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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