Examination of Witnesses (Questions 1-19)
MR ROGER
BOOTLE, PROFESSOR
ANTON MUSCATELLI,
PROFESSOR DANNY
QUAH AND
MR JOHN
BUTLER
7 MARCH 2006
Q1 Chairman: Good morning. May I welcome
you all to the session, particularly those who are here for the
first time. Roger, could I ask you to start by introducing yourself,
please.
Mr Bootle: Roger Bootle of Capital
Economics.
Professor Muscatelli: Anton Muscatelli,
the University of Glasgow.
Professor Quah: Danny Quah, the
London School of Economics.
Mr Butler: John Butler, HSBC.
Q2 Chairman: Welcome to all of you.
The February Inflation Report shows CPI inflation forecast at
2% for the next three years. It looks as if the Bank have everything
spot on. What are your comments?
Mr Butler: The first comment I
would make is that this is, almost by construction, the whole
point of the Inflation Report: if they forecast that inflation
would overshoot or undershoot in a couple of years' time, the
obvious question is why they have not done something. So I think
partly the constraints of the Inflation Report mean that they
have to give a fairly dull forecast. The other issue I would have
is that I do not think this fully reflects the risks that some
of the MPC members have been making in speeches of late. Mervyn
King has been highlighting the end of the nice period—the
non-inflationary consistently expansionary period—and highlighting
that that was unlikely to be repeated, almost saying that was
his central projection was that there would be much more volatility
in output. I think that sits oddly with the Inflation Report.
I do not think those risks come across in the Inflation Report,
where, as you say, inflation seems to be at target almost every
quarter right through the period.
Professor Muscatelli: One of the
difficulties MPC has in forecasting over the next year or two
is that there are forces driving in both directions. If there
are risks for inflation on the upside, in terms of understanding
how energy prices might feed through into wages and prices, there
are also downside risks to the world economy. I think all this
tells us is that the risks are balanced; it is not saying there
will not be any volatility. I agree with John: it shows that they
believe there will not be any major volatility, but it does not
say there will not be any volatility.
Q3 Chairman: Do you agree with the
MPC decision to hold rates?
Professor Quah: Yes, I do. I think
the MPC's forecast of inflation growth is roughly spot on and
correct, given the risks and balances identified. I think the
risks, as my other colleagues here have said already, are relatively
great ones. It is going forwards that these risks will emerge.
To the extent that we still see instability and inflation on growth
it will be from an increased manifestation of a number of large
risks out there. A number of these have already been measured.
My three favourites have to do with long-term interest rates (the
spread of the yield growth); global imbalances; and global liquidity.
Let me leave it at that. If we get further into discussion I am
happy to expand on this.
Mr Bootle: I would say that, although
the Bank has things pretty much spot on, has managed the economy
remarkably well over the last couple of years, I am persuaded
of the same view that Stephen Nickell holds; namely, that there
is a significant downside risk to economic activity and the Bank's
forecast remains rather optimistic. I do not find, myself—judging
around the edges, because, on the whole, I would not want to criticise
the Bank very strongly—that the Bank is too optimistic on
economic activity and therefore too optimistic on inflation.
Q4 Chairman: You mentioned in the
press at the weekend that you expected interest rates to fall
in the coming year?
Mr Bootle: Yes, that is absolutely
right.
Q5 Chairman: Do people agree with
that?
Mr Butler: I am in the same camp.
I think they are too optimistic about growth and inflation during
the course of this year. As the year progresses, we then will
have disappointments, particularly on the consumer side, which
will force them to respond.
Professor Muscatelli: If you had
asked me that question in November, I would have been on the side
of those who favoured a 0.25% cut. Now, given the latest figures
we have for both GDP and consumer expenditure, I would be in favour
of holding interest rates at this stage.
Professor Quah: I fully agree
with the MPC decision at this stage to keep interest rates constant.
My prediction is that going forwards over the next year we will
be seeing interest rate cuts. We will see circumstances emerge
in the world that will lead the MPC to decide if it is a good
thing to do to cut interest rates.
Q6 Peter Viggers: OECD seems to have
perceived, both in the European Central Bank and in Japan, a tendency
to think that perhaps an increase in interest rates would be appropriate.
The OECD has warned against that. If the OECD expectations were
to be fulfilled would you worry if the interest rates externally
were going up, staying the same or going down?
Professor Quah: If we look at
the chart on page 5 of the current Inflation Report, the euro
area in the ECB has been contributing greatly to global liquidity—a
fact that journalists and public discussion have not yet picked
up.[1]
Now, given that, it might well be sensible for the ECB to raise
interest rates in the future. The Japanese case is peculiar, because,
although it remains the world's second largest economy, they have
this massive programme to try to get prices going and they have
started to pick up. I suspect though it is too early to think
about the Japanese raising interest rates.
Mr Bootle: I do not think there
is any reason to believe it is odd for UK interest rates to be
stable or going down at a time when other rates internationally
are going up. It is true to say that over history major steps
in interest rates tend to be shared in all major countries, but
it is not true to say that the minor movements are always shared.
There are examples where interest rates have gone in one direction
in this country and in another direction in other countries. You
have to take into account the different circumstances of both
the euro zone and Japan: Japan is emerging from a long time with
inflation and interest rates at zero; the ECB is nothing like
as strong as that. It is very likely they have to want to raise
them; it is normal for them to want to raise them; the Bank of
England raised interest rates some time before. Interest rates
of 4.5% compared to zero and 2.25% is a completely different ball
game. There is no reason why our rates cannot go down while theirs
go up.
Q7 Chairman: Roger, your newspaper
articles referred to that. You were obviously very successful
with your economic forecasting in Capital Economics during 2005,
but, on your predictions for a housing market crash of 20% or
less, why was the Bootle theory such a miserable failure?
Mr Bootle: First of all, I am
not sure it was so much of a failure, in that the forecast was
20% over a number of years. The fall in individual years was never,
of course, as great as that. Secondly what happened to the housing
market last year is a matter of some dispute. It is true that
the Halifax and Nationwide measures showed prices moving up reasonably
sharply, 5% or so, but a number of other measures did not: the
home track website, newhomes.com, the Royal Institute of Chartered
Surveyors. A number of other indicators suggested the market was
in fact quite weak. If you look at housing transactions—
Q8 Chairman: There was a 20% to 30%
fall in house prices.
Mr Bootle: No, I have just said,
the forecast was never 20% fall in house prices in a single year.
Q9 Chairman: So you were wrong.
Mr Bootle: The forecast was never
20% in a single year and there are some of these housing indicators
which did suggest that house prices did fall last year. A number
of indicators say they fell.
Q10 Chairman: Does anybody want to
stick their neck out as much as Roger, that house prices are going
to fall as much as 20% or 30%. Danny, what would you say?
Professor Quah: No, I just cannot
see that happening.
Professor Muscatelli: I cannot
see that either.
Mr Butler: The fact that house
prices picked up at the end of last year is not necessarily evidence
that the risk in the housing market has disappeared. Turning back
to the Inflation Report, one of the main messages from the Bank
of England's Inflation Report is that they have changed their
story to become much more optimistic on the consumer side and
a large proportion or a large source to that optimism comes from
a rebound in house prices. Okay, I do not foresee a 20% to 30%
fall in house prices. Although the risks are there, you probably
need a much bigger trigger than anyone is forecasting—but
those risks have not disappeared. Valuations in the housing market
are still incredibly expensive.
Q11 Chairman: We all live with risk
in the economic field, do we not? We live with risks every day,
do we not?
Mr Butler: Absolutely.
Professor Muscatelli: There is
a very interesting discussion of risk premia in this quarterly
report of the Bank. Of all the explanations they have put forward,
I would certainly favour the last one, which is that they would
probably see a very temporary but narrowing of risk premia due
to poor liquidity. That is the point Danny was making earlier.
We might see a reversal of that, but that does not imply a crash,
necessarily, of house prices. You might find that price increases
will moderate. In relative terms, they will not rise as fast as
they have in the recent times.
Q12 Jim Cousins: In the United States
the stock of unsold residential property is running at some of
its highest levels ever against a background still of asset prices
increasing. Obviously it considers how long those two things can
run on together. Do we know anything about the stock of unsold
property in this country?
Mr Butler: The only real evidence
we have to go on is some of the survey evidence like that of the
Royal Institute of Chartered Surveyors. If you look at the evidence
available, it suggests the stock of unsold property is at all-time
low. One of the reasons house prices may have been so strong is
because of the mismatch between demand and supply, in that there
is a lack of new housing coming on the market. If what you are
seeing in the US is rising stock, the latest evidence in the UK
is the opposite of that.
Q13 Kerry McCarthy: You have touched
on some of the things I was going to bring in, but we have historically
low levels of yield on long-dated Government bonds—and I
think we have touched on the extent to which the reduction in
risk premia is a factor in that. Could you elaborate on that?
I am particularly interested in what Professor Muscatelli said
about the fact that with some of the new financial products on
the market, credit derivatives and so on, although they may have
played a part in driving down risk premia at the moment, people
do not understand the extent to which the risk is still inherent
in those products.
Professor Muscatelli: If we look
at long-term interest rates, I think something particular is happening
there obviously at the long-end, and this has been widely discussed
in the press. It has been partly due to the way in which pension
funds are behaving, and there also seems to be some spill-over
effect with foreign institutions purchasing long-term gilts. There
is a difficulty here I think for the Government in terms of managing
its debt. The Chancellor has made an announcement publicly that
he will try to move supply towards that end of the liquidity spectrum,
but I think the difficulty there is you cannot simply fund at
a single maturity, you have to make sure the market is liquid
at a different maturity. It is a balancing act. I think it is
of concern that we have seen this happening in long-term bonds,
but it is difficult to know how that will unwind actually.
Professor Quah: There seem to
be a number of parts to your question. One is: What are the global
changes that have led to this profound decline in long-term yields—worldwide,
not just in the UK? I think Anton [Muscatelli] and other people
have mentioned how some of this has to do with changes in the
global economy out there, how China and Japan and other countries
will grow their foreign reserves. These countries are now deathly
afraid of the kind of foreign exchange financial crises that the
Far East went through in 1997; they are building huge reserves
of western financial assets—and some of that has to do with
risk management and financial innovation that is happening in
these western economies and so on. So I think that your question
has to do with how we expect some of these factors might unwind.
To the extent that they unwind, long-term interest rates rise,
the prices of long-term assets decline, consumer wealth declines,
and economies in general in the West will slow down as a result
of that. Your point about financial innovation and people not
properly understanding risk is proper and cogent: that might well
happen. But I think an even larger risk is what happens when the
faster growing economies or oil producing economies elsewhere
in the world decide that they no longer wish to hold long-term
western financial instruments.
Q14 Kerry McCarthy: We have taken
evidence and had various meetings, both in the States and here,
about credit derivatives and other products like that. I think
virtually everyone we have spoken to has said, "Yes, the
market does not fully understand what it is doing. There is the
potential for, if not catastrophe, then something potentially
serious, to happen." I am not quite sure where we are going
with that. Everyone knows there is something out there that could
be a problem, but are there any triggering factors that you think
would cause the scenario that people talk about to happen?
Professor Quah: If it is investor
sentiment, people holding financial instruments that they do not
properly understand and they consider faddish to want to do, then
that consumer sentiment can be quite volatile and can turn around.
But something else has to trigger that. I think investors are
typically quite happy believing that they have done the right
thing. If they are heavily into certain kinds of financial instruments,
unless something changes, they will want to believe they have
done the right thing so they will continue to hold those.
Q15 Kerry McCarthy: You mentioned
the market might correct itself by increasing yield—and
perhaps I could bring other people in now. If so, how long would
this take?
Mr Butler: I think what is happening
in terms of long-term interest rates has been more pronounced
in the UK than elsewhere. The move in long-term rates has been
more evident in the UK, partly because of the pension issue and
the asset liability and mismatch. It is the million dollar question
as to how long this can go on. Long-term interest rates, 1% below,
does not seem to me to make much economic or investment sense
and at some point that will unwind, but that some point could
be a couple of years because we do not know how big the flows
in terms of demand from pension funds will be and we do not know
of the supply in terms of the amount of gilt issuance or corporate
issuance that will come through and hit the market. My guess is
it is not something that is going to unwind any time soon.
Mr Bootle: I would draw a distinction
between the UK elements and international elements. As other speakers
have said, there are major international forces keeping global
interest rates low—to do with excessive savings, excessive
liquidity and so on and so forth. I do not myself think the chances
of those forces changing very quickly are all that great. They
certainly can change—and the big risk is undoubtedly for
an upward move in real interest rates. But is the behaviour of
China, for instance, going to change in a matter of months? I
think it is highly unlikely. That element will not change for
years. But the UK-specific part of this, which is to do with the
forces that have pushed down UK long-index link yields below 0.5%
for 50 years, surely could change. That is to do with the regulation
of pension funds and the behaviour of pension fund managers and
trustees in relation to those regulations and the behaviour of
the Treasury in regard to issuing stocks. I think any one of those
things could change in a matter of weeks.
Kerry McCarthy: I will leave it there,
thank you.
Q16 Lorely Burt: I would like to
ask you for your views on the growth of the broad money which
was reported in the February Inflation Report, just asking you
to speculate really as to why you think there is that growth.
Have you seen any evidence of non-banking institutions building
up deposits, maybe with the intention of purchasing assets, or
do you think it is because there is more uncertainty or do you
think they are doing it because they think the value of assets
is going to fall?
Professor Muscatelli: I think
one has to treat this with care because this is quite a volatile
aggregate anyway. If you look at the graph over the last decade/15
years, it is an aggregate that is hugely volatile, and I do not
think we should draw any rash conclusions. [2]One
of the factors that has been mentioned has been the behaviour
of foreign institutions purchasing UK gilts, which obviously then
impacts on the way in which M4 grows. I personally would not think
that at the moment there is huge concern over this, but others
may disagree.
Mr Bootle: I would not be heavily
concerned about it but of course there are some people who are.
This touches on a matter of economic philosophy really, whether
you think this aggregate conveys some uniquely important and reliable
message about future inflation. I profoundly do not. On the basis
of history, I think there have been so many occasions when it
has led you up the garden path, because how it grows is a reflection
of a complex movement of assets and liabilities between all sorts
of players in the financial system and there is no presumption
that because growth has been very high that necessarily means
inflation is coming around the corner. Where I think it can be
useful to some extent—and this is how the ECB uses it—is
as a sort of confirmatory variable in relation to what else is
going on in the economy. If there were clear signs that growth
looked as though it might be quite strong and at the same time
money supply growth was strong, I would regard that as a helpful
confirming indicator. But if there are good reasons to believe
that the economy overall is on the soft side—and we are
looking at a monetary indicator which says the opposite—I,
for one, would not be deflected by the evidence from the real
economy.
Professor Quah: This issue of
broad money is where we are trying to understand an outcome that
emerges as a result of two sets of agents. One set of agents is
that underlying the supply of credit and liquidity and money;
the other side is that on the demand side: consumers and businesses.
M4, broad measures of money, more than most other measures of
money, reflect what is happening on the demand side. Your question
then can also be thought of as: "Why are businesses and consumers
out there building up liquidity, building up their holdings of
broad assets like this? Are they anticipating, are they saving
in some kind of buffer-stock way for some downturn in the future?
Do they have grand investment plans that have not yet shown up
in the weak investment numbers?" The problem is that we do
not know, and it is not something that the Monetary Policy Committee,
the Bank of England or monetary authorities can determine from
within just themselves, from within what happens within the Bank.
We need to know what is happening out there more—and I am
at a loss on this. I just do not know why this is happening.
Mr Butler: One of the issues which
has been incredibly important through the last year is that corporates
have been cash rich, the cost of capital has been low, and yet
their appetite to spend and increase activity has been fairly
small. One of the biggest disappointments the Bank of England
faced last year was not necessarily on the consumer side; it was
the lack of investment coming through—which shows a degree
of uncertainty and almost a savings glut out there.
Professor Muscatelli: Given what
is happening in terms of yields being quite low in terms of bonds,
it is not entirely surprising that you see people holding cash
where the yields might be comparable or only at cash in the case
of M4.
Q17 Lorely Burt: That is fascinating:
four very different views. Could I move on to talk about financial
distress and bad debt provision. The number of households in financial
distress has risen sharply over the last couple of years, but
the Bank of England does not seem too perturbed about that. They
keep on telling us that it does not pose a significant risk to
the macro-economic outlook. I would be interested in your views
on that.
Mr Butler: I would probably be
a little more concerned. I think the last year has probably told
us two things of the UK consumer. The first is that you do not
get a housing market crash or consumer recession unless you have
a trigger like rates going up aggressively, but, equally, you
still had this significant slow-down in the housing market and
significant slow-down on the consumer side on very little bad
news. Interest rates did not go up far. I think that shows an
increased sensitivity on the household sector to smaller and smaller
shocks and that increased sensitivity is in a backdrop in which
debts are at record heights. I think the issue, going forward,
is that the arrears you have mentioned and repossession orders
have been rising. Part of it has been the change in the laws,
part of it has not, but it has been happening in a backdrop in
which the labour market has been very strong. It might be coming
from low levels, but I think the move is worrying. I think, going
forward, if the interest rate risk may be capped, the key indicator
to be tracking would be seeing whether the labour market is going
to be deteriorating. Over the last three months, you have seen
the fastest fall in employment in the UK since the last recession.
If that continued, then these stress indicators will become far
more striking and I think then the confidence you would have in
a consumer recovery would be dampened significantly.
Q18 Lorely Burt: Stephen Nickell
suggested that this high level of borrowing is not necessarily
a problem because in the event of a shock to consumption monetary
policy could be eased to stimulate demand. I would be interested
in your views on that.
Mr Butler: I would be less confident.
I think we have lived in a golden age since the Bank of England
got independence, in terms of: every time they have cut interest
rates it has typically been in response to a global shock and
they have been cutting rates into a domestic environment where
unemployment has fallen. If we are now moving into a period where
unemployment is starting to trend higher, interest rates becomes
less effective. I think people are less willing to respond to
interest rate cuts and buy another car, another house when unemployment
is rising. I think interest rates in that environment get used,
just like the corporate sector in the last few years, in terms
of reorganising your balance sheet rather that stimulating you
to go out and spend.
Lorely Burt: Thank you. That is very
interesting.
Q19 Mr Fallon: John Butler, I notice
in your submission that you pointed to the shift of emphasis in
the Inflation Report away from investment back to consumer spending.
How credible was the Bank's forecast of 3% this year?
Mr Butler: Any forecast is credible.
My preferences would be similar to what Roger highlighted earlier:
I would say the risks are on the downside. It is interesting,
as you say, that over the last three months they have a very similar
growth forecast for this year but the story is fundamentally different
from three months ago. Three months ago, it was investment led;
now it is a consumer led story. That has come against a backdrop
in which over the last three months you have seen a significant
squeeze on disposable income, partly because of energy bills rising,
and a backdrop in which the labour market is now showing signs
of deteriorating. My unease about their forecast is that it is
a consumer recovery, based on asset prices, which a year ago was
a link the Bank of England was at pains to stress was not there.
1 Inflation Report February 2006, Bank of England,
chart A, p. 5.<fe Back
2
Inflation Report February 2006, Bank of England, chart
1.5, p. 9. Back
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