Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1-19)

MR MERVYN KING, SIR JOHN GIEVE, MR CHARLIE BEAN, PROFESSOR TIM BESLEY AND PROFESSOR DAVID BLANCHFLOWER

30 NOVEMBER 2006

  Q1 Chairman: Governor, good morning to you and your colleagues and welcome to the committee. Would you introduce your colleagues for the shorthand writer, please?

  Mr King: Indeed. On my right is Charlie Bean, the Executive Director for Monetary Policy and Chief Economist, on his right is Professor Tim Besley, one of our new external members, on my left is Sir John Gieve, the Deputy Governor for Financial Stability, and on his left is Professor David Blanchflower, also one of our external members.

  Q2  Chairman: Governor, you have a short statement to make.

  Mr King: I do. I am very grateful for this opportunity to explain the reasons for the Monetary Policy Committee's decisions on interest rates since we last appeared before you in June. Since then the bank rate has been increased twice, in August and November, and it now stands at 5%. The British economy has continued to experience steady growth with low inflation. For the past year GDP has grown at a rate close to its long-term average, but inflation has picked up and has been above the 2% target since May. It was 2.4% in October and has risen by half a percentage point since the beginning of the year. Over that period official estimates of the growth of consumer spending have been volatile, but business investment has been stronger than the committee anticipated and surveys of exports remain at high levels. The outlook remains one of a continued modest rebalancing of demand, with consumer spending growing at close to its long-run average rate over the forecast period, business investment continuing to recover, and net trade making a small positive contribution to growth. In its November Inflation Report, the MPC published a central projection in which output continues to grow at around its average rate over the past decade. Inflation is expected to rise further above the target in the near term before falling back to the target as energy price inflation falls. The risks to the outlook for inflation appear broadly balanced, although they are large in both directions. That is why the fan charts for inflation shown in both the August and November Inflation Reports are wider than in the recent past. In the medium term, the main risks concern the ability of firms to raise prices in order to rebuild profit margins and the extent to which pay growth remains muted. Continuing rapid growth of money and credit and uncertainty over the future path of energy prices illustrate the magnitude of the risks. There is particular uncertainty about the supply side of the economy. As a result, assessing the margin of spare resources in the British economy at present is unusually difficult. Unemployment has risen over the past year. Some of that rise probably reflects the impact of higher energy prices and some deterioration in the terms of trade. Despite muted pay growth, the total cost of employing labour has risen, so it is difficult to know how much of the rise in unemployment actually represents increased slack in the labour market, and capacity utilisation within companies, as measured by surveys, has risen since August. There is, of course, great uncertainty about the scale of migration from Eastern Europe and elsewhere, and that has clouded estimates of the supply capacity of the economy. Given these data uncertainties, the committee will, therefore, need to monitor particularly carefully developments in costs, pay and prices. Since the beginning of last month the committee has, I am glad to report, been back to its full strength of nine members. Chairman, those are the remarks that I would like to make this morning, and I and the other members of the MPC here today stand ready now to answer your questions.

  Q3  Chairman: Thank you, Governor. You mentioned that the risks to growth are broadly balanced. Why is there greater than usual uncertainty?

  Mr King: I think we are genuinely uncertain as to how price setting in the economy will respond to large movements in certain costs, such as energy prices. One might have expected that energy prices would simply just add to the movement of underlying inflation and one would be able to calculate the addition to inflation from increases in energy prices and these would simply drop out as energy prices fell back. I think the situation is more complicated. It is not at all obvious that, in fact, inflation of other goods and services has remained independent of the actual changes in energy prices. There are a number of reasons for that, one of which, I think, is the credibility of the inflation target. Another is the impact of higher energy prices on the ability of households to spend as much on other goods and services as they might otherwise have done. And there is the fact that companies, in the wake of higher energy prices, have pushed down on other costs, which I think that has helped to keep pay growth relatively muted. So one of the challenges facing the committee, I think, is to judge how far you can think of inflation as being some underlying inflation plus energy prices; a view which we on the committee feel is too simple—we need to judge what is driving inflation as a whole. I think the other aspect that is particularly difficult at present is that, as I said in my opening remarks, we are particularly uncertain about the supply side of the economy and the rate at which the economy could grow without generating inflationary pressure.

  Q4  Chairman: Could I ask the other witnesses if they agree that the risks are broadly balanced and whether they have anything to add to that?

  Mr Bean: To a first order, yes. If anything, I would have some slight upside risk to my inflation outlook and some slight downside risk to my growth outlook relative to the central projections of the committee, but they are pretty small beer.

  Professor Besley: I would tend to think of the inflation resource though as somewhat to the upside, but I do agree that it would be very difficult with the degree of uncertainty as outlined by the Governor to form a very strong view.

  Sir John Gieve: Within the range, I am broadly balanced perhaps a bit more upside on both.

  Professor Blanchflower: I am probably at the other end, some concerns on both sides but, on balance, somewhat concerned about what is on the downside and what has gone on in the labour market, but there is not a great difference between us, I would say.

  Q5  Chairman: Governor, on equity prices the Inflation Report discusses the continued rise, especially since the end of July. The FTSE All Share Index averaged 3162 in the 15 working days to 8 November, some .1% higher than the starting point in the report. What factors do you believe are driving these rises, how sustainable are they and what effect would they have on consumption?

  Mr King: When we last appeared before you we thought that we were beginning to see a correction to the very low level of long-term real interest rates, which had been described by Alan Greenspan at the Fed last year as a conundrum. We did not really understand why long-term real interest rates had been pushed down so low (and it did not look to be a sustainable feature of the world economy) and, when we last appeared before you there were signs of that unwinding. In fact long-term real interest rates have fallen back somewhat since then and, I think, given those very low levels of long-term real interest rates, it is not terribly surprising that asset prices of all kinds have been rising. We have seen this not just in equity markets; we have seen it bond markets, you can see it in house prices; indeed, you can see it in the market for fine art. Asset markets of all kinds have been remarkably buoyant in the last half year.

  Q6  Mr Fallon: Governor, there seems to be a lot of uncertainty around this morning. In your opening statement you said there was uncertainty of energy prices, you said there was particular uncertainty about the supply side, you said it was difficult to know about unemployment, there was great uncertainty about the scale of migration, data uncertainties. You put rates up this month; does the bank actually know what is going on?

  Mr King: The quotes you have made there do not all refer to independent issues. The question of migration and data uncertainties on the supply side are all wrapped into the same area. What I said was that the committee, in these circumstances, given the particular uncertainties about the supply side, is bound, I think, to put slightly more weight than it might normally put on the indicators of cost, pay and prices themselves. The drawback, of course, is that this is very much at the end of the transmission mechanism. We would like to be able to go further back to anticipate what may happen, but that is particularly difficult. I think the worst thing we could do is to pretend to know things that we do not know. There is enormous uncertainty and it does cloud the interpretation of the statistical picture.

  Q7  Mr Fallon: You are certainly not pretending to know things you do not know. Your Deputy Governor, Rachel Lomax, made a speech on Monday and she said, in the case of monetary policy, "taking out insurance against risks that do not materialise can inject unnecessary volatility into the economy". Do you agree with that?

  Mr King: Of course, as a theoretical proposition, yes. But I think those who voted for an interest rate increase in November did not say to themselves "We are taking out insurance against something." They looked at the overall outlook for inflation: the central projection and broad balance in risks—perhaps for inflation slightly on the upside. I think the central projection and the outlook for inflation shown in the fan chart suggested that a rise in interest rates was necessary, and that was certainly my view.

  Q8  Mr Fallon: How costly was the insurance that you bought with the increase in the number?

  Mr King: I do not think we have taken out insurance. We have made a judgment about the outlook for inflation and raised interest rates in order to keep the outlook for inflation on track to meet the target.

  Q9  Mr Fallon: She says there could be a cost if we get this wrong in terms of jobs.

  Mr King: Of course there could. There is always a cost. Every decision on interest rates, whether to change them or leave them unchanged, has a cost in both directions. If you fail to make a change that later proves necessary, there will be clearly costs for that. If we had not moved and inflation had picked up, looking ahead 12, 18 months, two years, there would have been a cost to that. It is always a question of balancing the costs of action versus inaction. That is a decision we face every month and it is always perfectly reasonable for people to take different views on that. The whole merit of the committee is that no-one can say it is obvious that one course of action is right and the other is wrong. It is never like that. The merit of the committee is that you have nine people who are chosen for their abilities to make that decision and, in the long-term, I think you get better results by relying on the majority view of those nine people and, in turn, all of us, I think, have been in a minority, but the committee structure is what gives the framework strength.

  Q10  Mr Fallon: One uncertainty you have not mentioned particularly this morning is house prices. How concerned are you, not just by the continued growth in house prices but the current level of house prices?

  Mr King: As I said, I think my concern is about the level of asset prices in general, not just one particular example of that. That does carry with it, I think, the implication that the outlook for demand is stronger than many people thought. When we last came before you, even in the late spring, there were still many people who doubted whether the UK economy had really recovered from the slowdown in 2005. We are now seeing four successive quarters of pretty steady and buoyant growth, so the economy clearly has recovered, and I think it is no accident that that has gone along with rapid growth in money and credit which has helped to underpin the level of asset prices. These, therefore, are things which we have to take into our judgment about the outlook for demand and inflation over the next two years as well.

  Q11  Mr Fallon: I pick out house prices because most of our decisions probably do not deal in fine art. That was one of the other asset prices that you mentioned. On house prices, where do you think the vulnerability is now?

  Mr King: The reason I did not pick out house prices is that, if what we are seeing is a generalised increase in asset prices, then you would not look for an explanation of that particularly in the housing market, you would look for it in terms of factors which apply to all assets, for example long-term real interest rates, which I think is the major factor underpinning the level of asset prices. The question, and this is the issue, I think, confronting those who have a particular interest in the housing market, is that if there were a change in the general level of real interest rates around the world economy, then all asset prices will be affected. House prices will be affected too; but I simply do not know what the outlook is for long-term real interest rates.

  Q12  Chairman: There has been an increase in the median loan to income rate on new mortgages. What can you tell us about the distribution around that median?

  Mr King: The data series for the loan to value ratios in the mortgage market has a break in it around 2003, or a couple of years ago, when the data source switches from the Council of Mortgage Lenders to the FSA, but, broadly speaking, if you look at high loan to value ratios—this is not loan to income but loan to value ratios—they are still very much lower then they were in the early 1990s. If you take as an example what fraction of new mortgages are taken out which are more than 90% of the value of the property against which they are secured, that ratio was in excess of 50% in the early 1990s and now it is between 20 and 25%, so it is markedly lower. I think this is one reason why lenders, in particular, feel that there are fewer risks associated with home lending than there were in the late 1980s early 1990s. There is a very telling chart in the Inflation Report which shows that if you look at mortgage arrears there has been a small pick up recently, and, indeed, all measures of areas of indebtedness have picked up, but the increase is tiny in comparison with the change between where it was in the early 1990s and where it is now. On the basis of that, I do not think that there will be any enormous concern about serious problems in paying debt. The significant negative equity problems that we did see in the early 1990s would only occur now after a very significant fall in house prices. Clearly, it is not our central view.

  Q13  Chairman: There has also been a slight rise in the level of repossessions, and Abbey recently announced that they would lend borrowers up to five times their income. Are you surprised that some of them are relaxing their lending criteria at such a time?

  Mr King: I have said before, and I am happy to repeat it, that all lenders and borrowers should think very carefully before they either lend or borrow. I do not think it is particularly surprising that we have seen an increase in loan to income ratios because we have moved to a point, as is the implication of Mr Fallon's question, where house prices are higher relative to other components of spending than for some considerable while. If that were to be maintained, you would expect that a larger fraction of a household's income over their lifetime would have to be devoted to housing if they wanted to buy the same degree of housing services. Even if they did not buy quite the same quantity of housing services as previous generations, one might well expect that the fraction of their lifetime spending on housing would be high. That means, I think, that they are likely to start with a mortgage relative to income which is higher than in the past. That does not mean that they will not pay it off. I think if you look at the figures, although there has been a small pick up, as you say, over the last year or so, the degree of mortgage arrears is well, well down on where it was in the early 1990s.

  Q14  Angela Eagle: Sticking with the housing market for a while, do you worry that some of the price increases are being driven by speculation that what happened in the past will continue to happen in the future at the same level? In other words, house prices will continue to rise very much above other prices and, therefore, people are expecting that and acting on a wrong expectation.

  Mr King: People will always (and they are right to do so) think about the future value of the house when buying it. When they buy a house they are not buying a house whose value is determined by some aggregate nationwide housing index, they are buying a particular house in a particular location in a particular community and they should think very carefully about what value that house might have in the future. That is part of the decision. I think the word "speculation" can also be used to describe a completely rational judgment of whether it is sensible to invest so much in a house in that particular location. I think families have to do that. Whether these judgments turn out to be correct or not is very hard to say, and I do not think anyone buying would pretend to themselves that they knew how far the value will change in the future. None of us know that. It is a judgment. That is not a reason for not buying a house, it is simply recognising that there is bound to be uncertainty about future values, and that applies, obviously, to any asset. I do not think using the word "speculation" is helpful in understanding the judgments that people have to make. In answering the question, "What will happen to house prices?", I think that is a very difficult judgment and it would be foolish of me to pretend that either I or anybody on the committee has any deep insight into something that none of us can really pretend to know.

  Q15  Angela Eagle: Being the soothsayers of doom for many years that have forecast bubble after bubble after bubble, almost like an Aero chocolate bar, and none of them have really appeared, but they are at it again forecasting bubbles. You are all fairly sanguine about that. You do not lose sleep over it?

  Mr King: We are never sanguine. Central bankers try not to lose sleep, but we always worry. We are concerned about all of these things, and, as I said, there are risks in the housing market, as in all asset markets, but none of us can easily know. I point to the factor that I think is the biggest risk facing us in the world economy, which is that low levels of long-term real interest rates have led to very high asset price levels. That has helped to sustain demand. It is quite conceivable that these low levels of long-term real rates will continue, but they may not and, if they were to adjust quickly, then you might see quite sharp movements in asset prices overall and that would have some impact on the world economy, not just the UK but the world economy, and that would make it a more difficult situation for us to handle.

  Q16  Angela Eagle: In essence, you are more worried about other asset prices than house prices?

  Mr King: We are worried about all asset prices, but the last thing I am going to do is to make it easy for people to say that the Bank is concerned only about one asset price. We are not. We are targeting inflation, not house prices, and we are concerned about the outlook for the economy as a whole, not just one market within it.

  Q17  Chairman: The fine art one is not your one number consideration, is it?

  Mr King: Of course it is not. Inflation is our number one consideration.

  Q18  Mr Breed: In the November Inflation Report you have a very interesting box detailing some survey work you have done in respect of the distribution of debt and repayment difficulties, particularly in respect of unsecured debt. Some quite interesting information came out there. First of all, you chose to use terminology within that chart which asked people to say whether they thought the burden of their unsecured debt was somewhat of a burden, or a heavy burden, or perhaps not even a burden at all. In my experience some years ago when I was a lending bank manager, I am not quite certain that the majority of my customers who I thought were in a bit of a problem actually considered they were in a bit of a problem. First of all, are you sure that those who indicated what they thought was somewhat of a burden actually was probably more of a heavy burden and that those heavily burdened probably were disasters?

  Mr King: I am sure after they met you and you helped them understand that they were in trouble, their views changed.

  Q19  Mr Breed: So the ability of someone to define whether they are really in that sort of subjective area is something I personally find a bit difficult to believe. Anyway, just looking it up, the proportion of those that were reporting a problem has begun to rise and yet we know that people going into IVAs has increased. There are some strange sorts of figures here. Do you think that there has been a real change in the way in which people are dealing with this unsecured debt now that the IVA system has come in? Do you think that is having an effect on some of the figures and that people reporting heavy burdens is perhaps falling back because they have actually got rid of this heavy burden on to somebody else through an IVA?

  Mr King: There are several questions in all of that. I would like to ask Charlie in a minute to talk about the survey. You are quite right, these are subjective classifications and one cannot attach too much weight to them, but I think the point of it is to look at changes over time. If you saw significant changes in the responses to the same question over time, that might give you a real indication that something was happening in a way that you might not get by trying to put rather arbitrary quantitative questions into the same survey. I think the IVAs will have changed behaviour—they were intended to create a new opportunity for people. I think all I would like to say before handing over to Charlie is that the results of this survey and the comments I have just made on secured debt do still leave us with the view that the real problems in indebtedness are not in the mortgage market but in the unsecured debt market where a number of people have got themselves into desperately serious trouble. For them and for their families that is a really serious problem, but there are not enough of them and they are not rich enough to mean that this is likely to have a significant impact on total household spending, which is, of course, our concern, in judging the path of the economy as a whole. Indeed, part of the IVA process is to allow families in that position to put in place a programme to restructure the debt such that their spending does not have to fall drastically. It will not increase in future at the rate that they would have liked as they are paying off their debts, but they will not have to experience a sudden reduction in living standards. That is the point of the arrangement. I think, therefore, if you put all that together, you end up with a conclusion, as far as we are concerned on the MPC, that that is not likely to have a major impact on consumer spending. Of course there are risks, and further down the road, if the problems became much more serious and many more people were in trouble, we would have to revise that view, but so far, I think, our judgment is that it is not going to affect the economy as a whole, though, as I said, it is a major problem for those in trouble. Perhaps Charlie can say something about the survey.

  Mr Bean: As far as the question itself goes, we have adopted the form of the question precisely to keep continuity with an earlier survey question which was in the British Household Panel Survey. If you look at Chart A in the box that you are referring to, the data prior to 2004, which is in a slightly lighter shade, comes from that British Household Panel Survey. That question ceased in 2003, and what we wanted to do was maintain continuity so we could see how things were evolving over time. So that was the primary thinking behind the particular wording that we used. The thing I think I would pick up from what the Governor has just said is the blue bars down there, the people who are saying that debt is a heavy burden, are about 8% of the sample, but they correspond to only about 5% of income because they tend to be poorer households. You made reference to the number of households going into IVAs or bankruptcy. That is a much smaller fraction than this; it is about 0.2% of households per year. So that group is the very tail of this blue bar at the bottom. From the perspective of the Monetary Policy Committee, obviously if we saw the burden of debt rising sharply from these charts, we would be starting to get concerned that maybe that would be starting to have a significant macro-economic effect. But, as you can see from this chart, it does not look as if there has been much change there as regards unsecured debt. Also, Chart B is quite interesting because it shows that the upper tail of people with high debt has actually moved leftwards, which suggests that households with high debt are starting to get it under control. That is actually quite a positive sign; there is something that goes in a slightly different direction. Next week we will be publishing more analysis from this survey, and one thing that does come out in that is a slight increase in the fraction of households with secured debt (mortgages) that are finding it a burden, where a little bit under 8% of households have found that at some time in the last year they have thought they might have struggled to make a payment, and that is up a bit from a little under 7% a year earlier. There is a little bit of a sign of increased stress there, and that is consistent with the pick-up in repossessions. But the numbers are still way below what we saw in the early 1990s—less than half the levels that we saw then.


 
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