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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