Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

MR MERVYN KING, MS RACHAEL LOMAX, SIR JOHN GIEVE, MS KATE BARKER AND DR ANDREW SENTANCE

27 MARCH 2007

  Q20  Mr Newmark: Does anybody else want to comment on that? Shall I move on to housing? How would you currently describe the housing market?

  Mr King: Give me a range of adjectives you think might be appropriate here, and I can tell you!

  Q21  Mr Newmark: I will start off, then. Do you agree with the IMF's assessment, for example, that house prices are overvalued and that there is a risk "of an abrupt downward adjustment"?

  Mr King: It is always easier from a long distance to make judgments about over or undervaluation. It is clear that if you were to look at the housing market in terms of prices relative to a multiple of earnings then house prices look much higher than they were some years ago, but I am not sure if that is the right criterion. In the end, I suspect that to understand the housing market two very simple words help: supply and demand. On the demand side we have seen, as with other asset markets, very low, long-term real interest rates set in the world capital market. That, you would expect, would lead to a rise in the prices of all assets; there is no reason why housing should be an exception to that. Secondly, we are seeing, on the demand side, significant migration that is also bound to increase the demand for housing. We have the country's expert on my right-hand side—who has pointed to some of the shortcomings on the supply side of the UK housing market. If you put those two things together then, perhaps, it is not very surprising that house prices have been high. Where they will go in the future I do not pretend to know.

  Q22  Chairman: I wonder if we can bring in Kate, as she is the expert. Are you disappointed at the lack of progress so far on that?

  Ms Barker: Am I disappointed at the lack of progress? Certainly, it has taken quite a long time to produce some of the recommendations following the report on the housing supply, which, after all, I published three years ago. But I do not think it is surprising. Things do move quite slowly and it was important, for example, to change Planning Policy Guidance 3 into Planning Policy Statement 3; something which, I think, made considerable improvements. That did take time; it was right to take time, and to get it right. It is also true that the industry, having been running at a relatively low rate, would have had difficulty in pushing up supply much faster. It is the case that the supply of housing has been rising, certainly if you look not just at new-build but net additions (if you take conversions as well as new-build and then subtract demolitions). That has actually risen quite a lot and quite steadily, and is rising pretty much in line with what the Government was aiming to achieve when they produced their forecasts in December 2005. I think things are moving in the right direction. I was never under any illusion that the housing market supply was going to resolve itself overnight or even over three or four years.

  Q23  Mr Newmark: So, just to flesh that out a little bit, if we strip out, obviously, the people in the City who are pushing up a particular area geographically, if we go to where average house prices are, do you see any noticeable change—or what does your analysis say on a regional basis? Are things going on on a regional basis that we should be aware of or concerned with, with respect to housing?

  Ms Barker: I do not think the picture on a regional basis necessarily, in terms of affordability, as measured in the rather crude, price/income ratio way, is very much different to, in some cases, that in London. It is still very difficult for people further down the income bracket to get on what is called "the housing ladder" and particularly difficult for people who have no access to inter-generational flows of funds. I think the two things significant to from the big rise in house prices, (largely founded in lower long-term rates) have been a big shift in capital to people who own homes and away from those who do not, and also a big shift in housing wealth inequality between people whose families—

  Q24  Mr Newmark: So, by definition, what you are saying is, certainly at the lower end of the spectrum, house prices look like they are overvalued but they are overvalued because of a lack of supply. Is that what you are saying?

  Ms Barker: I do not think I am saying they are overvalued, because the combination of lower long-term rates and the relationship between supply and demand provide pretty good reasons for most of the rise we have had. It is possible that on top of that there is a small, slightly more speculative element in buy-to-let, but I would certainly hesitate to say that house prices were overvalued.

  Q25  Mr Newmark: If I can turn to borrowing, unsecured lending growth appears to be diminishing, according to your latest report that I saw, while secured borrowing has continued to grow fairly strongly. One explanation has been that banks are tightening their lending criteria. How widespread do you think such tightening has been and what is the chance of such tightening becoming more widespread?

  Mr King: There is no doubt that the rate of unsecured borrowing growth has fallen, most extremely, I think, in the case of credit cards, where two years ago credit card borrowing was growing at the rate of more than 20% a year and now it is growing at between 2 and 3% a year. So a very significant fall in the rate of growth of credit card borrowing. To be honest, that is probably a welcome development. We have commented here before that we think that the developments on the secured debt side have largely followed development in house prices and have not given rise to an experience of default or mortgage arrears. The housing market is still a very safe form of lending for the lenders. However, it is in the unsecured market where we have seen the problems of personal debt. Both from the borrowers' side as well as the lenders' side, there has been a recognition that those rates were unwise, and growth rates have really tailed off enormously.

  Q26  Mr Newmark: The fact that there is something like £1.3 trillion of loans out there, does that give you some cause for concern, or do you simply say: "Actually, it doesn't bother me; what I really focus on is the default rates, and as long as people can afford it they can keep borrowing and borrowing"?

  Mr King: In terms of housing debt what matters, really, is the relationship of the debt to the house value, allowing a pretty wide margin for fluctuations in house prices as well as their ability to service the mortgage. What we have seen is that with much lower interest rates in recent years it has been easier to service mortgage debt, and that has made it possible for people to borrow more in order to purchase houses of a higher price, but we have not seen an adverse experience in terms of repayment or arrears. That is a decision best left to those households themselves. It is on the unsecured side that we have seen a number of problems of household debt and difficulties that many households have got themselves into. So, both the borrowers and the lenders have been adjusting to that.

  Q27  Mr Newmark: If I take what you say, you are saying there has been a huge amount of lending historically, and the fact that there has been some tightening (not wanting to put words in your mouth) in the sub-prime or the unsecured market, should I say, is probably a good thing. I am just curious: what are the consequences of a widespread tightening of lending criteria? Is there an impact on the economy? Is there not? Obviously, there is an impact on people personally.

  Mr King: The impact you would see would be in terms of the growth of borrowing overall. As you pointed out, given that secured borrowing, which is the vast majority of overall debt (something like 83% of total borrowing is in the form of secured borrowing), the growth rate of debt overall and, hence, the impact on the economy is largely determined by the secured side, not the unsecured debt.

  Q28  Mr Love: Following on from that and some of your earlier answers, Professor David Miles has suggested (he is another expert in this area alongside Kate Barker) that there is an element of speculation in house prices, and that at some stage that has to come out. If you look at the problems in America, the problems have arisen because house prices are falling. Do you have any concerns about that?

  Mr King: I do not pretend to be able to forecast house prices, and most of those who try to do so have been proved wrong in recent years. Let me not go down that road. Let me ask the question: if house prices were to fall, what would be the consequences? If they were to fall by a relatively modest amount then I do not think the consequences would be very severe, because you would find, still, a very small number of households would find themselves in a position where they were described as having negative equity. As long as they go on servicing the mortgage, if indeed they would choose to do so, I do not think there will be any major difficulty. If there was a very large fall in house prices, which I think all of us think is unlikely but no one can rule out entirely, then the problem is much more severe. However, I think it would be wrong to look at it as a problem of housing, because you would have to ask the question: why did the price of houses fall so sharply? In large part, that would have to reflect some other shock to the economy as a whole. We have not seen that so far. If there were a shock to the economy as a whole, obviously, we would take some action to offset that shock but, so far, as I say, the simple-minded, forward projection of house price-to-earnings ratio has not been a very good predictor of what would happen in the housing market. There are very good reasons for that in the last few years: the very low level of long-term interest rates ought to push up all asset prices, and it has, and housing is no exception to that. If interest rates were to return to historically more normal levels then all asset prices would adjust, not just house prices, and then that would be a development that we would have to deal with. On the supply side, Kate has drawn attention to some of the difficulties. Again, I think, in any individual market you do not go very far wrong by thinking in terms of supply and demand.

  Q29  Mr Breed: Turning to domestic demand, we have been provided with a very helpful summary of the comments made in the November and February Inflation Reports on the components of GDP. On that basis, do any of the components of GDP forecast, such as consumption or net trade, give you any particular cause for concern?

  Mr King: Not cause for concern. I think we have seen the economy develop, as I said at the beginning, in a remarkably steady way over the past five quarters. There are signs of a modest rebalancing of demand with consumption growth, if you average out the experience of the last five quarters, growing close to, maybe a little bit below, its long run, historical average. Business investment, clearly, has now recovered and has been growing quite rapidly and we are beginning an adjustment now towards lower growth rates of public spending. The data on net trade are almost impossible to interpret because they are dominated by the effects of fraud. But I think we are beginning to see some signs of rebalancing, and I would welcome that. Overall, there are no obvious signs for concern but, as I say, the central view in all this is not one that is ever likely to materialise, and the role of the Committee is to take one month at a time, to look at the news on that month and to see whether the central projection is or is not materialising and what new developments have occurred. We always have to be alert to respond to those new developments.

  Q30  Mr Breed: As you mention trade and fraud, do you believe that the current Government's measures it has introduced fairly recently are having any significant effect on MTIC fraud.

  Mr King: Fraud? We cannot judge, but the numbers we have been given do show a substantial fall in fraud towards the end of last year, but I do not think we are the experts on fraud.

  Q31  Mr Breed: No, I do not think anybody is! On consumer spending, the recent data released suggests weakness in the services sector combined with higher retail sales. What is your opinion of the future path of consumption as you see it, perhaps, over the next 12 months or so?

  Mr King: As you said, the data in the last few quarters have been quite volatile, but it has been volatile in a particular way, with one quarter strong, one weak, one strong and one weak. That is a classic sign of measurement error in the data, and it could either be because spending is being allocated incorrectly to one quarter and it should have been given to the adjoining quarter, or it is because the seasonal adjustment has become more difficult. We know, for example, that people do not spend more or less simply because they are in Q1 or Q2; they may do because of the weather, and seasonal adjustment is a proxy for that, but with changes in the meteorological pattern that may affect the optimum seasonal adjustment. January was the warmest January since 1916. Who knows, but if you talk to retailers (which we do a lot) they never talk about: "This is the week in the year when sales are weak or strong"; they say: "A year ago the weather was wet, or warm, and hence you would expect the year-on-year figures to be either higher or lower". So they do put a lot of attention on the impact of weather. These adjustments are very hard to make. As I said, what we try and do is to look through this volatility, because it is very hard to understand. If you look through it you see that what has happened since the slowdown in the first half of 2005 is that consumer spending has recovered to grow at, perhaps, a little bit below but close to its long run historical average. I think that is where we would expect it to go in the future, consistent with a modest degree of rebalancing.

  Q32  Mr Breed: So you believe that the volatility shown is more of a technical measurement than it is to do with the underlying—

  Mr King: I suspect so. There is no obvious reason why people would want to spend in that volatile way. Again, the big picture is that these are not dramatic degrees of volatility, but I suspect it may well be to do with the measurement of the data, or seasonal adjustment.

  Q33  Mr Breed: Do you expect it to continue or do you expect that to be a blip?

  Mr King: Of volatility? Either because it is measurement error or because of difficulties of the seasonal adjustment, without being able to predict the weather or what the factors are that are leading to the seasonal pattern, I think it is impossible to know. Again, I do not think it matters very to us, because we try and look through the volatility and form a judgment about the underlying picture.

  Q34  Mr Gauke: Was there anything in last week's Budget—any of the announcements made there—that might affect your projections for GDP or inflation?

  Mr King: I do not think so. The big picture is no; the Budget overall was neutral. I do not think it affects our overall view of the path of fiscal policy. There are some minor aspects that we will look at in more detail between now and the next meeting. Some of the indexation of excise duties comes into effect later this year than we had previously understood to be the case and it is possible that because of the changes in capital allowances there may be an incentive to invest earlier than later. I do not think these are first order, and the overall picture is that the Budget does not change our view about the overall path of the economy or, indeed, fiscal policy.

  Q35  Mr Gauke: Is the fact that the borrowing figure was slightly higher than the Chancellor had previously predicted something that you consider significant at all?

  Mr King: In terms of the overall picture, looking at the years ahead, there is no significant change to the fiscal position. There is a shortfall relative to previous expectations of North Sea revenues, but the overall picture, I think, is broadly unchanged.

  Q36  Mr Gauke: The Red Book predicts inflation at a rate of 2% for 2007, 2008 and 2009, and this is consistent with the external forecasts as well. In your Inflation Report the external forecasters predict 2% for 2009-10. Is there an assumption from the Treasury, in their projections, that there will be a rise in interest rates before falling back? Or is it not possible to say?

  Mr King: That is a question you must ask them, and no doubt they will come to you and you can ask them what assumption they are making. For our own judgment, I think—and we saw this very clearly in the February Report—there is a good deal of uncertainty about the short-run path of inflation. I think it is fair to say that around 2% is the broad judgment that most forecasters have come to as to where inflation will be by the time we get to the end of this calendar year, but it does depend on the pace and extent of cuts in retail gas and electricity prices. The cuts that have been announced since we published our February Inflation Report are consistent with the judgment we made in the report. Our judgment was that over the next six months there would be the sort of cuts that have been announced. We also assumed there would be further cuts to come, and we will see whether that happens or not. The difficult judgment facing the Committee, and the important one, is to look through this short-term volatility of gas and electricity prices and try to judge where inflation is likely to settle once we have seen our way through this. It is quite tricky. In the last year we saw inflation pick up, in part, because of higher energy prices. This year, if those energy prices had stayed where they were, inflation would have come back again because there would not have been the base effect. But because they are now falling inflation will come down faster than we had previously thought. Equally, however, once you get into 2008, unless gas and electricity prices continue to fall, there will be a bounce back up again in inflation. So we have got to see through the increase last year, the sharp falls this year, the bounce-back in 2008 and try and see where all this leads to. That is not easy, and that is why it is perfectly easy to understand why there are differences of judgment on the Committee.

  Q37  Mr Gauke: Sir John, can I ask a quick question, with your experience within the Treasury? To what extent are the Treasury inflation projections independent from the Bank of England, or do they rely very heavily upon the MPC and the Bank of England's projections?

  Sir John Gieve: I think they do their own forecast, but it would be quite a big thing if they came to a very different view from us. So I think they do take our projection seriously.

  Q38  Chairman: I have a question for the other members, at the moment, Governor, and it is to do with the money aggregates. One of our contributors has highlighted the growth of the money supply, saying that it has been very high, 13-14%, in the recent past. What should the MPC make of the growth in the money supply at a time when consumer price pressures appear to be ebbing? How is it giving weight to such considerations when immediate inflationary pressures also seem to be ebbing? Can I ask other members: to what extent do you think the current growth in the monetary aggregates is providing information on the future path of inflation? Let us start with Dr Sentance.

  Dr Sentance: I think you can see there are two influences on the money supply. First, it can be reflecting the demand conditions in the economy and, second, it can reflect portfolio shifts in the investment community. A lot of the growth that we have seen has been in the other financial institutions, so there is certainly evidence that the composition of some portfolio shifts have been playing a part in that growth of the money supply. I think the way I would interpret it is to say that at a time when demand has been picking up across the economy over the course of the second half of 2006, it is certainly something we need to watch closely. The most recent figures have given slightly mixed signals; there did appear to be a deceleration but I think the last month was a little bit stronger. So my approach would be, certainly, to be watching it closely but to have an open mind about the extent to which this is reflecting demand conditions or portfolios shifts, and to use other information about the state of demand in the economy to help inform my judgment.

  Q39  Chairman: But all cannot be dismissed as technical in origin, in that it corresponds to increased holdings of money by financial institutions, which may have no relevance to economic activity. So, you would not dismiss it completely as just technical.

  Dr Sentance: Certainly not. No, I would not be in the position of dismissing the monetary data, but I think we need to be careful in interpreting it. Sometimes it is giving us useful signals. There was a tendency, for example, in the late-1980s to dismiss high monetary growth because in the early-1980s it had given some slightly misleading signals. It is something we need to take into account, but we should look at it alongside what other indicators are saying about demand conditions, in particular, because that is the sense in which I think it would be a worry—as a signal of strong demand conditions, both currently and in the future.

  Ms Lomax: I am a bit more sceptical than that. I find it very difficult to see much information in short-term movements in any of these monetary aggregates for movements in inflation over the next couple of years or so. I do not think anybody has estimated a stable demand for money function in the UK for many a long year, and even in the days when we thought there was a stable demand for money function we had a lot of difficulty in setting monetary policy with reference to the monetary aggregates, as I remember only too clearly from my period working on these issues in the Treasury in the 1980s. So I am pretty sceptical about the extent to which, looking at these figures from month-to-month or, even, quarter-to-quarter, we can say very much about what they are telling us about future inflation. In an economy with a sophisticated financial system, where there is a lot of financial innovation, these aggregates, which we have defined as money—and there is a whole industry around exactly what you measure and call money it is incredibly difficult to define what you mean by money, but assuming you have settled on some definitions—the simple relationships are very difficult to determine. In a much less sophisticated economy, which is much more controlled, where it is clear what money is, I think there may be a stable demand for money and monetary aggregates have some predictable relationship with future inflation. They are much easier to get a handle on. But in the sort of economy that we live in at the moment one has to be a bit more sceptical than that. I am afraid I am not a believer any more, having been a believer 20 years ago.


 
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