Select Committee on Treasury Twelfth Report

3   The economic context


8. Short-term interest rates are set by the MPC, with the Bank of England undertaking the money-market operations required to achieve that interest rate. Very briefly, short-term interest rates are set by the Bank through its role at the centre of the banking system. The official Bank rate is set by the Bank charging that amount of interest on the loans ordinary banks require overnight to balance their cash requirements. These banks will then change their interest rates in order to keep in line with the interest rate the Bank of England is offering. Subsequently in this report, unless stated otherwise, any mention of interest rates means short-term interest rates.

9. The inflation target is supposed to be met by the MPC raising or lowering interest rates. Inflation is affected by the interest rate in the following ways. Inflation should fall if interest rates are raised, but there is a lag to the full effect coming through, estimated to be around two years.[16] When interest rates rise, loans become more expensive. Those on variable mortgages have to pay more interest, and therefore have less money to spend on other goods and services in the economy. The rate of interest paid on savings also increases, which means that people may choose to save more, rather than consuming today. In this way, demand in the economy is reduced. This reduction in demand means that those who supply products may have to lower their prices (or raise them less quickly) in order to maintain their orders. Inflation therefore falls.

The past decade

10. Over the past decade, inflation has only once gone beyond one percentage point either side of the target, in March 2007. Mr Michael Saunders of Citigroup highlighted three reasons for this good performance: "The framework is good, the judgment is good and they have been lucky".[17] It was difficult for us to assess the balance between these three factors. A lot of witnesses were prepared to acknowledge the record of the MPC. Professor Tim Congdon told us that it had been "massively successful"[18], a view supported by Professor Simon Wren-Lewis, of Merton College, Oxford University, who told us that "the MPC has been very successful".[19] Professor Charles Goodhart, a former 'external' member of the MPC, remarked that the recent stability in inflation was both "remarkable" and "quite extraordinary".[20]

11. Some attributed the success at least in part to luck. Professor Wren-Lewis told us that "There is no doubt that [the MPC] has been lucky in the sense that it has not been a very turbulent period, so in that sense it has not been severely tested, but there have been problems that it has had to deal with."[21] Mr Ray Barrell of the National Institute of Economic and Social Research was only prepared to say that the MPC had been "successful" rather than "very successful", because it had not had to "avoid an accident", in that no such accident had loomed.[22] Mr Saunders also told us that the MPC were aware that they were operating against a "fortunate background".[23]

12. Others felt that more credit ought to be given to the MPC. Professor Anton Muscatelli of Heriot-Watt University commented that "if you look in terms of a sustained period of growth, the UK has actually fared very well compared to the other European economies which have been subject to very similar shocks, so I think [the MPC] has been very successful".[24] Mr Laurence Sanders of the Bank of Ireland told us he believed that "the fact that the Bank of England was so close to that central target consistently over a period of time represents a strong element of judgment", although with assistance from "global factors".[25]

13. The former Governor of the Bank of England, Lord George, was emphatic that he did not care whether it was luck or judgement, the outcome had shown the MPC to be a success. However, he did point out that the UK had narrowly avoided the recessions other countries had gone into after the Asian crisis, and that it was not "pure luck".[26] Ms Marian Bell, a former MPC member, also highlighted that there had been external shocks which the MPC had dealt with, telling us that:

it would have been quite easy for the MPC to get it wrong at different stages and notably it has not. I think it is quite wrong to think that it has been plain sailing and there have not been any risks. There have been big structural changes in the world economy and the UK economy and also a considerable number of shocks. The MPC has dealt with that extremely well.[27]

14. While it is difficult to quantify the contribution made by the Monetary Policy Committee to maintaining a low inflation rate over the last decade as distinct from the effects of wider changes in the global economy, the Monetary Policy Committee deserves a significant amount of credit for ensuring that inflation over the last decade has been both lower, and less volatile, than in preceding decades.

Risks ahead

15. Several different threats to the economic outlook for the next ten years were identified in evidence which might effect the work of the MPC. Professor Congdon highlighted the threat from the high rate of money growth, and the possibility of larger public deficits.[28] Mr Barrell warned that the Bank would have to be vigilant for asset price bubbles, and continue to monitor the scale of personal debt, and that in the end, the risk of banking crises had not gone away.[29] Professor Muscatelli commented on the continuing risk of a disorderly unwinding of global imbalances[30], a risk we have commented on in our Report on Globalisation: The role of the IMF.[31] Professor Wren-Lewis commented that the global imbalance risk appeared at the moment to be mainly between the United States and the Far East.[32]

16. The Bank of England in its written evidence highlighted two tailwinds that had operated over the last decade, globalisation[33] and an increase in the effective labour force.[34] According to the Bank, globalisation had benefited the economy by improving the terms of trade (by making imports cheaper), thus allowing a temporary reduction in the level of unemployment consistent with low inflation.[35] The increase in the labour force, according to the Bank, was due to "a decline in the natural rate of unemployment; increased labour force participation; and net inward migration, especially from the A8 countries".[36] This increase in the supply side of the economy had also reduced inflationary pressure. However, the risk was that these tailwinds were beginning to weaken. The previous decade had been referred to as the 'non-inflationary consistently expansionary decade' or 'nice' decade. The Bank provided us with a warning that, as these tailwinds dropped off, the next decade might not be so 'nice':

We cannot guarantee that the next ten years will be so "nice". Many of the benefits of globalisation have already worked through, and the adverse impact on commodity prices of the development of China and India is now being felt. And the effective labour force is unlikely to grow as rapidly as it has done over the past decade or so. Moreover, some aspects of the global economy look unsustainable, particularly the pattern of global current account imbalances and the low level of real interest rates and risk premia. So the macroeconomic context is likely to be somewhat less benign.[37]

17. Mr Sanders agreed that there might be some weakness from a diminishing globalisation tailwind, but felt that there was additional impetus from other economies than those in the Far East, such as Latin America, that was still to be felt.[38] Mr Richard Lambert, Director General of the CBI, commenting on the potential "lack of positive drivers going forward", such as globalisation and migration, felt that this was not an area for the MPC, but the Government to deal with, such as through the Leitch review into skills.[39] The then Chancellor of the Exchequer noted that oil and commodities prices posed a threat to the current stability of inflation, and also reiterated the Bank's conclusion that changes within the Chinese economy might mean that the benefits of globalisation might be diminishing. He added, however, that nobody knew what the effects of these different factors would be over the next ten years.[40]

18. Professor Goodhart highlighted that people had forgotten what the effects of high inflation were like, and that therefore people took the current stability of inflation "rather too much for granted".[41] Several issues, such as the recent rise in asset prices, the potential end of the tailwinds of an increasing effective labour supply and globalisation which have tended to reduce inflationary pressures in recent years, and the risk of a disorderly unwinding of global imbalances have been drawn to our attention as factors suggesting the possibility that the economic climate over the next ten years may not be as benign as that seen over the last decade. While we are sure that the Monetary Policy Committee are aware of this risk, it is important that the public are also prepared for the possibility of less benign conditions ahead. Later in this Report we examine actions that may be necessary to educate the public about monetary policy in more uncertain times.

Asset prices


19. One potential weakness in the future economic environment relates to whether the recent rise in asset prices will be followed by a rapid fall in those same prices, leading to possible knock-on effects on both economic growth and inflation. Professor Jagjit Chadha of Citigroup suggested that one reason why asset prices had risen so much was because the Bank had had to stimulate domestic inflation to counter the global reduction in traded goods inflation, and that there had therefore been "elevated levels of asset prices".[42] Mr Saunders told us that weak consumer prices had allowed the Bank to "tolerate" this rise in asset prices to prevent inflation undershooting the target.[43] He later said, however, that at times the MPC might not have put enough weight on asset prices in their deliberations, but that he agreed that they were unable explicitly to target house prices.[44] Professor Congdon linked the rise in asset prices to the rise in the money supply.[45] Ms Barker pointed out that, in a period of low-real interest rates, it was not surprising "to see asset prices rise because of course that changes the fundamental valuation of those asset prices".[46]

20. Dr Sushil Wadhwani, a former 'external' member of the MPC, presented one potential response to the rise in asset prices in his written evidence. While not advocating an explicit target for asset prices, he wrote that there should be a 'leaning against the wind' policy: where an asset price bubble was thought to be occurring, the MPC could "aim-off", raising interest rates to counter the bubble.[47] Dr Wadhwani told us that he continued to believe that the MPC "should be leaning against the wind in terms of asset prices".[48] However, Mr Barrell, while supportive of the policy, explained the consequences of such an action, telling us that "Holding interest rates higher than they otherwise would have been in order to deal with debt and to deal with asset prices and those risks means holding them higher than they really need to be to hit full employment immediately, so there is a choice, a trade-off".[49]

21. Professor Wren-Lewis highlighted the problems with the Bank targeting such asset price 'bubbles':

certainly it [The Bank of England] should be on the lookout for bubbles, that is periods in which asset prices in particular seem to depart from fundamentals, because potentially those bubbles can impact seriously on the economy. However, although in principle it should look out for those things and in principle could act to try and counteract them, in practice actually identifying when bubbles occur is incredibly difficult.[50]

Lord George warned against having an explicit target for asset prices, telling us:

Asset prices can be driven by all manner of outside considerations. It is tremendously important that the Monetary Policy Committee monitors, follows and studies what is happening to different asset prices, financial assets, housing and so on, as it does. Those subjects are studied extremely carefully within the bank and are discussed by the MPC. But if one decided to set a target for house prices and equity prices one would end up in 'heap on floor'. One just cannot focus on more than one objective.

Ms Bell was also cautious about the ability of the MPC to counter asset price bubbles, warning that "the best job the MPC can do is to focus very precisely on achieving exactly the target that has been set for it and not try to stabilise asset prices as well".[51]

22. The recent period of low interest rates has seen a rise in asset prices. One possible response by the Monetary Policy Committee would be to target such rising asset prices by 'leaning against the wind'—raising interest rates to deflate the bubble in those prices. However, such a move would presuppose the successful identification of such a bubble. On the evidence we have received, this is not possible with certainty. Furthermore, the only instrument available to the MPC is moving the interest rate, and increasing interest rates to counter a rise in certain asset prices could hamper economic growth across the economy, not just in the markets with rising prices. For such a policy to be worthwhile, therefore, the risk to the economy of a rapid fall in asset prices would have to exceed the actual cost of raising interest rates to counter the rising asset prices.


23. Any consideration of asset prices in the UK is likely to pay particular attention to housing, given that residential buildings accounted for 44.1% of the total assets (both financial and non-financial) of households and non-profit institutions serving households at the end of 2005.[52] Housing is also of interest because of the way in which the downturn of the late 1980s and early 1990s was centred around the housing market. Professor Congdon outlined the present situation, and what happened after the most recent house price cycles:

At the moment you have got an anomaly really, because house prices are out of line with incomes. What has happened in two previous cycles - a cycle in early 1970s and again in the late 1980s - was that we had this very high house price: earnings ratio and then a bust. The ratio came back in the first case with a lot of general inflation and in the second case with house prices falling quite sharply in nominal terms.[53]

Professor Congdon went on to say that a collapse in house prices was not inevitable. Rather than a bust, his view was there could be 'rust', with house prices rising less quickly than incomes in general, a point he reiterated later, by saying that in the last housing downturn which had macroeconomic effects, inflation had been in double-digits.[54]

24. Professor Wren-Lewis on the other hand drew attention to some research at Oxford University suggesting that going beyond price-income ratios, house prices were actually currently sustainable.[55] Mr Barrell agreed that this might be the case. In a world of more stable interest rates, the risk of owning a house may have fallen, stimulating demand, and thus prices. Therefore, in part, the MPC itself, by creating a low and stable interest rate environment, might have contributed to a rise in house prices.[56] Mr Saunders again returned to the point that the MPC had had to stimulate the domestic economy to prevent an inflation undershoot, and higher house prices had been a consequence of that.[57] Lord George told us that the need to stimulate domestic consumption had been the route chosen by the MPC at the beginning of the decade, in the face of weak business investment and global economic weakness, to prevent inflation undershooting the target, and that high asset prices - house prices in his example - were a "legacy to [his] successors" from the actions the MPC had undertaken under his Chairmanship.[58] It was up to the present MPC to "sort it out".[59]

25. As with the case of asset prices in general, Professor Congdon warned that the MPC could not target both house prices and the CPI together at the same time. All the MPC could do, and had done, was provide warnings. Using the housing market as an example, Lord George highlighted the problems in forecasting the end of asset price bubbles, telling us that:

When I was still in my day job a lot of people forecast a collapse in house prices over the next six to eight months. We are still waiting for it. One must be very cautious about that kind of projection.[60]

Another point of view was provided by Dr DeAnne Julius, a former external member of the MPC, who told us that she believed "that the issue of house prices in this country is mostly a supply-side phenomenon", and outside the influence of the MPC.[61]

Household debt

26. As a proportion of total financial liabilities of households and non-profit institutions serving households in the United Kingdom at the end of the fourth quarter of 2006, long-term loans secured on dwellings amounted to 76.4%, again highlighting the importance of the housing market to households' financial position.[62] Ms Barker confirmed that the rise in household debt was in part the other side of the same coin that saw rising house prices. She did not see any difficulties in repaying this debt as a monetary policy issue.[63] Mr Sanders also felt that interest rates were the key to the recent rise in household debt, because the low level of interest rates had led to cheaper debt repayments.[64]

27. Mr Barrell argued that the most effective way of dealing with the rise in household lending, by constraining lenders, lay with the Financial Services Authority, rather than the MPC.[65] He thought that the MPC had to be concerned about the rise in debt, because that rise also could lead to rising insolvencies, and potential problems in the banking system.[66] He felt that the Bank should have been signalling to the Financial Services Authority that there could be a problem.[67] Professor Muscatelli also agreed that this was an issue for the Bank to discuss with the FSA, saying that leverage was very important, but he also stated that household debt was not an issue for monetary policy.[68]

28. The rise in debt means that some consumers may have difficulties repaying that debt. Mr Sanders felt that there would be more problems with consumer debt over the next five to ten years.[69] Professor Goodhart informed us that the Bank analysed this as part of its financial stability remit, and while not a systemic issue, the rise in household debt was a social, distributional issue.[70] Professor Congdon was more forthright on this point, stating that "It is not [the MPC's] job to deal with those people who have got excessive debts and so on".[71] Ms Bell felt that only when debt began to effect the monetary transmission mechanism should it be taken into account when conducting monetary policy.[72]

29. We also heard evidence about the effect of the rise in debt in determining how interest rate movements would affect the economy. Professor Wren-Lewis pointed out that the rise in household debt, especially secured lending, had made the economy more sensitive to interest rates, and that the Bank would have to be more cautious when moving interest rates, because consumers might react more strongly to those movements than they had done in the past.[73] Professor Muscatelli argued that, while in certain situations consumers might react smoothly to interest rate changes, if there was a sudden change in circumstances, perhaps due to a rise in unemployment or a deep recession, then the Bank might find it harder to react, because interest rates alone might not be enough.[74] Mr Sanders felt that the increase in the stock of debt meant that the economy was more sensitive to changes in the interest rate, and that small changes in interest rates would now have a larger effect.[75]

30. Dr Wadhwani pointed out that the US sub-prime mortgage market problems would prove illuminating on whether debt issues would lead to macro-economic effects.[76] And Dr Andrew Sentance, an 'external' member of the MPC, reiterated that, because of the link between consumer spending and the build-up in consumer debt, this was something he was interested in building up a picture of.[77] Mr Ian McCafferty, Chief Economic Adviser at the CBI, also considered that the build-up in debt did not pose a systemic risk unless interest rates went very high (he quoted Bank evidence suggesting interest rate rises would have to be "well north of 7% or 8%"[78]), but that certain households were now very sensitive to any rise in the interest rate.[79] He also thought that the MPC ought to keep this issue in mind, but that it was not the role of the MPC to deal with the individual circumstances of certain households.[80]

31. The then Chancellor of the Exchequer assured us that, for those who were currently facing difficulties with debt, the Government was "putting in place measures that give proper advice, proper help, proper debt counselling, proper support, and obviously, we want the banks and the mortgage companies to be sensitive to people in the position that they find themselves in".[81] However, as a systemic risk, he pointed out that debt repayments as a percentage of income were not in as bad a position as suggested by our questions to him.[82] The weight of evidence we have received suggests that the rise in household debt is not on such a large scale as to exert significant influence on monetary policy. However, the risk remains that future interest rate rises will see larger numbers of households in financial difficulties than anticipated.

Monetary aggregates

32. Views on the extent to which the rise in money supply presented a threat to inflation in the future differed among witnesses. Different members of the MPC placed differing weights on the information monetary aggregates could provide. Ms Rachel Lomax, Deputy Governor of the Bank of England, was most sceptical of the information provided by the growth in the money supply, and told us that she found it "very difficult to see much information in short-term movements in any of these monetary aggregates for movements in inflation over the next couple of years or so".[83] On the other hand, Professor Tim Besley, an 'external' member of the MPC, while he did not agree with the simplistic notion that increasing money supply led to inflation and praised Bank research trying to assess the empirical implications of the recent growth in the money supply, believed that, when linked in with the asset and credit markets, the money supply figures posed an upside risk to inflation, because they "could ultimately spill over into demand-side pressures in the economy and therefore essentially lead to a different nominal path which leads to higher inflation".[84] The Governor of the Bank of England expressed concern about the recent rise in money growth. He stated that, while some of this growth was explained by inter-bank transfers, there still remained a component of broad money growth beyond this. He observed that inflation was a monetary phenomenon, and therefore the rise in money growth could suggest a pick-up of inflation in the medium term.[85]

33. We asked our other witnesses how the recent rise in the money supply ought to be interpreted by the MPC. Professor Congdon said that he had repeatedly expressed his concern about the strong growth in the money supply.[86] Professor Wren-Lewis agreed that the Bank ought to monitor monetary aggregates, but thought that, as an indicator, money supply was very unreliable and rapid increases in monetary aggregates had also happened with virtually no consequence to the real economy.[87] Professor Chadha, while not going as far as to suggest that the MPC should follow the European Central Bank approach of having money supply as a "second pillar", argued that "Money supply is absolutely a key variable to study in terms of thinking about the macroeconomy", in that it could provide information on the real-time state of the economy, and on certain sectors of the economy.[88] The then Chancellor of the Exchequer did not accept the idea of a fixed relationship between the money supply and inflation, and the view that therefore monetary aggregates could be targeted to keep inflation in check.[89] We have received differing evidence about the importance that should be attached to the rise in the money supply. While we acknowledge that it is difficult to assess what information such strong growth in the money supply might provide for future movements in the inflation rate, there is a possibility that, in the medium term, the current rise in the money supply might presage a higher path for inflation.

Inflation expectations

34. One important risk identified in evidence related to the possibility of inflation expectations coming loose from their anchor, especially should economic circumstances be less benign going forward. Mr Saunders, in his written evidence, explained that, if inflation expectations rose, then individuals would bargain for higher wages. Should these increases in wages be granted by firms, this would lead firms to raise prices to cover the cost, increasing inflation.[90] Explaining the importance of the recent anchoring of inflation expectations, Professor Wren-Lewis highlighted that "anchoring expectations does not so much make monetary policy more effective; I think it makes it easier, in the sense that if the economy is hit by shocks then the Bank has to do less to counteract those shocks than if expectations are much more volatile".[91] But Professor Chadha pointed out that there had been, in recent times, a slight shift upwards in inflation expectations, both on the CPI and RPI measures.[92] He suggested that there was a danger in overusing inflation expectations as a measure of inflationary pressure, because monetary policy was expected to move to counteract any movements within them, thus neutralising their informative power.[93]

35. Lord George pointed out that inflation expectations, while not anchored precisely to the target, were now no longer running into "double digits", and that this had been a success of the regime.[94] Dr Wadhwani agreed, stating that the lowering of inflation expectations since the 1997 reforms had been important, and "has made it much easier for the economy to handle the fluctuations in oil and commodity prices that we have seen".[95] Mr Lambert also said that inflation expectations had influenced the wage bargaining process, and that "people broadly trust the idea that, over time, the target will be met".[96] The anchoring of inflation expectations has had an important role in ensuring that inflation has varied by less than might have been expected given the external shocks faced by the economy in recent times. However, we remain concerned that, while inflation expectations appear anchored in financial markets, the general public appear to have less understanding of the monetary policy framework.

16   Bank of England Website, Back

17   Q 58 Back

18   Q 6 Back

19   IbidBack

20   Qq 143, 150 Back

21   Q 6 Back

22   Q 7 Back

23   Q 63 Back

24   Q 7 Back

25   Q 58 Back

26   Q 99 Back

27   Q 142 Back

28   Q 2 Back

29   Q 3 Back

30   Ibid. Back

31   Treasury Committee, Ninth Report of Session 2005-06, Globalisation: the role of the IMF, HC 875, para 9 Back

32   Q 3 Back

33   Ev 7 Back

34   Ev 8 Back

35   Ev 7-8 Back

36   Ev 8. The A8 countries are: Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia. Back

37   Ev 13 Back

38   Q 62  Back

39   Q 349 Back

40   Qq 448-449 Back

41   Q 143 Back

42   Q 61 Back

43   Q 63 Back

44   Q 67 Back

45   Q 8 Back

46   Q 189 Back

47   Ev 85 Back

48   Q 173 Back

49   Q 11 Back

50   Q 9 Back

51   Q 170 Back

52   Office for National Statistics, United Kingdom National Accounts 2006, Tables 6.1.9 and 10.10 Back

53   Q 8 Back

54   Qq 8, 15 Back

55   Q 9 Back

56   Q 10 Back

57   Q 67 Back

58   Q 117 Back

59   Ibid. Back

60   Q 127 Back

61   Q 170 Back

62   Office for National Statistics, Financial Statistics, May 2007, Table 12.1N Back

63   Q 188 Back

64   Q 66 Back

65   Q 11 Back

66   Ibid. Back

67   Q 12 Back

68   Q 15 Back

69   Q 68 Back

70   Q 174 Back

71   Q 14 Back

72   Q 170 Back

73   Q 14 Back

74   Q 17 Back

75   Q 68 Back

76   Q 175 Back

77   Q 191 Back

78   Q 385 Back

79   Q 352 Back

80   Q 353 Back

81   Q 422 Back

82   Ibid. Back

83   Treasury Committee, Bank of England February 2007 Inflation Report: Oral and written evidence, HC (2006-07) 414-i,, Q 39 Back

84   Q 192 Back

85   HC 414-i (2006-07), Q 42 Back

86   Q 2 Back

87   Q 18 Back

88   Q 71 Back

89   Q 423 Back

90   Ev 48 Back

91   Q 5 Back

92   Q 73 Back

93   Q 76 Back

94   Q 105 Back

95   Q 142 Back

96   Q 374 Back

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