Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

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

28 JUNE 2007

  Q20  John Thurso: How important do you think it is in considering future interest rate rises to actually factor in managing inflation expectations?

  Professor Besley: Inflation expectations I think are key and indeed our credibility is at the heart of that process. I think the credibility of the Committee—I can take no credit for this, having joined recently—has been built up through making a number of good calls over the years. In that sense those two things—establishing credibility and making good decisions—is what managing expectations is about. I see that as part and parcel of making good voting decisions.

  Q21  John Thurso: Governor, can I ask you—to a certain extent you have addressed bits of this already—in your opening statement you talked about gauging the outlook for inflation as a genuine challenge. What do you see as the main risk or risks around the MPC central projection for CPI inflation?

  Mr King: There are many risks and of course the reality is that the one thing that will not occur is the central projection so do not attach too much probability to that. I think on the downside the question is whether consumer spending would slow more quickly than is factored into the central view. So far the recovery in consumer spending has been probably faster than we had expected over the past year. However, we do see some signs of slowing in activity in the housing market although not really in the rates of increase of house prices as yet; anecdotally, although I think not yet in the official data, perhaps in spending on the high street, but we will see that as data comes through. If it turns out that the gradual increase in the fraction of household income that is being devoted to servicing debt, if that does bear down on real, disposable incomes available for discretionary spending, then maybe consumer spending would slow faster than is in the central projection, although it is not a particularly rapid growth rate. We certainly do not have in our central view growth rates of consumer spending of the sort that we have seen over most of the period of the MPC's existence. That is certainly one downside. The world economy is very hard to predict. We have been pleasantly surprised by how buoyant the world economy has been for three or four years now; there has been really remarkably strong growth. There is no immediate sign of that weakening markedly. The slow down in the United States has not really spread significantly outside the housing sector in the US, although there are signs that business investment may be being affected. The Euro area so far has been surprisingly strong in the last year. Asia, of course, continues to grow quickly. However, one can never tell when changes in attitudes towards spending, the balance between domestic demand and domestic output in Asia shift. That might trigger changes in exchange rates. There could be a lot more uncertainty about the world economy that would lead to slower growth of world demand and hence make life more difficult for our exporters. Those are some of the downside risks. On the upside I think we have talked a lot about the rapid growth of credit and, as a result, money, which has helped I think in the last two to three years to sustain the level of asset prices. We have continually been surprised by the fact that asset prices kept rising. You can see it in equity prices but asset prices of all kinds. That has helped to sustain demand. Inflation expectations have over the last year—insofar as one can measure them in the medium term, the gap between the yields on conventional gilts and index-linked gilts—crept up steadily by somewhere between a third and a half percentage point, enough to pose a question mark. Therefore I think there are the upside risks that perhaps inflation expectations, the pricing environment in which business operates, have changed not massively but just by enough to make us a little bit worried that when we see the volatility in energy prices pay its way through and settle down we end up with inflation not at the target but above it, not massively above it but enough above it that we would then have to take further action. I think that is why in the end I thought it was better to take action sooner rather than later to head off that risk.

  Q22  John Thurso: I think, as I recall, the last time you were talking to us, which was following your letter to the Chancellor, you told us that the view was that there was a relatively short term spike in inflation largely caused by retail energy prices going through but for the longer term you expected a return to near a more benign trend which was a theme that we heard when we were in Washington speaking both to the Fed and to the Central Bank of Canada. Is that still your view or has what has gone through over the last month or two changed that in any way? Do you still expect that trend to be more benign?

  Mr King: There is no doubt that the broad picture is the same, that when inflation rose from 2.8% to 3.1% triggering the letter that attracted a great deal of attention. We said then that we expected inflation to fall back quite sharply over the next few months. We then fell back to 2.8% the very next month; that did not attract quite so much attention as when it went up to 3.1%. It fell again to 2.5% the next month so it has already fallen noticeably below the level that would trigger a letter and we still have the impact of some of these reductions in gas and electricity prices still to come through. There may yet be further reductions in gas and electricity prices because of the gap between the wholesale and the retail price. As Rachel says, one thing that has changed since the time we wrote that letter is that oil prices are higher now and that may mean that petrol prices are a little bit higher than we thought they were going to be. It may affect the probability of further cuts in retail gas and electricity prices. These things are hard to judge. If anything food prices seem a little softer, they have come back a bit. We will see, but I think the big picture within the short run, inflation will fall back from that 3.1% number which triggered the letter to something close to the target is absolutely intact. What is much more difficult to judge—of course these are things that move slightly month by month and we have to form judgments about them, this is where the delicate judgment is—is not about that big picture in the short run which I think is comforting insofar as it may prevent a further move upwards in inflation expectations, but we have to look further ahead to where inflation will lie once these movements have passed through. There there are small changes from month to month and small differences in judgment which lead different members of the Committee to come down either on the side of perhaps a further increase or not this month. These are the judgments we have to make all the time. The big picture, which we said in the letter, that we expected inflation to fall back possibly quite sharply over the next few months is still intact and indeed inflation has fallen back quite sharply over the two months that we have had since we wrote the letter. That does not make us complacent because we are not banking on that to achieve our target in the medium term. We are far from complacent; we are trying to look through that volatility to work out where interest rates need to be set to make sure that after inflation has come back to around the target we keep it there indefinitely.

  Q23  Peter Viggers: Paul Tucker, I understand that you said a year ago that there were four objectives to your money market reforms. The Chairman put you on notice that we would ask for a progress report at about this time, so can we please have that progress report?

  Mr Tucker: There were four objectives. The first and by far the most important was to reduce volatility in short term money market rates, so the market in which we implement monetary policy. I am very glad that that has been successful. Volatility is much lower in short term money market rates and I hope it stays that way. The second objective was to improve the ability of the Bank through its operating system to inject liquidity into the banking system in normal conditions and in stress conditions. I believe that to be the case in normal conditions. I believe it to be the case in stress conditions but we thankfully have not yet been tested on that, but our apparatus is much better than it was in the past. The third objective was to make the system simpler. As I said last year, I have to be sure that it is simpler. We used to operate four times a day; we now basically operate once a week. We have expanded access to the Bank's balance sheet and to the Bank's operations. That brings me to the fourth objective which was to make the money markets more efficient. This time last year I said that that was something that would have to be judged over time and in the past few weeks we have issued a survey to participants in the market, not just to the core intermediaries in the market but to the users of the market on whom I place as much emphasis. We have that survey and done some other work; we will publish the results of that later in the year. So far as I can tell I think the reforms have been a success but that is something which we do not take for granted and we continue to monitor it. In particular I would say that without getting lost in the technical details the size of our weekly operations are very large and we are planning to reduce those by introducing another kind of operation where we lend to the banking system by plying bonds and that will come on stream I hope later this year or the beginning of next year.

  Mr King: Could I just add to that that I think it has been a tremendous success story. On the day I became Governor I talked to Paul and I said, "Paul, you know that I want you to move to a system which is very much simpler and has much less volatility in the overnight rate". Paul and his team have done it. It reflects great credit on them and we are now best practice in this area and witness other central banks taking a great interest in how we operate the system. Paul will not take anything for granted here but nevertheless it has been a great success.

  Q24  Peter Viggers: Paul and others have spoken about collateralised debt obligations and the complications and complexity of the system. The Governor has made the point that it is other institutions which have the duty to monitor the banking situation. Nevertheless, if there were to be a significant default it would impact on interest rates and the Bank would naturally be very involved. Is it possible to do a dry run in advance of any default to ascertain more clearly where the default will impact?

  Mr King: I do not think it is possible to predict where a possible crisis might occur. What it is possible to do is to make sure that the relevant tripartite authorities—Treasury, FSA and Bank—are primed and ready to know how they would work together and operate in such a crisis. Callum McCarthy and I, right from the very beginning of our appointments, put an enormous amount of weight on the need to carry out such crisis management exercises, both financial crises and also business continuity crises. We do regular exercises of that kind in order that we think through in advance in an exercise what sort of questions might arise, how we would manage to work together, what kind of collateral we would be willing to take and how we would deal with unusual kinds of collateral, how we would work with our colleagues abroad. We have been instrumental in trying to generate exercises of this kind across national borders. I think there is little point trying to pretend that you know where the crisis will hit; it will come somewhere unexpected. However, what you can do is to be prepared and to practise as far as possible how you would handle such crises so that insofar as you can prepare you are ready. That is what we do.

  Mr Tucker: One thing I would add to that, if I may, is that the other component of this is that we need a broad understanding of how the modern financial system works, capital markets and banking. That is something which we spend a great deal of time on both in my part of the Bank and in other parts of the Bank. The worst thing that can happen in a crisis in my view is that it breaks and on-one has the faintest idea what is going on or what type of thing is going on. We cannot predict where any pressure might come from but we do need to be equipped with an understanding of how capital markets work and we strive to attain that whilst never quite reaching the frontier.

  Q25  Jim Cousins: Professor Blanchflower, you described to the Committee this morning the labour market as a puzzle but in your article in the Quarterly Bulletin it seemed to me that you had in fact solved the puzzle. Can you explain why a puzzle that you thought you had solved in that article is still a puzzle for you?

  Professor Blanchflower: I do not think I have solved the puzzle. There is clearly evidence that wages have not increased and there is some weakness in that labour market so I think we have understood what is going on in the labour market. The puzzle is to understand how that fits with the other pieces of data on the demand side, the capacity pressures, the stories that employers are providing and in some sense why those pressures, if you like, have not fed through to positives in the labour market. That puzzle I think continues. One possibility is that perhaps there is more slack in the economy than one might think but there are other ways of interpreting it. I do not think that one has solved the puzzle. A puzzle perhaps that one is getting closer to understanding is the growth in self-employment. That appears to me now to have quite a lot to do with people taking liquidity from the growth in house prices and my concern is perhaps that that will not continue in the future but I would not say as a labour economist that one has solved what has happened in the labour market. I think there are continuing problems but we are now closer to understanding what has actually happened in the labour market.

  Q26  Jim Cousins: How long do you think present levels of consumption can be maintained, given your view of the labour market?

  Professor Blanchflower: My concern is that there is a considerable weakness. We have not seen substantial wage growth; there has been relatively benign growth, especially in the public sector. Over the last few years the public sector has done quite well. My concern is that there are perhaps more weaknesses than one might think and that it will feed through rather more rapidly into the household side as others have talked about. There are only relatively early signs of that. My concern is that it will feed through more strongly. I think I am rather more strongly on the downside than perhaps other members of the Committee. My concern there is that fixed interest rate mortgages which are coming up now may potentially feed through to consumption and there has not been substantial wage growth at all. My concern is on that side but I do not think I have solved the puzzle; I have solved bits of it.

  Q27  Jim Cousins: Professor Besley, you clearly take a very different view from that that we have just heard.

  Professor Besley: I would not want to exaggerate the differences on that issue. I suppose the only slightly different take on this issue that I would put is that one of the big questions for the consumer is how they are treating this in a forward looking sense. How much consumers want to adjust today to the hundred basis point increase that we have seen is going to depend upon the outlook and we know from a wide variety of research that consumers do, to a certain degree, take a while to adjust both for reasons of habit formation, the ability to borrow in the face of short term falls in disposable incomes and so forth. It is one of the imponderables and I do not have a clear-cut answer. At the moment I am trying to reach a view on just what the range of uncertainty is as to how far consumers are beginning to adjust to the hundred basis point increase. My view is that there is still, with the possibility for example of borrowing further at the point at which fixed rates come to an end during this year, it is possible to withdrew equity as a way of smoothing through this that we may see rather less adjustment in consumption than many people have been anticipating. What we need to do—this is what I am going to do in the speech that I will give—is to try to give a sense of the range of estimates that are plausible under different scenarios. I suppose I do take a view that when you factor in the possibility that there are a range of margins on which consumers can adjust it would be wrong to take a very mechanical view of the impact on the disposable income and just put that immediately onto the impact on consumption. I think there are many other things going on that would mean that the effect could be somewhat more muted than that.

  Q28  Jim Cousins: Given the difference of views that we have just heard expressed in a perfectly proper way, do you not think there is a risk that you make take a slug at inflationary expectations and seriously damage consumption levels?

  Mr King: I do not think we would take an action that seriously damages—

  Q29  Jim Cousins: You voted for it; you were not successful in achieving it.

  Mr King: No but I do not think that would have made the difference between a growth of consumer spending which has been at least as high as the average over post of the post-war period or a slight slow down which is probably what we need to see given the buoyancy of other components of demand. I do not think a quarter point difference in interest rates is as significant as maybe some would like to pretend; these are small touches on the tiller to try to keep inflation on track to meet the target.

  Q30  Jim Cousins: You have drawn attention to these increases in food and energy and fuel prices. If Professor Blanchflower is right, it is likely that there will be many people in the population who are simply victims of those price increases and they will be unable, through labour market behaviour, to protect themselves from those price increases. I come back to this point that against that background an attack on inflationary expectations may lead to a considerable fall in consumption because that is the only way that people whose real household income is falling can protect themselves.

  Mr King: I think I would put it the other way round, that if inflationary expectations were to rise significantly above the target and to get to a point that meant that we did have to attack them (to use your phrase) in order to have a chance of keeping inflation at the target, then if we left it that late the only way to achieve that objective would indeed be to engineer a more marked slow down. The argument for moving sooner rather than later is precisely to avoid having to engineer a major slow down.

  Q31  Jim Cousins: I wonder if I could ask Rachel Lomax, you did not vote for it in the last meeting of the Monetary Policy Committee, do you think pre-emptive strike against inflationary expectations in the way that the Governor has set out is the appropriate thing to do in a situation where so many people who live amongst us are helpless victims of the price increases they are experiencing?

  Ms Lomax: I did not think that we needed to have a pre-emptive strike in June; that is why I did not vote for it. I am conscious of the risk of over-doing it. We have done a hundred basis points in less than a year. I think there is a fair amount of tightening in the pipe line, the effects of which we have not yet seen, and that make me more of a gradualist perhaps than my colleague on the left. We may share an analysis but respond differently, as you very rightly said. I do tend to be a bit gradualist. There are a lot of uncertainties and I also do worry about overdoing it as well as the risks on the upside to inflation expectations. I do not believe we are behind the curve and that we have allowed things to get away from us. I think we were pleasantly surprised as we went through the wage round. I think Danny has made some very telling points on the labour market. It is a puzzle. Employment actually fell in the first quarter of this year. I think all those things together make me feel there was not a case for a pre-emptive strike. I also worry about putting up rates too far and finding it difficult to reverse them. It is actually quite difficult to cut rates when you have been on a tightening cycle unless you have very clear evidence that you have overdone it. So I do slightly worry that by being very aggressive we will find ourselves in the position where we see things slow too sharply and before we find ourselves confident enough to cut rates. That is the mentality of someone who approaches these things in a more gradualist spirit.

  Q32  Mr Todd: Professor Blanchflower is the labour market specialist amongst you but perhaps has not persuaded you all of his solution to this mystery of exactly what is going on. What do the rest of you feel is happening in the labour market?

  Mr King: There are several different hypotheses as to what is happening in the labour market, one is the one that Danny has outlined, that demand in the labour market is weaker. I think Danny has made a great contribution to the Committee; I do not think some of the members understand the intricacies of some of the statistics and data on the labour market.

  Q33  Mr Todd: Does that depend on whether or not one believes the statistics that you are presented with?

  Mr King: Danny, as well as everyone else on the Committee, is well aware of the problems in the data but he plays a very important role in helping us understand not only what the data are saying but also what the problems with the statistics are. The question is the economic interpretation; the data never tell you the answer. You have to keep asking the question, as I said in my speech in Cardiff, "Why are the data moving in this way?" Until you can answer that question you cannot draw a policy conclusion. There are several explanations as to why employment growth has been weak, one of which is that it looks as if participation in the labour force has actually fallen back in recent quarters, particularly among women. That would suggest that there may be a labour supply effect at least among those who are working in some of the service industries; government employment has fallen back apparently quite sharply in the last half year (that may have had something to do with the lower participation). I think it would be somewhat difficult to argue, I find, that demand in the labour market is very weak when the economy has being growing faster than its average in the post-war period. We have had remarkably steady growths now for six quarters and the economy has recovered much faster than many had expected at the beginning of last year.

  Q34  Mr Todd: Does it matter that there is a more rapid pace of substitution of labour, particularly in the service sector where introduction of relatively cheap technologies can reduce labour demand quite rapidly? We have seen business investment increasing relatively sharply recently; is that perhaps part of what is happening, that the advantages of employment of relatively low cost technologies has started to kick in?

  Mr King: I think you could argue that one of the incentives for rapid business investment would be to substitute to some extent for labour particularly in a period where real wages have not been growing very rapidly in the past four years. There has been remarkably slow growth in real disposable take-home pay which in itself may well have imparted some reluctance for an increase in labour supply in the domestic labour force.

  Q35  Mr Todd: We touched on the uncertainties of statistics and the Inflation Report did highlight an apparent reduction in the workforce over the last six months but one has to qualify that with "apparent" because indeed these are estimates which we will not see validated for some time yet. Has the MPC given some thought to how to design statistical data better—you were supplied it largely by the ONS together with more intuitive information from the employers themselves—so that you can get a clearer feel of what is happening? I would be interested in Professor Blanchflower's view on this. You have obviously looked at labour markets in other parts of the world, have you found it frustrating given the data sets that are available here and feel that we should be looking at other sources of information which are not available?

  Professor Blanchflower: Not especially. I think the quality of the data, certainly in the labour market, is pretty high. I do have concerns—the Committee has expressed them and the Governor has expressed them—about what is happening in the ONS and judging sample sizes of a number of surveys and difficulties of maintaining the quality of the data. I think the quality of the data, certainly internationally, is of comparable standards. The concern is going forward, whether they will be maintained.

  Mr King: There is one specific aspect that I think is not the fault of the ONS at all but it is an economic shift in the UK which has created a statistical difficulty, that is the very large scale inward migration of workers, particularly from Eastern Europe which has done two things. One is that it has made it more difficult for us to be confident that the surveys are indeed representing this group as well as the rest of the population so that there may not be an adequate representation of this group of people who are having a big impact on the labour market.

  Q36  Mr Todd: Yes, particularly because a lot of them frequently move in and out of the country.

  Mr King: Indeed. The second thing is that the movement itself means that our estimates of population totals are much more uncertain than they were before. Many of the numbers that we need in the labour market are obtained by the ONS going first to the survey of people in the labour force survey and then grossing those responses up to totals given by an estimate of population. We then compare that grossed up total with, say, GDP, to get a feel for what is happening. If we do not have a good estimate of the population, even though we may have a good estimate of GDP, we may not have good estimates of the total labour force in employment to compare it with.

  Q37  Mr Todd: We have touched on the function of the ONS and the anxiety about the future. When this Committee—sub-Committee I think actually—interviewed the ONS about changes taking place there I used the term "customers" when talking about those to whom they supply data. That appeared to be not a term that they were entirely familiar with. They rather saw themselves as guardians of data without necessarily developing an appropriate relationship with those to whom it was supplied in quality in terms, defining exactly what is required. Do you think you have been robust enough in communicating what you want? We know that you have been fairly robust recently because there have been some published materials.

  Mr King: This is part of the arrangement—a very clear arrangement—with the ONS and whether they like the word or not we feel treated very much as customers in the sense that at a working level they are extremely good at talking to our staff; there is a continuous, regular relationship between the two groups of staff who ask questions about how the data is collected and is it possible that there is a problem here, what do you think has been happening when these numbers come out? There is a very productive relationship between the two organisations. The Committee, once a year, writes a letter which sets out in very clear terms both what we felt about their performance in the previous year and what we would like to be the priorities for the ONS over the coming year. We have expressed a number of concerns; Danny has mentioned one. In the process of trying to re-engineer the National Accounts the ONS have decided that, given the resources at their disposal, that they will have to make some temporary cuts which make our lives more difficult so there will not be a full scale revision of the output data in this year's Blue Book. That is a minus for us but they have constraints on their resources; they have to make judgments about what their priorities are. They consulted us on that. In terms of the move to Newport which we commented on in our latest letter, we said that any transition of staff from one location to another may raise an issue and we are concerned that they do devote enough resources to make that transition so it does not affect the quality of the data. We wanted to make that point clearly to the ONS in advance so that they knew how much weight we put on the importance of high quality data and they could factor that into account when judging how much resource they should put into it. I make it quite clear that this is nothing to do with Newport, which is actually rather a good place given the proximity of so many universities and because of their track record in Newport in recent years. I would be just as much concerned if they were going from Newport to London as going from London to Newport. It is the fact that they are moving at all that raises the issue and it is a question of them putting enough resources in. We made that very clear. I also want to stress that at a working level there is a regular, daily contact between the two organisations such that whatever they feel about it we feel treated as good customers.

  Q38  Chairman: We share the same concerns as the Committee. We had the ONS before us and we feel they are just coping at the moment so we are going to keep an eye on that.

  Mr King: Thank you for that.

  Q39  Mr Love: Can I come back to this issue of inflation expectations? What do you think is the inter-relationship between interest rates and inflation expectations and how can we use one to affect the other?

  Mr King: I think inflation expectations in the medium term—which is what we care about a lot—does have a significant implication for our ability to move interest rates perhaps in a more gradual way. The power of interest rates does depend on credibility by which I mean the following. Suppose we get some inflationary shock maybe from higher oil prices, if inflation expectations remain anchored on the target that makes it much less likely that we would see second round consequences of the initial impact on prices either because other firms start to put up prices in the belief that they can pass the costs on or that wages pick up because they want to try to reclaim the purchasing power that has been lost. Then we have to move interest rates by more so the absolutely crucial point of continuing to anchor inflation expectations to the target is in order that we would not have to move interest rates by as much as we otherwise would if we lost control of inflation expectation. But of course in order to keep inflation expectations anchored to the target you have to take action that people believe will be effective in bringing inflation back to the target in the medium term. There is a close relationship but it is a strategic one. Our policy has to be based on the very clear objective that we intend to bring inflation back to the target and we intend to make that commitment credible and open and transparent to people so that they believe it. If they believe it then we will not have to move interest rates by as much as we otherwise would. I think that has been seen in the fact that over the last ten years we have not needed to move interest rates as much as needed to happen before but only because it was clear that we were prepared to move quickly and we were very focussed on achieving the target. There is plenty of scope for disagreement about the precise path of interest rates to achieve that, but that is not the issue. The issue is, is everyone on the Committee committed to getting inflation back to the target and keeping it there. That is why I think the framework matters crucially. The fact that we have a clear target, it is given to us and you can ask each individual member of the Committee why they have voted the way they have voted the way have, gives everyone a confidence, yes, these guys really are determined to bring inflation back to the target.


 
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