressures.
Q29 Norman Lamb: Let me return to the
housing market and personal debt again. Both Roger Bootle and
David Miles have talked in fairly stark terms about the situation
that we face now with the housing market. David Miles talked about
the house owners making a big mistake if they assume that prices
will continue to rise and you talk about the enormous consequences
for the economy of a crash. The IMF has given some evidence about
other country evidence. How high do you assess this risk that
there will be a sharp adjustment or a crash in the housing market?
Is it becoming more likely than not?
Mr Bootle: I do not think it is
a risk anymore, I think it is what one should centrally expect.
The higher the market goes the stronger that expectation should
become. I suppose there is just about a chance that the current
level of prices is sustainable, but I think it is now a pretty
Q30 Norman Lamb: Do you agree with that,
Professor Miles: I think it is
hard to tell a very credible story that the very strong increase
in house prices relative to earnings is all driven by fundamental
equilibrium reactions to changes in the economic environment and
therefore it is sustainable and I do not think the Monetary Policy
Committee believe that either. In fact they more or less say that.
They say that there are some reasons why house prices relative
to earnings might be higher now than on average over the past,
but then they say that although those factors may have some relevance,
it is hard to believe that house prices that are now 50% higher
relative to earnings than the average over the last 50 years is
really sustainable. The big question then is how you get back
to a more sustainable level and there are a lot of ways, but maybe
one could focus on two extreme ways. One would be that the adjustment
comes very rapidly and house prices fall by a large amount, perhaps
by 20 or 30% in the space of a year. That would bring with it
all kinds of problems. The other way or, if you like, the dream
scenario of a return to a more stable level is that house price
inflation falls close to zero and that because of the general
increase in earnings over time you gently drive the ratio of house
prices to earnings back to equilibrium. The question is how long
would that take. If you thought that there was something to be
said for the idea that house prices relative to earnings are a
bit higher now than in the pastmaybe you thought that they
should be 20% higher than the average over the last 40 or 50 yearsyou
would still need house prices to fall by about 30% relative to
earnings to get back to equilibrium. If house price inflation
fell to zero it would then take probably seven years to get back
there, assuming that average earnings rise at 4 or 5% a year which
would be consistent with inflation staying low. The gradual non-crash
path to equilibrium would take a long time to get there.
Q31 Norman Lamb: So you think that is
less likely than the crash path?
Professor Miles: In a sense there
are an infinite number of ways you could get there. One is a smooth
path, as smooth as it could be, but that takes an awfully long
time and on other paths things will happen very quickly. I think
the honest answer is nobody knows how it might happen and I think
the Bank is very agnostic about that. What they say is that they
anticipate that at some point house price inflation will slow
down and become lower than the increase in earnings. What they
do not say is what they consider the probability is of the very
rapid adjustment or the slow adjustment. I think there are good
reasons for that agnosticism. It is just very hard to predict
how quickly bubbles get burst.
Q32 Norman Lamb: We have heard about
the suggested shock treatments and continued back to back rises.
What is the risk of that shock treatment? Is the risk that it
could cause the damage that we have just been talking about, ie
result in a sudden adjustment?
Mr Walton: The housing market
and house prices do have quite a bit of momentum behind them.
If you suddenly start to get house prices falling, I suspect that
in itself will help to keep them falling for quite some time.
There is a question as to how sensitive the economy is to this.
If you look back over the last five years, you have seen a doubling
in house prices and yet the household savings ratio has essentially
remained stable. That does beg the question that if house prices
came down 20 or 30%, would that really do that much to economic
activity? I think it will push up the savings ratio. The good
thing in the current context is that the rest of the economy is
doing sufficiently well that it would be quite good if the consumer
took a backseat for a bit and could withstand that kind of adjustment.
Q33 Norman Lamb: How long would it take
to implement in the market the fixed rate mortgages that you have
set out in your report, and what would be the effect of that?
More fixed rate mortgages make the market less responsive to changes
in interest rates. Might that create more of a problem?
Professor Miles: I think what
one would want is a market where households, in deciding on what
house to buy and how much to borrow, took account of the possible
future course of interest rates and what might happen to affordability
down the road. That is what one would really like. It seems to
me that if people were thinking ahead to a greater extent than
they are now about affordability and where rates might go, they
would naturally look at fixed rate mortgages relative to variable
rate mortgages in a slightly different way and I think some of
the most important recommendations I make in my report are about
giving consumers better information and encouraging them to think
about where affordability might go in the longer term. If one
were in that kind of world there would be more longer-term fixed
rate mortgages. What impact would that have on monetary policy?
It is a two-edged sword; I do not think there is any way round
it. On the one hand it is pretty obvious that if there were substantially
more fixed rate mortgages the impact of a given change in interest
rates on the level of demands in the economy would be less than
it is now and in itself that is hardly an advantage. The other
side of the coin is that you can perhaps have a more stable housing
market because people are thinking about affordability over the
long term and that in itself would make the role and the job of
the Monetary Policy Committee far easier. One might not have got
into the kind of very difficult situation one is in right now
if households had taken a more forward looking view over the last
few years about where interest rates might go.
Q34 Norman Lamb: Can I just go on to
household debt very quickly. In chart 1.14, which I think is on
page 9 of the inflation report, there is the movement of debt
service payments as a percentage of income. How concerned are
you by what is shown in that chart, which is the aggregate debt
servicing costs as a percentage of household income rising sharply
over the next two years and returning to the levels of the very
Mr Bootle: I think it is extremely
concerning. David made the point earlier that because houses turnover
so relatively infrequently, around about 15% of the housing stock
turns over each year, the implications for the overall level of
borrowing of a given level of house prices do not come through
for many, many years. So if house prices do not rise at all from
where they are and interest rates do not rise the debt burden
will rise continually simply as a result of the fact that the
level of mortgage borrowing now has not yet adjusted to the level
of house prices and I think this is very worrying. If on top of
that you put significant increases in interest rates you can see
that the burden on consumers is potentially going to get very
Q35 Norman Lamb: Do you agree with the
Governor that a key difference between now and the early Nineties
is that this is now a predictable rise in debt servicing burden,
consumers can see it happening, whereas in the early Nineties
it was a sudden, unpredictable rise in interest rates that caused
so much trouble? Do you accept that analysis?
Mr Bootle: I do. Although I have
been warning of the great dangers of this increase in house prices
and the consequent rise in debt, I must stress that I do not think
that is the only reason for being a bit more comfortable about
it this time round compared to what happened then. There are all
sorts of other reasons. In the housing market housing transactions
rocketed just before the crash, the loan to value ratio was much
higher in the late Eighties than it is now and consequently negative
equity was much more prevalent then. Unemployment, of course,
soared in the early Nineties. I think what could happen this time
round is that we could reach this position where the burden of
debt payment is quite high, house prices fell and although there
would be a lot of discomfort and pain, I do not think it would
be anything like on the scale of the early Nineties.
Q36 Norman Lamb: Does the Treasury simply
have to stand by and watch all of this? Is it simply down to the
MPC to be doing what it can to try and make this very difficult
judgment between the shock treatment and the gradualist approach
and so forth or ought the Treasury to be engaging in some way
in this debate?
Mr Bootle: No, it does not have
to stand idly by, but I think there are political objections to
many of the measures one might want to consider. Putting a capital
gains tax on unoccupied housing might make a considerable difference,
but somehow I do not think it is on the cards, do you?
Q37 Angela Eagle: I want to ask a question
about the structure of the housing market because there are other
things that perhaps might be brought to bear on the issue. Clearly
there is a problem with supply which has been causing some of
the problems of rising prices and we also have a particularly
under-developed private rental sector in the UK. I wonder if you
would leave high macro-economics for a moment and comment on what
might be done structurally, as well as David Miles' report, to
do something to bring the housing market back into a more stable
situation for the future so we do not have to keep spending most
of our time in these hearings talking about what is going on in
the housing market.
Mr Walton: I think you should
probably be asking Kate Barker this question.
Q38 Angela Eagle: We will when she is
Mr Walton: There is a question
about the valuation of the housing market. It is true that house
prices are 50% higher than average earnings, but it is also true
that rents have risen sharply relative to average earnings over
the course of the past decade or so. They are about 25% higher
than their long run average. I do not think we measure rents very
well and that would certainly be an area that the Office for National
Statistics could look into perhaps in a bit more detail, but if
that is true then that obviously does reduce the over valuation.
The other point which is relevant is that real long-term interest
rates, which ultimately are the real factor which determines the
cost of borrowing, have fallen substantially over the course of
the past few years. They used to average close to 4%, but they
have been averaging less than 2% for the last five years or so.
When you take all those factors into account the housing market
in some sense looks no more over-valued than the bond market and
that is why I would be sceptical as to whether if we had had a
fixed rate mortgage market things would have been that much different.
Certainly, if we had a US-type market where you could re-mortgage
very easily, as rates came down and dragged down real long-term
yields you would probably have people locking into these very
long-term real interest rates and that would still have caused
quite a big expansion in house prices. I think a lot of this is
financial. There clearly are supply problems, but the housing
market at any point in time largely has a fixed supply, it is
very difficult to suddenly increase the supply overnight. If you
suddenly get incomes growing quite rapidly and if you have got
very low interest rates then you should not be that surprised
if you see house prices rising quite rapidly. Perhaps the problem
has been that monetary policy overall has been a bit loose over
the past three or four years and that has contributed to some
of this rapid increase in house prices.
Professor Miles: My view on the
supply side of things is that the relatively low level of new
housing supply in the UK is a very good explanation of why, over
the very long term, real house prices in the UK rise faster than
in many other countries, particularly if you compare us with the
US. I am not convinced that it is really at the heart of the story
behind the volatility in house prices from year to year. If one
takes the last 15 years or so, we have had periods of very rapid
rises in house prices and very rapid falls in house prices and
actually the supply of new housing coming onto the market has
been at a relatively low and stable level more or less throughout
that period. So to my mind a relatively low level of new house
building is a factor behind the long run trend in house prices
and it is not the most important part of the story about the volatility
from year to year where I think fluctuations in demand are really
the big story.
Q39 Angela Eagle: The whole structure
of financial strategy over the last year or so has been to expect,
as we had, growth to pick up, that there would be an adjustment
in the economy away from consumer spending which has kept it going
in the lean times and out into exports, manufacturing and various
other parts of the economy, yet consumption remains stubbornly
high and is refusing to some extent to give way to the other sectors
of the economy which now need to take over, and attempts to dampen
down consumption do not really seem to be working. Do you think
there is an adjustment in consumer behaviour which is making it
harder, without more drastic action, to drive out consumer expenditure
in order to make room for the other areas of the economy to come
through? Do you think that it is a modern phenomenon, is consumer
behaviour changing, is it the availability of easier debt or is
it just low interest rates? Do you think that there is something
interesting going on which we need to look at there?
Mr Walton: I personally think
you cannot compartmentalise the economy in these ways. The consumer
is fundamental to the whole economy. If you have got rapid growth
in investment and exports, that is going to generate jobs and
income and help consumption, so there is not this sort of simple
"the consumer must give way to somewhere else" because
the consumer is bound up with everything else. The consumer, to
my mind, has not particularly been behaving irresponsibly, but
the consumer has just been consuming its income for the last few
years and that is what you would normally expect to happen over
the long run. You certainly have not seen the late 1980s-type
boom where households deliberately went out and extracted equity
in order to finance consumption. That just has not been part of
the story this time round, in my view, and if you want consumption
growth to be slower, given that income growth is actually doing
quite well, then you essentially need policy to encourage the
savings ratio to rise and really the most effective way of doing
that is through higher interest rates.