Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 60-79)


28 MARCH 2006

  Q60 Chairman: Governor, good morning and welcome to you and your colleagues. Will you introduce your colleagues for the record please?

  Mr King: Yes. On my right is Charles Bean, Chief Economist at the Bank, on his right is Kate Barker, one of the external members of the MPC, on my left is Rachel Lomax, Deputy Governor for Monetary Policy, and on her left is Steve Nickell, also an external member of the MPC.

  Q61 Chairman: I believe you have a short opening statement to make.

  Mr King: Indeed I do, Chairman. I am grateful again for this opportunity to explain the reasons for the Monetary Policy Committee's decisions on interest rates since we last appeared before you in November. Since then the official interest rate has remained unchanged, and today you have the opportunity to ask members of the MPC to explain their votes in recent months. Over the past year, fluctuations in inflation have been dominated by the movements in energy prices. After first rising and then falling, inflation has, in the past four months, been very close to the 2% target. And last month CPI inflation was exactly 2.0%. In its latest Inflation Report, the MPC published a central projection for inflation which remained close to the target. But, of course, the chance that inflation will remain that close to the target throughout the forecast period is negligible. There are significant risks to the central projection on both the upside and downside. Driven by weakness in consumer spending, economic activity slowed at the beginning of 2005. Consumer spending and total output growth both recovered over the course of the year, and were close to their long-term average rates in the fourth quarter. If that continues over the coming quarters, then the annual rates of growth will pick up as the weak growth rates in early 2005 drop out of the comparison. The MPC's central projection is for quarterly growth rates to continue at around the rates experienced in the final quarter of last year. That seems to be supported by the available indicators of output growth in the first quarter of 2006. A puzzle is that the corresponding measures of expenditure growth appear somewhat weaker and there may be downside risks to consumer spending in particular. However, recent movements in asset prices, against the backdrop of a rapidly expanding world economy, should be supportive of private sector demand, and public expenditure growth remains robust. A major risk to the outlook for growth and inflation comes from energy prices. Past increases in oil and gas prices may have eroded the supply capacity of the economy and altered the balance between demand and supply. The increases in gas prices which were announced recently are likely to push inflation over the target in the short term and erode the purchasing power of household incomes thus slowing the growth of consumer spending. Fortunately, despite higher energy prices, earnings growth has so far remained relatively stable. Looking ahead, the MPC will monitor carefully developments in the labour market and measures of inflation expectations. Finally, I should remind the Committee that Steve Nickell will be leaving the Committee in May after serving for six successful years. For most of that period, inflation has been within 0.5 percentage points of the target. Richard Lambert is also leaving the Committee with immediate effect upon his appointment as Director-General of the CBI after three equally successful years. I would like to thank both Steve and Richard for their outstanding contributions to the work of the Committee. Chairman, those are the remarks that I would like to make this morning, and I and the other members of the Committee here today stand ready to answer your questions.

  Q62  Chairman: Thank you very much, Governor. May I add my congratulations to Professor Nickell and Richard Lambert for their courtesy to this Committee and their very helpful approach. I note that Professor Nickell was the first person here this morning at the House of Commons kicking his heels at nine o'clock so he is obviously keen to get on with his new life! There are a few questions to come before that. The February Inflation Report shows CPI inflation forecast at 2% for the next three years. In your statement you said that the chance that inflation will remain so close to the target throughout the forecast period is negligible. However, it seems to a student as though you have cracked it. Are you going to hold tutorials for your fellow central bankers?

  Mr King: No. I suspect that the only sensible thing to do in this circumstance is to join Steve and leave as soon as possible before inflation starts to move away from the target! It will undoubtedly be different from the target over the next two years, and it is the same point I am afraid I make with great tedium repeatedly to this Committee, which is that a forecast is not just a number. So our central projection is not the forecast. Our forecast is the entire fan chart, showing all the possible outcomes. I think the big picture that we wanted to get across in the Inflation Report is that there is not a great deal of spare capacity in the economy. There is certainly room for debate and the Committee has had a debate about precisely how much there is. Growth, after slowing at the beginning of last year, is back pretty close to trend rates. The Committee expects growth to be around trend and inflation to start bang on target. So the big picture is one that looks remarkably benign. There are many risks on either side, both in the world economy and at home which will, in the event, move inflation either side of the target. It is just that in our forecast in February it was not obvious to the Committee that there was a bias in the risks to inflation on one side or the other. The risks to inflation are fairly balanced and inflation looks to be on track to meet the target two years or so ahead. That is why we left interest rates unchanged.

  Q63  Chairman: At our last Committee hearing you had a fascinating exchange with Angela Eagle about your role as an Associate Fellow of the Royal Meteorological Society. Given that role and your Governor of the Bank of England role, what impact do you think the cold winter and high gas prices had on the work of the MPC? You have expertise in both these areas.

  Mr King: I think the expertise is probably more in one area than the other! There is no doubt, as I alluded to just now, that most of the volatility in inflation in the last year or so has come from movements in energy prices, first oil prices and now, more recently, gas prices. It is quite interesting to see that. Perhaps it is a tribute to the success of the overall framework that underlying inflation is broadly stable and that movements around 2% are coming from the short-term fluctuations in gas prices. Those movements, in particular, certainly mean that inflation in the next few months may well turn out to be above target because we have now seen announcements of higher gas prices. That information we did not have when we made our February inflation projection. Of course, that will unwind and we would have a correspondingly somewhat lower projection in the second year. But looking through to about two years ahead, all those effects will dissipate, so it is very much a near-term effect. The size of the changes in gas prices are clearly very striking and it reflects the fact that the gas market is very much a spot market. We have very little storage capacity in this country. The Rough storage facility is out of action for the next month or so because of a fire. It is true that there is the inter-connector with Belgium through which it had been hoped that gas would flow into the UK when prices were higher here than on the Continent. But I am not sure whether it was entirely reasonable to expect that, given that the gas market on the other side of the Channel is not exactly reminiscent of the group of atomistic competitors of textbook theory. We should put much more store into looking ahead: there will be not just an enhancement to that inter-connector with Belgium but also a new inter-connector with the Netherlands. The underlying economics of the gas market across the Channel are not likely to change quickly even though the European Commission is taking an interest in it. The real hope for the future is the new gas pipeline from Norway. Norway has always been a source of comfort to the UK in the supply of raw materials and I suspect it will come to our rescue again. There is some disagreement among the experts as to when that pipeline will be open. Some believe it will be ready at the beginning of the winter 2006-07; others feel it will not be ready until 2007. I think we do still face the prospect of remarkable volatility in gas prices, at least at the wholesale level, right through the next 12 months and that is a source of concern, particularly to firms for whom gas prices are quite a significant proportion of their overall costs.

  Q64  Chairman: Professor Nickell, after six years on the MPC, what do you consider to be your most significant contribution to the work of the MPC?

  Professor Nickell: When I started out I had to fill in an exam paper and I went and looked at this exam paper because one of the questions on the exam paper was "What criteria do you believe should be used to assess your record as an MPC member?" and one of the things I wrote down was that inflation should stay close to the target. Well, that seems fair enough. The other criterion I put was "Would I have made a significant, positive contribution to the analysis of the MPC in the view of both other members of the Committee and outside observers?" That is a hard question for me to answer.

  Q65  Chairman: Can I help you by quoting your exam paper because in that you said, "Of course, the ultimate proof of the MPC pudding is in the inflationary eating". That is so elegant! Would you agree with that?

  Professor Nickell: What, the elegance? Yes, of course! As the Governor has already told you, the inflation has done what it was supposed to on my watch, although it could be argued that the consequences of my decisions will last for some time to come so this episode is not really over. I guess I feel that I have done my bit. I have tried to explain my reasoning as well as I could and I have made some contribution to thinking about house prices and about the change in target and so on. Although it is hard for me to make these sort of judgments, I do not feel I have anything much to be ashamed of.

  Q66  Chairman: Of course not.

  Mr King: Can I add one point which I think is relevant here? Clearly the proof of the pudding is in the eating and we hope that all our clients out there enjoyed the eating of the relatively low and stable inflation rate, but, of course, what goes on in the kitchen is not really visible to many of the customers. Many outside commentators view the Committee as a group of people who have completely fixed views, who come to the table and who simply battle with each other for supremacy about the outcome. One thing which that view overlooks is that what the Committee really does is not to struggle with each other but to struggle with the issues and the data. Steve has made an enormously important contribution to the conversations that we have had in the forecast round and in each month's analysis to make sure that we have discussed the underlying economic issues. To my mind that is the test of how well the Committee as a whole is working. Both Steve and Richard have made very important contributions in that joint collective intellectual endeavour.

  Q67  Chairman: In terms of the UK's monetary policy framework, do you have any suggestions as to how that could be improved?

  Professor Nickell: One of the keys to such success as the Committee has is because it is a group of individuals who individually come to a decision about monetary policy by making their own decisions and then letting the majority voting take its course. I think this is a very good way of making decisions and it is superior to an alternative mechanism, which is a group of individuals coming together and trying to reach a consensus. I think the former method is probably a bit better. My own feeling in the light of this, to encourage what one might call this individualistic pattern that I have got in mind, is that I personally feel that each member of the Committee should own a paragraph of the minutes. The majority of the Committee do not agree with this so it is not likely to happen any time soon, but that is my personal view because I think that that would increase transparency. It would also increase the opportunity for grandstanding, which is always the danger in these things, but I think that on balance it would be a good move.

  Q68  Chairman: During your appointment hearing in May 2000, when you were questioned by this Committee, you said you did not want to be known particularly as someone who will end up in either the `hawk' or `dove' camp. It seems as though you have ended up in the dove category, certainly that is the way you have been painted by the media. What has brought you to that position? Has your background as a labour economist assisted that?

  Professor Nickell: No, I do not think so. The fact I finished up in the minority for cutting rates is a bit of an accident of timing in the sense that, as you know, I have been in the minority of voting for a raise and I have been in the minority of voting for a cut. I was in the minority of voting for a raise in 2003, which is not that long ago. By and large we now seem to be in a time where, at least in my view, if we are going to do anything, we are going to be cutting. So if there is going to be a minority, that is going to be the side on which it is on. I would not say that I have transformed from a hawk into a dove. If you recall the first meetings, I was in a minority for raising. It is just that that is the way that the economy is moving at the present time. I could have imagined times when I might have left the Committee where I might have been voting for a raise.

  Q69  Chairman: Governor, at the time of the Tonbridge robbery the Bank announced an immediate review of security to be undertaken by Sir John Gieve. Has that been undertaken and has he presented that report to you? Are you satisfied that the Bank's storage of notes is now sufficiently secure?

  Mr King: Yes. The review was in two parts. The first was an initial review; that has been presented. The second is a longer-term review of the security implications of the note circulation scheme. That is a scheme—and other countries have it too—under which notes are stored at different places around the country in order to minimise the number of journeys in lorries of bank notes from our printing works to regional banks around the country. The short-term review produced a number of recommendations for our own security which have been implemented. I hope you will forgive me if I do not give details of that. We produced a list of issues that we want all the members of the note circulation scheme to consider and they now have ten days to carry out an audit of their own security in order to see what changes will be necessary to comply with that. I think the review has produced some useful ideas, but I am not going to go into detail on that. In our case it already has been implemented and we will now look further at the scheme as a whole. One of the motives for having cash centres was to reduce the number of journeys carrying bank notes around the country. It is worth pointing out that last year the number of cash robberies was over 100 a month in the UK as a whole. There are a lot of attacks, relatively small scale, on lorries or other places holding cash. There were four attempted robberies of cash centres. There is clearly a trade-off between concentrating cash in one place, which is highly secure, or having many more movements of cash in ways which, inevitably, are less secure. We will re-examine that trade-off, but I have no reason to suppose that the judgment that was made when the scheme was set up was itself faulty in any way.

  Q70  Chairman: On a recent visit to the United States we had the opportunity to meet Ben Bernanke and he told us that he prefers to maintain the Federal Reserve's responsibility for banking regulation, due to possible co-ordination problems that might exist between the central bank and the separate regulator in the aftermath of a financial crisis. What changes have been made to the Memorandum of Understanding for Financial Stability to improve co-ordination between the Bank and the FSA, and are there any areas that require further improvement?

  Mr King: I think he is right to draw attention to a possible difficulty of separating supervision from the central bank and I think it is only a hypothetical risk but it is there. There is no doubt that, following the creation of the FSA, with a new body focusing on incorporating a number of other regulatory institutions and the Bank having lost supervision, there may have been some distance in terms of the practical day-to-day co-operation that might be necessary. Certainly when Callum McCarthy and I took over the first questions we asked were what exactly would happen in the event of a financial crisis, who would speak with whom; who would telephone whom. That has been clearly worked out and a lot of effort has been put in in the last two and a half years to putting together very detailed contingency plans as to how the FSA and the Bank would work together. Those plans cover who would speak with whom and the relative responsibilities of the two bodies in the event of a financial crisis. I am very glad to say that in two major respects I think the situation has been clarified. First of all—in terms of the detail of who would do what on the day and how we would communicate with each other—we have put in place very detailed arrangements for financial crisis management and we have practised them. There have been a series of exercises where we have been able to implement this and test it in the event of an emergency. Secondly, the Memorandum of Understanding between the Treasury, the Bank and the FSA, which was released on Budget Day, I think clarifies very greatly the relative responsibility of the different institutions which were not clear from the wording in the previous draft. In particular, it seems to me very clear now that, if there were to be any suggestion of public support to a bank or another financial institution in the event of a crisis, both the FSA and the Bank of England would give independent advice to the Chancellor as to the merits of that support. The Chancellor would decide whether or not public money should be used. If it was to be used, it is almost inevitable that that operation would be carried out by the Bank of England. But I would suspect that both the FSA and the Bank would, ex post, be accountable for the advice that they had given.

  Q71  Mr Fallon: I would like to turn now to the immediate past decisions of the Committee. Professor Nickell, you said in your 31 January speech that you voted for interest rate cuts in December and January because the "combination of the fading oil price effect and the absence of underlying inflationary pressure leads to CPI inflation undershooting the target further out if rates had been left on hold". Given that in the February Inflation Report the CPI inflation projections are considerably flatter, why did you continue to vote for reductions in both February and March?

  Professor Nickell: Basically because my personal projection would be a little bit below that in the Inflation Report. Perhaps I could expand a little. First of all, I think there is some degree of spare capacity in the economy. For example, since August 2004 unemployment has risen by about 150,000, which is about 0.5% of the labour force, and that plus the spare capacity within firms indicated by surveys following the relatively slow output growth last year indicates some degree of spare capacity in the economy. That means that looking at inflation going forward—and inflation going forward is determined by pressures on capacity—plus the more or less exogenous relative price changes that we have been seeing, such as oil and gas and imports of finished manufacturers and so on, so long as second round effects on wages continue to be absent, the oil and gas effect will wash out of the inflation rate after a year or so, so that pressures on capacity then become the driving force. Since we have some spare capacity, that means that if there is going to be pressure on capacity driving up inflation, that is going to require a period of above trend growth and it is my expectation at current interest rates that a long enough period of above trend growth will not be forthcoming. That is basically it.

  Q72  Mr Fallon: Do you think the growth forecasts are simply too simplistic?

  Professor Nickell: Yes.

  Q73  Mr Fallon: Kate Barker, why did you vote for no change?

  Ms Barker: I gave a speech last week in which I indicated that I have considerable sympathy with a number of the points that Steve Nickell has just made. In particular, my personal growth forecast would also be a little bit below the central projection of the MPC. However, in the short term the reason that I have not voted for any cut in interest rates is that I remain concerned about second round effects. Of course we have not seen these so far. If you look back over the past year or so, although CBI inflation has risen quite sharply, RPIX inflation has changed very little and we are now going to have a sustained period where we may find that CPI inflation runs a bit above target. I am not convinced with the pressures that are coming in from gas prices in the short term and possibly some continued greater pressures on import prices that we are quite through the short-term inflation pick up and that we are quite sure that we are not going to see some second round effects. At the moment, particularly as the economy is performing reasonably well, it is reasonably close to trend, I do not see the urgency for an interest rate cut.

  Q74  Mr Fallon: Governor, could I ask you about the increasing concentration of the interest rate changes into the Inflation Report months, the four months in which you publish your report. I think it is true to say that more than half the interest rate decisions taken since June 1997 have been in those months, and since late 2001 only two of the nine changes have been in months other than February, May, August or November. Are you not concerned that the financial markets might start to assume that these changes will mostly occur in the months in which you publish your report?

  Mr King: No, I am not worried about that. As long as people can see what we are doing and draw their own conclusions, that is transparency. The evidence shows that it is twice as likely that we would change rates in an Inflation Report month than in other months. I think that is rather natural because that is the month in which we can take a fresh look at the position. We can go back and say, "Did we really get it right last time? Let us take a completely fresh look." In the intervening months it is rather natural to focus on the monthly data and the changes over that month. I do not think that it is surprising. Indeed you can see in other countries that they can operate monetary policy perfectly adequately by having meetings less frequently than once a month. It is never really possible to say that this is the month in which a change should be made; there is always some uncertainty. I think it is quite natural that there would be a greater frequency of changes in an Inflation Report month, but it certainly is not the case that we would not be prepared to change interest rates outside an Inflation Report month; it will depend on the evidence that is in front of us. We are willing to change interest rates in any given month. I have never heard anyone say we should not do it because it is not an Inflation Report month. There is a quarterly cycle of data too. We chose the Inflation Report months to coincide with the months in which we had the first estimate of the national accounts, growth for the previous quarter and some of the quarterly surveys. There is far more data at that quarterly frequency as well as the forecast process in which the Committee spends many days together debating the outlook.

  Q75  Mr Fallon: I appreciate that the number of meetings is laid down in a Statute. Do you not see that it might make people question the usefulness or ask what you are doing in the other meetings?

  Mr King: That is for them to question. We know what we are doing in those meetings and people can see the decisions in the minutes. There is a natural monthly round to the data and it makes sense for us to meet monthly and to debate the data. I do not have any qualms about the fact that it has turned out to be the case ex post that interest rates change more frequently in Inflation Report months. I do not think anyone goes into a month thinking "Oh no, we won't do it because it is not an Inflation Report month". We form a judgment about the outlook for inflation.

  Q76  Mr Fallon: Rachel, four of your five change votes have been in those Inflation Report months. Have you not been feeling some tendency to wait for the Inflation Report sometimes? Why have four of your five votes been in those months?

  Ms Lomax: When you take a judgment about interest rates you are taking a judgment about where inflation is likely to go and the Inflation Report month is the moment where you really pull things together and have a more considered look at all that. I agree it is a perfectly natural way of doing it both from the point of view of the Committee is thinking about where inflation is going and also from the point of view of explaining to the outside world why we are doing what we are doing. Those are the months when we publish an Inflation Report and that is the time when you can really set out your thinking most clearly. I do not find it odd that we make changes more frequently in Inflation Report months. It does not mean that we are committed to doing it, but it is a natural tendency given the way we approach policy making.

  Q77  Mr Fallon: It might be dangerous if the outside world started to assume you were more likely to make changes in those months.

  Ms Lomax: I think they already do.

  Q78  Mr Fallon: And you do not see a danger in that?

  Ms Lomax: Occasionally we are going to take them by surprise and that is not the end of the world either, but you have got to have a good story when you do.

  Q79  Mr Newmark: I guess my focus is going to be on why the Bank is more optimistic with GDP growth versus external forecasters. According to the February Inflation Report, external forecasters attributed fairly low probabilities of 14 and 19% that GDP would exceed 3% during the three months ending 31 December 2006 and 2007 respectively. This compares to the Bank's estimates of 48% and 50% probability that growth will exceed 3% in these periods. I am just curious as to why there are these differences.

  Mr Bean: I think the way you have phrased the question is already quite useful because you have phrased it in terms of probabilities, and there is nothing that is certain in this world looking ahead. It is true that we have taken a somewhat more optimistic view than many outside forecasters, not all by any means, but that reflects our assessment of the impact of things like the rise in equity prices and the recent pick up in the housing market onto consumer spending, a judgment that net trade will no longer detract quite so much from growth as it has in the past and return to contributing a broadly neutral amount to growth, and also a modest pick up in investment. We have been disappointed with investment outturns and feel that they are likely to remain subdued in the near term but further down the road to pick up a little bit. And we also have some continued impulse from government spending. I would want to stress that our central projection does not see growth much above the UK's long-term trend growth rate. It is only a little bit above that as you go into 2007 and in that sense it is not a particularly optimistic projection. So far, some of the indicators for output in the first quarter of this year suggest that indeed growth has returned to something like the UK's historical trend. So really we are not projecting anything that is very much stronger than that going forward.

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