House of COMMONS






November 2008 Inflation Report



Tuesday 25 November 2008



Evidence heard in Public Questions 1 - 77





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Transcribed by the Official Shorthand Writers to the Houses of Parliament:

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Oral Evidence

Taken before the Treasury Committee

on Tuesday 25 November 2008

Members present

John McFall, in the Chair

Nick Ainger

Mr Graham Brady

Mr Colin Breed

Mr Michael Fallon

Mr Andrew Love

John Thurso

Mr Mark Todd

Sir Peter Viggers


Witnesses: Mr Mervyn King, Governor of the Bank of England, Mr Charles Bean, Deputy Governor of the Bank of England (Monetary Policy), Sir John Gieve KGB, Deputy Governor of the Bank of England (Financial Stability), Dr Andrew Sentance, external member of the Monetary Policy Committee and Ms Kate Barker, external member of the Monetary Policy Committee, gave evidence.

Q1 Chairman: Governor, welcome to you and your colleagues on the November Inflation Report. For the shorthand writer's benefit, could you introduce the members of your team?

Mr King: Good morning, Chairman, and to all Members of the Committee. On my right is Charlie Bean, the Deputy Governor for Monetary Policy; on his right is Andrew Sentance, one of the external members; on my left is John Gieve, Deputy Governor for Financial Stability, and on his left Kate Barker, another external member.

Q2 Chairman: Thank you, Governor. Do you have an opening statement?

Mr King: I do, thank you, Chairman. In the past two months, a remarkable set of events has transformed the outlook for the UK and global economies. As a result, inflation is now falling sharply and economic activity contracting. Three factors have driven the shift in the outlook. First, following the failure of Lehman Brothers, the turmoil that has affected financial markets over the past year intensified into the most serious financial crisis since the outbreak of the Great War. The flow of lending to households and businesses has been severely disrupted. Confidence has been badly affected. All this will hold back demand growth looking into next year. Second, the short-run indicators for activity have turned down sharply both at home and abroad. Surveys, reports from the Bank's Agents and indeed my own discussions with businesses suggest that there was a significant fall off in demand coming into the fourth quarter. As I remarked last month, the UK economy probably entered a recession in the second half of 2008. That is reflected in the labour market - unemployment has been rising at its fastest rate for 17 years. Third, although CPI inflation did rise above 5% in September, as we had expected, it has now started to fall sharply: to 4.5% in October. Oil prices have collapsed by around two-thirds since the summer, and the price of metals on world markets has halved. Measures of short-run inflation expectations have retreated. And the cut in VAT announced yesterday will also lower inflation in the short run. Given these three factors, the outlook for inflation has shifted down significantly. Over the next few months inflation will be markedly lower than we anticipated in August. It is likely that inflation will return to target at some point early next year, although the precise speed at which inflation falls back will depend on how quickly the recent depreciation of sterling feeds into consumer prices. As a result, the upside risk to inflation in the medium term, emanating from elevated inflation expectations that had been important for much of this year, has receded. And the downside risk, reflecting the possibility that weak demand might pull inflation below the 2% target in the medium term, has increased significantly. The MPC has responded accordingly - cutting interest rates, in concert with other major central banks, by half a percentage point in October and by a further 1.5 percentage points in November. This monetary policy response has been complemented by some very significant policy measures taken by the UK Government. In early October a major package of measures designed to recapitalise and restore confidence to the banking system was unveiled. Those measures were designed to increase the buffer between the capital held by banks and the regulatory required minimum level of capital, allowing them to cushion future losses and restore normal lending to the rest of the economy. And yesterday the Chancellor announced measures designed to support aggregate spending in the short run. These measures will act to mitigate the slowdown in activity over the next year. Much though still remains to be done and very significant policy changes lay ahead. Domestically, the most pressing is to ensure that normal bank lending is resumed. Without that, the downturn in activity could become protracted and extremely damaging. There is also work to do to guard against future financial crises. Given the global nature of our financial system, much of that will need to take place at an international level. In particular, reforms of the international monetary system and improvements to the regulation of banks' capital and liquidity provisioning are priorities. Chairman, these are exceptional and difficult times. The financial crisis is affecting every family and business in the country. It also poses enormous challenges to policy makers around the world. But our inflation targeting framework remains well suited to confront the challenge of ensuring an overall balance between demand and supply in the economy in the medium term. The MPC remains very focused on that task, and will take whatever action is necessary to ensure that inflation is close to target in the medium term and, in so doing, to help the economy resume growth at a sustainable rate.

Q3 Chairman: Thank you very much, Governor. At the November press conference, in response to questions from the press that the MPC was behind the curve, you said that that was not the case. Yet between the August and November inflation reports the GDP forecast had fallen by around 2 percentage points. Is that not a major correction?

Mr King: No. This has been a very significant change in the outlook between the beginning of September and where we are now, and by far the biggest revision in a forecast that we have made. We did it because there was an extraordinary amount of news which hit the world economy - not just our own. I mentioned the three key points in my opening statement, namely the extraordinary collapse of confidence in the banking system - not just here but in other countries too - the very significant impact on confidence as visible in the short-run activity indicators, and, thirdly, this extraordinary collapse of oil and commodity prices, where oil prices went from almost $150 a barrel in the summer to $50 a barrel now, and not just the oil prices but commodities more generally too. These have been extraordinary changes, and, as a result, we have changed our view about the outlook and, indeed, therefore, the appropriate level of Bank Rate.

Q4 Chairman: Thank you. At the G20 there was much discussion about a co-ordinated reduction in interest rates. Indeed, the Prime Minister, speaking to the Council on Foreign Relations, suggested that co-ordinated interest rate reduction. To what extent are you concerned, if at all, that there is a creeping politicisation of interest rate setting on the global stage and nationally?

Mr King: I am not. I do not think either I or any of my colleagues in the central banking world have come under pressure to change interest rates. Certainly, (I can speak for myself) the Bank has not, at any point, come under pressure to change interest rates. We have made our own judgments about the right level of Bank Rate to ensure that we can meet our objective of keeping inflation close to the target and, in so doing, to ensure the best chance for stable growth in the future.

Q5 Chairman: There has been suggestion in the press about the Treasury wanting a preferred interest rate and ministerial pronouncements on that. Have you ever come under any pressure on that, or has there been any talk about the Government using reserved powers?

Mr King: Certainly not to me. I have regular meetings with the Chancellor and I would explain to him our judgment about the economic position, but at no point has either this or the previous Chancellor ever suggested what ought to be the decision on interest rates.

Q6 Chairman: Inflation was the issue a few months ago and now we could be considering deflation as an issue over the next few years. How serious a possibility do you think that is?

Mr King: It is not our central projection, in the sense that for CPI inflation our central view is still that the measure of CPI will remain positive. I think it is probably worth distinguishing between two different definitions of deflation in this context. One is simply a point of time when the inflation measure actually turns negative. That is very likely to happen to RPI inflation next year - in fact almost certain to happen now with the cut in VAT - and it may happen to CPI inflation, though it is not our central view. The other definition of deflation is the one that economists worry about, which is a period of continuing, self-reinforcing falls in prices which then make it very difficult for real interest rates to fall to sufficiently low levels to get out of a downturn in spending. I do not think we feel that is the position that we are in or likely to be in, because the likely duration of the period when the measured inflation rate will be negative is likely to be pretty short - indeed, the VAT cut would itself be reversed. So I do not think we feel that we are likely to be facing a protracted period of falling prices, which is the concern that economists have when that word deflation is used.

Q7 Chairman: The Committee, a few weeks ago, visited Japan to get the experience of their "lost decade", as they called it, and we were informed that the Japanese Government, along with the Bank of Japan, had to have co-ordinated actions there. How would such co-operation go in this country, given the MPC's committee structure, if it happened?

Mr King: It is clear that the Bank of England Act gives the authority to set decisions on monetary policy to the MPC, and monetary policy includes the Bank Rate but is not restricted to it. However, when interest rates get to the zero level, if we ever were to get to that level (and neither we nor the Americans have been at that level - Japan, clearly, have got very close to it), at that point there needs to be a close co-ordination between government and the central bank because monetary policy is very close to government debt management. Then it is very much a question of how the different types of instruments that the Government uses to finance itself are determined - whether they start to issue very short-term instruments in order to make more liquid the portfolios of the private sector. So there would need, if we got to that point, to be close co-operation between the Treasury and the Bank, but the decision-making power as to what the Bank would do would still rest with the MPC.

Q8 Chairman: On the issue of bank lending, Governor, you have made a number of statements about that, and in your opening statement you made it clear it is an issue of real concern yet. I have had quite a number of letters from businesses on that very issue. Indeed, just before the meeting this morning, I opened my mail and there was one from a family business which has been in business for 50 years, employing over 100 staff. They mentioned the relationship with their bank - I will not mention the bank's name - but they are telling me that the bank has increased their margin on borrowing by 33%, for the company, from 2007; a change from the base rate to Libor making debt repayments 50% higher than 2007, and increased debt from interest rate protection products supplied by the bank are no longer effective as a consequence of the change to their facilities to Libor, which the bank has put them on. They did tell us that the bank wanted a margin above the base rate from them, and that is 33%, and, also, the margin on their overdraft facility increased by over 75%. They say that in the current climate additional money is not available, and so that can only be recouped by job losses, and there are no other banks in business at the moment for them - not because it is a high-risk business, they point out, but because credit for the banks has been built up (?). They make a plea to me, saying: "This business has been built up over 50 years by hardworking families and local people, and we are determined to continue but job losses are inevitable." Governor, how can we ensure that banks keep lending? I remember when the bank recapitalisation was made in October that there was a credit guarantee scheme along with that. Is there an opportunity there for us to do something so that we eliminate the pessimism or reduce the pessimism and increase the confidence?

Mr King: You are not alone in receiving letters like that, and our agents around the country have received a number of reports from businesses along those same lines. I am in no doubt that the single most pressing challenge to domestic economic policy is to get the banking system to resume lending in any normal sense. That is more important than anything else at present. In part it is to ensure that the kind of business that you describe can continue and we do not needlessly see good businesses come to an end, and, indeed, further on, if that were to happen, then you would start to see the concerns about deflation that you mentioned earlier come to pass. It is of overriding importance that we deal with this problem. So what to do about it? The first thing is that we need better monitoring. We do not have, I think, adequate monitoring of the lending that is going on. If you look at the aggregate statistics, you could be, I think, misled into thinking that the scale of total lending by the banking system is still growing at a quite comfortable rate, but much of that accounts for intra-group transactions between banks, and a good deal of the rest of it is lending to the financial sector, not to the real economy. Our own anecdotes suggest that, certainly in the past month, lending to businesses and, indeed, to households has been extremely weak. So there is a real source of concern there, and the first thing we must do is put in place better procedures for monitoring, and I hope that there will be a statement later today from either the Government or the tripartite authorities which will announce measures to improve monitoring. The second is that we need, I think, to make absolutely clear to financial markets what the aim of the bank recapitalisation package was. That is, that it was to give capital to banks so that they would have a cushion or margin over and above their regulatory required minimum, which would give them comfort that they could absorb future losses as we move into recession and still continue to lend. I think what has happened is that financial markets, looking further down the road, have said: "It is pretty clear that in the long run the banking system is going to have to have less borrowing and more capital", and therefore they are imposing on banks almost a market-based higher minimum capital requirement. I think it is of the utmost importance that the tripartite authorities make crystal clear that regulatory minimum requirements have not been raised and, if anything, in these circumstances, might be lowered because banks will need to see their capital used to absorb losses in order to maintain lending. That is the second point: monitoring and then making absolutely clear what the position is. The third is that we may not have come to an end of the process of recapitalisation. It may be that the banks will need more capital, in which case that should be put in. We have seen that happen in the United States and we should not shy away from that if it proves to be necessary. The last step would be that, in the last resort, we have not given all this support to the banking system for no avail. We have lent hundreds and hundreds of billions of pounds to the banking system; we have injected £37 billion directly from the taxpayer into the banks, and an extra amount of capital is being raised by banks - over £50 billion in total is going in. This was not done merely to protect the banks; this was done in order that the flow of lending to the real economy could continue at normal rates. One way or another, that has to be seen to happen. So we have to monitor, we have to ensure that the financial markets themselves are not putting too much pressure on banks and allowing that capital to be used to absorb losses; we will need to put further capital in if necessary and, in the last resort, you cannot rule out measures where the Government would have to intervene directly to ensure that that flow of lending continues. The banking system is too important just to be left to its own devices.

Q9 Chairman: Governor, that is hugely helpful. What you are really saying, in terms of this capital that is in here, is they should be using it and banks should be looked at on a countercyclical basis: that in the good times they have more capital and in the bad times they have less. However, that message does not seem to have got out because the message that has got out is that "This is a certain level of capital and that is sacred; we are not going to touch that".

Mr King: I think the difficulty we have is that we have an international system for setting capital requirements for banks - the Basel 2 requirement - which built into it an element of pro-cyclicality not counter-cyclicality. In other words, when times got tough banks withdrew the amount of lending in order to build up their capital. That, everyone agrees, I think, is the wrong way to go - the Financial Stability Forum internationally has said that. Domestically, we have to make sure that we put in place measures to offset the impact of those Basel requirements, and in the short run if that means reducing the minimum capital requirements, so be it. These are precisely the times - these are extraordinary and unusual times - when you would think it appropriate to reduce the minimum capital requirements at the same time as ensuring that banks have enough capital to give them a cushion to absorb likely future losses. They need to know that they have that cushion that they can use to absorb losses in order to feel that it is sensible for them, and responsible of them, to extend lending. So we have to do that for the banks. However, if we need to inject more capital or take measures, we should not shy away from that.

Q10 Chairman: Governor, if we get nothing else out of this morning, I think that is important in itself, because I do not think that message has got across in the public domain, and I think we really need to do that if we want to keep our economy going.

Mr King: Indeed. I think we will see the tripartite authorities and the Government making that amply clear later today.

Q11 Chairman: The credit guarantee scheme - that was quite an innovative scheme.

Mr King: Yes.

Q12 Chairman: There could be initiatives around that, could there not?

Mr King: Indeed, and I think that scheme is being used, and the amount which banks are borrowing through that scheme are continuing to rise. It is a helpful scheme; it is time-limited - that makes sense too - but, nevertheless, we should be encouraging banks to use that scheme as far as possible to generate the funding that they can then use to lend to the real economy.

Q13 Chairman: Governor, we will be discussing other people's policies this morning, not least yesterday's - my colleagues are very interested in the fiscal stimulus. Was this a gamble, or a gamble squared or a gamble cubed?

Mr King: I think these are words which I am happy to leave to you to decide the adjective to apply. As I said in the November inflation report press conference, I thought in these extraordinary circumstances a modest fiscal stimulus was perfectly reasonable and appropriate, provided it met two conditions: the first condition was that it was temporary and the second condition was that it set out a very clear map and path back to fiscal sustainability. I think the announcements made yesterday meet those two conditions. Of course, the proof of the pudding, in terms of ensuring that we do get back to fiscal sustainability, will be in the eating, and there is a long, hard path back to fiscal sustainability. I think the measures announced yesterday did meet those two criteria.

Q14 Mr Fallon: Governor, the Minutes of November showed that you seriously considered a 2% reduction in rates, and one reason you stayed your hand was, of course, you knew the Pre-Budget Report was coming. How does the scale of the borrowing announced yesterday strengthen the case for further rate cuts in the immediate future?

Mr King: I think that is something which all of us on the Committee want to go away and reflect on and discuss. I do not want to give an immediate response to that. We have our meeting coming up in December and you will see the outcome of that when we get to the meeting. I think it would be wrong for us to pretend to be able to give a considered reaction to the announcements of yesterday immediately this morning.

Q15 Mr Fallon: Let us try somebody else. Kate Barker, when you saw the figures yesterday do they strengthen or weaken the case for further cuts?

Ms Barker: I am afraid I am going to, largely, echo what the Governor says and I do not want to prejudge today the way in which we might think about it. We were very clear when we took our decision in November that this is one of the things that would affect the decision we came to take in December; to think about not just the size of the cut but, also, the way in which it was made, the way in which it was likely to affect the economy in the short and the long term. Of course, we have some expectation, I think, in our minds; we have not yet had the opportunity to sit down and do all the analysis that we would need to to decide whether what has actually happened strengthens or weakens the case, relative to what I felt about what we might do in December a couple of weeks go.

Q16 Mr Fallon: Sir John Gieve, the Governor's reply at the press conference was that fiscal policy could complement, but it has to be temporary and it has to be consistent, as he says, with the medium-term framework showing a sustainable path. If the Governor is already satisfied that yesterday's package meets those two tests, presumably, you would draw some conclusion about the short-term movement in rates.

Sir John Gieve: I will join my colleagues in not telling you how I am going to vote next meeting. Clearly, our forecast did not take account of any additional fiscal stimulus; the Government has given an additional fiscal stimulus and that will, other things being equal, raise the path of growth in the short term a bit and, maybe, the inflation prospects a little further out once the VAT effects fall out of the equation. So the question, I guess, for us is how much is it going to raise that and does it still leave something more to be done? I cannot tell you how I am going to vote because I have not yet decided.

Q17 Mr Fallon: Sure, but the Governor went on to say at the press conference that if it doesn't "... the benefits can be lost in terms of higher longer-term interest rates". Do you accept that?

Sir John Gieve: I think that was probably a point about the sustainability, and I very much agree that no one would want to start exactly by saying we want an 8% borrowing requirement. That is obviously extremely high. There has to be a credible path back to a more balanced number. On the other hand, I think, in these circumstances, you have to start where you are and the case for a fiscal stimulus was a strong one.

Q18 Mr Fallon: However, you think the path back is credible? You have made that judgment already.

Sir John Gieve: It is a commitment, and I have no reason to doubt that the Governor is committed to getting there. Obviously, it will require great determination over a period of years. If you go back 15 years to the 1990s, we saw the borrowing requirement rise to about 8% then, at the peak, and in fact it was brought back, back to a positive surplus, ten years later. So it is perfectly possible to do it but it does require sustained determination.

Q19 Mr Fallon: The timescale yesterday was seven years, not ten.

Sir John Gieve: I am just trying to think. I think seven years gets it back to current balance, does it not? I cannot quite remember how long it took to get back to current balance in the 1990s. I would have to check that.

Q20 Mr Fallon: You think the path is credible. I want to be clear about that.

Sir John Gieve: It is certainly achievable.

Q21 Mr Fallon: Mr Bean, can you help us on the immediate effects? Is it not more likely, given the pressures on household finances at the moment and the reduction in credit that we have been discussing earlier, that people will simply save now, having been warned about tax increases to come, rather than spend, and pay off credit cards rather than use them?

Mr Bean: There is always a worry with temporary tax changes that it may not lead to very much effect on spending. A temporary cut in Income Tax is likely to be saved, for instance. What you can argue, I think, is that a cut in Value Added Tax at least gives households an incentive to bring forward some spending from the future to the present in some sort of switching over time. In that sense, I personally think it is quite a sensible measure to go for in the current culture (?); it is a measure that works because it is temporary.

Q22 Mr Fallon: Dr Sentance, what was your view of yesterday's package?

Dr Sentance: If you look at the borrowing numbers they are a product of two things: one is the stimulus that the Government provided through its cutting VAT and other measures but, also, the bulk of the increase in borrowing is a reflection of the deterioration in the outlook for the economy. When it comes to interest rate decisions looking forward, I think we will be looking at the judgment, yes, of the stimulus of the fiscal package but, also, the evidence that we have got from the progress of the real economy and, indeed, the issue that we were just discussing about how lower interest rates are feeding through into the rates actually paid by businesses and individuals, which is an important influence on the monetary stimulus that we are providing at the moment.

Q23 Mr Brady: Governor, how long would you expect it to be before you can see whether the stimulus package is starting to have the kind of effect that was hoped for?

Mr King: The "stimulus package" meaning yesterday or ----

Q24 Mr Brady: Yesterday in particular.

Mr King: I think well into next year. As Charlie Bean said, obviously one of the likely impacts of the temporary reduction in VAT is that during the second half of next year there will be a lot of advertisements saying: "Buy now before VAT goes up in January 2010". So precisely when this expenditure-switching will occur is not entirely easy to judge. However, of course, the real problem is to know what the counterfactual is. It is very hard to judge the impact of any policy measure without knowing precisely what the counterfactual is - what would have happened had you not done it. That, simply, we do not know; we do not know how quickly spending would have tailed off, how orders would have declined. That is why in these circumstances almost any policy measure is really about trying to balance risks.

Q25 Mr Brady: So it is not likely to have a direct effect on your decisions at your next meeting?

Mr King: We will certainly look at our judgment of all the measures taken; we will go through the PBR very carefully and all the small print to see what other measures are in there in order to work out the overall impact and see what judgment we make about the time path of activity and output and, hence, the path of inflation. The big picture here, which we should not lose sight of, is that we are facing an extraordinary set of circumstances in which confidence in the banking system around the world has collapsed, thus making the finance of ordinary industry and purchase very difficult - not just expensive but very difficult. That is potentially very damaging indeed. Therefore, we do need to take measures to ensure that we solve that big problem. That is the big downside risk, and that is why I attach enormous weight to re-establishing the firm lending to the economy as opposed to marginal changes in the outlook for demand and activity which are the usual minutia that forecasters and policy makers focus on. This is really about a big downside risk.

Q26 Mr Brady: Can I ask you and, perhaps, any of your colleagues to comment on the particular decision to reduce VAT on a temporary basis rather than some of the other things that might have been done? Does that impact more obviously on inflation in the medium term as opposed to demand, or is it principally a demand stimulus?

Mr King: I think, as Professor Bean said, the idea behind it, at least in the textbooks, is that you can try to switch expenditure from one period to another. That has pluses in that you may be able to move expenditure to a period when otherwise you would expect demand to be rather weaker; it has minuses in that if you get the timing wrong and demand turns out to be weak just after you put the rate back up, then it may be switching expenditure at the wrong time. These are risks that need to be taken. There are enormous challenges for policy. Mr Fallon rightly pointed to the challenge posed by the overall scale of borrowing, and there is no doubt this is a major challenge, but we have to try and balance the risks. We are going to have a long, hard path back to fiscal sustainability because the debt has been increased not just by a downturn in the economy but, also, by the need to recapitalise the banks and provide so much lending to the banking system. This is a problem facing all Western governments - indeed, governments around the world.

Q27 Mr Brady: Many people, after yesterday, are saying that a 2.5% cut in VAT is not going to make much difference; if you walk down the High Street you will see shops making cuts of 20%, 30% or more in prices. Would it not have been more effective, perhaps, to reduce National Insurance?

Mr King: I do not think so. If you want to have the impact on expenditure switching, then actually doing it through VAT is probably more likely to be effective. We have seen in the past temporary incentives to capital spending have been used, like changing the rate of investment allowances. That is another measure that has been used in the past. People have focused on measures directly trying to switch the timing of expenditure.

Q28 Mr Brady: So the effect comes towards the end of a temporary period, not towards the beginning?

Mr King: It is more likely to but, of course, people who have been thinking of spending may decide that some point in the next year is a good time to spend, why not do it now rather than the second half of next year? Decisions will vary from one individual or household to another.

Q29 Mr Brady: Finally, could I ask something completely different, to go back to your comments about the banking recapitalisation? One of the messages we were given fairly clearly in Japan was that one of the things that was crucial to them sorting out their problems was dealing with troubled assets. Is it not the case that one of the things we have failed to do so far in the UK is really get to grips with that problem of bad debts and troubled assets? Should some focus be turned to that rather than further recapitalisation?

Mr King: That is very hard to judge, for two reasons: one is that I do not think it is obvious that we have, on the same scale of the United States, the same degree of bad assets - certainly originating in domestic lending. The second is that the United States found it very hard to work out a practical method for buying those assets without getting themselves in a position where they, on behalf of the taxpayer, were overpaying and getting the wrong assets offered to the government in an auction process. So from a process which began as a process designed to put in place auctions to buy toxic assets, in the end, they could not actually work out practical ways of doing it sufficiently quickly, and they switched the focus of their scheme more towards a recapitalisation of the banking system along the lines that the UK carried out. So I think there are good reasons for preferring the recapitalisation route, and if you go far enough with the recapitalisation then it should actually allow banks to absorb the losses that may occur on what bad assets they have down the road. The financing of those bad assets we have been able to provide help with through the special liquidity scheme. So we are the only central bank that has offered a scheme under which we are willing to lend for three years against assets held when the crisis hit in the second half of 2007. That enables the banks to finance those assets without transferring to the taxpayer the risk of loss on bad assets, because the banks may know which are the bad ones but we do not. Therefore, in any process of a sale the ones that you get offered in the auction are the ones you really do not want to buy.

Q30 Nick Ainger: Governor, in response to earlier questions from the Chairman, you spoke about the availability of credit for the real economy. Obviously, the monetary stimulus comes through from the substantial cut in Bank Rate. How concerned are you that, in fact, that significant cut is not being passed on to the real economy whether it be for mortgage holders or small businesses?

Mr King: I think we recognise that part of the process by which banks are recapitalising themselves is to increase the margin between the rate at which they borrow and lend. That margin reached unsustainably low levels in the first half of 2007 - quite remarkably low levels. At times some of the lending that was being carried on was being carried on almost at a loss in the middle of 2007. So it was not surprising that from then on we have seen the wedge between the rate at which banks borrow and the rates at which they are willing to lend widen. We have seen, in the last couple of months, that the Libor rate has actually fallen by the full extent of our cut in Bank Rate. The spread has not fallen back, which we might have hoped, but the rate did fall back. It is clear that the rate on standard variable rate mortgages has fallen back by the full amount, but some of the banks that have tracker mortgages, following the cut of 150 basis points (1.5 percentage points) that we made earlier this month, withdrew some of the tracker products. They are now reintroducing them but at a higher rate, so that they have not fallen back by the full amount of the cut in Bank Rate. They have fallen back but not by the full amount. At one level I think the Committee understands that this means in such circumstances that we may need to cut Bank Rate by more than we would otherwise have done precisely to have the right impact on the rate that is being charged to final borrowers. We are conscious of that and that enters into our judgment about how we calibrate the required scale of the cut in Bank Rate. I think this is tied up with the issue of the willingness of banks to lend. My feeling is that the right strategy is to try and tackle head on this question of banks being willing to lend, and to cut the amount of Bank Rate that we think is necessary to ensure that after the margin has widened a bit then the appropriate cut is made in the rate charged to final borrowers. I think we should accept that part of the process of restoring the banking system to a more normal state is to allow that margin to widen. If we can solve the problem of the amount which banks are willing to lend then we will start to see the rates adjust in line with Bank Rate as they used to.

Q31 Nick Ainger: How does that square with the statements that have been made by the Chancellor that he wants to see credit availability at the same levels as 2007 following, as you indicated earlier, the massive injection that has been made of taxpayers' money into the banking system?

Mr King: I think that is a question you will have to put to him. We do not want to go back to the levels of the first half of 2007. I would not put it, myself, in terms of a particular number; I would like to feel that the banks would be in a position where they would be able to say to their branches and their managers: "Look, if you find profitable lending opportunities, lend". What is happening, at present, is that what the banks are saying to themselves is: "Even if we see some apparently profitable lending opportunities, we had better forgo them because we are under enormous pressure to reduce the scale of our leverage" (to use that awful word) "of borrowing and we have to reduce the scale of our balance sheet." So they are giving up profitable lending opportunities in order to behave defensively and reduce the size of their balance sheet. Individually, it makes sense for a bank to behave in that way; collectively, it makes no sense at all, because if all the banks behave in that way not only will the economy go into a steep recession but the banks themselves will start to see even bigger losses on their pre-existing loans. So it is not collectively in their interests to behave in this way, and that is the challenge that we have to confront in dealing with the banks, which is to find a way in which their individual incentives do not lead to a collective outcome that is clearly adverse.

Q32 Nick Ainger: Governor, on that point, what role will the new lending panel have? Will it be able to address those sorts of issues that the Bank is going to be represented on the lending panel? Is that a forum where these issues can actually be thrashed out? Thrashed out they must be because whatever the MPC does in terms of Bank Rate it is not having the effect that we would all like to see on the real economy.

Mr King: I totally agree, and I think they have to be thrashed out. I think you will find that in a statement today there will be an announcement about widening the remit and the membership of that panel to make sure that it achieves exactly the conversation and discussion that you have just mentioned.

Nick Ainger: Thank you.

Q33 Chairman: Governor, on Nick's point about Libor, the Committee would like a note from you on Libor, because when the debate was taking place about the 1.5% cut being passed on, the banks, in discussion with me and others, said: "Wait a minute. This is getting too far. It's saying we are being forced to pass this 1.5% on; we've only charged people the Libor rate for mortgages." Amongst other things, Governor, it is a three-month rate. So if people are being charged that for their mortgages it would just produce chaos in the market. So we need to have a more fundamental understanding of Libor, and I was taken by Wilhelm Buiter's blog when he said: "Libor is the rate at which banks don't lend to one another". There is a lot in here, and as a Committee we really want to explore this, so could you give us an initial answer on that and give us a comprehensive note?

Mr King: You would like both an answer and a comprehensive note?

Q34 Chairman: Yes.

Mr King: I can better Wilhelm Buiter's blog. It is in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content. I think it is convenient, very often, for people to justify what they do for other reasons, in terms of Libor, but it is not a rate at which anyone is actually borrowing. It is hard to see how it can actually have much of an impact. There is no doubt that what it is representing is the widespread loss of confidence in the financial community at large - not just banks but the financial community at large - in banks, as such. Eighteen months ago it was quite normal for anybody, including companies, to be willing to lend to a bank unsecured for three months at a very tiny margin over Bank Rate, because it was felt unthinkable that this was a risky loan. The world has changed totally; people are very worried about lending, and indeed hardly anybody is willing to lend to any bank around the world for three months unsecured; they want to lend secured. As I have said to the Committee before, I think that in future we will see far less lending to banks on an unsecured basis and far more on a secured basis. The inter-bank market has very often been a market in which overnight or short-term cash holdings can be distributed around the banking system, and banks were willing to do it with each other unsecured at Libor. I just do not think it plays that role now, and I think we are going to see developing over the next few years a much more intensive method in which banks can redistribute cash surpluses and shortages among each other on a more secured basis. At present they are doing it directly with the central bank, and that is true around the world, not just in the UK.

Chairman: So there is more to it than meets the eye. We look forward to your comprehensive note. That was a great primer. Thank you.

Q35 Sir Peter Viggers: May I return to the point of fiscal stimulus? You have been completely consistent in saying that fiscal stimulus could be justified if it is temporary ("strictly temporary", to quote you, Governor) and that tax and spending come back into a sustainable balance over the medium term. The Government's proposals will bring the tax and spending back into a sustainable balance in 2015/2016, which is after the election after next. That is even on their optimistic assumptions. Are you saying that that is temporary, or have you changed your mind?

Mr King: No, the measures that are being taken to stimulate activity are temporary. I have said there were two conditions: that the measures be temporary (they are temporary) and, secondly, that there was a path back to fiscal sustainability. As you rightly point out, that path is long and hard and the implied ratio of debt to national income only starts falling in 2015/2016, which is a very long way away. That is an indication of how serious the fiscal position is at present.

Q36 John Thurso: Governor, as you said, the most pressing thing is to ensure that normal bank lending is resumed, and you have given a very full answer to the Chairman and Mr Ainger. Can I press you on just one point on that? A number of the bankers that I have spoken to seem to think that having passed Go and got the £500 billion it is business as usual and they do not need to worry too much, and heads down and they will soon be kind of all right. Should not the Government, or the Bank, or somebody, actually produce a memorandum of understanding or a concordat - something - that actually sets out clearly the principles? We seem to have a divergence of view between the bankers, who kind of are going: "Phew! Thank you very much, now let's get on with life", and all the rest of us who are saying: "We're giving you the money for a purpose."

Mr King: I do not think I know many bankers who think it is sort of "business as usual" or that they are saying: "Phew!" The reason is because they have been given massive amounts of public support. You are absolutely right; hundreds of billions of taxpayers' money has been lent to the banks. However, it has only been lent to the banks, and they are going to have to repay it. The problem facing the banks is that they feel under enormous pressure now; having gone through a long period in which the amount of money they borrowed grew very rapidly, they now realise that their gearing ratios and leverage was much too high and they are under enormous pressure to reduce it - this is pressure coming from the market - because if they do not take steps to reduce it their share price falls. So one can understand why the banks individually think that it is in their interests financially to reduce lending to reduce the size of their balance sheet. Collectively, of course, I do not think this does make sense because they are merely exacerbating the downturn which will increase their own losses in the future and damage their underlying capital position. So there is, I think, a real chance here to bring the banks together in order to say: "Look, how can we, collectively, get out of this?" I do not think it is in the banks' collective interest that we go into a deep recession or downturn. However, individually, I think one can understand the pressures that they are under. The recapitalisation has certainly eased those pressures and it prevented the banks from failing, which is where they would otherwise have been, but it has not got them yet to a position where they feel confident enough to resume lending. We have to get to that point, and if it means some kind of concordat, so be it. One way or another we have to find a means to get the banking system to resume lending. I do not think, at this stage, I want to rule anything out, though I do think there is a sequence to start here, and the first thing is to start with more intensive monitoring and then discussions with the banks.

Q37 John Thurso: It does seem to me, Governor, that - and you quite rightly make a difference between what is in the interests of an individual bank and what the collective system requires, which appears to be diametrically opposite at the moment - without some form of formal concordat or MOU or something that lays out the principles (not telling how the bank has to run its business but lays out the principles), then there is nothing for the individual institution to be guided by. It seemed to me it was a pretty strong need to arrive where you want to arrive.

Mr King: I do not want to prejudge what is the right way through this. What you say may well turn out to be necessary. I think we should, first of all, find out what answers the banks have as to how we are going to get through this, and then see. I certainly do not rule out the approach that you suggest.

Q38 John Thurso: Can I turn to another point you made in your opening statement, which is the impact of Lehman Brothers and the destabilising factor that that was. With the benefit of hindsight, do you think Lehman Brothers was actually a systemic risk and was too large to have been allowed to fail?

Mr King: I think with the benefit of hindsight it was clear that after Lehman Brothers failed the sequence of events occurred which led to the collapse of confidence in the banking and wider financial system that has proved deeply damaging. I do not think it was inevitable that that happened. I do not think questions of confidence are ever questions of inevitability, but it happens. I just do not think it makes sense to blame the US authorities for that; I do not think they could easily have known, nor did many people say so immediately - and they did not have any powers. In fact, one of the most interesting things about the experience was how many of my colleagues in the United States said: "Now I realise why you, the UK, have been talking about having proper powers to deal with banks", because Lehman Brothers was not a deposit-taking institution, it did not come under the FBIC and they did not have the powers to deal with it as they would have been able to do with a deposit-taking institution. They will obviously want to look at that in the future. Be that as it may, we are where we are, Lehman Brothers did fail and it did lead to a quite extraordinary sequence of events, which has led to the biggest banks in the world getting to the point of virtual collapse. I do not think anyone had anticipated that that was likely, or even remotely likely, to happen. It is something that people thought was associated with reading about the financial history of the 19th Century. However, it happened and we have to confront the circumstances and find a way through it.

Q39 John Thurso: You make an interesting point about their not having the powers. In this country do you feel that we have the appropriate powers if, God forbid, anything similar were to happen?

Mr King: We will have, I hope, thanks to all of you voting through ---

Q40 John Thurso: You have not at the moment.

Mr King: We do not have, as the Americans did, the separation between investment banks and commercial banks. Of course, they do not have that distinction any more now because, following the failure of Lehman Brothers, there are no investment banks left; the ones that were have now converted into commercial banks. So, willy-nilly, we have got to a point where I hope we will have the powers that the Americans have.

Q41 John Thurso: Sir John, could I, perhaps, ask you how important was the failure of Lehman Brothers in the events that unfolded over here in this country for financial stability?

Sir John Gieve: I think it was absolutely key. It was a huge shock and if you look at the graphs, CDF spreads and Libor spreads - they all shot through the roof. Quite clearly, it had not been foreseen, and within four days the US Treasury had to launch its first 700 billion programme to rescue the whole system. So it was very important. I think the reason for that was that the authorities, on both sides of Atlantic, had been thought to be pursuing a strategy of providing liquidity to the market to give most banks the time to adjust, and to rescue or, at least, cushion the resolution of failing institutions, and prevent those coming as a surprise or happening in a disorderly way. After the Bear Stearns rescue that did, for several months, seem to have the effect of calming markets and bringing some of the spreads down. Then when Lehmans fell through the net, I think that called all of that into question, and that was a very big shock.

Q42 John Thurso: There was a very interesting comment about Citibank, which is basically that it is just too big, period; it is just too big an institution. Do you think we have arrived at the point when global banks are actually too big and too dangerous and that we need to get back to smaller-sized institutions?

Sir John Gieve: The banks that have proved most difficult, I think, to manage are the ones which are not just big but which try to combine the full range of banking approaches, and Citi and UBS are both examples of how difficult it is to combine a big investment bank - a leading investment bank - with a leading commercial bank. If you look at some of the other big banks which have kept to a slightly narrower range - HSBC would be an example of that, and Santander - they have not actually run into quite the same problems. So I am not sure it is size but the difficulty of properly combining a bank that does everything, the full service, across big markets and retail markets, which is a problem. The other point which I guess Lehmans illustrates very well is that if you do have giant financial conglomerates which operate on a global basis you need to work very hard on global co-ordination for crisis handling. I think we saw in the Lehman case, and in a smaller way in the Iceland cases, how difficult that is and that is one of the key lessons I have drawn from this crisis: we need to redouble our efforts to get proper international contingency planning, especially for the bigger, international banks.

Q43 John Thurso: Kate Barker, can I ask you: what is your current assessment of the state of the housing market?

Ms Barker: That is a very broad question. I am certainly not going to make any predictions on house prices themselves. There is a whole set of warnings about that kind of activity. It is absolutely apparent, of course, as we saw in the new starts and completions figures this week, that the housing market is extremely difficult, partly because of the problems we have already discussed this morning about mortgage lending and the supply of mortgage lending, and now, on top of that, there is the problem of confidence in the market. So that it is quite difficult, I think, to distinguish whether or not it is demand for mortgages which is the problem or the supply. We will not, of course, see a turn in that until we see confidence return to the economy more generally. I think it is quite important to stress that it is the economy more generally that leads the housing market; not, in my view, the housing market that drives the economy, and until we start to see lending coming back - and we have had a very extensive discussion about the kinds of conditions where lending might come back to more normal levels not just for businesses but, also, of course, for consumers in the mortgage market.

Q44 John Thurso: Is there anything the Government should be doing to try and stabilise house prices? Or has this just got to take its course?

Ms Barker: Personally, I do not think that attempts to stabilise house prices are necessarily sensible in a direct way. I have just said that the issue, I think, really, is stabilising the economy. If you are successful in stabilising the economy, which is clearly what many of the policy measures introduced over the last month are aiming at, then, of course, the housing market itself will start to stabilise. In the short term, of course, the Government is doing some things which I welcome to try and ensure the construction industry is kept going through the bringing forward of investment in social housing. That seems to be very sensible and the best way in which to direct its efforts.

Q45 Mr Breed: Following on from what John Thurso just said, do you believe that there is an over-concentration of banking in this country where we have too few banks that are now too large and they have actually contributed to the current problem and will certainly contribute to the ability to properly regulate them even if we get the Banking Bill through?

Mr King: Certainly there is an issue about the degree of concentration. We do have a highly concentrated banking system and it has created problems in that if there are difficulties in any one bank which might lead there to be a case for a resolution of a bank using the new powers we immediately find ourselves dealing with a bank which is much bigger than anything the Americans have ever had to deal with. When they have failing banks they are all very much smaller. Ours seem to be bigger and that inevitably creates a problem because it becomes a bigger political issue if nothing else. However, I think the issue is broader than that. I do not think the issue is the size of individual banks. I think it goes back to the question that John talked about, the size of the banking sector. If you were to say to me what is the big lesson that I draw from all of this as opposed to lots of the smaller ones, I think it is that, not just in the UK but around the world, monetary policy did a pretty good job of maintaining a balance between demand and supply and keeping inflation low and stable, and bank rate was used to do that but bank rate cannot be used to do other things at the same time if it is maintaining a balance. What we failed to do was prevent a very rapid expansion of the size of the financial sector to the point where the very size of its balance sheet, and in particular the amount of money which it had borrowed, created a potential instability. I think we have come to recognise that there is a genuine policy objective in not letting the banking system become too big, and in particular that much of the activity that was going on over the last ten years did not take the form of attracting more deposits from households in order to lend to businesses but took the form of borrowing in wholesale markets, very often to engage in proprietary trading where lots of new instruments were created and the people who created them were the same people who were buying them and so there was massive expansion of the balance sheet, particularly of large international banks and when trouble hit unravelling this became incredibly difficult. The lesson I draw from this is not that bank rate should in some sense be diverted from its task of maintaining a balance but that we need new policy instruments which can be used to try to stabilise the growth rate of the financial sector, in particular the banking sector, because of the potential damage that a banking system that gets into trouble can cause for the rest of the economy.

Q46 Mr Breed: Thank you, and I hope that those new policy objectives are going to be something somebody worked on. I do not think the Banking Bill is going to address it.

Mr King: No, but the Banking Bill, if I can add just one point, was the first set of lessons that we learned from this crisis in the UK, which was how to deal with individual banks. Because of our own experience in the UK we have a lot of lessons to learn about how to deal with individual banks and the Banking Bill deals with that. What we now need to go on to do is debate the issues about what happens for the banking system as a whole. These are separate issues. I think we know what the lessons are and both Charlie and John have talked in recent speeches about the sort of instrument that we should discuss, which is using capital requirements in a counter-cyclical way so that, instead of giving directions to individual banks, we change the incentives that all banks face in order to slow down the rapid expansion of the banking system when it threatens to become excessive and to reverse it so that it does not have to de-leverage too quickly when it faces individual incentives to do that. There is much more to be said on that, and in part, unlike the Banking Bill, this is not something that we can easily do alone; we need to do it with our international partners, but it is, I think, the big lesson from this crisis.

Q47 Mr Breed: Mr Bean, can I finally ask about sterling? Obviously, we have seen a massive and very rapid decline which has some benefits and some disbenefits. To what extent do you think benefits on the export side of our economy to use this sterling weakness are likely, bearing in mind the current overall global economy? How do you think with such lack of demand we can use the weakness of sterling in some positive way?

Mr Bean: It is clearly a very challenging environment for exporters but I would like to turn it round the other way: think how much worse it would be if exporters did not have the advantage of a much more competitive level of sterling now than a year ago. Sterling is down a little bit more than 20% in effective terms. We have always recognised that at some stage the economy would need to rebalance away from domestic demand towards the external sector as part of the process of correcting an unsustainably large current account deficit. The depreciation that we have seen over the past year is an integral part of that process. It is about the right sort of order of magnitude that is required. Clearly, it would be desirable if that rebalancing process was taking place in an environment where the rest of the world was strong rather than slowing but I would much rather be in a position where we have a lower level of sterling and some stimulus to the economy at the moment than the opposite.

Q48 Mr Breed: But if sterling keeps falling, and there is no indication as yet that it has bottomed out, inevitably that will add to inflation, so therefore we get no particular benefit from the weakness in exports but we have potential upswing in inflation. Where are those points? Where does that happen?

Mr Bean: There are two elements I would like to pick up on in that. The first thing is that there is a distinction between a decline in sterling that is necessary as part of a rebalancing process of demand. As I say, the sort of depreciation that we have seen over the past year I regard as the right order of magnitude. As for whether it is exactly right or not, who knows, but it seems to me the right sort of magnitude. An alternative scenario is one where external investors lose faith in the policy framework that the UK operates under and expect much faster rates of inflation in the future or something like that which results in downward pressure on sterling now, an old-fashioned sterling crisis, if you like. That, I have to say, I would be much more worried about, if there was a lack of support for sterling on the down side. I do not think that is the position we are in at the moment.

Q49 Mr Breed: And you do not think that will happen in 2009?

Mr Bean: I certainly hope it will not happen in 2009.

Q50 Sir Peter Viggers: Your Inflation Report looks at consumer spending which has, of course, been quite high with quite high levels of household borrowing. What is the balance between the fall-off in the availability of credit and households' desire to increase their savings as a precautionary measure as a contributor to the current reduction in household spending?

Mr King: This is a forecast that we have all put together so why do I not ask Andrew to come in and talk about that?

Dr Sentance: The outlook that we see for consumer spending is to be weak in the short term but to pick up in the second half of 2009, and I think there are a couple of main elements contributing to that pick-up in consumer spending. One is a recovery in the growth of real disposable income and that is an unwinding in a sense of the negative influences on real disposable income that we have seen over the last year with high oil and food prices, and, secondly, the monetary policy stimulus but also fiscal policy stimulus that we are seeing coming through in various ways. At the same time as people are seeing their real disposable incomes rise I think they will devote some of that to increased savings as well as increased spending, so there will be a balance between the amount of real disposable income that goes into spending and saving. We do see that the savings ratio forecast, the central forecast, implies a rise in the savings ratio gradually over the period of the forecast as well, but we also see, particularly in the second half of next year onwards, a recovery in consumer spending.

Q51 Sir Peter Viggers: Consumer spending, of course, assists the economy to move forward and gain confidence. Should we, the Government, the Bank of England, be encouraging consumers to spend or to save?

Dr Sentance: I do not think we should be in an exhortation mode but I think the policies that have been deployed over the last few months should act as some degree of incentive to spend - first of all the relaxation of monetary policy that we have made and also the fiscal stimulus in the reduction of VAT that we discussed earlier, and I think that is appropriate in macroeconomic terms given the economic outlook that we have, to be providing some policy stimulus to spending because we see that demand is getting very weak. However, for individuals, I think it is for individuals to respond to those price signals, the level of interest rates, the VAT change, as they see most appropriate in their individual circumstances. From a macroeconomic standpoint I think it is quite right for there to be some stimulus to spending at the moment.

Q52 Mr Todd: Have you asked Professor Blanchflower where he keeps his crystal ball?

Mr King: We ask him to bring it to each of our meetings.

Q53 Mr Todd: You see the point of the question? He was somewhat an outlier in the MPC's decision-making process. I am sure he is not the kind of person to sit around saying, "I told you so", at various points but has it made you reflect on the evidence that confronted you at earlier points in the year when he obviously was taking a very different view from the rest of you?

Mr King: I do not think it has made us reflect on that because, as I said, we feel the situation changed very dramatically between the August inflation report and the November one and I think most of the rest of the world also found itself in that position. What it does do, I think, is demonstrate the strength of the MPC as a committee where vigorous debate, open debate, is welcomed and a key part of the process. There are many monetary policy committees around the world where someone who is in a minority might never get a chance to express their views openly. We welcome that; we have the self-confidence to debate these things publicly.

Q54 Mr Todd: I think that is perfectly fair. The evidence I think he spent quite a lot of time looking at and emphasising to us was labour market data and I just wondered whether that had made any of you reflect that perhaps that data needed closer scrutiny in the decision-making process than perhaps it had been given up until now. I do not know; maybe it has not occurred to you.

Mr King: I do not think it changed our broad view, but clearly what has happened in the labour market, and it is beginning now, is that we are starting to see significant rises in unemployment resulting from the changes that we saw in that period between September and November.

Q55 Mr Todd: But he saw it earlier.

Mr King: Yes, but one thing which I think we all do on the Committee is listen to each other. We have spent a good deal of time not debating or challenging each other but having a genuine conversation across the table about what is going on in the labour market and Danny has played an absolutely crucial role in that because he is an expert in that area. We do have lots of conversations, we always have had, about what is going on in the labour market. I think that is the strength of the MPC, that it is a group of people all of whom do have expertise in various parts of the economy.

Q56 Mr Todd: Fine. I was intrigued as to the dynamics but the Inflation Report highlighted the difficulties of companies obtaining resources to invest at the moment. I would assume - and perhaps this is best directed to Dr Sentence as the person who has the business background within the MPC most recently - that one of the major constraints on investment is simply the uncertainty of the market at the moment, regardless of what credit might be available.

Mr King: Perhaps we can ask Andrew and Kate to answer that.

Dr Sentance: We get some quite good survey evidence particularly from the CBI's industrial trends survey which asks companies about the main factors constraining their investment and, you are quite right, uncertainty about demand is the most significant factor at present. It is generally quite an important factor, particularly when demand is turning down. However, it was also very striking that in the last survey in October external finance as a constraint on investment jumped up to the level of, I think, about 16% of companies, which is the highest that the survey has recorded over the period that they have been asking that question, since 1979. Therefore, yes, uncertainty in demand is probably the main factor underpinning the slowdown investment intentions, but over the last few months certainly there is evidence that external finance considerations are coming into play in a way that we had not seen, according to that survey evidence, in previous downturns, and I think that is an important factor to take into account.

Ms Barker: Quite a number of questions that in some sense people have asked today have revolved around trying to assess how changes in the world, changes in investment or in consumption reflect changes in different things. One of the problems with the present situation is that it is incredibly difficult, as I said about housing, to disentangle things that are affecting the demand for investment funds and things that affect the supply of it because, of course, one of the reasons companies do not feel very keen on investing is that they know other people are experiencing difficulty in borrowing and therefore the economy is slowing down. That, of course, is the danger of the downward spiral that we have all been talking about and why the point about trying to attack these things at the root cause is the right way to go forward, and why I think that to try to work out which bits are really affecting people at any one time is not going to turn out to be terribly helpful. I agree with Andrew: it is hardly surprising since both of us have in our time been responsible for the CBI survey, but it was very interesting to see that line move so much. During the whole seven years I looked after the survey that line was totally uninteresting and I think it was pretty uninteresting during most of the 50 years the survey has been running, so this was a very marked move and it did suggest that companies were finding external finance difficult in a way that they have not for a very long time.

Q57 Mr Todd: Regardless of market conditions?

Ms Barker: Regardless of market conditions, yes.

Q58 Mr Todd: We have had announcements today from the UK. We await announcements from the new Obama government when it takes office. International action to stimulate demand is critical to the value of the actions taken in the UK. We can but make a small difference. What indications are you getting that we will see appropriate responses? We saw the G20 discussions on this. What indications are you getting that that will be of an appropriate scale to make a difference?

Mr King: I am in no doubt as to the gravity which governments around the world attach to this situation. I think we saw that first at the IMF meeting on about 10 or 11 October when the G7 adopted a strikingly different mode of discussion and communiqué. We have seen it carried forward into bilateral discussions. We have seen the European summits. We had the G2 meeting, and we have seen now a clear statement of intent from the new US leadership. All this is very welcome because the big lesson of the early 1930s was that what really tipped what might have been a serious recession into a world depression was the inability of governments to work together to overcome these problems. At the high level I have no doubt that governments will recognise the importance of the situation and take appropriate steps, and, having worked very closely with Tim Geitner in his capacity as a central banker, I look forward to working with him when he chairs the G7 Finance Ministers and Central Bank Governors meetings. Larry Summers is returning to the White House, so I saw a very capable team there. I also very much hope that Paul Volcker's influence will be to the fore because this is a time in dealing with banking problems when someone of his integrity and standing is going to be very important in finding a way forward in terms of how we manage the structure of the banking system in the future. The concern that I have is that when dealing with the high level international issues and the need to stimulate the economy governments will recognise the position but nevertheless individual governments will face enormous pressures from individual industries and they may take measures which they think are not protectionist in intent but are designed to help a particular industry. If they are going to take steps to put money in to support and sustain activity in that industry they will want to make sure there is enough domestic demand for the output of that industry and it would be only too easy by accident to slip into a sequence of measures that looked as if they made sense individually but added up to what would turn out to be a move towards, in effect, a protectionist application of policy. I think that is the risk, so what we need is not just leadership in macro policy but leadership in microeconomic policy to avoid going down the road of protectionism by accident through subsidies to individual industries, difficult though that is in present circumstances. That is where I think the real challenge for governments to work together will come.

Mr Todd: You anticipated my "buts" question very accurately there.

Chairman: Do you need to ask it?

Q59 Mr Todd: No, I am not going to ask it. I am merely going to remark that your reference to the 1930s was, of course, an illustration of exactly some of that tendency. To what extent has this crisis demonstrated that the rapidly developing economies, China and India, are not decoupled in any sense but are very closely engaged with the health of the rest of the world, or do you feel that some of the statements about decoupling have been proved to have some substance?

Mr King: I think the concept is a rather bizarre one because the idea that you are either coupled or decoupled from the rest of the world does not make any sense. The right question is, what is the degree of integration and interaction and how far quantitatively does a slowdown in one part of the world lead to a slowdown elsewhere? The big difference from before is that there is no doubt that the source of demand in the world economy in recent years has been in large part due to the growth rate in Asia, China, India, other economies there. We have seen how important potential demand or lack of it is from oil producing countries. We are in one world economy. If you go to most of the analyses of the ultimate causes of this financial crisis they go back to the unforeseen consequences of a single world capital market where financial flows and capital flows led to a very large fall in interest rates which generated a search for yield and many of the financial failings that we have seen. The integration of the world economy has on the one hand led to a bigger increase in our standard of living than we would otherwise have had. As I have said to this Committee before, our estimate is that between the early 1990s and early 2000s our standard of living rose by one percentage point a year more than it would otherwise have done because of the integration of these economies into the world economy. That was the big plus. We have yet to learn successfully how to cope with the challenges that arise in terms of the extraordinary volatility in commodity prices and the consequences of capital flows and exchange rate arrangements which have worked well within the G7 but not well between the G7 and the rest of the world. These are major problems facing us. We do need to take a look at the international monetary system. We do need to look at the behaviour of oil and commodity prices. There are many problems in the world economy where we are all in it together and we have not really adopted that in our policy-making approaches. We have all assumed that if we just did the right thing for ourselves all would work out in the best of all possible world and that has not turned out to be the case.

Chairman: On oil and commodity prices we have our resident expert, Nick Ainger.

Q60 Nick Ainger: I wish I were.

Mr King: Can we ask the questions then and Mr Ainger answer?

Q61 Nick Ainger: I am glad you touched on this issue of the extraordinary fluctuations because obviously, certainly in the first half of the year, it was driving your decisions in many ways and it has led to the situation where we were likely to enter a recession even without the effects of the credit crunch hitting us. In the Inflation Report you say in relation to oil prices, "Financial market prices such as futures have not provided an accurate guide to changes in prices recently". This is since August. Why do you think that is?

Mr King: Over a short period like a few months into August that could just be chance. People make one judgment and it turns out to be wrong. The difficulty with any futures market like that is that in a commodity where it can be stored to some extent it becomes like an asset and any information that people have about the future price is represented in today's price. Hence any future moves are unpredictable so any futures curve is based on, if you like, merely a statement about what the interest rate looks like over the future and movements in the actual price will always be unexpected; that is what we are saying, and the scale of the price movements both up and down has been so large. I do not think that is so surprising but I would be interested in your views on this. From our perspective the futures market more than a short period ahead is really very thin and this does cause a problem because markets can be very effective in guiding resources but the futures market in oil is too thin to be an effective guide. For example, potential producers of new sources of oil, like these famous Canadian tar sands producers, cannot sell their oil ten years forward. If they could their investment today would be a lot less uncertain and they could get rid of a lot of that uncertainty. They would not be gambling on what the price would be in ten years' time, they would be able to sell it ten years forward. It sounds a good idea to have a futures market because then producers can offload that uncertainty onto others. The question is, who is going to buy oil ten years forward? Lots of people who use oil so it might be that airline companies could buy oil ten years forward, but the reason they do not is that they cannot sell their tickets ten years forward. You get led down a path where the reason these markets do not exist is that you cannot get markets for everything to exist ten years forward. I think the absence of an effective forward market in oil is a problem in getting to a situation where, in the absence of that market, the spot price is then very sensitive to quite small movements in production because the producers need to be very confident that the price is going to stay high for a long period before investing in new supply. That makes the current price, I think, very volatile to small differences in current demand and current supply. That is what we have seen in recent years. There is certainly scope for discussing among the major energy consuming countries how far it is possible to create in some way, with government support, a much deeper and longer futures market.

Q62 Nick Ainger: It is an interesting idea. One of the issues which I have become not involved in but certainly have examined is the gearing effect where there are relatively small changes because, as you say, there may be a problem in Nigeria or whatever, but that suddenly seems to be magnified. There seems to be a huge gearing effect and I wonder if anyone within the Bank, because obviously this is so important to all world economies, is looking at what impact the index funds have on what in production terms overall is a relatively minor change up or down but there does seem to be this huge gearing taking place.

Mr King: It is an interesting question as to how far financial investments in these markets are having an impact. It is always hard to judge because normally you would think that the more activity there was in these funds the more stabilising that speculation might but, but it has not seemed to be the case. Perhaps I could ask Charlie to come in here.

Mr Bean: Our take on this is that the primary reason for this excessive volatility in the price, if you like, is that both the supply and the demand sides of the market are very price elastic so you only need small changes in one or the other to lead to big changes in the price. It is possible that financial speculation plays some role in magnifying those movements but we do not think it is the primary driver and there is one quite important piece of information here, which is that if you look at similar commodity markets where financial speculators are not particularly active you see the same sort of highly volatile movements in the price, so we think that is one reason for not thinking that the primary culprits are operators in the financial markets. Having said that, certainly at high frequency they may well play a role in magnifying movements.

Nick Ainger: But as these are such important issues at the moment because we are facing a global downturn and prices are coming down dramatically, once we come out of this are we going to go back to this incredible volatility which will make your jobs incredibly difficult in trying to control inflation and also have again a hugely negative effect on the global economy?

Q63 Chairman: I think it is unfair not to ask Andrew Sentance to reply to that, given his aviation experience. He can give us an insider view here.

Dr Sentance: I certainly agree with the Governor: it is very difficult to sell tickets ten years ahead. In terms of what we have seen with the oil price over the summer, I would agree with Charlie that in general it seems that the fundamentals have been the dominant factor but the speed with which things moved up to $140 dollars and then moved back down again is quite striking and observers of the oil market whom I respect do believe that in that episode some financial market interaction seemed to have a role to play. I think the more general point which you raise is an important one. I do think we have to recognise that during the last five to six years we went through quite an exceptional period. If you look at the growth of the global economy, and particularly the contribution of emerging market economies in Asia to that growth over the mid 2000s, you would have to go back to the late sixties and early seventies to find such a strong period of growth in the global economy. It may be that though there are structural features which are driving forward the emerging markets we might look back on that period of growth as rather exceptional and one that was potentially unsustainable in terms of the pressure it put on oil and commodity markets. The difficulty is what mechanism can come into play to ensure that the world economy as a whole enjoys the right rate of growth, and that comes back to the issues that we talked about earlier in terms of international co-ordination. Certainly the exceptional growth that we have seen over the last five to six years to my mind has played an important part in the volatility of oil and commodity prices.

Chairman: We are going to come back to this issue in the new year.

Q64 Mr Love: Governor, in your statement that you read out you said, "The UK economy probably entered recession in the second half of 2008. That is reflected in the labour market. Unemployment has been rising at its fastest rate for 17 years". Would I be right to interpret that as a partial recognition that perhaps the Bank was a little slow in terms of its forecasts?

Mr King: Certainly we did not anticipate the changes that occurred. If you go back to the first nine months of this year I think everyone would recognise that we had to balance two risks. Moreover, those risks were getting bigger on both sides. One was the risk that high inflation would lead to expectations of inflation that would be very difficult to dislodge and painful to dislodge on the one hand, and on the other hand the risk that there would be a downturn that would pull inflation below the target. These risks existed, and indeed I remember we came before this Committee last time only two and a half months ago and I was pressed quite hard, and perfectly reasonably, on whether we could maintain the credibility of the Monetary Policy Committee if inflation were to go over 5%. No-one is pressing on that this morning because the situation has changed a lot. I do think that the situation has changed very significantly over the past two to three months but we did not anticipate the future accurately; that is certainly the case.

Q65 Mr Love: But you are confident that your November report is an accurate reflection as best you understand it?

Mr King: What we are always doing here is not pretending that we can foresee perfectly the future. We have never done that. I have been coming for over 15 years to this Committee and on every single occasion I think I have stressed that all we can do is state a balance of risks and a statement of probabilities.

Q66 Mr Love: I understand that.

Mr King: We cannot foresee the future. We do believe that the November report has a good view, a reasonable view, of where the risks lie on both the up side and the down side.

Q67 Mr Love: Your November report in terms of output is suggesting that it will dip to round about 2% loss of output some time round about the middle of 2009 and then recuperate. Can you give us some idea in terms of the total loss to output that that will mean and, more importantly, would you agree - and I am accepting that these are figures without any recognition of the stimulus package - with what the CBI said yesterday, "This fiscal stimulus is going to cost the Government less than doing nothing because of the impact on unemployment"?

Mr King: I do not want to comment on the last statement about numbers which one would have to look at. Certainly our view of the outlook is broadly similar to that of the Treasury as published yesterday. They have taken into account the impact of the stimulus package. We have not been able to do that yet. We will look at that again in our December meeting and you will see our latest projections next February when we produce the next Inflation Report. However, there is no doubt that one of the reasons for thinking that a temporary stimulus package at this juncture makes some sense is the need to avoid the implications for activity, output, unemployment and indeed revenues to the Government of a very sharp downturn that will come unless we are able to reverse some of the loss of activity we are seeing at present.

Q68 Mr Love: Could I press you on something you said there because a lot of commentators are characterising the Treasury's statement yesterday as being optimistic? Their suggestion that by the second half of 2009 we will be moving back into growth and that we will have significant growth in 2010, you are suggesting is not far away from what the Bank is currently seeing?

Mr King: It is very close to our -----

Q69 Mr Love: So you would not characterise it as being optimistic?

Mr King: I never use adjectives that other people put into my mouth to characterise anything. What I would say is that this is a central view but it is only a central view and the chances of it materialising in quite that way are very close to zero but there are risks on both sides. What we have stressed is that in setting policy you need to look at the balance of risks. That is why we feel that the very significant package of policy measures that has been taken which now spans monetary policy, fiscal policy and recapitalising the banking system, all of these are appropriate at this juncture, but in broad terms our forecast, allowing for all the probabilities, is close to that of the Treasury that was published yesterday.

Q70 Mr Love: Charlie, you would not disagree with that?

Mr Bean: No. The one thing I was also going to add earlier to what the Governor said was simply to note that we are not the only people who have markedly revised down our forecast since the summer. If you look at Consensus's forecast, that is, the average of outside forecasters, for growth in 2009, we have revised down our projection by about two percentage points for 2009; Consensus's forecast was revised down 1.8%, of which almost 1% is just in the last month. The IMF equally revised down markedly their projections for the UK about one percentage point between October and November and, similarly significantly, revised down the projections, it should be said, for other countries as well, so it reflects this fact that there has been a lot of news about economic prospects in the last two or three months.

Q71 Mr Love: Governor, I was intrigued by something you said earlier in response to a question by John Thurso in relation to a possible concordat to ensure lending rates were not pushed up. You said that you would not rule anything out. Does that include nationalisation of the banks?

Mr King: I think, given what we have seen, it would be an extremely brave person that would rule anything out. It is very unlikely to be the first option but remember that the Government now owns the majority holding of shares in more than one bank. The United States has just acquired a very significant stake in Citibank, the biggest bank in the world. These are not steps that anyone set out to think were good things they wanted to do in themselves but in times of financial crisis it would be a very serious error to rule out measures which may ultimately prove necessary.

Q72 Mr Love: Yesterday in his report Sir James Crosby suggested that there would be no net lending next year and suggested that there ought to be guarantees for mortgage-backed securities. The Chancellor seemed to welcome to that but said it might fall foul of state aid rules. What is your response to it?

Mr King: I think these proposals evolved out of an earlier report that he made when he was looking at the state of the housing market on its own. Since then we have put in place the credit guarantee scheme which is designed for a time limited period to give incentives to the banking system to make it possible for the banks to borrow money irrespective of which kind of lending they want to use that borrowing to fund. I think it would make sense now for the Chancellor - and I am sure he will do this - to reflect on how you would look at the Crosby scheme and the credit guarantee scheme together. It does not make sense to have two completely separate packages, so it would make sense to think how the credit guarantee scheme, which offers guarantees for unsecured borrowing, would fit with the Crosby proposals which offer guarantees for secured borrowing. They are different types of borrowing. The Crosby scheme is restricted to only one kind of lending. It is not obvious to me why you would want to discriminate in favour of mortgage lending as opposed to lending to small businesses, for example. It would be a big mistake to regenerate lots of lending for the housing market at the expense of crowding out lending to small businesses. What is most important now is to sit back and ask how these Crosby proposals would fit with the proposal for the credit guarantee scheme which I see as a broader based scheme which does not discriminate among different kinds of lending. The final point I would make on that is that the Crosby proposal is very specifically aimed at guaranteeing mortgage-backed securities. I am all in favour of finding ways of encouraging a sustainable rate of mortgage lending but I am not entirely confident that the best way to do this is to resurrect an instrument which, for rather good reasons, has fallen out of favour. It is quite striking that in the last two or three days some of the American rating agencies have made clear that they would not be very enthusiastic about giving high ratings to mortgage-backed securities unless a lot more information were provided about who the borrowers were behind those pieces of paper, and one can understand that. I think it is perfectly reasonable to set as an objective the wish to ensure an adequate flow of mortgage lending but the best way of doing that in present circumstances I think we need to look at and I am quite sure the Chancellor will take his time now to reflect on these proposals before coming back with an integrated an approach to this with the credit guarantee scheme.

Q73 Mr Love: The stock market has received news of the PBR and appears to like it. I know that you cannot give a considered reaction and you will in your next report, but have you had any opportunity to consider how the markets, particularly foreign exchange markets and bond markets, have responded to the PBR, and is there any evidence that they do not think it is either affordable or credible?

Mr King: Mr Love, I never cease to be surprised by the reactions of financial markets and I do not think my surprise is going to end today.

Q74 Chairman: Governor, we are coming to a close but can I ask you about the banking crisis? We are issuing our terms of reference today and they are quite extensive. You said you would look at issues other than the bank rate. I wonder, in light of the terms of reference we are going to produce, whether the Bank could have a look at that and come back to us and give us an idea of what further initiatives you are contemplating and maybe where we can go in the banking crisis inquiry.

Mr King: We will certainly do that. This is the last time we will come before you in 2008. I have lost count of how many times I have been here. It has been a -----

Q75 Chairman: I think it is six times.

Mr King: Eight times, I think. It has been a tumultuous year. I do not think anybody round this table anticipated we would be discussing these issues 18 months ago. It has been an extraordinary experience and the most important thing is that we learn the lessons from it. I think that your report on Northern Rock helped enormously in guiding the drawing of lessons on the resolution of individual banks. We have seen that in the Banking Bill. I am sure there is more to be done on that, but that is the first chunk. The second issue though, which I think is relevant to your new inquiry, is that, as I said earlier, I genuinely think that the use of bank rate or interest rates around the world has been successfully deployed in an inflation-targeting framework to maintain a balance between demand and supply, but what was missing was a range of policy instruments in what is called the macro-prudential area, not to do with individual banks but to do with the banking sector as a whole. I think that is the next area of work where both you and we, and indeed internationally our colleagues overseas, need to focus.

Q76 Chairman: I have certainly found the evidence this morning fascinating and I am grateful to all of you for coming along. Further to Mr Love's question, I cannot take it then that for "optimism" read "central forecast", can I?

Mr King: People often ask me should I not be giving everyone reassurance, and I say that I think what people want from a central bank is a reflective, calm analysis and an honest statement of the position, but a statement not just of where we are but of what we intend to do about it. I want to assure everybody that we will take whatever action we feel is necessary on interest rates to steer the economy back into calmer waters. With that may I wish you all a very happy and definitely peaceful Christmas.

Q77 Chairman: And, Governor, I can say to you that I do not envisage you coming back before the end of 2008.

Mr King: Thank you very much. I was hoping you could slip and say 2009.

Chairman: Okay, thanks very much.