Select Committee on Treasury Minutes of Evidence


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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