Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 60-79)

MR LAURENCE SANDERS, MR MICHAEL SAUNDERS AND PROFESSOR JAGJIT CHADHA

6 MARCH 2007

  Q60  Chairman: We have an hour to do all this, so we do not want to stop your flow but the issue of globalisation is what I want to go on to next. The Bank of England in its evidence to us has identified two "tail winds" by which they describe globalisation and an expansion in the labour supply, and they feel that they have provided the impetus for a benign economic environment over the last decade. That situation may change over the next decade; do you feel that enough is being done, either by the Bank or the Government to prepare for the loss of these beneficial drivers?

  Professor Chadha: Let me just understand the question, you mean the beneficial drivers of globalisation and the labour supply.

  Q61  Chairman: Yes.

  Professor Chadha: Have we got a flexible enough regime to deal with the removal of these factors that have been beneficial in the past? It is a real issue looking forward and one way to think about the main risks of the current conjuncture is that we have had a sharp downward shock to traded sector prices; that means in order to meet a given inflation target we have had to have higher non-traded inflation than you would otherwise have had. That has meant high levels of domestic consumption and public consumption and, along with that, low levels of real interest rates in order to stimulate domestic demand to get average inflation at its target. This has resulted in the consequences of there being elevated levels of asset prices, as most obviously observed by examining house prices. In a sense, what is going to happen when those head winds disappear, when the traded sector prices start to rise again—we are going to have to have a long period where the economy is going to have to be run at something less than full capacity, or over-full capacity. I am not sure, going ahead, how we are going to be able to take the steam out of the economy gradually and allow those household balances and those asset prices to adjust in a manner that does not leave a long-lived downward threat to economic stability going forward.

  Q62  Chairman: Do you have any comments on globalisation, Laurence?

  Mr Sanders: In terms of the head winds the Bank of England describes, this is important. The Bank of England has had a favourable environment internationally over the past 10 years and my perception is that the environment will be marginally less favourable over the next five years as the growth of the developing countries produces more consumption for consumer goods. To date there has been a significant benefit to the UK economy as a result of low cost imports, but as time goes by these countries will spend more of their GNP on domestic consumption. My personal view is that this will be an important factor, shall we say, between five and 10 years down the road, because there are new sources of supply coming on board—for example, the African countries are expanding rapidly now and I believe that the African countries will become what I would term the lion economies over the next 10 years or so, and also Latin America too has very significant potential, so I still see the beneficial effect. One point not in my submission is that since I wrote the submission I believe that there has been more progress on the Doha trade round. This is very important, both from the viewpoint of the developing countries and from a UK perspective. The UK is a major trading nation and if there is a reduction in import tariffs then this would of course smooth the path of the Bank of England over the next five years or so. There is a great deal more I could say on these subjects, but I had better pass on to Michael.

  Q63  Chairman: I want brief but cogent answers the whole way through, please, because it helps you and us. Michael.

  Mr Saunders: The MPC are quite aware, as their speeches have made clear, of the extent to which they have been operating against a fortunate background, and in a sense it has been the weakness of consumer goods prices which has allowed them to tolerate high growth of money, credit, asset prices and services inflation, because they have needed that to stop inflation undershooting the overall target, and they have made it very clear that they think the next few years could be less nice, the trade-off will be worse. The area where there are questions is whether the framework and the political support for the MPC are prepared enough for a period in which their job gets more difficult. They themselves are prepared for it though.

  Q64  Peter Viggers: Circumstances have indeed been benign. Can I put it to you that the Chancellor of the Exchequer for a couple of years followed his predecessor's overall spending policies and then eased off very considerably and allowed greater growth in public expenditure, and this is now coming home. You will have seen reports of the International Monetary Fund Report which are published this morning and, just to pick five points out: the public spending surge of 2001 to 2004 led to a sharp deterioration in the fiscal balance—point number one. Rising net public debt—point number two. Leaving little room for manoeuvre in the face of global downturn—point number three. The Chancellor has started to rein in spending but much remains to be done, and then the final point, the IMF warns that further increases in tax rates would risk adversely affecting incentives to work and invest. Whereas the MPC has been very successful in working in a benign environment, what can the MPC do, how can the MPC prepare for a potentially less advantageous background?

  Mr Sanders: It is very important that the MPC continues to monitor the economy rigorously. I attend the regional meetings, as do my colleagues, of the Bank of England, and they do speak to a wide range of business executives; therefore they are very familiar with the incentive aspects, and I know that the regional reports do play a role in the MPC decision-making. One important factor is the dialogue between the MPC and Government, and I have long argued that fiscal and monetary policy must be compatible. This is essential for economic success and I believe that fiscal policy has been broadly compatible with monetary policy over the past 10 years as a whole, and this is one reason why we have had the success in UK economic policy. It is important to maintain control over the fiscal stance; I am not an expert on public finance but I do perceive that the percentage of GDP accounted for by public debt has risen in recent years. In respect of the increase in 2001-02, that was appropriate; the world was experiencing a downturn and it was right that the Chancellor of the Exchequer did expand fiscal policy during that period. We have now reached a stage where UK growth is around about 3% per annum, the Bank of England is tightening policy and therefore the Chancellor will have to follow suit with a gradual tightening of fiscal policy over the next five years if we are to maintain our record of good sustained growth, low inflation and low unemployment. The Chancellor will probably have to tighten policy gradually over the next five years.

  Professor Chadha: Very briefly, there are two issues as far as fiscal policy is concerned. We need to be absolutely sure that the fiscal plans are such that the debt to GDP level is stabilised, so there is no sense in which there should be drift in the level of debt to GDP, and that means writing down fiscal plans in terms of expected taxes and expenditures that mean debt is stabilised at some given level. What that level is, there is a range of estimates out there, but we think somewhere between 30% to 40% of GDP would be a sensible level for debt to GDP. As far as interest rates are concerned, the Bank of England will know when setting interest rates what the fiscal path is in terms of taxes and expenditure; therefore it can predicate its interest rate stream on that fiscal path and to the extent that fiscal policy is too tight—or too lax indeed—you will see interest rates higher to some extent, or lower than they would otherwise be. I do not think necessarily over the business cycle that that is a particular problem.

  Mr Saunders: The issues which you have raised, of whether there is enough safety margin in policy, are all to do with fiscal policy and they are not ones which the MPC set. The IMF warnings on fiscal policy are well-taken; the deficit is higher than you would like it to be for this stage of the cycle, but that is not something which the MPC can affect, they have quite sensibly taken the view that they will keep out of fiscal policy discussions unless fiscal policy starts to affect inflation prospects, and at the moment it does not.

  Q65  Peter Viggers: Of course, the MPC is very much, in golf terms, a one-club player is it not?

  Mr Sanders: That is a very good description, yes; it is very effective club.

  Chairman: We need Jack Nicklaus.

  Peter Viggers: I will leave it at that, Chairman, thank you.

  Q66  Mr Love: I was just going to agree with you, Chairman, what you need is a Jack Nicklaus to swing the club to make sure he gets it right. Can I turn to house prices? To what extent would you agree that the rise in house prices, indeed the rise in household debt, is a consequence of the low inflation we have had in recent years?

  Mr Sanders: That has been a key driver of house prices, another key driver is personal disposable income, and the fact that we have had an upturn in economic growth, I believe that trend growth now is about 2¾% as opposed to 2½% over the past 50 years as a whole, so the prosperity of the economy has also been another factor. Interest rates, both base rates and short term rates—in respect of the mortgage market it is the two and three year interest rates which tend to be key drivers. Currently, around 80% of mortgages are on fixed rates and they will tend to be two and three year periods; interest rates in the longer periods are determined partly by international forces, but interest rates have probably been the key driver because they have increased people's ability to repay debt. Another factor though has been the confidence factor, the fact that we have had relatively low stable inflation over the past 10 years has reduced people's risk assessment of house purchase and therefore people are more willing to take on slightly higher levels of debt in the current environment, but you are right that interest rates have been the key driver.

  Q67  Mr Love: Would anybody demur, I assume you all agree with that?

  Mr Saunders: To me this brings us back to the point we were talking about a minute ago, that the MPC have had this fortunate background of falling goods prices. If you are to stop inflation undershooting you need to pump up domestic demand, the service sector and inflation and with that tolerate, and at times encourage, an asset price boom, otherwise inflation as a whole undershoots. So if they had resisted the house price boom they would have had a bigger inflation undershoot and probably faced criticism for that. I think there are times when the MPC might not have put enough weight on asset prices, both houses and equities, as lead guides to growth, but that is not saying they should target asset prices as a separate objective because they cannot do that.

  Q68  Mr Love: Let me take you on a stage, do all of you believe that the economy is now more sensitive to interest rates? Although we talk about fixed rates, most of them are still variable; how sensitive is the economy and has that been fully taken into account by the Monetary Policy Committee?

  Mr Sanders: The economy is more sensitive to interest rates, but the build-up of household debt, even with two and three-year fixed rates, eventually those rates will run off and people will therefore be sensitive to the refinancing of rates. The economy is therefore far more sensitive to interest rates than has been the case and I would imagine that the Bank of England is aware of that. Certainly, I have discussed that factor with the Bank of England regional agent and I know that the agent speaks with our chief executive and the director of our mortgage division and the Bank of England closely monitors the mortgage market. I believe that the Bank of England has taken this on board and, as a result of the increase in debt, it probably means that the Bank of England can secure its objectives by a marginally lower level of interest rates than would otherwise have been the case. From the personal borrower's point of view, there are going to be more challenges over the next five to 10 years or so, so the majority of borrowers, I believe, are taking the view that a fixed rate has advantages in the current environment and recently, we have seen a notable increase in the amount of 10-year fixed rate mortgage business written.

  Q69  Mr Love: Mr Saunders, you mentioned earlier that they had to set interest rates in order to keep inflation within the target range. The recent period of economic stability that we have been talking about has been with a period of low interest rates, has this led to an inability of firms to correctly price risk?

  Mr Saunders: Can I come back on this, because this is important; it is also important to put into context this question of increased sensitivity to interest rates. One of the other changes in the economy, apart from high debt levels and, hence, an increased sensitivity to rates, is increased sensitivity to the re-pricing of risk across the business cycle which affects the ability of both companies and households to borrow. If you like, it is the feedback from the state of the economy to the availability of credit, and that occurs through changes in credit spreads or just a willingness of lenders to advance credit to riskier projects. What we saw in 2001, 2002 and 2003, a period when the global economy was very weak, was wide credit spreads and consequent weakness in business investment, much harder for firms to get going, hence monetary policy had to be quite loose to provide a stimulus against that. Now that we have had several years of decent growth, credit availability is much more ample, so on the one side higher debt levels make consumers more sensitive to higher interest rates, but on the other side things that would never have got financed a few years ago, or not financed on as favourable terms, now do get financed, so there is a cyclical overlay to credit availability which you need to take account of.

  Q70  Mr Love: The question I really wanted to ask you was if they did set interest rates in the way you have suggested and it had the impact, should they have been taking other measures, not the Bank of England but perhaps the Treasury or the Chancellor taking some measure to deal with the house price inflation that was a consequence of the interest rate policy that they were setting?

  Mr Sanders: In respect of other measures, there are various fiscal measures which are available to the authorities, but interest rates are probably the key driver of the housing market and the interest rate weapon is probably the most effective weapon to control housing. The interest rate weapon feeds into a number of other areas as well; when it comes to asset prices interest rates have a major effect on equity prices and they also have a major effect on investment, so the interest rate weapon is a very powerful weapon and I believe it is probably the most effective weapon for controlling the level of house price inflation. The main reason for house price inflation is an excess of demand over supply; it is quite a significant factor and we expect this to continue for some time. Whatever measures the Government takes, this excess of demand over supply is probably likely to continue over the next five years or so. I am quite willing to go into this factor in more detail and I am quite happy also to provide a written statement on this if members require that.

  Chairman: If you could give us a written statement that would be helpful. [7]We will have to move on.

  Mr Love: Just a quick one in relation to money supply. The Bank has noted the fact that money supply is increasing very rapidly, it is taking it more into account. It has not been terribly transparent about how much it is taking that into account; is this the correct reaction from the Bank in terms of money supply?

  Q71  Chairman: Perhaps just one of you could give us an answer.

  Professor Chadha: Money supply is absolutely a key variable to study in terms of thinking about the macroeconomy. It does not mean you should go to the extent of having a second pillar, such as we see at the ECB, but very briefly there are a number of reasons. Firstly, data gets revised. In real time we do not know the state of the economy, we do not know whether it is growing at 3% or 2% and the data that gets released gets revised in different directions. Money is a measure of real time transactions and therefore has information for us as we try to gauge the true state of the economy. Secondly, we know money has information on various sectors; for example, narrow money might tell us about retail sales or consumption patterns and certain aggregates of broad money may tell us about investment plans by firms, so by studying the components and particular measures of money we may get measures of real activity at a sectoral level. You are right to say that money is often associated with asset price inflation, so again if we look at the counterparties of lending and try to understand into which parts of the economy that is going, that may give us some information about whether there is an asset price bubble. That said—and I just want to finish on one brief point on housing itself—we should not necessarily think that house price inflation is a bad thing. A lot of theory tells us that consumers want to smooth their consumption over their income path. In the past, consumers were often credit-constrained because they required collateral in order to borrow, and the extent to which the equity in their houses increases allows them to borrow today for durable expenditure and smooth their consumption path through time, is beneficial to those consumers. So it is not necessarily the case that either house price inflation is necessarily bad, or that the debt that they take on is some kind of disequilibrium phenomenon that is going to crash as soon as interest rates return to some normal level. We should not necessarily think it is a bad thing therefore. Finally, I have not seen work to suggest that necessarily the economy is more sensitive now to interest rates than it was in the past, for some of the reasons Michael was suggesting: that we have new cohorts of people with access to credit, but also if we look at the asset side of the balance sheet, net worth is as strong as it was before so, okay, we are more indebted but we have also got more wealth than we had before so the net effects are not clear. We need more work in that area.

  Q72  Ms Keeble: I want to ask about the consumer price index, whether or not it is the best measure of inflation for the MPC to use. Do you think it should be modified in any way, for example by taking into account house prices? Do you think there is an issue about credibility given that there is a current debate now about inflation and it is the first time I certainly have seen it in the public domain for a good many years? Do you think there is an issue perhaps about the credibility of the MPC if its discussions about inflation are out of kilter with what the general public experience, or should the MPC just say that is not our business, we do not have to worry about it?

  Professor Chadha: It is true to say that the RPI as it was traditionally defined had a higher component of housing costs in it, the CPI has not. In a sense that increases the weight that the MPC should put on housing price developments in order to forecast future trend in the CPI because it is that which they are trying to stabilise. That said, it is also clear if you look at the very long run in these price indices they do not really diverge in a persistent manner over the long run, so it does not particularly matter which measure of the price level we target over the medium term as far as the MPC is concerned, but we must learn to extract the information that is given from the divergences that we may observe in real time.

  Q73  Ms Keeble: There is a factor in management of the economy, especially around inflation, which is partly around public confidence and public credibility. Do you think it helps in managing the economy—and in particular the MPC has a very critical job in managing inflation—if there is a really serious feeling out there amongst the public, and while I do not know about my colleagues I get about 20 or 30 e-mails a day from public sector employees currently who are talking about inflation. They might be put up to it, but they are still doing it. Do you think there is an issue about public confidence if there is a serious debate about what rate inflation is currently and if that is perceived to be different, not just from what the Government is saying but from what the MPC is saying?

  Professor Chadha: I will give you two bits of data that back up your observation from your constituents perhaps and other colleagues. Ten years forwards from the yield curve in early 2005 was something like 2.9% suggesting that RPI inflation as expected by market participants on their trading nominal and real bonds, was about 2.9%. Today that is 3.2%, it has gone up 30 basis points, so you look at the change rather than the level. If we do a survey of City and other forecasting houses on inflation, a year ago those survey expectations of 2007 were around 2%, and they have gone up as of February to about 2.3%, so there has been drift up in those key inflation expectations. The inflation expectation there may not be strictly aligned to the CPI target that the MPC is charged with pursuing; it is therefore incumbent upon the MPC in terms of transparency to explain how by meeting their CPI target these other measures, the RPI or the RPIX, would also come back to something in line with price stability. There needs to be further explanation of how these other things will come back into line.

  Q74  Ms Keeble: Do you think they are providing that explanation adequately and do you think they have to either do that or adjust the CPI?

  Professor Chadha: The argument they are following is that the Bank of England wants to pursue what they call flexible inflation targeting, which means that in the presence of maybe elevated asset prices there is a possibility of vulnerable household balance sheets. It may want to return inflation to its target at a slower rate than it may have wanted to in the past; the problem with that in real time is that it is observationally equivalent to some drift in the inflation target itself. To some extent there has not been a clear explanation of what in effect flexible inflation targeting really means, and how you explain to people that you are in fact going to meet your target. We can talk about the inflation report in February later on, but I just want to give that very brief answer and I am happy to return to that point later.

  Q75  Jim Cousins: Do you think there has been a systematic tendency by the MPC to under-estimate the impact of globalisation on product prices here and the impact on the labour market of inwards migration?

  Mr Sanders: My personal perception is that that is not the case. When I attend the regional briefings of the Bank of England the question of migration is mentioned by the Bank of England representatives and by business-people consistently. In terms of the global effect, this too is something which is consistently mentioned at these briefings, so my feeling is that the Bank of England has taken due note of the factors. It is a challenge though, both to the Bank of England and other forecasters, that the global economy is now changing at a more rapid rate, so therefore it is probably more difficult for the Bank of England or indeed any policy-maker to ascertain quite what is happening in the global economy; its job in that respect is more difficult, but my perception is that the Bank of England does take full account of these measures, but that is just one personal perception.

  Mr Saunders: I have to say that actually I would disagree. They probably have under-estimated their impact and I would say that applies to virtually all economic forecasters. Almost everyone has been surprised at the extent to which consumer goods prices fell year after year for the last eight years, and the pace of inward migration from Eastern Europe after the opening up of the EU in 2004. The MPC has probably been quicker than most in appreciating the importance of those things, but those shocks have just been much greater and much more disinflationary than almost anyone had expected and, of course, the question going forward is just whether that will continue. I would say they have understandably under-estimated the effect.

  Professor Chadha: There has been more generally a problem with inflation forecasting equations, possibly for the sake of globalisation or labour mobility reasons, but also because of credibility. Inflation expectations have been reasonably well anchored, which means that when we try to run the models that we have run in the past, cost mark-up type models and others, we have not seen inflation emerge in the way that it has before and it has been a widespread phenomenon. There has been a lot of work in the States finding inflation-forecasting equations not working very well, and indeed in the UK as well, but as my colleague suggested there are some good reasons ex post to explain why those equations have fallen down. The key problem is the inflation expectations in all of this.

  Q76  Jim Cousins: Dealing with inflationary expectations and taking the point that has just been made to the Committee about the re-pricing of risk, do you think there could be problems going forward in those matters?

  Professor Chadha: The issue about inflation expectations is that in this world in which structural economic equations seem to have failed in some sense, inflation expectations have become almost a way of summing up all our knowledge of all the possible models into one key indicator, which is what is happening to inflation expectations. The central banks have tried to learn from inflation expectations in the sense that if we do not know the true model, what we will try and do is just learn about inflationary pressure through what agents and financial market participants expect inflation to be. From the learning process they may decide to manage those inflation expectations, in terms of the sense in which they may decide to feed back from them, so that when inflation expectations start to rise they may decide to raise policy in order to stabilise those inflation expectations. The problem then comes in the next step, that those inflation expectations may stop giving you the information that they gave you before because they incorporate an expectation that the policy itself will move to stabilise them and they will not necessarily themselves convey inflationary pressure. That is a real danger we are now in, that the inflation expectations themselves stop giving the information back to the central bankers that there is incipient inflationary pressure.

  Q77  Jim Cousins: The point of my question was really precisely about those second order effects and I would be interested in the views of the other two witnesses.

  Mr Sanders: In respect of the forecasters' records, the Bank of England and most City economists place a great deal of emphasis on econometric modelling and, by definition, this involves observations of past experience. The experience of econometric modelling is that it works very well in a fairly stable environment, but when you have a major change in external factors it presents more challenges and that is one reason why some economists have not been too successful in the past two years. I hasten to add that I have a high regards, along with my colleagues, of most of the economists in the City, but it is more of a challenge when you get these changes and it is going to be more of a challenge over the next five years at a time when the global economy is expanding. The Bank of England does attach great stead to survey data, feedback from industrialists and from those in the public sector as to what they perceive is likely to happen in the future. Economic forecasting is not only projecting what happened in the past forward, it is also a question of what is going to happen in the future and the Bank of England also spends a lot of time discussing with business leaders as to how they see their business over the next five to 10 years. This is going to be increasingly important in the international world. In respect of the comments made, could I ask whether there is one specific point you would like me to comment on in respect of the Professor's comments?

  Q78  Jim Cousins: This particular bit of the democratic deficit will be in trouble with the Chairman if I encourage you to speak too much, but I am content with that. Just one more point, you have raised the issue yourselves that public sector workers may feel that the inflation they are experiencing as individuals is running at a much higher rate than is being recognised by the target-setters and they might conceivably try to put pressure on the Chancellor to produce a different inflation target to recognise that. Do you think it is the Chancellor who should set the inflation target or somebody else?

  Mr Saunders: In the long run it makes little difference as to whether you target CPI or RPIX, both would be fine. I feel it should not be as easy to change the target as it is now; if you have a target you should stick to it and to me the cost is more changing the target rather than what the particular target is.

  Professor Chadha: In terms of democracy the Chancellor is an elected person, he is representing the party of government and he should be the person who sets the target. The Bank of England is operationally independent to pursue that target with the MPC and the instrument at their disposal which is the short term interest rate, so I am perfectly happy with the current arrangements.

  Mr Sanders: My view is that an inflation target must be credible, and my feeling is that there is a gap now between what people's perception of inflation is and the CPI measure. I believe the European Union are going to move their own measure of CPI in 2009 to incorporate an element of housing costs and I would imagine that sooner or later we are going to follow suit. I believe that that change should come in the UK sooner rather than later and it is very important that public perception of inflation is the same as the financial markets' knowledge of inflation. The general public can understand the concept of RPIX, which is headline RPI less mortgage interest; most people understand the concept that with mortgage interest they are buying an asset as opposed to spending money on consumer items, so that would be credible but I would not imagine that the average person in the street would fully comprehend what CPI means. I believe that the inflation target is credible, must be credible, and that is going to be more important over the next five years at a time when the inflationary climate will probably be slightly less benign than it is currently.

  Chairman: You have given us a big educational challenge there: everybody has got to understand what CPI is; there will have to be a lot of money spent on that which will maybe have some implications.

  Q79  Mr Gauke: Could I just turn to the appointments process and ask you whether you consider that a more transparent appointments process would be to the good, or whether you share the concerns of the Chancellor that this is an area that is market-sensitive, given your City perspective. Do you agree with that?

  Mr Sanders: In respect of the appointment, first of all I would like to emphasise that the calibre of MPC members in my view has been very high and they have done a very effective job. In respect of the appointment process, that largely is a question for democratically elected politicians; from a City perspective what we are looking for is a person who can do the job effectively and, not only make the interest rate decisions, but also communicate the decisions to industry and to those in the public sector. The communication is going to be an increasingly important part of an MPC member's role over the next few years or so. From a transparency point of view there may be a case for having a civil servant appointments procedure in place, but it is very important that the members of the MPC are questioned and endorsed by members of the Treasury Select Committee; it is very important that you monitor the process. In respect of the appointment, that is one for democratically elected politicians.

  Mr Saunders: My view is that there should be some external source of shortlist or check on the candidates. People so far have been good, but you asked right at the start of the last session what are the risks for the next 10 years and one of the issues is whether a future Chancellor at any point would seek to change the target or the appointment process in a way which undermines the aim of inflation stability. That is a weakness.


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