Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 80-99)


29 JUNE 2006

  Q80  Mr Love: Except that in Germany it seems to be export-led growth in their economy, which will impact on our market?

  Mr King: I am sure the wives and girlfriends of our team out there are doing a great job, at least in Germany if not here.

  Q81  Chairman: Paul, the sterling money markets operations, could you tell us what your objectives are for that, and how would you measure that performance if asked to do so in a year's time?

  Mr Tucker: Absolutely. We have four objectives, Chairman. The first is to reduce the volatility of our overnight money market rate from where it has been. Relative to many markets abroad, for as long as the Governor and I can remember, our overnight money market rate has been unusually high, especially unusually high for a great global financial centre. I want to put emphasis on this, because this is the key objective, and it has made the sterling money markets a relatively unattractive place unless you were already an expert. That was the first objective. I will come back to that. The second was to give the banking system more flexibility in managing their liquidity, both as a system and at the level of individual banks. The third was to make the system simpler. The fourth, connected with all of those, is to foster a more efficient money market. In terms of how I would measure it, the first one is straightforward; we would measure simply the day-to-day volatility of the overnight money market rate relative to the past and relative to that in the euro area and in the dollar money markets. So far, and we are only six weeks into this thing, it is much lower than in the past and in line with the dollar area and the euro area. But I rather agree with what is implicit in your question, this is something to look back on after a year rather than to declare a victory after six weeks. The second objective, in terms of making the system more flexible for their liquidity management, I think we can be reasonably confident that is achieved. Historically, very few banks have banked with the Bank of England and participated in our operations; that has roughly tripled and, in terms of the share of the sterling banking system, now accounts for about 90% of banking activity out there. That has given far more banks direct access to our balance-sheet (a); (b) for the first time ever, banks can borrow from us on demand during the day, at a penalty rate, against high quality collateral, in unlimited amounts; and (c) rather than having to balance their books with us at the end of each day, now they target an average balance over a month and that gives them much greater day-to-day flexibility in their liquidity management. The third objective, as I say, was to make it simpler; that was associated with the hyperactivity which characterised our system in the past. We would conduct what are known as open-market operations, which is just lending to the banking system, up to four times a day; now we do so once a week. Also, we have aimed to explain, for the first time, in this document which we put out in the middle of May, how our objectives are achieved, so we stand to be accounted for on that as well. The fourth, whether we succeed in fostering more efficient money markets, will take longer to judge and is associated with the benefits of bringing volatility down and making the system more comprehensible. When we announced these reforms, the European treasurer of one of the biggest companies in the world wrote to me and said, "We have used the sterling money markets relatively little; if you achieve your objectives, we think we will use them rather more." That is the kind of thing which, qualitatively, at least, we should be able to track over one, or two, or maybe three years, and even longer.

  Chairman: Alright; we will come back to it in a year's time. Thank you very much.

  Q82  Kerry McCarthy: You talked about business investment picking up but there does not seem to be a great deal of evidence, there is evidence but it seems to be fairly mixed. The CBI have suggested that there is going to be a continuing decline in investment, and your own agent survey has said that business investment remains subdued. What are the grounds for the optimism?

  Mr King: The latest figure does suggest an increase but the surveys are more optimistic than the data—there is a mismatch between the two—it has been a bit of a puzzle as to why investment appears to have been weak relative to the path of output growth, compared with past recoveries, so I think we would expect it. You are quite right in saying that there is no evidence, and certainly I would not want to use a figure of, I think it is, 1.7% growth in the first quarter as any hard evidence, because these are volatile data, they move around and they can get revised. We certainly do not have any hard evidence as yet. There was a very similar puzzle in both the United States and the euro area, why was business investment weak when they were beginning to recover after the downturn in 2000; in the past year they have seen business investment pick up and, in large part, that puzzle has gone away. We have not seen that yet. I think it would not be unreasonable to suppose that we will see some recovery, but there is a lot of uncertainty about that.

  Q83  Kerry McCarthy: I think the underlying point is, on the evidence that we have been given, I think Professor Muscatelli said that eventually you would expect some of the pent-up investment to happen, but it does seem predicated very much on the idea that it has not happened for a while and therefore it has got to happen at some point, rather than any hard evidence?

  Mr King: When we make our forecasts we have a central view. That is not a statement of what we say will happen, the probability that it will actually happen is pretty low, as I have already said, almost negligible. We feel that a sensible, central view would be to expect some recovery, not a dramatic recovery but some recovery, for the reasons that we have seen it elsewhere, and you would expect it, given the fact that we have seen a recovery now in output and the surveys have been stronger than the actual data. I think some recovery was not an unreasonable central view, but certainly I share your view that there is a lot of uncertainty about that.

  Q84  Kerry McCarthy: To what extent do you think factors such as pension contributions are a contributory factor?

  Mr King: It is very hard to know. We have used our Agents and talked to firms and we get mixed responses, to be honest. There is no doubt that on our visits around the country, if you ask businesses, some certainly will say that it has been a contributory factor, others will say that it has been a major problem. It is very important logically to separate out the amount of money that has to be put aside to fund past pension accruals about which you can do nothing. They are a fixed cost and should not alter decisions about whether it make sense to invest to ensure the continuing success and profitability of the business. Of course, firms also have said, "The cost of these pension schemes is sufficiently high that we can't continue to offer the same pension benefits for current and future service," and certainly that has been cut back dramatically in the last five years. In terms of having to fund the deficits which are reflecting the additional computed cost of past service, about which companies can do nothing, they have to meet that, it may be just cutting off your nose to spite your face to say, "I've got to pay this money into the pension fund therefore I simply won't invest." While companies are severely cash-constrained, that may well be the outcome, and undoubtedly some firms are in that position; but others who feel they can afford to borrow to finance investment will try to separate out these two factors.

  Q85  Kerry McCarthy: Are you saying that there is evidence that the fact that some companies are really shaping their pension provision, going forward, is likely to have a positive effect on investment?

  Mr King: It may have one on employment. I think that there has been a very significant change in the provision of private pensions in the UK in the past five years or so. Clearly that has altered the total cost of employing the workforce going forward. It may be, particularly for new entrants into firms, that firms actually have found a way to reduce their labour costs in a way which encourages employment rather than investment.

  Q86  Kerry McCarthy: In terms of the current debate about pensions, going forward, and particularly compulsory employer contributions, I think Mr Tucker said, in a recent speech, that the actual risk of further increases to pension contributions was having a negative impact on business investment. Is that a view which you share; is that a concern?

  Mr King: Many firms have raised that, and of course they can control the liability which they incur for future pension contributions. There is nothing now which firms can do easily to alter the changes in the computed cost of meeting liabilities they have incurred already. If longevity rises and interest rates were to fall back again, the present value of meeting those liabilities might well increase, yet again. To the extent that does create uncertainty about the cash flow position, it may well as I say, lead some businesses to be more cautious, but not all. Some firms may be able to separate out these two factors and it does not make sense to forego investment opportunities if those investment opportunities definitely would be seen as profitable in their own right.

  Q87  Mr Gauke: It was put to us by Michael Saunders of Citigroup that there is a view within the MPC that trend productivity growth may have weakened of late and therefore trend growth in the economy may also have weakened. To what extent do you agree that there is that view within the MPC; do you share that view yourself?

  Mr King: Different people have different views, so you can ask the four people here what they think. I think the discussion that we have had, on the Committee, was not about trend productivity growth but a combination of two things. One was the observation that productivity growth had fallen quite markedly, and I think, by and large, we thought the main explanation of that was the fact that firms were still continuing to employ people in a period when output growth had slowed. As output growth has picked up, that impact on productivity indeed has started to unwind. The other factor we looked at was higher oil and energy prices, as happened in the 1970s, may well have raised questions about the growth of productivity which would result; maybe there would be an impact on wage costs, which, because it reduced the real take-home pay of employees, would actually make it harder to generate the increased supply which was necessary to validate the trend productivity growth rates. Also, it might mean that some of the capital equipment in use was made redundant because it was using an inefficient amount of energy, and so there might be scrapping of capital equipment. Those possibilities were raised and they were discussed. I do not think the Committee feels there is a great deal of hard evidence, but it is a possibility and we have raised it as a risk. It was something therefore that we took into account. In our projections, in the central view, there was no impact on productivity growth from either of these developments, and I think there were different views on the Committee as to how important they might be. Those views did vary quite widely, from a view that there would be no impact to a view that there might well be some impact. Probably there was, and indeed it had contributed, in part, to the rise in unemployment—not as the major factor but as some part of it.

  Q88  Mr Gauke: Can I ask whether anyone has anything else to add on trend productivity growth or deal on trend growth?

  Mr Bean: That is a pretty fair description of the key channels that we discussed. As the Governor said, different members of the Committee took slightly different positions on the relative likelihood of things like capital scrapping effects. For my part, my interpretation of the slow-down in productivity growth through 2004 into 2005 was that it was primarily a cyclical phenomenon and did not really indicate a slowing in underlying productivity and that capital scrapping effects were probably fairly modest; there is no doubt that there will be some effect there. I recognise that certainly one could take a different view and frankly it is very difficult to draw a firm conclusion with the data that is available.

  Q89  Mr Gauke: When you are looking at productivity growth, to what extent do you distinguish between the private sector and the public sector? There is an argument that public sector productivity growth is lower and that drags down the average, therefore the average figure is unsophisticated and that one needs to look at the private sector productivity growth. Is that a fair analysis and do you distinguish between the two?

  Mr King: It is certainly relevant to us, when making our inflation projections, not to get bogged down in a debate about how to measure public sector output. That is, however, a very important debate in order to measure the contribution of the public sector to national income. What we can do is ask a different question, which is, what is the impact of the public sector in terms of its demand on the resources which it is using to produce whatever it is that it is producing? That is primarily in terms of the labour demand but also in terms of the goods and services which the public sector is buying from the rest of the economy. That is how we would calculate the impact of the public sector. I think you are right to say, "Well, do concepts of our trend productivity growth help or not?" I think, in the private sector, probably they do, in the public sector they do not, because the methods used to calculate the output in the public sector have been changing in recent years, so you would expect there to be changes in the measured productivity growth, even if you did or did not agree on what was actually the underlying growth rate of productivity. The numbers that are produced by the ONS have been changing, and that is a challenge to them, it is a very important one to try to work out, as far as possible, what is the output produced, but it is not one in which the MPC need to get embroiled, because actually we can look at the impact of the public sector and the resource demand it is putting on the rest of the economy.

  Q90  Mr Gauke: Briefly, how would you describe the impact of the public sector in that way, given that in recent years it has grown quite substantially?

  Mr King: Obviously, it has employed many more people and those people then are not available for employment in the private sector, so that is something which is relevant when assessing the degree of pressure in the labour market, and we can look at that.

  Q91  Mr Gauke: Would it be fair to say that means that interest rates may be higher—may be higher—than otherwise they would be had that not happened?

  Mr King: Not if the Government is financing the higher public expenditure in terms of higher taxes, because the higher taxes then will be slowing the growth rate of private spending in order to release resources to finance the higher public spending. I think, in part, that is what has happened, and we talked about that as part of the explanation for the timing of the slow-down and the sharpness of the slow-down in consumer spending; it came at a point when real, disposable take-home pay was actually slightly negative rather than positive.

  Q92  Mr Gauke: Can I just return to the issue of trend growth. Professor Muscatelli told us that low investment over the past couple of years may have impacted upon trend growth and therefore that gives you less flexibility when it comes to the interest rate cycle. How would you respond to those comments?

  Mr King: I will ask Charlie to comment in a minute because he has looked at this issue quite carefully. When thinking about the growth of the economy, obviously one is looking at growth of business investment, but in terms of its impact on the potential supply capacity of the economy it is the level of investment. If investment is growing more slowly than otherwise it would have done the level is going to be less after a few years, but, remember, we had pretty high levels of business investment in the late 1990s which brought up our capacity. Whether the level of productivity and supply capacity is lower now than we would have expected 10 years ago is not obvious to me, because what you are seeing is different timing of the path of business investment. Charlie is much closer to that and he has looked at that issue quite closely.

  Mr Bean: The thing I would say is that we build our estimate of the economy's supply capacity from the bottom up, if you like, and automatically that means that when there is a slowing in investment it feeds through directly into our assessment of the supply capacity of the economy. In that respect, we are rather different from the Treasury and the way that they construct their estimates of trend productivity growth, which does not rely on taking on board what is actually happening to investment, and then working out what that implies for firms' supply capacity. The direct implication of the relatively subdued rates of investment over the last few years has been that our estimates of spare capacity have been growing that bit more slowly, and if they pick up in the future, as we expect them to, albeit modestly, that would lead to a pick-up in the rate of growth of supply capacity. We do not see any particular reason for thinking that the rate of growth of productivity which is not associated with capital, what economists refer to as total factor productivity—sort of disembodied productivity growth which is associated with research and development and more efficient management techniques, and so forth—there is no particular evidence that has picked up, although it is one of the areas that we have been studying particularly closely. Of course, if you look in the US, there has been a marked acceleration in that component of productivity associated particularly with the ICT revolution. There has been some consideration of whether we might see the same ICT-driven pick-up in productivity growth here, but so far there is relatively little evidence of it in the data.

  Q93  Mr Gauke: Obviously, this Committee is very interested in globalisation, and so on, to discuss these more mobile factors of production; in those circumstances, to what extent are spare capacity and the link to spare capacity inflation weakened, does it matter any more?

  Mr King: I think there is a lot of confusion on this topic. We have our own currency, we determine the inflation rate of that currency; it does not matter what the output gap is in the rest of the world. If we want to have a lot of inflation or a lot of deflation, we can give you that. The fact that the output gap in the rest of the world moves around a lot may make our job harder, but the fact that we have our own currency is what determines the fact that we can have our own inflation rate. Where there is an issue, I think, which has changed the transmission mechanism of monetary policy, is that with much more open capital markets and mobile capital flows, the asset prices in the economy often are determined as much by what is happening overseas as developments in the UK economy. Indeed what has been discussed quite a lot in the last decade is the extent to which investors have been moving towards a position in which, around the world, everyone has got rather similar portfolios, so pension funds in the US will have some US shares, some European shares, some Japanese shares, maybe even Chinese shares, in proportion to the weights of these countries in the world, and so will British pension funds and European pension funds. In other words, the portfolios are becoming closer. If that is the case then our asset prices may be being driven as much by monetary policy overseas as by here. That does not mean to say that we cannot determine our own inflation rate in the longer run, but it does mean to say that the transmission mechanism may be somewhat different, because we do not simply determine our own asset price levels in the way that we would if we lived in a completely closed economy.

  Q94  Chairman: Governor, can I say that is the first thing you have ever offered this Committee, and it is totally and utterly unacceptable, higher inflation.

  Mr King: I agree, Chairman.

  Q95  Mr Todd: Going back to some questions that Kerry was asking about, the implications of increased contribution towards pension costs, would you endorse the call for greater transparency in the declaration of the cost of pensions so that they are clearer in collective bargaining terms among those who have to analyse their impact? At the moment, many employees do not understand the implications of the additional costs which may be involved and are not entirely sure that those bargaining about them always do either.

  Mr King: I do not want to endorse any call for compulsory changes. That is not for me; that is for others involved in reporting.

  Q96  Mr Todd: A good PSO?

  Mr King: Certainly it would be of value if we all understood it better; the question is how we get from here to there. There is no doubt that some of the calculations that are presented are not the easiest to understand or follow. I think a greater economic input into the sorts of calculations that are made would be of enormous value, as opposed to purely the accounting calculations, and I do think that it must be very confusing for people to see that there are two or three different ways in which the valuations of their pension scheme are presented. I think there is value in individuals understanding that, in addition to their wage packet, there is also an amount of compensation which is being put to one side which is financing the future pension benefit they will receive as a result of that employment.

  Q97  Mr Todd: Would you also share the view that there is a possibility of pension cost, corrective measures, actually having an inflationary impact at some point? You have noted, obviously, that companies have been dealing with deficits or responding to worker demands for improved pension terms, but presumably over time that can drive up business costs and potentially contribute to inflation?

  Mr King: I think firms then can take steps to control their own costs, and of course that is exactly what they have been doing in recent years, in reforming their pension schemes. One of the benefits of a greater understanding of the cost of providing pensions, to which you referred earlier, would be that it would make it clearer that there is a trade-off between benefits in the form of pensions or benefits in the form of pay today.

  Q98  Mr Todd: Turning to broader labour market issues, would you take the view that the labour market has loosened substantially over the last six months, and perhaps much greater than it has for quite some considerable time?

  Mr King: Let me ask Kate to come in and comment on that.

  Ms Barker: I think certainly it is true that the labour market has weakened over the past six months, it is correct to say, more than it has in the recent past, but to say it is a significant weakening of the labour market would be overstating it. There have been, of course, different trends going on, and a particular trend which has been quite marked over the past year is that we have seen a rise in people's willingness to participate in the labour market. In fact, that comes back to some of the questions raised about productivity. We are not seeing people withdrawing from the labour market, although the proportion of people who are wishing to participate in the labour market is higher, and that, of course, has been one of the things which has caused unemployment to rise. Alongside that, in some sense, we discussed this when we were talking about the productivity cycle. We have been through a period where output growth has been a bit slow and, although firms did not actually get rid of a lot of people, they have not been hiring quite as much and so employment has not risen quite as quickly, but, on the whole, if anything, employment has been at least as strong as we expected and in some periods last year was rather stronger. So it would be overstating the case to say that the labour market has weakened significantly; certainly it has slackened a little bit. On top of this, of course, we have had effectively an influx of migrant labour, so in some sense the supply side of the labour market has grown quite a lot and a little bit faster than the demand for labour. That is a better way of putting it. We have had a slackening, which has not necessarily reflected a big weakness in the economy, and, looking forward, I suppose that is uncertainty. I would not anticipate seeing the slackening going very much further.

  Q99  Mr Todd: In quite an active month for speaking, Governor, you did make some references to the impacts of migration on our economy and some guarded remarks about the relatively incomplete information on which we work at the moment. Are you seeking to commission more robust research on the way in which migration and other challenges in the composition of our labour market may impact on our economy?

  Mr King: Our staff are examining all of these questions, but the big handicap is lack of data, the data are both scarce and inadequate to carry out a full study.

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