Examination of Witnesses (Questions 1-19)
MR MERVYN
KING, MS
RACHAEL LOMAX,
SIR JOHN
GIEVE, MS
KATE BARKER
AND DR
ANDREW SENTANCE
27 MARCH 2007
Q1 Chairman: Governor, good morning to
you and your colleagues, and welcome to this evidence session
on the Inflation Report.
Mr King: Good morning, Chairman.
Q2 Chairman: Can you introduce your
colleagues for the Shorthand Writer, please?
Mr King: Yes, thank you very much
Chairman. On my right is Sir John Gieve, Deputy Governor for financial
stability, and on his right is Kate Barker, one of our external
members. On my left is RACHAEL Lomax, Deputy Governor for monetary
policy, and on her left is Andrew Sentance, one of our external
members.
Q3 Chairman: I think you have an
opening statement, Governor.
Mr King: I do, Chairman. I am
very grateful, again, for this opportunity to explain the reasons
for the Monetary Policy Committee's decisions on interest rates
since we last appeared before you in November. Following the increases
in August and November last year, Bank Rate was further raised
to 5.25% in January and was left unchanged at the meetings in
February and March. The UK economy has expanded at a remarkably
steady rate over the past five quarters; output growth in the
year to the fourth quarter of 2006 was 3%. But CPI inflation has
remained above the 2% target. It was 2.8% in February, almost
one percentage point higher than a year ago. In its February Inflation
Report, the MPC published a central projection in which output
growth was expected to continue at around its recent rate, and
inflation to fall back quite sharply later this year as lower
retail gas and electricity prices entered household bills, in
contrast with the substantial rises last year that have pushed
up on inflation. Since then we have seen turbulence in world financial
markets at the end of February and mixed signals about the economy
at home. The sharp falls in asset prices and the widening of risk
premia that were evident during late February have at least partially
unwound. The FTSE All-Share index, which fell by around 5%, has
all but regained its level prior to the onset of the turbulence.
The main exception is the sub-prime mortgage market in the United
States where the increase in spreads, which reflected higher default
rates, has persisted. Those market movements appear to reflect
a questioning by investors of previous levels of risk premia as
they engaged in a process of trial and error to discover the new
equilibrium level of prices. That led to some volatility in asset
prices generally. No doubt the process of price discovery will
continue as investors assess the risks inherent in their positions
and exposures, and it is too early to say whether the period of
greater volatility is over. News about the UK economy since the
February Inflation Report has been mixed. Consumer spending
growth has been volatile—at least as recorded in the official
data—and there are now some signs that the housing market
is beginning to slow. Business investment, however, has grown
rapidly over the past year. And after a short period of weakness
there are signs that manufacturing output is strengthening. Sterling
fell both before and during the recent turbulence and the effective
exchange rate index remains around 2% below its level at the time
of the February report. These developments are consistent with
a continued modest rebalancing of demand. Inflation has been volatile
in recent months. The news in the unexpected fall in inflation
from 3% to 2.7% in January was largely offset by the subsequent
unexpected pick up to 2.8% in February. In the coming months further
volatility in inflation is likely as retail gas and electricity
prices fall. The challenge facing the MPC is to look through those
short-term fluctuations, although it is far from easy to judge
where inflation is likely to settle once energy prices have stabilised.
In such circumstances it is not surprising that there are differences
of emphasis among members of the Committee on the nature and extent
of risk to inflation in the medium term. In February the judgment
of the Committee was that the central projection for CPI inflation
some two years ahead was around the 2% target but with the risks
to the upside. The balance of the news since then provides no
clear reason to change that judgment. The Committee will continue
to monitor carefully the risks to inflation as they unfold. And
it remains ready to take whatever action might be necessary to
keep inflation on track to hit the target. Chairman, those are
the remarks that I would like to make this morning, and now I
and the other members of the MPC here today stand ready to answer
your questions.
Q4 Chairman: Thank you very much,
Governor. The January rise seemed to surprise financial markets.
Do you think there was a failure in communication from the Bank
in that the markets themselves were not prepared for that statement?
Mr King: No, I do not think it
was quite as much of a surprise as some have made out. Financial
markets had fully priced in a rise in February; it did come a
month earlier than many had expected but I think that much of
the difficulty stems from the fact that, I am afraid, some City
economists appear to have painted themselves into a corner where
they claim to be able to predict precisely the month in which
an interest rate change will occur. Since that is not something
that we feel able to do on the MPC, it is not clear to me why
they feel able to do it. Much of the comment after the change
was in the spirit of, well, perhaps the particular month in which
it occurred was a surprise but, to be honest, the data were indicating
very clearly that that is the direction in which rates were going.
Q5 Chairman: You mentioned in your
opening statement that there were differences in emphasis amongst
members of the Committee regarding the risk to inflation in the
medium term. RACHAEL, you were the only one here, I think, who
did not vote for a rate rise in January. What are your views,
then, on the future of inflation and the risks in the medium term?
Can I ask other members who were here who did vote along with
the Governor to give their views, but RACHAEL, since you are the
odd one out here, on that particular issue?
Ms Lomax: The question is: why
did I not vote for a rate rise in January? I did not think the
evidence was quite there and I wanted to process it through the
February forecast, which we were just about to start work on.
I had not voted for the rate rise in November, so I guess I was
starting further back than other people in feeling that the next
movement, clearly, was going to be another rise. So I needed,
probably, a bit more convincing. However, I did think the news
had been upside since November, but I wanted time to reflect a
bit more on it. We did have advance notice of the CPI figure for
December, which was quite a high number, 3%, and I did consider
whether that was a reason for bringing forward the decision. On
balance I thought it was not. I think you need to look at these
sharp, month-to-month movements in the light of the longer-term
developments before deciding how much information they have got
in them. So I preferred to wait.
Q6 Chairman: Kate, the evidence was
not there. What about your view on that?
Ms Barker: I was happy to vote
for the rise in January. There is a question about the forecast
round but experience on the Committee has not suggested to me
that necessarily after the process of the forecast rounds you
do learn very much more. There are times in which you do but I
did not think that was a round which was likely to shed much light
on the issues, partly, I think, because the nature of the questions
we are facing is slightly different at the moment. We are more
confident, of course, in what we think might happen to growth
(to the extent one is ever confident) than we are on what is going
to happen to inflation. There is a lot of uncertainty about where
inflation is going to settle, as the Governor said, once the energy
price has fed its way through, and that is a question which is
very difficult to resolve in a forecast round. Also, in common
with other members, there was a question of the wage rounds; January,
of course, is a very big month for private sector settlements.
I was not particularly swayed by the 3% inflation number but I
was swayed by the fact that we are having a long period of inflation,
quite a bit above target, and I thought it was a good thing to
make it absolutely clear that we were determined to get inflation
back to target in the medium term.
Q7 Chairman: Sir John?
Sir John Gieve: I was in the same
camp as Kate. I thought, on the analysis of the demand/supply
balance, the news was on the upside since November and I thought
that it looked as though the 50 basis point increase we had made
earlier in the year would not be enough, so I thought, on that
side, there was a case for increasing. I also thought that, at
a time when the inflation figures were coming in very strong,
on the RPI as well as the CPI, it was a good time to emphasise
that this was a blip and we would bring it back to target shortly.
So there was a signalling message as well.
Q8 Chairman: Dr Sentance, as a new
member, were you just easing yourself in and playing safe?
Dr Sentance: No, not playing safe
at all. I think the factors in my mind—some of them have
already been touched on—were that through the second half
of 2006 we had seen demand picking up and inflation picking up
together, and then the question was: do we feel we had done enough
in terms of interest rates in order to restrain demand and get
on top of inflation? It seemed to me that the evidence in January
was that we had not done enough and we needed to go further. There
was a case for waiting for the February Inflation Report but I
felt that we would not accumulate sufficient new evidence by February,
really, to change that judgment, and the evidence that had come
in over the two months between November and January (because in
December we took a pause and we decided to wait and see and I
supported that view) was consistent with this strong-ish demand
picture. Inflation had been rising and, like Sir John, I think
it was important for the Bank to send a clear signal that it was
on the case and it was prepared to act—perhaps a bit earlier
than the markets were expecting—to keep inflation in check.
Q9 Chairman: Governor, we would like
to look at money and asset prices, and I will hand over to Brooks,
but, first of all, could I ask: long run interest rates once again
appear to be on the rise. To what do you attribute that rise,
and what are the consequences for UK monetary policy?
Mr King: I am not sure things
really are on the rise. We had a chart in our Inflation Report
which plotted long-term interest rates, chart 1.2.
Q10 Chairman: You say in your Inflation
Report "Long-term nominal forward interest rates have risen
a little in the United Kingdom over the past three months".
Mr King: A little, but the big
picture, as you can see from chart 1.2 of the report, is how low
long-term interest rates are, both nominal and real. Indeed, since
that chart was constructed, if you were to plot it a little further
they would come back a little way. So I do not think that the
movements we have seen are terribly significant compared with
the big fact, which is that both nominal and real long-term interest
rates are remarkably low. If you look at real interest rates,
the implied forward rates (that is the real short-term interest
rates that markets are expecting to see in ten years' time) remain
at around 1%, which is a remarkably low level. So I think there
are certainly movements up and down from month to month, but the
big picture is still that these long- term real interest rates
are remarkably low.
Q11 Mr Newmark: The Inflation Report
discusses the finding that the 2006 rise in equity prices appears,
according to the results of a simple accounting model, not in
the main to be explained by earnings, or long-term interest rates.
So I am just curious; how do you explain this?
Mr King: The change on the year
is difficult to link to changes in long-term real interest rates
as they remain very low and did not change much over the year.
All you are left with then is some unexplained factor. I think
the attempt to explain movements in share prices in terms of something
which you can think of as either a fundamental or speculation
is a doomed exercise because most of the variables that affect
share prices are unobservable; they are expectations of the future.
Whether this was expectations of future earnings or whether this
was expectations of where risk premia would be in the future or,
indeed, expectations of where long-term interest rates will be,
none of us can easily tell. To some extent, I think it is a doomed
exercise to try to claim that one can winkle out from the data
an explanation for changes in something that is the present discounted
value of a stream of earnings into the infinite future.
Q12 Mr Newmark: You can look at prices
from a historic basis and look at them from a cash flow multiple,
and prices from a cash flow multiple standpoint seem to be going
up a lot. If you can take one sector of the economy that looks
like it is driving it, the amount of money that is flowing into
private equity, for example, is pushing up equity prices; there
is cheap capital from the City, so if I look at the level that
banks are prepared to lend to companies to buy other companies
or to lend to private equity firms, the cash flow multiples that
they are willing to lend at seem to be, sometimes, two or three
multiple points higher than they were, for example, two to three
years ago. That is one area that seems to be driving it. There
is a sense that I pick up from the City that people think that
equity prices are overvalued. I am just curious: do you believe
that or not?
Mr King: If enough people thought
that equity prices were overvalued you would think that they would
be selling them and they would not be overvalued any more.
Q13 Mr Newmark: You know as well
as I do that when people have funds to manage, or money to manage,
there is a lot of pressure to put that money to work, and they
can either put it into some sort of debt instrument or they can
put it into equity instruments.
Mr King: If they thought that
equities were overvalued they would be switching it from equities
to another instrument. You do make the important point about the
flow of money. This, elsewhere, has been given the name of "the
search for yield". There are many investment funds searching
for yield. What that does is to drive down the yield on a wide
range of assets, but that is the same phenomenon as the low level
of long-term interest rates. Since we could not detect that a
change in that during 2006 could be used to explain the change
in share prices in that year, I am not quite sure that the search
for yield itself is an explanation for why prices rose.
Q14 Mr Newmark: You do not see the
people who are managing assets effectively chasing the yield curve
down in order to—
Mr King: There is an element of
the amount of liquidity around the world in that period. I think
the key thing to stress here is the significance of the world
capital market; it is not a series of unconnected, national capital
markets. There is a world capital market, and with very accommodative
monetary policy over the last few years that has certainly enabled
a large amount of liquidity to be made available to investment
in assets—"searching for yield"—which has
driven down yields. That is absolutely right. However, what we
point out in the Report is that it is quite difficult to see what
the yields were that were driven down that explain the rise in
share prices, unless it were a change in the risk premia that
people were willing to hold those assets in return for. It is
certainly possible that the amount of liquidity created did affect
the risk premia of investors. I do not regard that as a fundamental
explanation; it is simply saying a large amount of money was searching
for yield, and that affects the risk premia that people are willing
to hold. That may have boosted prices.
Q15 Mr Newmark: You are not making
a judgment on whether prices are overvalued; you are simply saying
the market is what the market is.
Mr King: It is, and I think very
few people in the past who have been willing to say, "I know
that prices are over or undervalued" have consistently been
able to demonstrate that they were right. I am not going to go
down that road. What is certainly true is that the level of a
risk premium at which it is sensible to imagine that these assets
will be traded in the future is something which is almost impossible
to observe as being related to a variable, such as GDP growth
or something you can tangibly see. That is why, in my opening
statement, I referred to the fact that when there is a shock to
prices investors then question whether the current level of risk
premia or prices will persist and then they enter a process of
price discovery. That is what we are seeing and I expect that
we will see further episodes of that kind.
Q16 Mr Newmark: I want to move away
from simply making judgments on overvalue or undervalue and look
at volatility for a second. There has recently been an increase
in volatility.
Mr King: Yes.
Q17 Mr Newmark: As opposed to prices
going up in equity markets. What are your contacts telling you
about what is happening? How has this influenced your thinking
or your team's thinking on the economy in general—specifically
addressing volatility?
Mr King: Indeed. There was a period
of volatility in late February/early March. That has receded,
in large part. Many prices have returned to their previous levels.
The process of price discovery did not lead to a very different
level of prices resulting as a new equilibrium, except in those
cases where there was some observable fundamental that appeared
to have changed. I singled out the US sub-prime mortgage market
because that is one case where you can visibly see in recent months
a sharp rise in defaults. That has led to wider spreads in that
market, which have persisted.
Q18 Mr Newmark: Does what is going
on in the sub-prime market, though, give an indication of what
is in store, effectively, for the prime markets?
Mr King: Not necessarily, no,
and certainly not outside the United States.
Q19 Mr Newmark: I do not see your
thinking when you say one does not affect the other.
Mr King: Because in the sub-prime
mortgage markets in the United States there has been a noticeable
increase in defaults. In, say, the UK mortgage market, arrears
on mortgages last year fell relative to the year before. We are
not seeing the same default experience on other types of credit.
If we were then you would expect to see a widening of spreads,
but so far we have not seen that.
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