Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 60 - 78)



  Q60  Jim Cousins: This morning you drew the attention of all of us to the forthcoming wage round and it surprises me that you do not think a signal of 2% in public sector pay is being helpful.

  Ms Lomax: We shall be looking at what is happening to private sector settlements in particular and we shall be reacting to that. I am not sure what else to tell you.

  Q61  Jim Cousins: Your colleague does not think the Chancellor's comments were helpful—

  Ms Lomax: No, I did not say they were not helpful: I said that I did not have a view on whether they were helpful. It is not my position to pass judgment on whether the Chancellor's opinions on these things are helpful or not.

  Q62  Jim Cousins: Mr Walton, may I ask you whether you have a view on whether you think the Chancellor's comments were helpful?

  Mr Walton: There was a thing in the Chancellor's letter to the Public Review Body about the importance of not converting a temporary increase in inflation into a permanent increase in wages and I think that is a message which needs to go out to the public sector as well as to the private sector. In my view it would be as damaging if you had public sector wage inflation running away to compensate for these higher oil prices, because they would almost inevitably have some knock-on effect to the private sector as well. Whatever the precise number for the public sector pay increase should be, what is certainly clear is that for the economy as a whole we do not want to see pay increases which are at all higher in this coming pay round than we had in the last pay round.

  Q63  Jim Cousins: So it was helpful.

  Mr Walton: It is helpful not to have a knock-on effect from the pick-up in consumer price inflation into wage settlements.

  Q64  Jim Cousins: Sir Andrew, you referred to yourself as a man whose contribution was based on intuition.

  Sir Andrew Large: Not wholly, but that is an element of it.

  Q65  Jim Cousins: Yes, indeed; rather than being a professional macroeconomist. You heard what your colleagues have said about the helpfulness of the Chancellor's signal about public sector pay in looking at the next wage round. Intuitively, do you think it was helpful enough?

  Sir Andrew Large: I certainly think that the outcomes from both public and private sector, if they are lower and more closely aligned to the target, are going to give us an easier passage in terms of meeting the inflation target. To that extent, anything which is done which has an impact on maintaining wage demands to those levels is helpful.

  Q66  Jim Cousins: Do you think that was helpful enough? Do you think more is required?

  Sir Andrew Large: In spite of my intuition, I am afraid that it does not extend to knowing what the outcome of the Chancellor's exhortations will be. We shall just have to see how that emerges.

  Q67  Jim Cousins: Governor, I thought you gave a very clear signal to us this morning and it followed your comments in November. You gave a very clear signal that if second-round increases in pay, as you put it to us this morning, did not respond to the signals which you were clearly trying to give, you would use interest rates as establishing a kind of follow-on incomes policy. Do you think that is an appropriate use of the powers of the Monetary Policy Committee?

  Mr King: I never use the words "incomes policy" and let me assure you that I do not want to do so.

  Q68  Jim Cousins: Indeed you did not. Look to your left.

  Mr King: Could you elaborate on this point?

  Q69  Jim Cousins: I was inviting you just to consider the picture on the wall.

  Mr King: Let me be helpful to you and answer the question which I think you are putting, though I am not entirely clear. We shall set interest rates on the basis of the outlook for inflation, nothing more, nothing less. We do not set interest rates on the basis of any other outlook. One of the contributions to the judgment of the outlook for inflation is what we think is happening to labour market inflation and to average earnings growth. I said this morning, and I said last week, that the Committee have drawn great comfort from the fact that we have not seen second-round effects so far; there have been no second-round effects visible in average earnings growth. It is important that there not be second-round effects because if there were, that would help to push up inflation relative to our central projection, which does not include any second-round effects in the future. If there were to be any, that would push up our inflation projection and, other things being equal—of course in practice they never are—would make it more likely than not that policy would be tightened, that is higher interest rates. That point is made explicit in the Inflation Report. It says that if these effects were to be seen, inflation and unemployment would rise because we would have to respond to higher inflation. Therefore, to go back to your first question, the Chancellor is certainly right to draw attention to the need in both public and private sectors for earnings growth not to try to compensate for that part of the pick-up of inflation which corresponds to higher energy prices. He is responsible for the public sector wage settlement and that is why he speaks specifically about it. I agree totally with Rachel, that we should not be commenting on whether a particular number which he chooses is right or wrong. It is for him and people in the public sector to judge. The MPC does not say what any individual wage settlement should be. We are not in that business and that is why I should not want to be associated with the phrase "incomes policy". It is for people to bargain their own wages, both employers and employees. Our concern is what comes out of that process. The most important thing—and I think this is the point the Chancellor has stressed before and I am happy to stress again today—is that those people who enter into wage bargaining agreements should take into account that we intend to keep inflation close to 2%. That is the basis on which they should conduct the wage negotiations and that is all I am saying.

  Q70  Jim Cousins: Let us just be very clear about this point. You have given a very strong indication, alongside the Chancellor, that if the signals you are giving this morning about second-round pay effects are not delivered, then the interest rate weapon will be used.

  Mr King: No, I have not said that. What I have said is that if there were to be further increases in average earnings growth that would be one of the factors we should look at. If nothing else were to change from our outlook for the future that would lead to some action. But we have to look at what else is changing. We are not drawing direct causation from one to another, but a clear part of our inflation outlook is a judgment about stability in average earnings growth.

  Q71  Mr Love: May I take you back to comments which were made in a question from Mr Ruffley about this relationship between house prices and consumer spending? Last November the Bank was suggesting that the link was not as direct as previously assumed, indeed you stated that it was not straightforward. Yet this morning, in response to the question, you were suggesting that there was more of a direct link. Can you tell us what the Bank's thinking is and the relationship between house prices and inflation?

  Mr King: There is clearly some link; the issue is how big it is. The basic point which we have tried to make over a long period is that you cannot answer that question without trying to ask what it is about house prices which leads people to spend more. The answer is that that will change over time. There is no simple mechanical link, as too many econometricians who just run equations and do nothing else, fall into the trap of thinking. It is hard to see why there should be a direct link in terms of wealth. You have to live somewhere. If house prices go up and you sell the house, you need to buy another one. It is not obvious why there is an immediate, direct wealth link. It is true that if you want to sell your house and go to live abroad, or live in a much smaller place, you will be better off if house prices have gone up and you can spend more. Equally, if you are one of the group of people who have not yet become a home owner and want to, then you will be made worse off by a rise in house prices. Those two groups broadly offset each other; perhaps not exactly, but broadly. The big effect is not likely to come through a wealth effect. The big effect seems to come through the fact that if you have a house which is worth more than your mortgage and you want to borrow money against your future income to spend, you have some safe asset—some collateral—against which you can borrow at much cheaper rates than you could if you went into the unsecured debt market. The ability to borrow more cheaply against your home than borrowing in any other form is what means the house price, if it is creating collateral against which people can borrow, will push up consumer spending. The extent to which it will do that will depend first of all upon how much extra collateral there is. If you start from a position where there is a lot of extra equity in homes, as there is now, and you get a bit more, it is not clear that will actually do a great deal. Secondly, you need to want to borrow anyway. You do not want to borrow against the future just because house prices have gone up, but probably because you are optimistic about the future. What we have seen in the past is that there have been times when there has been a close correlation between house price rises and consumer spending, as in the late 1980s. At other times there has been a very weak correlation, as in the early 2000s. There is no good economic reason to suppose that correlation is going to be stable over time; it will vary according to the circumstances. Sometimes it will be strong and sometimes weak. That is the point we have been trying to hammer home so that people think about the underlying economics of it, tell a story about it and not just come up with some regression coefficient.

  Q72  Mr Love: I want to move on now to monetary policy and output stabilisation, harking back to your analogy of weather forecasting. You have been trying to talk down the unrealistic expectations which some people have that we are effectively going to abolish the business cycle. In your Cass business school lecture recently you repeated what you have often said about no long-run trade-off between inflation and output. You also said that in principle there is a permanent trade-off between the volatility of inflation and output. Perhaps you could give us a little more about what you think that is.

  Mr King: If the MPC were to try to bring inflation back to the target within a few months, then it could only do so by making quite violent swings in interest rates which would lead to greater volatility of outputs. The remit which we have been given by the Chancellor makes quite clear that we should look ahead in order to avoid undesirable volatility in output and employment. If we were to try to stabilise things too quickly in terms of inflation, then we would generate undesirable volatility in output. That is why what we try to do is to look ahead two years and keep inflation on track to meet the target in the medium term.

  Q73  Mr Love: May I turn to Kate Barker? In a recent speech which you made you indicated that the MPC should be prepared to contemplate the inflation forecast around the two-year horizon being away from the target, if this were due primarily to a supply shock, and if the interest rate response needed to bring inflation to target more quickly would lead to significant output volatility. Can you explain the reason why you have taken that view?

  Ms Barker: That is really the same point about undesirable volatility. In fact this situation has never arisen: we have never had a supply shock which has been so great that we felt that inflation was going to be a long way away at the two-year horizon. In principle it the case, that when you have a movement in inflation you look at why it has taken place and what the costs of bringing it back to target over a particular time period are. That might mean that there were circumstances, though they would be fairly extreme, where you would say that for those reasons you would take a little bit longer to bring inflation back to target. I have to say, however, that they would be circumstances where inflation would probably have gone rather further away from target than it has under the present regime.

  Q74  Mr Todd: Why do you think forward investment has been so sluggish? Or has it been and this was just another data problem?

  Mr King: It probably has been. Even if we were to observe the data perfectly, which we cannot, I suspect that business investment has been weaker than we had expected. Interestingly, this is true not just of the United Kingdom, but also of the United States and the euro area. I had a central bank governor from Eastern Europe in my office yesterday and he asked whether I understood why business investment was so weak. He has experienced it too. I do not think we really understand it, to be honest. The conditions for investment seem very favourable; profitability is strong, cash flow is strong, the real cost of capital is the lowest in a generation. All of these are conditions where we would expect business investment to start to recover. But it has been weaker, given what has happened to output, than we had expected. It is possible that as a result, there is still a bit of an overhang of investment from the late 1990s, when there was strong business investment right across the Western world. Of course it was the downturn in investment, particularly in 2000, which led to the sharp slowdown there. It is possible that it is beginning to pick up. We have seen some recovery in the US—we have seen capital goods orders pick up in the US—and euro area. It may be that over the next year we shall see here too the recovery in business investment, but I am afraid I do not have a good explanation as to why it has been so weak in the past couple of years.

  Q75  Mr Todd: One small contributor, bearing in mind that it does not affect more than a proportion of the economy, would be funding pension fund deficits and alternative use of cash. Is that something you have monitored in any way?

  Mr King: We have. I cannot say that in the last six months or so it has been a factor which businesses themselves have said to us was the major cause. They were more concerned about that in 2004; some of them made the adjustments and since then, on average—clearly not true for every business by any means—cash flows continue to be strong, profitability has improved, the cost of capital has fallen. All of these things have made it possible to invest.

  Q76  Mr Todd: Might one explanation be that we do have access to relatively cheap labour? Obviously one driver for capital investment is substitution of expensive labour. We had this discussion earlier right at the start. Is that possible?

  Mr King: That would be inclined to be a much longer-term effect. What we have been expecting was the normal cyclical recovery in business investment. Business investment is quite volatile. It can fall when the economy slows and it grows quite rapidly when the economy picks up. It is not that business investment has been falling, it is just that it has not picked up as quickly as you might normally have expected during a cyclical recovery. It is that which has been surprising.

  Q77  Mr Todd: It deserves more research then.

  Mr King: I am sure many things deserve more research. We shall continue to look at it, but what is interesting is that it is not just a UK phenomenon. We have discussed it at the BIS when central banks get together and I think we should do so again, but I do not think that elsewhere there is a particularly compelling explanation either. In the United States attention has been drawn to the effect of corporate scandals and uncertainty facing managers. These explanations are much too vague to be compelling. There may be truth in them, but I should not want to claim that there is.

  Q78  Peter Viggers: You made it clear in the Inflation Report in August and elsewhere that you do not like fixed dating of the economic cycle. When the Chancellor of the Exchequer decided in July that he was going to change the dates of the economic cycle, to what extent did he consult the Bank?

  Mr King: He did not consult the Bank and there is no reason why he should: the task of the Treasury is different from that of the Bank. Our job is to look forward and to make judgments about where inflation is going and set interest rates. He has created a fiscal rule which makes it necessary to look backwards over a particular cycle and that is not something we have to do. There was no reason for him to consult us and he did not.

  Chairman: Governor, may I thank you and your colleagues for your appearance this morning. It has been a very lively session. We know Mr Walton in another guise, but in your new role we look forward to regular appearances before the Committee over the coming years. Sir Andrew, may we thank you for your cooperation and courtesy to the Committee over the years, with maybe one word of advice to you: watch out for any flying questionnaires. Thank you very much.

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