Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 40-59)

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

27 MARCH 2007

  Q40  Chairman: Are you a believer still, Kate? Were you ever a believer?

  Ms Barker: I think I have never been a believer; I think I am very much in RACHAEL's camp. I do look at these numbers but, like Andrew, I tend to ask the question: is it corroborating other things that you think are going on in the economy? The truth is, I find it very hard to know how much weight to put on them. There have certainly been plenty of periods in the past where they have proved to be simply telling us about changes in behaviour in the system rather than really telling us anything about inflation. The difficulty in distinguishing between a period where it really is telling us something about inflation and periods where it is simply changes over the financial market or changes in behaviour is so great that, in the end, I do not give them very much weight.

  Q41  Chairman: Sir John, you would always be dispassionate, would you not?

  Sir John Gieve: I hope so. I agree with RACHAEL that there is no clear equation which links increases in the money supply or a particular aggregate this year with an inflation performance in a year or two's time. We tried to find one in the 1980s; it was extremely hard, and we never quite pinned it down. Nonetheless, in the long run there is a very well-established association between money growth and inflation, so I do not think you can ignore it. The big problem of interpreting the results for the last couple of years has been how much of this is reflecting structural change in the financial sector: securitisation, the use of cash to provide margins against derivatives, and so on. We know that accounts for a chunk of it, and we have not yet seen that very rapid growth in the financial sector feed through into the household sector. Household deposits have, on the whole, stayed varying around 8%, very solidly, for years, but we need to be alert to the fact that it might feed through in time.

  Q42  Chairman: No chance of a revivalist meeting here, is there?

  Mr King: I am not sure what you mean by "a revivalist meeting". I am more concerned about the monetary aggregates than some of my colleagues. I think there are two main reasons for that. One is the extent of the growth of broad money. It goes back to some of the things I discussed at the beginning with Mr Newmark, about the growth of liquidity and asset prices. Although, as Andrew Sentance said, you have to look very carefully at the data, and it is fair to say that some of the increase in broad money is reflecting what probably ought not to be recorded as an increase in money because it is essentially an inter-bank transaction, not a transaction between the banking sector and the rest of the economy (which is the purpose of these aggregates to measure). Nevertheless, even if you were to do that you would still end up with pretty rapid growth of broad money. So the question is how would I react to that? I would say that the second reason I am concerned is that—and the example I would give is the present situation—we know there is a lot of volatility in retail gas and electricity prices over the next two years and we have to look through that. I said: the question is where will inflation settle two years from now? The answer to that question is really all about the nominal anchor for inflation in the UK economy. What I know is that the nominal anchor is not determined by real variables, like output and employment and investment and consumption. Inflation, in the jargon of economists, is a nominal variable, not a real variable; it has to be determined, in the end, by some monetary variable. There are many economists who prefer, for all the very good reasons that RACHAEL explained, not to look at money but, instead, to think of interest rates and inflation expectations as being the nominal anchor. However, inflation expectations are pretty vague things; they are not easy to measure, they are not well-pinned-down, and my concern about the money numbers would be whether or not they are telling us something about what may be happening to inflation expectations, not over the next two years but between, say, two and five years—that medium-term horizon which is the anchor for inflation in the UK. Therefore, I totally agree with my colleagues that there is no mechanical relationship that one can usually exploit, but I do think that one must look carefully at these numbers and take them into account, and they do, in my view, pose an upside risk to inflation, which I think was one of the things that those who voted for an interest rate increase in January took into account. This is a very difficult area because, as I say, there is no settled or simple mechanical link between any of these aggregates and what may happen to inflation in the foreseeable future, but to ignore it as a potential medium-term influence, I think, could lead into tricky territory.

  Q43  Mr Fallon: We are all non-believers now! Could I ask somebody about the aggregate output growth table on page 25 of the Inflation Report? Bridget Rosewell yesterday gave evidence to this Committee pointing out that private sector employment is now virtually the same as it was 30 years ago; that the big increase has been in public sector employment. In this chart you have shown how the various output measures aggregated have grown since 2005. What is the outlook for these measures?

  Mr King: What we are concerned with, and what this box is all about, is trying to say: how can we measure the impact of the public sector and public spending plans on the resources available for the private sector? Because the ONS have changed the conventions which they use to measure public sector output, we have not found that their estimates of that are terribly helpful to us. They are making their own adjustments to the level of output and productivity in the public sector, but what matters, in terms of the resources available in the economy and the pressure of demand overall on the supply capacity of the economy, is the extent to which the public sector is subtracting from the resources available to the private sector, either in terms of direct employment, because those people if they are working for the public sector cannot work for the private sector, or because the public sector is buying goods and services which are not available then for the private sector. What we are trying to calculate in our measures here, is to try and get round the problem that none of us really know what the true output or productivity in the public sector is; they have perfectly understandable reasons (this is the Atkinson programme of work) for trying to work out the value of output in the education and health sector, but whatever judgment you make about that is not really relevant to the question of what are the resources available in the private sector and what is a pressure of demand on capacity. So we are trying to abstract from the important but quite separate question of what is the value of the public sector output to look at a measure of resources available for the private sector which private sector demand can then use.

  Q44  Mr Fallon: I understand that, and you calculate this measure of total demand for resources. What I am asking you is whether you are forecasting that to increase now.

  Mr King: It will increase. In the sense that we do not think that the share of the public sector in total output is going to rise in the next few months, the growth rates will come down. We do not publish a forecast for that, so I am not going to be precise in terms of numbers, but it goes into our judgment about the growth of overall output in the economy. The forecasts for output growth that we produce are designed to be comparable to the ONS measure of output growth so that people can then compare the outturns which the ONS publish with the forecast that we make.

  Q45  Mr Fallon: Can I ask Andrew Sentance: the Quarterly Bulletin says that recent migrant inflows may have helped to ease inflationary pressures, but I think you made a speech at the end of January suggesting these migrant inflows may have eased off now. Is that your view?

  Dr Sentance: That was not the main point I was making in the speech. The point I was making in the speech was that in the labour market we have benefited over the last decade from a fall in the equilibrium employment rate in the economy which, almost arithmetically, could not be repeated and was unlikely to be such a strong contributor to growth in the medium term. To some extent, that was being made up in the short term by the fact that labour participation was increasing and migrant labour was increasing, so we were getting increased labour supply from other sources that were contributing, at least in the short term, to the trend growth of the economy. I think the point that I was making was we had much more uncertainty about how long those trends would continue, and about their impact on the medium-term growth rate of the economy. So rather than make an observation about what was happening in the short term, I was saying that we had more uncertainty about the medium-term growth rate from the contribution of labour supply factors at the moment.

  Q46  Mr Fallon: So you are saying we cannot be sure that those migrant inflows will continue to ease inflationary pressure.

  Dr Sentance: That was the point I was making. We need to look at that in terms of looking at the labour market pressure from month-to-month, from quarter-to-quarter rather than assuming that this will continue indefinitely. We need to be particularly sensitive to what the labour market indicators are telling us about the amount of slack and the amount of inflationary pressure.

  Q47  Mr Fallon: RACHAEL Lomax, what is your current opinion on the overall level of the output gap?

  Ms Lomax: This is a major uncertainty for us, at the moment. I think we are probably not far away from full capacity, at the moment. These measures of capacity utilisation within firms which we tend to quote in the Inflation Report are pretty uncertain, but they do suggest that the level of capacity utilisation within firms is quite high. If you look at the labour market, I think there may have been a degree of slack in the labour market last year, but some of that has been taken up a bit. So, given the margins of uncertainty around any statement about capacity, I think we are not far from full capacity at the moment.

  Q48  Mr Fallon: The Chancellor in the Red Book last week seems to have the economy running at trend; he has a straight, flat line through the forecast period.

  Ms Lomax: I assume that reflects the same judgment on the part of the Treasury, if I understand the way they do their calculations. They tend to take up any slack in the economy when they project GDP forward. So if they have got the economy growing at trend it suggests they think we are not very far away from full capacity at the moment. I have not discussed the forecast with them, by the way, I am just inferring from what I know of the way they tend to approach these things.

  Q49  Mr Fallon: Does anybody here think the economy is not at trend or very close to it?

  Mr King: You are putting very precise words into our mouths and asking us to dissent from it. I do not think anyone can really know, and I must say that I myself have doubts as to whether in a situation where it is possible to acquire labour from abroad when demand for labour expands here, the output gap is as precise and useful a concept as it was. The ability to recruit migrant labour does actually undermine, to some extent, the ability to construct, and the usefulness of, a concept such as the output gap. In broad terms, the Treasury say in the Red Book that they believe that whatever they think the output gap is will close in the first quarter of this year, and then will remain roughly where it is. That is consistent with our forecast that their growth rate in the central view is very similar to ours, but I go back to the point I make each time I come, which is: for heaven's sake, please do not put too much weight on the central projection; it is very unlikely to materialise. A forecast has to focus on the risks as well, otherwise it is of little value.

  Q50  Mr Fallon: The Treasury seem very clear. They say: "The small negative output gap is expected to have closed early in 2007".

  Mr King: That is what they say. They have their view of the output gap and we—

  Q51  Mr Fallon: You are not so sure?

  Mr King: They have a particular concept which they call the output gap. Other people use the phrase "output gap" to refer to a different measure altogether. So there are many different ways of defining the output gap. I have some doubts as to whether it is quite as easy to define the output gap in a situation where there is a pool of labour, offshore, that one can bring in when demand for labour is there.

  Q52  Chairman: Sir John, can I add to Michael's question to Andrew about immigration and the future? I note you made a speech last night to the London Society of Chartered Accountants. I enjoyed your speech because you say in there: "The history of each financial centre has been shaped by a myriad of factors from empire, the role of guilds, proximity of kings and government." Very good. But we then go on to: "The issue of the free movement of labour within the European Union and the relative openness to migration by those with specific expertise from outside it. It has also meant that employers from financial sectors can access the world labour market, and the relative flexibility in the UK compared to others in Europe may also be a factor." Are you optimistic of the future in terms of the inflow of labour to the United Kingdom, and particularly the City of London, where it can keep its competitive global advantage?

  Sir John Gieve: I am not going to comment on immigration policy, which is not for me. What I was saying in the speech was that the most important factor, which was, if you like, reinforcing London's comparative advantage, was the concentration of skilled labour, and that one element of that, especially in recent years, has been the ability to bring the best people from abroad. I think that has worked very effectively and is something that people in the City comment on. The point of the speech was to say that the development of capital markets worldwide should provide more scope for the concentration of wholesale financial business, and that would tend to reinforce London's position, providing we do not make any mistakes.

  Q53  Chairman: I bring you back to the point you made—sorry to press you. You say: "The free movement of labour within the European Union and the relative openness to immigration" allows the financial centre to access the labour market. So you would like to see that continue.

  Sir John Gieve: Well, I was commenting on the facts, but yes, I think it has worked pretty well.

  Q54  John Thurso: I wanted to ask about inflation expectations but, before I do that, can I just ask a question about risk and particularly, I suppose, lending risk. Is it of concern to you that risk is less obvious, ie, a couple of decades ago it could be clearly seen on the balance sheet of a few major primary institutions, whereas now, through complex instruments and the use of secondary institutions, it is much more diffuse in the economy? Does that concern you and does it pose a risk to stability and inflation?

  Mr King: As such, I am not concerned by that. Indeed, I think in many ways it has great merits because the fact that you could observe it all on the balance sheet of a small number of big institutions reflected the fact that the risk was in the hands of a small number of big institutions. They were rather risky and that meant that the State in a sense had to stand behind them. That is the classic problem of banking relationships where you can have a small number of large banks whose assets are in the form of illiquid loans and whose liabilities are in the form of liquid deposits which can be taken out on call almost immediately. They have a very unstable balance sheet. That is not a very happy position to be in, so I think it is much better to move to a financial system in which, for all the major financial institutions, their balance sheets have much less risk on them and almost inevitably that means that the risk must, therefore, be shared across a much wider range of financial institutions and indeed individuals. I think that is a sensible development and, far from being worried about it, I welcome it. Now, of course there are aspects, quite separate in principle, of recent developments, namely the development of the creation of a wide range of new financial instruments. This is technically not the same phenomenon as spreading the risk outside a small number of large banks and there is a separate issue there which is whether the existence of these markets creates the possibility that some key institutions in the banking sector will find themselves trading in markets where one day the liquidity in it might just dry up. That is something that we need to be concerned about and it is something which our market intelligence function, under John, looks at on a regular basis and which is discussed within the framework of the tripartite standing committee. However, I do not think the fact that there is a question about that which we have to monitor is something which should lead us to ignore the real benefits that result from no longer concentrating the risk in a small number of institutions. Many of my colleagues on the Continent always used to say they liked risk in the banking sector because they could control it, but what they were doing was not controlling the risks, they were nationalising them, and those risks became risks to the taxpayer, not risks to the people who were taking the decisions about the use of the assets. I do not think it is sensible for that to fall on the taxpayer; I think it is more sensible for people in those financial markets to know that they can lose money, and indeed we have seen in recent cases one or two institutions go under where people have lost money, presumably rather wealthy people who have gambled and lost, and I think that is probably where the consequences of failure to assess risk properly should lie.

  Q55  John Thurso: Do you think, therefore, that the problems with the US sub-prime market are going to be seen in that context, in other words, of people having taken a risk and got it slightly wrong and, therefore, not of particular concern?

  Mr King: Well, I think our American colleagues would say that they are obviously monitoring this very closely. They do not at present see any feedthrough from the institutions in the sub-prime market and the broader banking system or credit markets, and indeed that would only occur were there to be significant defaults in those other credit markets, but the fact that some of those institutions made mistakes is maybe a timely reminder that it is possible to lose money in these markets.

  Q56  John Thurso: Turning to inflation expectations, according to a number of surveys, there has been an increase in household expectations for inflation which one might expect to put upward pressure on settlements. What insight do you have into the interrelationship between interest rates and inflation expectation?

  Mr King: Well, I think this is a very important, but quite difficult, area, in large part because it is difficult to be entirely confident as to what these measures of inflation expectation are telling you. In terms of household surveys, we have seen over the past year, first of all, some pick-up in inflation expectations and in one of these surveys more recently a fallback again. The timing of these movements suggests that it is not unconnected with noticeable changes in prices and major items of expenditure, like gas and electricity. Those expectations may be rather short-lived, therefore, and not be a good guide to underlying inflation expectations more generally. In the financial markets, expectations of inflation looking further ahead have risen over the past year. That is not a welcome development because one of the great achievements, I think, of the new framework was the fall in inflation expectations when the Monetary Policy Committee was set up in 1997. It is very hard to know how much weight to put on it because these measures are derived from looking at the yields on index-linked gilts, on the one hand, and conventional gilts, on the other. There may be all sorts of other factors which are influencing the relative yields, and the risk premium itself is one of those factors. Nevertheless, it is a concern, but I think one has to see it in context. The magnitude of the pick-up is still relatively small compared with the movements of inflation we have seen compared with the past. We are now talking about a world in which inflation still has not moved more than one percentage point away from the target in any single month since December 1992 and in which, in our central view, it is likely gradually to come down and fall during this year. So there may have been some pick-up and it is a matter of concern because it may affect our judgment as to where inflation will settle once we have seen gas and electricity prices settle down, but, nevertheless, we are in a world where these movements are relatively small and I think that is a comforting thing which we should hold on to.

  Q57  John Thurso: Would you expect, therefore, that inflation expectations would return to somewhere nearer the target level?

  Mr King: Well, it depends. If we can ensure that inflation does do that and people believe that it will continue to be there, then yes, but I think this is where we cannot just rely on inflation expectations doing the job for us; we have got to take action. Indeed, as John said, one of the reasons for the move in rates in January was to give clear signals that we would take action in order to bring that about.

  Q58  John Thurso: In looking at perceptions of inflation, is part of the problem the fact that there seem to be two economies? There is the one we discuss in this Committee and the Government discuss and then there is the one we all have on the high street, and the general perception is that the one on the high street which takes up my disposable income has more inflation in it than the one which the Government are talking about. To what extent is that a factor?

  Mr King: I do not think it is and I think that is not a true perception. Indeed, I think if you were to measure inflation literally on the high street, you would find it hard to see any sign of inflation at all on the high street because it is services that are not sold through the high street itself which always have a higher inflation rate.

  Q59  John Thurso: Forgive my imprecise phraseology then.

  Mr King: But it does go to general perception that inflation is higher than the official measure, I think that is ultimately what the question is about, and I do not really accept that either. I say that because I think the official measure we have, CPI, is a very comprehensive measure, and I will come back to how comprehensive in a minute. It is constructed in a very professional way, using thousands of inspectors who, across the country, measure very carefully the prices of goods and services in a wide variety of retail outlets, so I do not think I would criticise the way in which it is put together. It does exclude council tax and housing, owner-occupied housing, and that must be relevant to the view of anyone asking themselves, "Has the cost of living for me gone up?". I think what is more important perhaps in terms of perception, and there is a very interesting observation which we allude to in the Report, is that, if you were to ask people, "Think back over the last six to 12 months and remember everything that you bought in the last six to 12 months and we'll tell you how much the price of that has gone up or down relative to last year", if you calculated the inflation rate that way, you would get a number that is noticeably higher than the official inflation rate. Why? Because the things which have been falling in price, keeping inflation down, have been those things like consumer durables that people buy less frequently than every six to 12 months. It is the imported, manufactured consumer durables which are bought by most people not every year, but occasionally, which are the things which have been falling in price and hence bringing the inflation rate down relative to the price of other things. I think there is a relationship between how frequently you buy something and what has been happening to the inflation rate of that. But what is relevant to us, as the Monetary Policy Committee, is to ensure that the price of the shopping basket for the UK as a whole is not rising or falling, that the rate of inflation should be 2%. I think it is quite possible to understand why in the past two years the impression that inflation is higher than the official rate has grown because that would be a correct impression of what has been happening with the things that you bought in the last three, six, nine months or so, but, if you look at the entire shopping basket and take into account things that maybe you have not bought last year and I have not bought last year, but which somebody has been buying, then actually inflation is correctly measured by CPI, with the exception of housing, as I say.


 
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