Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 60-79)


27 MARCH 2007

  Q60  John Thurso: You mentioned the frequency of purchase and I think the ONS have undertaken some work on that. How much do you take that into account in the MPC's deliberation or is it just a `take note' factor?

  Mr King: I think it is a `take note' factor because this difference is really something that has been particularly large in the last two years and I would expect that to unwind.

  Q61  Mr Love: Governor, first of all, I should apologise. There is nothing worse than asking a question, getting half-way through and having to come back to it at the end, so I do apologise for following up on the question I asked you earlier on. In response to Mr Thurso on the US sub-prime market, I agree entirely that some of the exotic practices there are not being replicated over here, but there are certain trends that are going on. The proportion of sub-prime lending and totally new lending is going up and the proportion of, shall we say, riskier characteristics of the people they are lending to in the sub-prime market seems to be going up, and there is some concern about this. Is that something that you are monitoring and do we need to be taking some action to restrain that at the present time?

  Mr King: Well, we do regularly monitor it in John's area and also in the markets area of the Bank. We hold meetings with the lenders to discuss what is going on and whether they have changed the degree of restriction which they impose and the conditions which they impose on lending. We are, in fact, going to start to publish before long a new survey of lenders in the credit market. I do think that they are very conscious of their risk experience and they will not have been unaware of the problems that have occurred in the US market. I think they do look very carefully at what happens here, but of course, if they were to refuse to lend altogether, I am sure that many members of your Committee would be saying, "Well, why is it that people on low incomes can't get mortgages?", so it is important that people have access to a competitive mortgage market, and I do think the lenders are very conscious of how risky that may or may not be. After all, most of those households try very, very hard to meet their mortgage obligations, the last thing they want to do is to fail to meet their mortgage obligations, and I think it is no accident that the problems we have seen in repayments of debt have occurred not in the mortgage market, but in the unsecured market, store cards, credit cards and so on.

  Q62  Mr Love: I understand that, but I think it was The Economist at the weekend which was pointing out that, whilst all these problems are occurring in the US, the amount of money that is flowing into sub-prime areas in this country still continues to increase. Is there not some concern about that? I know the experience is not exactly replicated, but we do not appear to be learning the lessons.

  Mr King: All I can say is that, if we look at the latest data and ask the question, "What fraction of new mortgages are bigger than 90% of the value of the house?", that figure has risen somewhat, but it is still below 30%. In the early 1990s it was over 60%, so I think we are a long way away from a situation in which mortgages are being granted on those risky terms.

  Q63  Mr Love: If I can move you on to business investment, the Budget suggests that there will be a significant continuing increase in business investment and I think the Chancellor proclaimed that this was the start of the rebalancing of the economy. Do you take as optimistic a view and do you think the economy is beginning to rebalance or are we still too dependent on our consumption?

  Mr King: I think we are beginning to see a rebalancing certainly between consumption and business investment. Part of the strength of business investment last year was investment in the North Sea which, because it led to times when the plant was out of action, also reduced production and revenues, but not all of it. Business investment has been growing strongly and I think we would expect that to continue, so I think I would take the broad view. I think the difficulty in judging how far the rebalancing has gone is on the trade side where we have not really seen much of a change yet, but no doubt in due course we will see some, but it is very hard to predict when that will be. Consumption is no longer growing at the rate that it was in the late 1990s and early 2000s, it is growing at a completely sustainable rate, and I think that business investment, after a period when we were puzzled why it had not picked up, has picked up now and is growing quite strongly, so there are certainly some genuine signs already in the data of some rebalancing. The uncertainty is as to how far it will go and whether it will actually reach the trade side.

  Q64  Mr Love: If we look forward, does it not mean that, if consumption continues, government expenditure is going to decline somewhat?

  Mr King: The rate of growth, not the level.

  Q65  Mr Love: Does that not mean that we need to be making that up on our trade position, yet, looking out there at Europe in particular, it does not look as if trade is going to be able to fill that gap?

  Mr King: I think there are two things to be said about that. The first is that the euro area is now growing much more strongly than for some while and indeed in the last few months we have seen good news on the euro area. Whereas the growth rate in the US has been revised downwards, that in the euroarea has been revised upwards. I think that area is producing more good news than for some time. The second is that in terms of our overall current account, although we have a trade deficit, what we seem to have been able to do is to pull off the trick of earning a higher rate of return on our assets abroad than we are paying on our liabilities to those who own UK assets but live abroad. We have been earning a surplus there which has helped to offset the deficit on the trade account. How far that is sustainable remains to be seen, but it has certainly helped so far. It is unlikely to change dramatically or very quickly, but in the long run I think we will need to see some rebalancing of the economy to reduce the trade deficit, I have no doubt about that, but it is very hard to know when and there seems no immediate pressure to bring that about quickly because, if there were, then I think you would see some downward movement in the exchange rate leading to the expectation of a gradual adjustment.

  Q66  Mr Love: Earlier in the year, you were expressing concern about wage settlements, that real disposable incomes were not rising and RPI inflation on which most are based was quite high. Are you still concerned? Is the outlook now much more benign than it was?

  Mr King: I think it is too early to judge on that and I think that was always one of the risks which we identified. There is certainly no sign of that risk materialising at this stage and nothing we have seen so far would suggest that it has materialised, but I think it is too early to draw any strong conclusion on that front.

  Q67  Mr Love: What is the evidence you are getting from your people in the regions?

  Mr King: That there is some modest pick-up in settlements relative to last year, although certainly less than would have provoked our concern, but, as I say, we have not seen the full results yet and, therefore, I would not want to draw a strong conclusion at this stage.

  Q68  Mr Breed: I want really to go back to the regional disparities, I suppose. There is some sort of feeling that pay settlements are raising much more pressure to increase pay there. What evidence do you get? With what sort of regularity do you get the evidence from your regional agents in terms of specifically what they are seeing on the ground in different parts of the country? Obviously I am concerned very much with the south-west of England, but it is very different from here obviously and the other parts.

  Mr King: I think it is very different in different sectors and industries rather than in different regions, as such. It is up to us how often we get the data from our agents. We always ask them to do a regular annual survey to coincide with the pay round, although I think we have come to the conclusion that the concept of a pay round is no longer as relevant as it was in the private sector at least. It still is relevant in the public sector, but less so in the private sector, but, as I say, our general view is that there does not seem to be very much change compared with last year.

  Q69  Mr Breed: Do you have a comment on the suggestion that in the public sector people are going to get paid differentially for the same job, depending on where they live?

  Mr King: I think that is a question you will have to put to those responsible for the public sector.

  Q70  Chairman: We have put it to the Chancellor for the past few years! Could I ask the question about RPI because it is at its highest rate for 15 years and I wonder if I could address this to everyone, the concern about it feeding into pay settlements. Do you regard it as a temporary phenomenon and what account of the RPI do you make in your deliberations?

  Ms Barker: Well, it is certainly the case that people often talk about RPI as being the index that determines pay settlements, although in fact, if you look back over history, it is by no means a one-to-one linkage and I am personally rather sceptical of the idea that it does influence pay settlements. The main influence on pay settlements almost certainly is demand and supply in the labour market, and we have talked about why migrant labour in particular has eased off skill shortages that were probably otherwise emerging in quite a number of industries. I was in the North East last week and I was very struck by the fact that, of the firms we talked to about pay settlements, the vast majority said that they were settling at, or very little different from, the rate at which they settled last year, despite the fact that RPI is so high. So, whereas RPI may very well be the starting point, particularly in a negotiation where unions are involved, it certainly is not the finish, but the finish depends on how the company is doing and it depends on demand and supply. I was always somewhat sceptical that there would be a direct feedthrough to settlements, but I did recognise that as a risk and it was indeed one of the risks I took into account in voting for higher rates in January, although I have to say so far the evidence is that it has not been realised, but we are a long way from knowing the full story about what has happened to settlements in the first half of this year.

  Q71  Chairman: So you are not sure if it is temporary or not?

  Ms Barker: The rise in RPI?

  Q72  Chairman: Yes.

  Ms Barker: Well, the rise in RPI, the rise and the other indices will be affected very much by what happens to utility bills over the next few months. The expectation is that we will see some fallback from this very high level.

  Sir John Gieve: I think over the medium term these indices tend to move together. But certainly RPI is the best-known price index and, therefore, it could have an influence on people's inflation expectations, and I think more people probably look at that than of the CPI. It certainly influences what workers demand, but it does not necessarily influence what they are given. There are two factors in the labour market really. One is that the increasing importance of bonuses and discretionary pay additions means that the pay round is less important than it used to be, and the second is that, as Mervyn was saying, we cannot yet see a big increase in the level of settlements this year. So so far, so good. The big news, I think, in the labour market on the wage front, for me (and perhaps this is just from my past interest) has been the very tight grip taken on the Public Sector Review Body settlements, which was tough by anyone's standards and I think also has some feedthrough into the likely future fiscal path.

  Q73  Chairman: Has it been a temporary phenomenon? What is your view?

  Sir John Gieve: I am expecting all the price indices to fall when the gas price cuts come through later in the year. The gap between the CPI and RPI varies from time to time, depending on mortgages and council tax, and I have not got it in my mind how far it will narrow or widen in the next year.

  Q74  Chairman: RACHAEL, is that good news for my constituents at my surgery on Friday, that gas bills are going to come down and the Deputy Governor of the Bank of England tells us that?

  Ms Lomax: I think they certainly should come down, should they not? Wholesale gas prices have come right down, so there is no reason why retail gas prices should not follow them. There is not a lot to add to what my colleagues have just said, except of course that one reason why the RPI is as high as it is is because we have been putting up interest rates.

  Q75  Chairman: You took account of it in your deliberations?

  Ms Lomax: No, it is an unavoidable consequence and that is why we never use the RPI as a target variable because it has this perverse property that, when you put up interest rates to bring inflation down, the RPI itself rises. So, providing we do not go on raising interest rates, that will sooner or later work its way through.

  Dr Sentance: I would expect the recent rise in RPI inflation to be temporary and for it to come down as inflation comes back to target. I think the issue which is reflected in the Inflation Report discussion is that there is quite a bit of uncertainty about that path of inflation and how quickly it will come back to target. I think that has a bearing on the secondary issue about how this might feed through into pay settlements and obviously the longer the measure of inflation continues at a high level, the greater is the risk that it will feed through into pay. But there are factors that we have talked about, gas and electricity prices, which cause us to be hopeful that inflation will come down reasonably quickly over the first half of this year, and we will need to monitor on a month-by-month basis the extent to which that is coming through.

  Q76  Chairman: Governor, in your speech in Birmingham in January, you mentioned that the rise in CPI inflation over the last year was not anticipated by the MPC a year ago. In the light of your experience, have you taken any steps to improve the monitoring of that?

  Mr King: No, because, as I said, a forecast is never a central projection; it is a set of probabilities about various outcomes. It is always interesting to go back and ask the question, "What were the things that occurred that were not present in our central projection?", and there are two main things to say about that. One was that we did not anticipate the increases in gas and electricity prices that took place in the second half of last year, it was not in the central projection and perfectly reasonably so, and the second was that there were other factors which clearly led to a pick-up of inflation that we had not anticipated, and I tried in that speech to set out arguments as to what those factors might be. It could be either pressure of demand on capacity or a rise in inflation expectations, but certainly one of the things we have seen in recent months which we had not expected is the noticeable rise in the number of firms who say they are now confident that they can make price increases stick, and that is something that has been concerning us. It is always very important to go back and ask the question, "How did the world evolve in a way which was not in our central projection?", but that is something that I would expect to happen. The chance of the central projection materialising is always, as I say at these hearings, close to zero and that is very important. I deeply regret the fact that most forecasters publish numbers for their forecasts as if they are bound to happen when the chances of that happening are close to zero. It is a fan chart or nothing, as far as I am concerned!

  Q77  Chairman: I will finish on the prospects of inflation and maybe ask everyone for a final comment on that. Looking at the sensitivity of CPI forecasts in your Inflation Report, how sensitive is the current CPI forecast to the assumed future path of interest rates and what are the risks around that assumption?

  Dr Sentance: I think the forecast we produced was on the expectation that was in the market at the time of the Inflation Report, which suggested that interest rates would go up a little bit further, and we showed that, if interest rates were constant, the outlook for inflation would not be to come down quite as closely to the target, but I think the risks around that are probably the more significant thing. From my perspective, as we have pointed out, we can see some factors that will mechanically help to produce lower inflation in terms of energy prices, gas and electricity prices. But of course we need to think about what are going to be the pressures on the other prices in the basket, and we have seen a pick-up in demand over the second half of last year as well as the high price expectations the Governor has referred to. So there is a risk that those factors could keep us above target perhaps for longer than the central forecast is suggesting. I voted for an interest rate rise in February, not in the March meeting, but in February partly because I was concerned about that risk and that is a risk that I am particularly focusing on.

  Ms Lomax: The big debate really over the last few months has been the extent to which the pick-up in inflation has been reflecting supply shocks, like the gas and electricity prices we have been talking about or the underlying pressure of demand on capacity, and I think we have all had slightly different views on that. I think the next six to nine months is going to be really interesting in throwing light on that issue, so in a sense what happens to inflation after that, for me, will depend slightly on what the inflation outturn over the next six to nine months is. I may have been wrong, in which case I will change my mind, but, on the other hand, maybe inflation will turn out quite a bit lower than we are predicting in the Inflation Report. What one feels about inflation in two years' time is path-dependent, in that sense. As for how sensitive is the inflation outlook to interest rates, I think it depends on what happens to the exchange rate. A lot of the transmission mechanism is through the exchange rate and it is always quite difficult to call that. If the exchange rate has not moved, then interest rates can have surprisingly little effect certainly in our model and, if the exchange rate does move, they can be much more powerful. So in terms of the conditioning assumptions in the forecast: well people can get very excited about the odd 0.25%, but I would not read an awful lot into that as a statement of intent about where interest rates are going.

  Ms Barker: We discussed it at length of course in the Inflation Report, as we always do, all those various risks around the path to inflation, but I think one fundamental, obvious point really is we talked about the fact that certainly in the business sector, and noticeably the manufacturing sector, price expectations at the moment are relatively strong. Certainly if you talk to companies, they are more inclined to say they are able to pass cost pressures on, and that has not been my experience most of the time while I have been on the Committee. But of course what is very difficult to tell is whether this is a temporary or permanent state of affairs because ultimately prices in these markets, as we have said, and in many other markets will be set by demand and supply, so we are sort of back to the uncertainties we all expressed earlier around exactly where the output gap is. It is a different way of saying, that I agree with RACHAEL, that we are not going to find out in the next couple of months exactly where the balance lies and all we can do is look at all the indicators we have and take our best view. My own view is that probably the output gap is, as a lot of people have said, roughly around trend, but there is an enormous amount of uncertainty and perhaps more uncertainty than typical.

  Sir John Gieve: I have not a lot to add to that. I think I was with the majority in thinking that the risks to our inflation projection were slightly on the downside in the short term, but on the upside at the sort of two-year horizon. What are the risks to that and the risks I am worried about? I suppose there are two on the upside. One is that consumption growth will be stronger than we have expected, and that will be an upside pressure on the demand side. The second is the point that Kate made about expectations not so much among wage-demanders, but among price-setters among companies. Now, there is a sense that there is a little bit more pricing power in the market now and I will be watching to see whether that comes through in the next few months.

  Q78  Chairman: Governor, RACHAEL has offered us the prospect of a tasty six to nine months. You had the first word, but do you want the last one?

  Mr King: There is only one extra point I would make to your Committee which is that it is quite tempting to try and forecast inflation by simply adding on what we know is going to happen to gas and electricity prices, and that is a mistake. What happens to other prices is not independent of what is happening to gas and electricity prices. These big changes in relative prices do affect the short-term dynamics of inflation overall, that is true, but in the medium term they do not, and I think the big challenge for us, and what is so difficult is to know, is exactly how far the big movements in energy prices that we have seen, both up and now down at the retail level, actually influence the way in which firms set the prices for other goods and services. It is very hard to know how to judge that and that is why the next six to nine months will be very interesting and very important for monetary policy. Our job is to ensure that month by month we all keep taking decisions on interest rates, to keep our judgment as to where inflation is likely to settle, looking two years or so ahead, at the target, and that is what we will commit to do.

  Q79  Chairman: Governor, can I thank you and your colleagues for your appearance this morning; it is very helpful to us. We are mindful that you are coming back in April for our inquiry into the MPC ten years on.

  Mr King: Yes, and we look forward to that.

  Chairman: We are grateful, we thank you for the written evidence to date and we look forward to our April meeting. Thank you very much.

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