Examination of Witnesses (Questions 1-19)|
6 MARCH 2007
Q1 Chairman: Good morning and welcome
to our evidence session, the first one on the Monetary Policy
Committee of the Bank of England: 10 years on. We are delighted
that you have accepted our invitation to kick off this very important
inquiry. We have an hour for this session so not everyone need
feel obliged to answer every single question, and then maybe we
will get through in that time. Could you introduce yourselves
for the shorthand writer, please.
Professor Wren-Lewis: Professor
Simon Wren-Lewis from Oxford University.
Professor Congdon: I am Tim Congdon.
I was on the Treasury Panel in the 1990s and I am now associated
with the London School of Economics.
Professor Muscatelli: Anton Muscatelli,
Mr Barrell: I am Ray Barrell and
I am a member of the National Institute in London.
Q2 Chairman: Welcome. The MPC appears
to have been successful over the last 10 years. However, even
the Bank admits that the next 10 years may not be as easy. As
the Governor said it will not be perhaps as "nice" a
decade. What do you regard as the greatest threat to monetary
stability over the next 10 years? Professor Congdon?
Professor Congdon: At the moment
there is a rather high rate of monetary growth and I would say
that is a threat over the next few quarters. Then in the longer
run there is always the problem of large budget deficits, if they
return. On the supply side of the economy I would mention the
likelihoodwell, the certaintythat oil and gas revenues
will be less than they were in the last 10 years and in the 1990s.
Q3 Chairman: Does anyone else want
to add to that?
Professor Muscatelli: I highlighted
in my evidence the last time I met the Committee that I thought
global imbalances were still an issue and I think that is something
that needs to be watched, especially as we see what happens in
Asia in terms of the rate of growth in these economies. The Bank
has highlighted the impact from the incorporation of these countries
into the world economy on the level of inflation and it has also
been the cause of some of the global imbalances we have seen.
It will be interesting to see how that unwinds over the next few
years and if the rate of growth changes in these countries.
Mr Barrell: Monetary stability
means a number of things. There is almost a continuum of issues
here. One can say what are the threats to the short-term stability
of inflation and obviously there are things like instability in
exchange rates, shocks to expectations, but also there are risks,
and we must not forget them, to monetary stability from the occasional
dangerous event, like for instance banking crises. The Bank has
to keep an eye on issues like the emergence of debt and asset
price bubbles partly because large-scale personal debt and large-scale
asset bubbles can be harbingers of banking crises. Banking crises
are very unlikely but when they do turn up they are very dangerous,
so stability is two ends of a continuum: keeping it stable now
and avoiding the big dangers in the future. We have not completely
removed the risks of banking crises. The fact that nothing has
gone wrong partly reflects the fact that nothing has gone wrong,
and we still have to keep on eye on those big risks.
Professor Wren-Lewis: I concur
with all those thoughts. I have just one thing to say on the subject
of global imbalances, which I agree is a risk. It is not necessarily
something that is going to impact very strongly on the UK because
I think it is essentially an issue to do with the United States
and the Far East, China in particular, and it may be that the
problem resolves itself just between those two countries, so there
is not necessarily an impact on the UK, but if things do not work
out as perhaps they should then there may be some repercussions
in Europe and the UK.
Q4 Chairman: To what extent is the
anchoring of inflation expectations around the inflation target
important in ensuring that monetary policy is effective?
Professor Congdon: It is very
important because obviously there is, in the short run at least,
an effect from inflation expectations to such things as pay bargaining;
no-one disputes that. The question is "in the long run what
is the cause of inflation". There is not much doubt that
in the long run it is the quantity of money rising faster than
the quantity of goods and services. What one has is this problem
of how relevant is the behaviour of money to inflation. Even if
expectations are firmly entrenched at this very low level, will
that in the end ensure that the Bank of England can get away with
monetary growth in double digits? I doubt it.
Q5 Chairman: Did you want to come
in, Professor Wren-Lewis?
Professor Wren-Lewis: I do not
think I would quite put it the way Tim does. I think 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. I think it
certainly makes the Bank's job easier and less painful, but it
does not mean that if those expectations are not anchored the
Monetary Policy Committee could not do its job; it could. I do
not share the view that the source of all evil is in monetary
Chairman: Thankfully we have a difference
of opinion early on in this inquiry and that is good! Peter?
Q6 Peter Viggers: How successful
do you think the Monetary Policy Committee has been over the last
10 years and is its success more due to luck than judgment? Just
to frame the question, the Bank of England in writing to us quotes
Ben Bernanke, the Chairman of the Federal Reserve, in saying that
if anyone does say it is luck they under-estimate the extent to
which the imposition of better policy frameworks has reduced the
impact of shocks, so how successful do you think the MPC has been?
Professor Wren-Lewis: I think
the MPC has been very successful. There is no doubt that it 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. It has
had to vary interest rates and it seems to me that it has varied
them in a very intelligent and prudent way, so I think the MPC
has been successful, in my view.
Professor Congdon: I think it
has been massively successful and that has been the result of
good policy and, in particular, the adoption of a sensible framework.
If one goes back to the period up to the Second World War, a period
of about 150 years or so, the economy was basically managed on
Bank rates and the economy was sensitive to movements in interest
rates. That Bank rate system worked. The focus on interest rates
was then very much diluted in the 1940s and 1950s because of Keynesian
economics. We had all sorts of, in my view, mistaken approaches,
in particular things like incomes policies and over-reliance on
fiscal policies. What has happened in the last 20 years is a return,
in effect, to the Bank rate tradition. But instead of it being
focused on the exchange rate, it is focused on controlling the
growth of domestic demand to keep output at trend, and it has
been very successful. In my view, it is as if there are different
ways of dealing with illness; some of them are bad therapies,
some are good therapies, and they have chosen the right therapy.
Q7 Peter Viggers: We do not need
everyone to answer every question unless you particularly wish
to add something.
Professor Muscatelli: The only
thing I would highlightand I certainly would agree with
what has been said so faris the fact that when you try
and measure success in an attempt by the Bank, as well as other
commentators in the written evidence, just by volatility over
the period then it seems as if the UK has done pretty well, just
as well as some of the other economies. However, we have to remember
just how much poorer UK macro policy was in the preceding two
decades and really the UK lagged behind. Also rather than looking
at volatility, 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 it has been very successful.
Mr Barrell: Although I would agree
largely with what my colleagues have said, I would use only the
word "successful". You can only be "very"
successful if you avoid an accident when an accident is looming
and there has been no accident looming, therefore it has not really
been tested. The Bank has been lucky, as Ben Bernanke says, in
that the world has changed to a better monetary policy environment
and that has allowed it to change to a better monetary policy
environment and improve massively on the UK's monetary policy
performance. The Bank of England system since 1992-93 has been
much more successful than any previous regime we have had in the
UK in the post-War period: so successful, yes; very successful,
we cannot know that yet.
Q8 Peter Viggers: Okay because there
may be problems coming. For instance, house prices are about two-thirds
above where you would expect in terms of the average historical
ratio of house prices to income. Do you think the Monetary Policy
Committee has been successful in integrating house prices into
its equations? Is there more it should do?
Professor Congdon: There is this
general problem about asset prices. In my view, in the end there
is a relationship between the growth of money, the behaviour of
asset prices and movements in national income and expenditure.
In the long run these are all related. At the moment you have
got an anomaly really, because house prices are out of line with
incomes. What has happened in two previous cyclesa cycle
in early 1970s and again in the late 1980swas 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. I think there is a medium-term problem out there
and the question is whether there will be a bust or a gradual
what is called "rust", in other words a long period
in which house prices go sideways. My guess is that it is more
likely they will go sideways for a period than collapse. Logically,
history says there should be a problem of adjustment in the next
few years with house prices.
Q9 Peter Viggers: So looking at what
Professor Wren-Lewis rather endearingly calls "bubbles"that
is, as it were, irrational exuberance in pricesdo you think
that it possible or wise for the Bank of England to try to identify
these bubbles? Can I bring in here the comments of the International
Monetary Fund which has said that Mr Brown, the Chancellor, should
be building in cushions needed to respond to adverse shocks and
that should be a priority. What they have indicated really is
that in following his predecessor Ken Clarke's policies for a
couple of years the present Chancellor was cautious. He then let
the brakes off and we are now, as it were, at scene VI of Hogarth's
A Rake's Progress where he is needing to slam on the overall
controls. Can you comment on that?
Professor Wren-Lewis: There are
a number of parts to that question. On the issue of house prices
and whether the Bank should try and identify bubbles, certainly
it 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.
Let us take the issue of house prices. It is far from clear whether
the current level of house prices represents in any sense a bubble.
For example, some of my colleagues at Oxford have suggested that
if you go beyond rather simple price:income ratios and look at
other factors that would influence house prices, then the current
house prices might well be at a sensible level and not represent
a bubble. So I think the problem with trying to pick bubbles is
that it is very difficult to actually identify a bubble at the
time. These things are only clear 10 years after the event. That
is why I think it is dangerous to expect the Bank to do too much
in this area.
Q10 Peter Viggers: Because the thrust
of the IMF comment says that "the public spending surge of
2001-2004 led to a sharp deterioration in the fiscal balance and
rising net public debt, leaving little room for manoeuvre in the
face of a global downturn." Would you regard this as a problem?
Mr Barrell: I agree strongly with
that and I have said similar things myself. I do not think the
MPC can do very much about the Chancellor's spending and tax decisions.
The MPC's remit is to deal with the consequences of that increase
in public spending. On house prices, I think there is something
one can add to that which is the same thing about public spending.
When there a risk, like too much public spending for stability
or too high house prices, then the Bank of England can hold interest
rates slightly higher than it otherwise would have done, and I
think that is wise. We have to remember though that the Monetary
Policy Committee may actually be part of the cause of the rise
in house prices and that could be a good thing. Volatility has
come down massively in the UK; therefore the risks of owning a
house have come down massively in the UK, therefore the demand
for housing is shooting up. Exactly the same thing has happened
in Ireland and in Spain. Suddenly interest rates are much more
stable and the world is more stable and people demand more houses
and house prices have come up, so it may not be a bubble; it may
be the result of the Monetary Policy Committee's actions being
so successful rather than the Chancellor's actions of pouring
in rather more money than he perhaps should.
Q11 Mr Love: Can I turn to household
debt: do any of you think that the Bank of England should have
been more proactive in dealing with the issue of household debt?
Mr Barrell: It is very hard for
the Bank to do that because one of the things that happened when
the Bank was given independence was that certain parts of financial
stability were separated from the Bank's remit into the FSA, and
to the extent that we might be seeing too much debt rising, the
most effective instrument for dealing with that would be constraints
on lenders and the Bank of England cannot do that, so the Monetary
Policy Committee cannot do that. Again, it should be keeping a
careful eye on the rise of household debt because the rise of
debt raises the risks of bankruptcy and raises the risks of problems
in the banking sector and therefore it is one of those long-distance
threats, it is not an immediate threatand if the banking
system begins to have problems that scale of debt will cause it
severe problems, so the Bank of England should again perhaps be
cautious on interest rates and holding interest rates higher than
they would otherwise have been. That is not always popular with
this Committee and we have discussed this before. 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.
Q12 Mr Love: Can I just ask you whether
you think that the Bank should have signalled action to the FSA
or the Treasury?
Mr Barrell: I personally think
they should have done. I do not know exactly what channels of
communication they have between each other. I would hope that
the Bank is aware of the risks from excessive debt of banking
crises because it is relatively well known in the academic literature.
I think they should have been signalling perhaps more worry about
the scale of debt than they have.
Q13 Mr Love: Do you agree Professor
Professor Congdon: The Bank cannot
try simultaneously to control house prices and the Consumer Price
Index; that is not possible, so when you have (as we have had
in the last few years) a large rise, an apparently anomalous rise
in house prices to some extent, there is not much the MPC can
do. Of course it can give warnings and it has been doing that.
Can I just say, as I said in my evidence, that the striking feature
of the behaviour of the British people is how sensible they are?
The ratios of wealth to income have been fairly stable in the
long run. Wealth is much larger than debt. At the moment net wealth
to income is at an all-time high. The debt is dominated by secured
debt, it is secured against houses, and the unsecured debt is
always smallit is very small at the momentrelative
to total wealth. On the whole people behave sensibly. I am not
saying there are not exceptions, which is unfortunate, but on
the whole people are very sensible.
Q14 Mr Love: Those who think there
is a problem point out the fact that those who hold the wealth
are not the same as those who hold the unsecured debt. Is there
a problem for those people who hold the unsecured debt and is
that an issue that the Bank should be concerned about?
Professor Congdon: This probably
sounds slightly heartless but I think this is a problem really
for individuals and social security; it is not a problem of monetary
policy. This probably does sound a bit harsh but one cannot get
round it; this is not the Bank's job. It is not their job to deal
with those people who have got excessive debts and so on. I am
sorry for them, but that is not the point. It is not the Bank's
job to deal with those individuals. Its job is to keep the overall
inflation rate stable.
Professor Wren-Lewis: I would
agree with that in the sense that the Bank can express concern
but it cannot act to deal with that problem. The one point I would
like to add is that the big increase in secured debt does pose
direct problems for the MPC because it probably means that the
economy is going to be more sensitive to interest rate changes
than it has been in the past. I think that makes the Bank's job
when it has to raise interest rates, for example to cool the economy,
that much more difficult because it really needs to tread a little
bit more cautiously than it might have done in the past because
there is this amount of debt out there, and as a result consumers
might react much more to interest rates than they have in the
Q15 Mr Love: I want to come on to
that issue of sensitivity to rising interest rates but before
I do, do any of you think, along with Mr Barrell, that there is
a role here in terms of this unsecured household debt for the
FSA and the Treasury? Do you think action should be taken by someone
if not the Bank of England?
Professor Muscatelli: First of
all, on the issue of leverage, I think this is the biggest risk.
The thing is we have not had a recession over the last period.
If we had a recession similar to that in the early 1990s, given
the high leverage situation, it would pose significant problems
for the Bank. In terms of what can be done, I think it is certainly
a role for the FSA to look at the way in which lenders behave,
but I would agree with Professor Congdon this is not a matter
for monetary policy and it is certainly not a matter for the Bank
of England. It is a matter for the Government and it is a matter
for the FSA to keep an eye on to see whether the sector is behaving
Professor Congdon: I am not denying
that, if there were two years of 10% falls in house prices that
would be very relevant to monetary policy because there would
be effects on consumer spending and there would be effects on
the banks and the building societies. In the early 1990s negative
equity did impose heavy losses on the banks and building societies.
But the situation now is not like the early 1990s when we were
trying to get inflation down from double digits, and so in that
sense I am not expecting a repetition of that.
Q16 Mr Love: Can I come on to this
issue about sensitivity to changes in interest rates. Is there
any way in which the Bank should be able to measure this more
effectively and accurately than it does? Professor Wren-Lewis,
you have an ironic look on your face so I thought I would start
Professor Wren-Lewis: In a sense
I am sure it is doing everything it can. The problem with macroeconomics
is that you can never nail things down precisely, there is always
a huge amount of uncertainty. However, I am sure with the kind
of calculations where you look at the proportion of debt and you
look at microeconomic studies of how individuals react to interest
rate changes with particular levels of debt that the Bank has
pored all over that evidence. I am not sure that there is anything
obvious more that it could do.
Q17 Mr Love: Let me ask you all and
maybe somebody could give a comment about whether or not there
is a linear relationship here between increases in the interest
rate and decreases in consumption or whether there is mythical
problem that once you reach a certain level, consumption will
change very, very rapidly. Does anyone have a view on that?
Professor Muscatelli: I think
the problem is exactly what we were discussing a moment ago which
is the relationship may be linear within certain bands, within
a certain situation if that persists, but all you need is a major
discontinuity because borrowers are constrained for that to change.
If you have a situation where unemployment rises very suddenly
or you have a big recession, then non-linearities do kick in and
people do find it very difficult to smooth their consumption over
time and at that point it becomes much more difficult for the
Bank to do something about it because it is not only necessarily
about reducing interest rates and reducing the debt burden but
also about the impact that has on employment prospects because
it is a combination of a variety of things. It is the interest
payments on the debt but it is also the extent to which people
are in employment or not. If you look again back to the 1990s,
in some cases the problems of negative equity and people defaulting
on their mortgage payments were to do as much with their employment
prospects as with the actual interest payments per se. These sudden
major changes can cause discontinuities and at that point the
uncertainty which Professor Wren-Lewis referred to kicks in because
you are almost in a different regime at that point.
Q18 Mr Love: The other question I
was going to ask arises from Professor Congdon's comments earlier.
The Bank seems to have been paying much more attention to money
supply figures than it has in the past and of course they have
been rising very quickly. I think we know Professor Congdon's
view in relation to that. I wondered whether anyone else wanted
to comment on whether this was a sensible way for the Bank to
Professor Wren-Lewis: It certainly
is something that the Bank should be concerned about in that very
rapid increases in monetary policy have, on occasion, signalled
a more serous problem to come. However, as an indicator it is
very unreliable and rapid increases in monetary aggregates have
also happened with virtually no consequence to the real economy.
In a sense it is something the Bank should keep an eye on, but
if nothing else happens to worry the Bank and there is no supporting
evidence that demand is building up, then I think it is just one
of these problems that will turn out not to be a problem in the
long run and that is how it looks to me at the moment. It is certainly
right that the Bank should keep an eye on it.
Q19 Ms Keeble: To what extent do
you think that the Consumer Price Index remains a credible target
for inflation in the UK? Perhaps Professor Congdon if you could
answer and Mr Barrell could you respond on that point.
Professor Congdon: There has obviously
been a problem in the last few months with the Retail Price Index
being so far ahead of the Consumer Price Index. There have been
periods in the past when the two indices have diverged very markedly.
I have not got any very strong thing to say about it. Obviously
insofar as the Retail Price Index affects pay bargaining then
that is, in a way, the one that really matters. By the way, I
do not deny wage costs are very important to the inflationary
process. There is obviously at the moment this whole question
of monetary policy affecting largely the private sector. In the
public sector it is much more a matter of bargaining and in a
way just brute force, frankly, who wins between the Treasury and
the Chancellor, and the public sector unions. I think that is
something to watch out for because there has been a long history
in Britain of trouble on inflation after the public sector unions
force big pay rises through strike action. We seem to be facing
something like that, on a lot smaller scale than in the past but
it is there.