Examination of Witnesses (Questions 1-19)|
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 narrowfive
to fourand 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 borrowerswe
have been saying that for some time nowbut 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
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 lenderswhy 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 groupbut 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
waysalthough it is a small marketto 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
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 peoplecertainly not the Governorare
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 haveand I think others
haveis: 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 thoughtand do not thinkthat 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 sectorfor instance the private equity
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 discussingthe
erosion of terms and conditions, the erosion of covenantsthe
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 erodedand
that is not reflected in the priceis 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
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 cloudedas it has not been for quite a
long timeby 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
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 sequentiallynot just in the last couple of
months, as you will be awareto move a little faster and
to position ourselves against possible inflation risks looking
through the medium term.