Select Committee on Treasury Minutes of Evidence


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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