Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1-19)

MR MERVYN KING, MS RACHAEL LOMAX, MR PAUL TUCKER, PROFESSOR TIM BESLEY AND PROFESSOR DAVID BLANCHFLOWER

28 JUNE 2007

  Q1 Chairman: Governor, good morning to you and your colleagues and welcome to the Committee. For the shorthandwriter can you introduce your team, please?

Mr King: Thank you very much, Chairman, and good morning to every member of the Committee. On my right is Paul Tucker, the Executive Director for Markets; on his right is Professor David Danny Blanchflower, one of our External Members; on my left is Rachael Lomax, Deputy Governor for Monetary Policy; on her left is Professor Tim Besley, another of our External Members.

  Q2  Chairman: Governor, you have an opening statement I believe.

  Mr King: I am grateful as ever for this opportunity to explain to members of the Committee the reasons for our decisions on interest rates since our appearance before you last in March. The bank rate was raised to 5.5% in May and has now risen by one percentage point in total over the past year. Output growth has so far proved resilient in the face of those rises in bank rate. Growth has been remarkably stable for around 18 months now and in the year to the first quarter of 2007 was 2.9%. Inflation, however, has been volatile. It picked up from 1.8% in March last year to 3.1% in March this year which triggered an open letter from me to the Chancellor. It has now started to fall back quite sharply to 2.8% in April and 2.5% in May as lower retail gas and electricity prices have entered household bills in contrast with the substantial rises last year. In its May Inflation Report the MPC published a central projection in which output growth was expected to continue at close to its recent rate and inflation was expected to fall back further before settling around the 2% target. The MPC judged that the risks to the outlook for inflation were to the upside. Since our May Report the world economy has continued to expand rapidly. Against that background oil prices have risen by 9% and there have been some sharp rises in yields on long-term government bonds. Those yields have, for more than a year now, been surprisingly low and that has boosted asset prices in general. The recent rise in yields has not so far been associated with significant changes in other asset prices. The outlook remains one of a modest rebalancing of demand. Business investment has been strong over the past year as have surveys of manufacturing output growth. There have been some further signs of slowing in activity in the housing market and there are tentative signals that consumer spending may be softening. The balance of risks to the outlook for inflation remains to the upside. Money and credit continue to expand rapidly and there is particular uncertainty surrounding the high levels of indicators of businesses' pricing intentions. There is as yet, though, still no sign that wage pressures have increased so if these pricing intentions have arisen because businesses wish to pass on higher energy costs that had previously been absorbed in margins, they should fall back as energy prices stabilise. The upside risks, however, are that intended price increases are the result of pressures on capacity which surveys suggest have built up over the past year or higher inflation expectations. The MPC will continue to monitor closely these indicators of pricing intentions as well as nominal developments in the economy more generally. Looking through the volatility of energy prices in the near term to gauge the outlook for inflation further ahead is a genuine challenge and that is why it should not be surprising that there have been differences of view amongst the MPC about the level of bank rate required to bring inflation back to the target and keep it there. I can assure you that every member of the MPC is committed to hitting the 2% target. Chairman, those are the remarks that I would like to make this morning and I and the other members of the Committee here today stand ready to answer your questions.

  Q3  Chairman: Thank you very much, Governor. At the June meeting the vote was very narrow—five to four—and a lot talk and comment have been made since that meeting. One headline in one of the papers (I think it was someone who advises our Committee) said: "Critical time for the Governor if he is outvoted again". How do you view that?

  Mr King: I think our process is one in which everybody who enters that room does so in the spirit of trying collectively to tease out what is the right policy. At the end of that meeting we say, "In the end there are good arguments on both sides but actually my view, when push comes to shove, is that this is the measure that we should take". Then we see where the majority opinion lies and that produces the decision. I think we all feel that in the long run that produces the best set of decisions on interest rates. It logically follows, therefore, that it is very likely that in turn, as time goes by, every member of the Committee will find themselves at some point in a minority and indeed every member of the Committee has been in a minority at some point in the recent past. I have now been in the minority for two months in 2005 and again earlier this month. I do not think this has any particular consequence; it did not last time, the fuss died down, people stopped commenting on it. I do not feel particularly concerned about it. I do not think the Committee does but you can ask them what their view is. I think this is the inevitable outcome of a process designed to get the best decisions out of a group of nine people who, together, pool their expertise and judgment about the economic outlook.

  Q4  Chairman: Governor, you made a speech at the Mansion House and while I enjoyed the speech, there were a number of comments which I thought quite serious. You did say: "More than one banker and merchant in the City has said to me recently, `I cannot recall a time when credit was more easily available'." You went on to say "New and evermore complex financial instruments create different risks. Exotic instruments are now issued for which the distribution of returns is considerably more complicated than that on the basic loans underlying them." You cautioned people by saying, "Be cautious about how much you borrow is not a bad maxim for each and every one of us here tonight". You made me go back and thumb through my old copy of John Kenneth Galbraith's The Great Crash 1929. In his forward to the third edition he says, comparing the 1960s and 1970s with the 1920s, that in both periods leverage was rediscovered and heralded as the financial innovation of the age. He ends up by saying, "Yet the lesson is evident. The story of the boom and crash of 1929 is worth telling for its own sake. Great drama joined in those months with a luminous insanity." Are there any parallels with today?

  Mr King: I will leave you and others who are better equipped than me to do the literary reviews as to whether or not we should draw comparisons. Let me just restrict my comments to where we are now. The only comparison I would make is that most financial crises have involved a very high degree of leverage. That is the risk to the system as a whole. Of course that is the Bank's interest in this, the stability of the financial system as a whole. What I was trying to do in that speech, having said on earlier occasions, "Think before you borrow" was to say: "Think before you lend". In other words, lenders should think through the complexity of the instrument in which they are investing their funds, the complexity of the returns and the distribution in returns that result from those instruments. Also, the potential liquidity of the market in which those instruments can be traded if we ever got to a point where some of the lenders decided, in the company of other lenders, to try to liquefy their investments at the same time. That is when you start to find the liquidity in the market is drying up, when the complexity of the instrument starts to hit home and people realise that maybe their balance sheet is not quite as secure as they had thought. What I was doing was merely saying to the lender, "Look, think very carefully." Not just to borrowers—we have been saying that for some time now—but also the lenders.

  Q5  Angela Eagle: You also expressed a worry in earlier comments around the Inflation Report that you were worried that banks were now indulging in lax lending and that some appear to be lending money, particularly to private equity companies, at below the base rate. Is this something that keeps you awake at night?

  Mr King: I do not think that particular example is one that keeps me awake at night. I think there are few, if any, actual examples of that, but there are obviously moves towards the system in which the degree of covenants, for example, that are attached to loans, have become much less restrictive and again what I wanted to do was to say to the lenders and those who invest in them, "Just be a bit cautious now; think very carefully about what you are doing because the responsibility if the instruments in which you are investing go wrong will be yours." They ought to think very carefully, particularly when lending on investments where a very high proportion of the finance is being undertaken by the lenders and those who are putting equity in may be putting in a very small proportion. Are the lenders really convinced that the incentives facing the equity investors are in line with the incentives which the lenders want them to pursue?

  Q6  Angela Eagle: This is essentially the private equity model where levels of leverage are going up to 70% perhaps in a buy-out and there is more of it about since it has been so easy to lend. Are we seeing a situation developing now where leverage is more a way of purchasing rather than lending from funds and that the pricing of that risk because of the parcelling out and hedging is becoming less and less obvious and therefore we may be seeing a situation where entire companies are vulnerable to particularly exogenous shocks that they might not have priced in the particular parcelling out that they did?

  Mr King: I think that is certainly a good question to ask of the lenders—why someone would be willing to lend such a large fraction of the total cost of the purchase of a company if all the control is vested in the hands of another group—but that is a question for the lenders to worry about. Are the incentives which those who do have control actually consistent with the incentives that the lenders would like them to follow? Or do those who have control have much greater incentives to take risk than the lenders actually would wish them to have? That is a question which I wanted to pose to the lenders, to ask themselves, "Are you, the lenders, content with finding yourselves in that position?"

  Q7  Angela Eagle: There has been the near collapse of a couple of hedge funds in America associated with the sub-prime mortgage issue which is quite similar in many ways—although it is a small market—to the way that private equity works here. Can you see that the spreading of that kind of model might pose a risk in terms of leverage and exogenous shocks?

  Mr King: I do not think one should generalise from two specific funds. However, I do think there are some general issues which go back to what I was talking about in my Mansion House speech which is the liquidity of the market in a very complex instrument, particularly when times become difficult and a number of people try to get out at the same time. That is something we find very hard to judge before we get there. These are not deep and liquid markets. The instruments are complex, they are sophisticated and that gives many advantages. One of the disadvantages of moving away from plain vanilla instruments is that the markets are not as deep and liquid and it is very hard to predict. That is a question again that the lenders need to ask themselves, "How difficult will it be to convert their balance sheet into a more liquid form when they want to do so? Can they be confident that they will be able to sell the assets or the collateral which they have taken in respect of some of these loans?" Paul Tucker has been to the US very recently, in the last week or so, in order to find out more about all this, so let me ask Paul to comment specifically on this issue.

  Mr Tucker: First of all I would associate myself with everything the Governor has said. I think it is absolutely right to pose this question. One of the unknowable things is that as well as the increase in leverage which you rightly highlight the loans have been more dispersed than in the past. A number of people—certainly not the Governor—are fond of saying, "We do not know where the risk is, that is a terrible thing" and I think that gets the issue wrong. The fact that we do not know where the risk is implies that it is not held in the core of the banking system? That is partly a good thing. The question I would have—and I think others have—is: Are we clear about the circumstances in which risk would flow back to the banking system? That is partly through their financing of hedge funds (we saw some of that last week) and partly through their market-making activities. It is their responsibility and the responsibility of their regulators to ensure that each of them has those risks under control. The other thing I would say is that I think it is helpful to distinguish between a fast-fuse risk and a slow-fuse risk. I think the Governor was discussing the fast-fuse risk, that you'd better run for the exits in an illiquid market. The other risk is that in conditions where credit may be under-priced, gradually the leverage of the corporate sector as a whole in aggregate creeps up. That has been happening in degree but not yet probably to the excesses of 15 years go.

  Q8  Chairman: In your speech to the Merrill Lynch conference in April you said, " ... that `we' no longer know where risk lies. Most often, the `we' is the official sector, and in particular bank regulators. But `we' might just as well be the management of banks and dealers."

  Mr Tucker: That was precisely my point. I think there is a benign element in the sense that risk has been dispersed. I think there is a question about banks pinning down, being clear about just what risk would flow back to them in stressed conditions.

  Q9  Mr Fallon: Rachel Lomax, Sir John Gieve spoke on Tuesday of a "wide acceptance that there may be a case for monetary policy to `lean into the wind' in a cyclical upswing". If you accept that why did you sit on your hands at the last meeting?

  Ms Lomax: I voted for a rate rise in May along with every other member of the Committee and the forecast which we published at that time was conditioned on the expectation that rates might rise some time in the second half of this year. At the last meeting the question for me was not so much "Why wait?" but "What's the rush? Why should we raise rates again?" I do not think that was something that we signalled in May and it is not something that the forecast implied was necessary. The data we had had on the month did not suggest that things had moved in a particularly worrying way. Indeed, there were beginning to be some signs of softening in consumer spending and in the housing market which I wanted to keep an eye on for the rest of this year. The big question for me is what effect the tightening that is already in the pipeline is going to have; I do not think we have seen the full effect yet. I think there are a lot of uncertainties about the outlook and I want to see some data before I decide whether rates need to go higher or not.

  Q10  Mr Fallon: You have not seen that data yet.

  Ms Lomax: No, there has been very little data published since the June meeting and not an awful lot since the May Inflation Report.

  Q11  Mr Fallon: Paul Tucker, the Governor this morning has spoken about the rapid expansion of money and credit and Sir John Gieve referred to it as well. Why are you not as concerned?

  Mr Tucker: I think calibrating degrees of concern is quite hard. I certainly follow what is going on in money credit and asset prices and that is fed into my assessment of what is going on for a long time as has been apparent in my answer to the earlier questions. To the extent that easy credit conditions has been reflected in elevated asset prices, I think that is something that we have been trying to capture in our forecasts and certainly I have been trying to capture in my vote for a long time. I have not thought—and do not think—that the rapid growth of money in and of itself threatens dislodgement of inflation expectations in the near term.

  Q12  Mr Fallon: Are you simply waiting for more data?

  Mr Tucker: In terms of my own vote, in April I said that with rates set then at five and a quarter in upward sloping yield curve I thought we were edging towards restrictive monetary conditions, and I said that that provided us with an appropriate platform going forward. When I reached May I was therefore content to vote for an increase in interest rates because I thought that the market conditions, the pressure on supply, warranted it. When I got to June I did not think there had been sufficient information coming out between May and June to change that stance and furthermore I thought that an increase in rates in June could have mistakenly conveyed to the community, to the economy, that we thought that conditions were more difficult than I personally believe. I do think that with an upward sloping yield curve implying some further monetary tightening that we are in an appropriate position to bear down on inflation over the medium term.

  Q13  Mr Fallon: Professor Blanchflower, you were another dove in June; what are you waiting for?

  Professor Blanchflower: I associate myself very much with what Rachel and Paul said. In May I did vote for an increase and my concern particularly then was, given the 3.1% and the open letter it was very important to make sure that inflation was anchored and that we are tough on inflation. My view is that in June not very much had actually emerged; there was no obvious reason to move in and I continued to have concerns about the labour market and to try to square that with some of the pressures that are appearing on the demand side. So yes, I am looking at the data but not that much more has emerged since that point and the labour market for me continues to be a major puzzle. Certainly the suggestions that major increases were going to take off have not occurred and they have remained benign throughout. We have to try to reconcile what is happening with the labour market with these other stories that we have talked about.

  Q14  Mr Simon: Just going back to Mr Tucker's answer to Angela about leverage, there was one sentence where you talked about aggregate levels of leverage being excessive. (You would need a few ellipses to make it say that but all those words were in it.) Every single witness we have questioned in the Private Equity inquiry, practitioners and academics, in answer to the question, "Is there such a thing as excessive debt in the sector or in the economy?" they have all said categorically no. Obviously you can have an excessively leveraged deal but the market will correct that. I just want to be clear, Mr Tucker and Governor, if it is your view that it is possible for there to be too much debt in a sector—for instance the private equity sector.

  Mr Tucker: I would not think about it in sectoral terms; I would think about it in terms of the economy as a whole and the answer to that question is yes. Do I think we are there at the moment? I think that is hard to judge in aggregate terms; no, in the corporate sector. Are some individual companies excessively leveraged? I do not have a clue which ones they would be. I think in terms of what we have been discussing—the erosion of terms and conditions, the erosion of covenants—the important thing is that that should be reflected in the price of the debt, the terms of the credit. One of the things that I think has been put to you is that the erosion of covenants provides great flexibility in terms of managing these businesses. I think that may be true but it relies upon the management of the businesses, when they come under pressure acting in a disciplined way. One of the benefits of covenants is a bit of a jolt. We all need that occasionally as managers. Someone comes in and says, "Hold on, we ought to have a think about this". That is the role of covenants in the past. A world in which covenants are eroded—and that is not reflected in the price—is a world in which there may be greater flexibility (I absolutely agree about that) but in which problems might just creep on for a little bit longer and where recovery rates might be a little bit lower in the future. Will that necessarily be the case? Absolutely not because, as the Governor said, it really depends on the lenders identifying their incentives and bringing those to the management table in some other way.

  Q15  Mr Simon: Governor, is that your view too, that aggregate levels of debt can be too high and is therefore a public policy question?

  Mr King: I do not think any of us can easily and know and I think the point of my speech at the Mansion House was to suggest that people ask themselves the question: "If you are valuing and pricing some of these complex instruments in terms of models, what assumptions are those models making about the ease and ability to sell those models at a particular price?" The liquidity of the markets may dry up and that should be reflected in the pricing of the models and the risk that people are taking. So I think it is extremely hard to judge.

  Q16  Mr Simon: More generally, just whipping across the table, what economic indicators will you each respectively be most closely looking at over the next three to six months?

  Professor Blanchflower: Obviously, as I have said already, I have been very concerned about the labour market and I am going to be looking at consumption and the extent to which people moving from fixed interest mortgages are going to have to have increased payments and that might potentially lead through to household spending. I am concerned about that. Those are the two big things that I am concerned about.

  Mr Tucker: Short lists are invidious in a sense because the nature of the exercise is to be eclectic and follow more or less everything in terms of working out what is going on. If I have to list a few I would specify consumption and household conditions to see whether the past interest rate increases are taking effect; global demand conditions; capacity pressures and the surveys and other indicators of pricing pressures to which the Governor has already referred; and absolutely crucially all the time inflation expectations.

  Professor Besley: I particularly look on the consumption side. In fact I am going to give a speech on this in July and at that point hopefully I will be able to reach a firmer view on that. I am concerned, as are others, about the continued developments in money and credit and I will continue to monitor those. Equally I think underpinning what we have seen over the last six months has been a strong global economy and I will continue to monitor international developments and the implications of those to the UK.

  Ms Lomax: As people have said, the developments in the household sector and the housing market as well, particularly the labour market. I also think near term inflation pressures; I am quite concerned that inflation should indeed come down in the way that we have forecast. A temporary rise in inflation is one thing but I think it is very important that inflation does come down as we have forecast it. I will be looking at those short term inflation pressures and that is where the pricing surveys come in.

  Mr King: I think it is a question of trying to see which risks are materialising. That is the key thing. For the upside risks I think it is pricing attentions, capacity pressures, inflation expectation. For the downside pressures I think it is consumer spending and whether there are signs of slowing there. As Paul says we have to put it altogether, make an overall judgment about the outlook, and see where the risks lie. Those are the ones that I would look at in particular. I think that the underlying growth of money and credit has gone up again in the last month. That is a concern which feeds through via inflation expectations, to pricing intentions and indeed to asset prices and capacity pressures. Also the short run movements that Rachel referred to; we have seen an increase in oil prices; we have seen weaker food prices and we know, based on the experience in the last year, that you can see quite big movements in the short run in our CPI target measure of inflation reflecting specific factors like energy prices or food prices and our challenge is to look through that to the medium term. It is not easy but the picture is being clouded—as it has not been for quite a long time—by these short run movements to which others may be tempted to give more weight. If that does show up in inflation expectations that matters to us but again we do not have very good measures of inflation expectations. So it is a difficult picture overall; a difficult period in which to make judgments which is why I think we have come down on different sides of the fence in one or two decisions, but our task is to look though the short run volatility of inflation.

  Q17  John Thurso: Professor Besley, could I ask you what was your reasoning behind your vote in the June meeting?

  Professor Besley: I share the analysis of many other members of the Committee but I suppose if I were to come to one factor that perhaps more than any other was behind the vote was I think a slightly different thinking in terms of strategy. In the current situation I feel that if we move rates more in the short term it may mean that we can head off having to do so more and later if we end up in a situation where we find inflation is above target in, say, a year's time. I am equally concerned that we move now at a point where the economy is still fairly strong and put ourselves in a better position to be on top of inflation all year round. It is not a difference of analysis of specific factors I think. Broadly I still see the balance of risks as to the upside looking a year round. I believe that by moving more now we would place ourselves better to deal with those risks.

  Q18  John Thurso: On that basis would you give consideration to a half point rather than a quarter point rise to fulfil that objective?

  Professor Besley: At every meeting one considers all possible rises, positive and negative. In that sense it is always a possibility. In each of the last meetings I have come down in favour of voting for a quarter point rise and that was my sincere view at each meeting.

  Q19  John Thurso: Going back to what you were just saying, is there merit in actually a half point which would have a certain surprise factor, I suppose, to achieve the objective of damping down expectations and bringing things into line earlier rather than having to have successive quarters which may add up to more in the longer run?

  Professor Besley: There can be merit in a half point rise. Whether one would be doing it specifically to shock or surprise, I doubt that that would be the motivation. I would do it only if I felt that it was a necessary move and given the volatility and the uncertainty that we have discussed, I think some element of caution is warranted. I feel there has been a need sequentially—not just in the last couple of months, as you will be aware—to move a little faster and to position ourselves against possible inflation risks looking through the medium term.


 
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