Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 242-259)


24 APRIL 2007

  Q242 Chairman: Governor, good morning to your and your colleagues and welcome to this inquiry, ten years on. Inflation reached 3.1% in March and you wrote a letter to the Chancellor explaining what the MPC were trying to do to keep inflation on target. What was the principal aim, in your mind, of that letter? Governor, may I say that we are not going to be talking about the Inflation Report here; that is for another time.

  Mr King: Indeed. I think it was to give an opportunity to explain in greater detail what otherwise had been the case—why the Committee thought that inflation had risen to that level—although of course there was little opportunity for the Committee to have an in-depth discussion of that to point out again what our framework for policy is and to say what we would do to deal with that situation. That was the purpose of the letter and I think it served it pretty well.

  Q243 Chairman: Some commentators have said that the Bank needs to do more to cement low inflation and to convince people that low inflation is non-negotiable. How far have you got to go on that?

  Mr King: That remains to be seen. Most of the measures of inflation expectations are still close to the target. There is not very much evidence of any significant pick-up. We have spent a lot of time in the last 12 months thinking about whether inflation expectations have risen. That is referred to in almost all the minutes over the past year. We have talked about that. We have spent a great deal of time talking to people around the country to make clear that we are completely determined to bring inflation back to target. In the end, I think what people should draw most comfort from is that the arrangements for the Monetary Policy Committee give each member of the MPC individual and personal accountability for taking decisions in a way that ultimately will bring inflation back to target. That is our purpose in life and we are held publicly accountable by you and others for that. It is that strength of the incentives that we face that should give people comfort.

  Q244  Chairman: You mentioned in your submission to us the tailwinds of globalisation and the expansion in the labour supply. If these do go, do you think you are doing enough to prepare people for that?

  Mr King: As conditions change then we will need to rethink our policy stance and decide what the level of interest rates needs to be. I think we have done a good job in explaining to people that the main aim of the MPC is to maintain a balance between demand and supply in the economy. As the supply conditions change in the economy, we need to take steps to lead to a change in the outlook for demand.

  Q245  Mr Gauke: We heard last month from three of you about your views on the importance of monetary aggregates. Can I ask Paul Tucker and Charles Bean to what extent do you think monetary aggregates should play an important role in your deliberations?

  Mr Tucker: We cannot deliver our objective by just looking at real economy variables such as output growth and employment and so on. We have to look at so-called nominal things and that includes inflation expectations which the Governor has already mentioned and discussed, and money forms part of that. I see it as probably no more than an amber light. I do not think the relationship between money and inflation over the past 20 to 30 years has been sufficiently reliable that we can say: yes, we have something that we can really rely on. To have put that part of our history behind us is a good thing, but it can be an amber light. What does that mean? It means that if one sees rapid money expansion, or indeed very low money growth, one should take the lid off and try and see what is going on underneath. That is my own approach and I did that in a speech in December.

  Mr Bean: I would very much endorse that. People used to think that there was a close relationship between money stock and nominal demand and therefore you could control the level of spending in the economy by keeping the money supply growing at a steady rate. What the experience of the last 20 years or so has shown us is that relationship is not a tight one. That is not the same as saying there is no information in movements in various measures of money, but it does suggest that you need to try and understand exactly what is driving the relationship between money and nominal spending in the economy. At the current juncture quite a lot of the rapid money growth is confined to a particular sector—other financial companies—which is a very heterogeneous collection of institutions. It is not clear what is driving all of those factors, so a task that we have been faced with is trying to dig down to better understand what is going on. The real answer is not to look at it as a single, all powerful indicator, but to look at it as one of a range of variables that potentially provide useful information; look at it alongside measures of the development of credit in the economy, look at what has happened to asset prices as well and try to form an overall picture of the monetary forces that are embedded within the economy.

  Q246  Mr Gauke: Governor, you said to us last month that you were more concerned about the monetary aggregates than some of your colleagues. Do you feel there was something of a criticism made yesterday by the likes of Charles Goodheart, Tim Congdon and Gordon Pepper that we had a recent double digit rise in the monetary base and that this is storing up trouble and that perhaps the MPC has not done enough about that?

  Mr King: I believe you are referring to a letter that I saw published this morning in the press. I think they made two very important points in the letter which I do not think members of the Committee would disagree with. First, the two key points they make are the need in present circumstances to look beyond the short-run volatility of energy prices. We saw in the last part of last year the pick-up of CPI inflation reflecting partly a rise in domestic energy prices. We now expect a fallback reflecting the "base effects" of those changes last year and cuts in gas and electricity prices this year. Our view is broadly as it was in February, that there could be quite a sharp fallback in inflation over the next four to six months. But we will see. For monetary policy the important point is not to get caught up in all that, although it was important to draw that to people's attention in the wake of inflation hitting 3.1%, but to look beyond that through this fog to the medium term picture. I totally agree with that. The second important point they make is that, when looking at inflation beyond the fog, you do need to think carefully about inflation expectations and about monetary and credit growth, because these are the nominal variables that will shape the path for inflation. That is an extremely difficult thing to do and I think in their letter they acknowledge and, as Paul pointed out, there is great difficulty in making a clear numerical link between a picture growth rate of money and credit and the consequences for inflation, but that there is a link I am perfectly confident of and think it is an important factor for the Committee to look at. There is a third point where I would not agree with them and I thought they did not give enough weight to this because they rather linked together money and credit growth in the UK with the behaviour of asset prices in the UK. I think that in recent years that has not been so obvious a link. In a global capital market, where money can move in and out freely, what determines asset prices in the UK is very much a function of what is going on in the world capital market. A big feature of recent years has been the very sharp fall in real interest rates, not just in the UK but around the world, and also a fall in risk premia around the world. That has driven up asset prices—all types of assets—as we have discussed before. That is not something that you can easily say is the logical consequence of rapid money growth in the UK. It may well reflect, and it probably to some extent does reflect, easier monetary policy around the world, but UK assets are being bought by overseas' residents, and we in turn are buying overseas' assets. The impact of higher asset prices, if that is thought to be important, cannot just be linked solely and exclusively to UK monetary policy and the growth of money and credit here. That is an area where perhaps the letter did not do enough justice to the openness of the capital market, but in the end I totally agree with them that inflation is made at home. Whether or not we have inflation in the UK does depend on the monetary policy stance of the MPC. As we all pointed out in the letter that I sent to Gordon Brown, the MPC to a person is determined to bring inflation back to target.

  Q247  Mr Gauke: Do you think that in particular the cut in interest rates in August 2005, with the benefit of hindsight given where we are with inflation just at the moment, was unfortunate and that one of the reasons why that may have happened was because insufficient weight was placed on monetary aggregates?

  Mr King: That kind of judgment I leave to the commentators and to the historians. For the Monetary Policy Committee the only meeting that matters is not one that took place two years ago, but the next meeting.

  Q248  Mr Gauke: You sound like a football manager.

  Mr King: It is a very good principle. The only meeting that matters to the MPC is the next one. There is no point playing today meetings that we are going to have in August, September, October; the one that matters to us is the next one in May. Equally, I am not going to revisit the ones we have had in the past. We do, as a Committee, look back and learn from what has happened in the economy and whether the outturns were different from what we had expected (or the same for different reasons)—that is an important part of our work—but I do not think it makes sense to go back and say what would we have done then had we known what we know today. That is the proper role of a historian and we should not be judging that ourselves.

  Q249  Mr Gauke: Can I move on to a different area which is the relationship between monetary policy and fiscal policy. How important is that relationship and how important is the Chancellor's decisions on fiscal policy in determining interest rates in your role on the MPC?

  Mr King: At one level it is very important in that if fiscal policy were set in a way that would lead to a prospect of very large budget deficits, then I think it would be extremely difficult for us to manage inflation expectations which have been the anchor of the framework for monetary policy. In a big sense fiscal policy does matter because it can undermine monetary policy. I do not think that has been the case in the past decade. Equally, I do not think there is a great deal of fine-tuning here. The most important point about the link is that when decisions in the Treasury are made about taxes and revenues—and the consequences for borrowing—that they know we on the Monetary Policy Committee will be looking at the impact of that on the level of demand in the economy and taking steps to ensure that nothing that happens in the budgetary side is going to affect the chances of our meeting the inflation target. The Treasury itself knows when making its budget that we will take offsetting action if that appears necessary. The fact that they know that we will be behaving in that way gives them a pretty strong incentive to stick to their fiscal rules.

  Q250  Mr Gauke: In your time on the MPC—we had a tight fiscal policy after 1997; in 2002 there was something of a loosening—would you agree with what the National Institute of Economic and Social Research have said in their evidence to us that: "there is little doubt that the conduct of fiscal policy in recent years has meant that interest rates have needed to be higher than they would otherwise be"?[2] Did you detect any changes in fiscal policy in 2002? Is that a matter that you were conscious of and adjusted policy accordingly?

  Mr King: I think it is very hard to know what would have happened to interest rates had fiscal policy been somewhat different because I cannot judge how the Committee as a whole would have responded to that. I do not think there has been any real significant change. What happened was that spending grew much quicker than it did before and taxes rose. There has been a significant increase in the share of taxes in household incomes in GDP but then that was necessary. What matters to us is not the rate of spending growth or taxes taken separately, but looking at them together. I do not think there has been a dramatic change but your own report made clear that it makes sense for the rules to be set in a somewhat more forward-looking way and I see some merit in that. We are a million miles away from some of the fiscal problems that we have experienced in the past.

  Q251  Angela Eagle: Governor, the day it emerged that you had sent a letter to the Chancellor explaining the current rate of inflation as required, I was phoned up by a journalist who was wondering whether I would be demanding your immediate resignation.

  Mr King: I did not receive it if you sent it.

  Q252  Angela Eagle: You did not see me demanding it. Do you think that this response says more about your successes as a Committee in never having to send a letter for 10 years, or your failure as a Committee to communicate to the journalistic profession precisely what your role is?

  Mr King: I think the ambition of explaining monetary policy successfully to the journalistic profession, as you put it, is a continuing task that we engage in all the time and we repeat this at all of our Inflation Report press conferences. I think there has been a significant improvement in the quality of reporting among the specialised economic press. Undoubtedly when something like this happens it has what I might call "political overtones" and then you drag in a different kind of journalist who writes about it from a different perspective and I rather suspect that is a large element of what you have been seeing.

  Q253  Angela Eagle: You are a very perceptive man, Governor. Earlier we were talking about perhaps some changes to the way the MPC works, Rachel Lomax. The independent members used the phrase that the whole process has been "dynamically evolving"; in other words, there has not been any great shift in structure but there have been tweaks and changes in the past 10 years. Is that your experience of the way the Committee has worked and do you think that the system needs any radical change or the dynamic evolution just needs to continue?

  Ms Lomax: I think there have been modest changes during the time that I have been on the Committee; for example, in the way that we run the briefings from the staff for the monthly policy meetings. It is actually quite a stable process, very heavily engineered. We do the same thing every month and every quarter. There is not a huge amount of change; it is very predictable. That is actually part of its strength. You can envisage doing it quite differently. I do not think there is any real need to do it quite differently. I do not think there is a pressing need to change the way that we do it but I could certainly envisage approaching it in a slightly different way, as indeed other people do. "Dynamic" is not quite the word I would use for the amount of change we have had.

  Q254  Angela Eagle: Do you think there is a risk on the other side that if there is radical change it might actually disrupt the process and cause a volatility in the way the Committee works that might be damaging?

  Ms Lomax: I think that is one reason why the amount of change has been pretty modest. There is a great strength in behaving in a predictable way in terms of communicating with the outside world and in terms of going through the data in a systematic way as it comes in. We probably ought to avoid radical change unless there is a really good reason for it.

  Q255  Angela Eagle: Do you think that if there is this predictability and it is not dynamic, but marginally evolving as a process, that there may be a risk of it becoming institutionalised and somehow staid and not able to respond?

  Ms Lomax: It is always a challenge to keep the process fresh and that is one of the reasons why it is good to have turnover on the Committee and to have fresh people. We have had rather a lot of turnover on the Committee in the last year, but the idea of having new people come on is one of the most important ways in which the whole process keeps itself fresh.

  Q256  Angela Eagle: Therefore are you happy with the kind of length of appointments that there are? Do you think that is about right or that it should be wider or smaller?

  Ms Lomax: If one were starting again one would probably go for longer terms for the externals. Three years is actually quite a short period of time for somebody who has not been engaged in this kind of process before to fully get themselves up to speed, to make a real contribution, to develop their own ideas and see the consequences of their own past decisions come back to haunt them. On reflection, three years is probably too short.

  Q257  Angela Eagle: John Gieve, do you think that there is any obvious tension between the internals and the externals on the Committee, or are you all just mucking in together?

  Sir John Gieve: I do not think it does split down into the internals versus the externals. All the meetings I have about monetary policy, apart from meetings I arrange with individual members of staff, are with the whole Committee. We do not have a pre-meeting of the internals. I have not noticed a particular tension. It is a collective process but it is not a consensus process. The important thing is that each individual is coming to their own decision and their own personal credibility is on the line. It is not a team event in that way.

  Q258  Angela Eagle: This is possibly an odd question to ask of an ex Permanent Secretary, but do you think there is a potential problem of institutionalisation on the Committee; that you just get into grooves that you cannot get out of?

  Sir John Gieve: I do not think it is happening to the MPC but I think that there is a very important risk in setting up an independent body that it gets into ruts. You get into a particular way of thinking and you get group think. What has happened here is that because you have external members—this is the main reason for having external members -you have people who challenge and who bring different viewpoints to the party and constantly shift the debate; I think that works very well. I was talking, for example, to another central bank which is thinking about its arrangements and currently has only internal members appointed working full-time in the bank. I think that arrangement would risk an institutionalisation of certain attitudes and approaches.

  Q259  Angela Eagle: We have got it about right in terms of turnover and mix and adding different things to the mix, do you think?

  Sir John Gieve: Yes, I think it does work well.

2   Ev 77-81 Back

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