Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

8 JUNE 2004

MR ROGER BOOTLE, PROFESSOR DAVID MILES AND MR DAVID WALTON

  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 revenue?

  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 detect almost.

  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 oil prices.

  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 places?

  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 policy.

  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 small chance.

  Q30 Norman Lamb: Do you agree with that, David Miles?

  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 past—maybe you thought that they should be 20% higher than the average over the last 40 or 50 years—you 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 early Nineties?

  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 large.

  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 here.

  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.


 
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