Examination of Witnesses (Questions 60
- 78)
THURSDAY 24 NOVEMBER 2005
MR MERVYN
KING, SIR
ANDREW LARGE,
MS RACHEL
LOMAX, MR
DAVID WALTON
AND MS
KATE BARKER
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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