UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 429 -i

House of COMMONS

MINUTES OF EVIDENCE

TAKEN BEFORE

TREASURY COMMITTEE

MAY 2010 INFLATION REPORT

Wednesday 28 July 2010

MR MERVYN KING, MR CHARLIE BEAN,

MR PAUL FISHER, MR DAVID MILES and MR ANDREW SENTANCE

Evidence heard in Public Questions 1 - 63

USE OF THE TRANSCRIPT

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

W B Gurney & Sons LLP, 10 Greycoat Place, London, SW1P 1SB

Telephone & Fax Number: 0207 960 6089

Oral Evidence

Taken before the Treasury Committee

on Wednesday 28 July 2010

Members present

Mr Andrew Tyrie, in the Chair

John Cryer

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andrew Love

John Mann

Mr George Mudie

Jesse Norman

David Rutley

John Thurso

Chuka Umunna

________________

Witnesses: Mr Mervyn King, Governor of the Bank of England, Mr Charlie Bean, Deputy Governor, Mr Paul Fisher, Executive Director, Markets, Mr David Miles, External Member of the Monetary Policy Committee and Mr Andrew Sentance, External Member of the Monetary Policy Committee, gave evidence.

Q1 Chair: We have quite a bit to do this morning, Governor, so I would like to crack straight on. I notice you have an opening statement you would like to make and if you do not mind I would like you to make a start.

Mr King: May I first congratulate you, Chairman and all members of the Committee on your election. I very much hope that our sessions together will prove constructive. I am particularly grateful to the Committee for allowing this session to take place today so that earlier this week I was able to attend a meeting in Basel of central bank governors and heads of supervision that took a further step forward towards a new global Basel III deal for capital and liquidity requirements on banks. In the years ahead such stronger capital and liquidity standards will help to ensure our financial system is more robust leaving it less likely to succumb to a crisis. In Basle we reaffirmed our collective view that it is important to implement the new standards over a long transition period because bank balance sheets are still recovering from the current crisis and we need banks to be able to expand their lending in order to support the wider economy before they are required to meet the new standards. The gradual improvement in credit conditions that was evident earlier in the year seems to have come to a halt in recent months and financial markets have generally been more volatile. In part that is because continuing concerns about the ability of some countries to achieve necessary fiscal consolidation are affecting confidence in the ability of their banks to repair their balance sheets. More fundamentally, the key underlying causes of the crisis in terms of the imbalances in global demand have still not been tackled. Those imbalances are likely to be larger this year than last and will probably still be around threequarters of their level at the peak immediately prior to the crisis. Until these underlying problems are resolved uncertainty about the outlook for the world economy will remain. Last week we learned of the strong 1.1% estimate of GDP growth in the second quarter. On the face of it that is encouraging, but we must be careful not to read too much into one number. The wider economic problems around the world underline the fact that we cannot be confident that the recovery in demand, output and employment here in the UK will be sustained. We continue to face the challenge of rebalancing our economy away from consumption towards net exports and raising our national savings rate. During the rebalancing there is a risk that the level of money spending in the UK will remain weak with the economy operating below capacity. That would push down on inflation potentially to a rate that is significantly below the 2% target. But there are also risks on the upside. CPI inflation is currently above the target at 3.2% and it has been high for much of the past four years. Given the changes to VAT announced in the Budget it is likely that inflation will remain above target for much of next year. If this high inflation were to become ingrained in inflation expectations it would be difficult to bring inflation back down again. The MPC faces a difficult challenge in balancing those risks. To do so we judged that at present it is right to keep our foot firmly on the monetary accelerator. As you would expect, there is a debate about quite how hard we should be pressing on the accelerator. In the months ahead it may be that the MPC judges that the inflation outlook warrants pushing down even harder or that we should ease back somewhat. The debate is about the appropriate degree of stimulus not about applying the brakes. Of course, there will come a point when we will certainly need to ease off the accelerator and return bank rate to more normal levels. I look forward to that time because it will probably be a signal that there is a smoother drive ahead with the economic outlook improving in a durable way, but I fear there is some considerable distance to travel before we can begin to use the word "normal" again. With that, Chairman, the other members of the MPC here today and I stand ready to answer your questions.

Q2 Chair: Governor, I am very grateful to you for giving us advance sight of this statement which I read 20 minutes ago and I did, I have to say, find a little of it elliptical when I first read it but you have added a word which was not in this statement which already brings some clarification. You said when you read out the statement: "It is right to keep our foot firmly on the monetary accelerator." The word "monetary" is not in the text in front of me. I take it that is a reference to interest rates?

Mr King: Interest rates and/or quantitative easing or asset purchases, ie, the instruments under the control of the Bank of England.

Q3 Chair: So you are arguing that we may need further measures and that you would not exclude the possibility of deploying further measures in addition to the ½% interest rates that we have got which of course are at historically low levels?

Mr King: I am arguing that we have room to use monetary policy in either direction. I do not want to prejudge where it will need to go. Our view so far has been that we have not needed to move in either direction but we are prepared to do so in either direction as seems appropriate.

Q4 Chair: If I may broaden this discussion to Andrew Sentance, do I take it that your view is that we should lift our foot a little from the accelerator?

Mr Sentance: Yes, I think that would be my view.

Q5 Chair: Would you explain "a little"?

Mr Sentance: My view is based on a number of things. Firstly, I see the policy settings we have got at the moment as quite extreme and providing quite a strong stimulus to the economy, and that was exactly the right thing to do when we put in place those policy settings, particularly over the middle of last year. Since then I think four things have changed and they cause me to want to reassess, in the Governor’s words, how hard we need to have our foot to the floor in terms of the monetary accelerator. Firstly, the international economy has turned round and has performed much more strongly than forecasts were suggesting in the middle of last year. International recovery is uneven and it is stronger in Asian emerging markets than it is in Europe but it is certainly, in terms of the pace of recovery, much stronger, say, than the IMS were forecasting a year ago. The UK economy has turned round and measures of nominal demand have picked up particularly strongly so that they are growing at about 6% annualised rate. We saw the Q2 figures to which the Governor referred. In my mind those confirm evidence that has been coming at us from business surveys and other sources for some time. The last two major business surveys we had from the British Chambers of Commerce and the CBI’s quarterly Industrial Trends Survey had some quite strong indicators. Thirdly, the amount of spare capacity that is in the economy is less on various measures, including the level of unemployment but also measures of capacity utilisation, than we were expecting a year ago. Fourthly, the performance of inflation and the inflation outlook has not been the way that we anticipated last year when we were putting in place the policy settings so we have seen inflation run much higher than we thought and probably expected to do so.

Q6 Chair: I would be very grateful if David Miles could comment on that.

Mr Miles: We remain in a pretty difficult situation with monetary policy and, as the Governor said, there are two risks and they are both big risks. The first is that with inflation having been above the target for an uncomfortably long time now it may become ingrained in people’s expectations and be difficult to bring down. On the other side there is a risk that the growth which we have seen might dwindle, peter out, the amount of slack in the economy may not fall back and underlying inflation pressures may fall to a level that takes inflation beneath the target. I think those are two large risks. It is difficult to set monetary policy when there are such offsetting risks. My own judgment remains that I think the most likely outcome is that inflation, looking through temporary factors such as the rise in VAT which comes through next year, will fall back to the target level and I think on balance keeping monetary policy at its current very expansionary setting is the right thing for now.

Q7 Chair: But you are not favouring further loosening and you have not advocated that?

Mr Miles: No. So far this year I have voted to keep the interest rate where it is pretty much at its floor and the stock of asset purchases at £200 billion. I think that just about balances those two risks in my mind.

Q8 Chair: So there is a balance of risk on either side but your Committee appears slightly inclined towards some tightening?

Mr King: It is a very difficult judgment. I agree with everything that Andrew said. I think there are other factors that David pointed to which have led a majority of Committee members to make no change so far and this is something we review at each meeting. We do not need to set policy in advance and we do not. We will come back to it at our next meeting. Clearly it is a fine balance of risks.

Q9 Chair: Do you think that the Budget made the risk of a double dip recession more likely?

Mr King: The Committee does not assess the impact of any one measure so I do not think I can answer that for the Committee. In my view, I do not think it made a significant difference. The aim of it was to try to deal with some of the downside risks that might have arisen had we not set out a mediumterm plan to eliminate the structural deficit. There are clearly risks facing the world economy and I think as far as the UK is concerned the biggest risks that we face are those coming from outside. I think in particular the conditions are in place, to use that hackneyed phrase, for a rebalancing of the UK economy but we do need a prosperous euro area for the fall in the effective exchange rate of sterling to be able to lead to an increase in exports.

Q10 Chair: I was just asking you for your view, Governor, whether you felt that it was made slightly more likely or not at all more likely.

Mr King: I do not think it made a significant difference to whether or not we will get what is technically called a double dip recession, no.

Chair: It made no difference, okay. Chuka Umunna?

Q11 Chuka Umunna: Obviously since you last appeared before this Committee, Governor, there has been a change in Government and I think it was on 20 May that there was a full Coalition Agreement between the two Coalition partners. That meant one of the Coalition parties, the Liberal Democrats, substantially changing their economic policy from that which they had been campaigning on. Around 14 May the Deputy Prime Minister met with you and he said of this meeting with you, in The Observer on 6 June, that you had a long conversation that caused him to change his mind on the pace and how deep fiscal consolidation should be. It might help if I just quote. He said in relation to you: "He couldn’t have been more emphatic. He said if you don’t do this then because of the deterioration of market conditions it will be even more painful to do it later." What did you say to the Deputy Prime Minister then about your views on the deficit that were not already in the public domain?

Mr King: I said nothing that was not already in the public domain. If I can go back to the sequence of events, I cannot remember the numbers of the dates but the election was on a Thursday, the results on a Friday, and over that weekend then there was obviously the European saga where the previous Chancellor Alistair Darling, who remained Chancellor, went to Brussels and led the discussions on behalf of the United Kingdom. Then we went through the following week. On the Wednesday there was the Inflation Report press conference. That is when I made a public comment in response to an open request from the new Government to comment publicly on the fiscal position, so I commented publicly at the Inflation Report press conference. The following Saturday, three days later, I had a telephone conversation with the Deputy Prime Minister. There was no meeting. I had a telephone conversation at which I basically repeated what I had said in the press conference.

Q12 Chuka Umunna: So your position had not particularly changed publicly?

Mr King: Between the Wednesday and the Saturday? No, not at all.

Q13 Chuka Umunna: Did you feel comfortable being drawn into essentially what were very politically sensitive matters around this time and do you feel comfortable with the Deputy Prime Minister citing this conversation with you as one of the primary factors causing him to change his position on what is essentially a fiscal as opposed to a monetary matter?

Mr King: I do not think central bankers ever feel comfortable when they are drawn into comments made by politicians but on this occasion the Government had asked openly in writing for me to express my views in public, which I did at the Inflation Report press conference. I was asked if I would accept a telephone call from the Deputy Prime Minister on the Saturday morning. I think it would have been unreasonable not to have accepted that telephone call and I did so and I had a private conversation.

Q14 Chuka Umunna: Did you feel that you were used in any way?

Mr King: No, I do not think so. There was nothing I said in that conversation that was different from what I said in public. Indeed, when giving advice I try to make sure the advice I give is foursquare in private and in public, and it clearly was on this occasion.

Q15 Chuka Umunna: Can I move on and ask a bit about labour demand. There has been a lot of debate about the figures that the OBR have put out, in particular in relation to their estimate of the private sector’s ability to create jobs as the public sector retrenches. I suppose depending from where you take your figures they foresee the private sector being able to create at least two million jobs. Do you think the OBR forecasts on job creation are sufficiently cautious?

Mr King: There are two parts to this; there is the impact on public sector employment and then on overall employment. On public sector employment, to be honest, we take our figures from the OBR because they are in a much better position than we are to judge figures for the public expenditure totals that would be available and the pay levels that will be made in the public sector, so the employment in the public sector is something that we would take from the OBR. What that means for the private sector depends on one’s overall macroeconomic judgment and that is one that we will reach in our forecast to be published on 12 August. We have not made that judgment yet. We will be working towards our overall view on the economy. I do not think I can comment on what is likely to be the outcome for the labour market as a whole.

Q16 Chuka Umunna: I suppose my final question is this: if growth is more sluggish than expected how do you think the Government should respond? Do you think they should stick with their current programme for fiscal consolidation if growth is more sluggish?

Mr King: It depends on how sluggish it is. The first response would be that the automatic stabilisers will clearly mean that the path of the actual deficit will reflect how strong or weak growth is. If growth is sluggish relative to the central projection in the OBR forecast on which the fiscal tightening path was predicated then the deficit would obviously narrow more slowly than that central plan. Conversely, if growth is stronger the deficit will narrow more quickly. That is the first degree of flexibility. The second is, and I think it is for us as the Monetary Policy Committee to respond, because if the outlook is either stronger or weaker than we had expected when making our policy decisions then other things being equal (of course in practice they never are) that would lead to an inflation outturn which we would expect to be either stronger or weaker than in our previous judgment and we would expect to make a policy adjustment for that. Once the automatic stabilisers and monetary policy have responded, if the degree of sluggishness is extreme then of course it is perfectly open to the Government to change the path on which it is planning to move. I think the most important point about the fiscal tightening was to have a path out there which demonstrated a clearly specified way in which we would get to a point where the ratio of debt to GDP would begin to start falling back. Even under the current plan the ratio of debt to GDP goes on rising right the way through this parliament until the end of it. It is very important to demonstrate not just to financial markets but to all agents in the economy that there is a plan under which at some point the ratio of debt to GDP will begin to fall back.

Q17 Andrea Leadsom: I would like to probe a bit more about quantitative easing because it is something that until a couple of years ago was pretty much confined to history books and we had very little experience of it, ever. Particularly Mr Fisher, you said that it was a very difficult decision when to stop adding to the QE proposal at £200 billion. What interests me is as Director of Markets what concerns do you have around QE as a proposition in itself? Do you worry that there is so little historical precedent to be able to evaluate the impact of QE on inflation? What makes you say it was such a very difficult decision when to stop?

Mr Fisher: You are quite right, it is the lack of track record and experience which is very much something which is in the textbooks as a tool for monetary policy and which we should be using but we had never done it before. Personally, I had never been involved in such an exercise. There was no doubt about the direction of the effects of QE but there was a question about the magnitude of the effects and it could work through a range of channels and trying to assess which of those channels it would work through and what the quantities would be in each of those channels was quite a complex thing to do. Then you get to a point and the decision is it 200 that you need to do or is it 220 or is it 180, and that is tricky. In fact, it is not actually that much more difficult than changing interest rates. When you change interest rates you do not know precisely which channels that is going to work through most and which it is going to affect and you are never quite sure whether you need to start at 5.5% or 6% if you are increasing interest rates, so it is similar sort of issues and uncertainty but you are doing something which you have not done before so you have not quite got the historic experience with which to calibrate it.

Q18 Andrea Leadsom: How will you unwind it and what are the prospective impacts on the economy of unwinding the QE programme?

Mr Fisher: You start from the expectation that it would be symmetric that the effects would unwind. It may not be exactly but that will be the starting point. As the Governor said in his Mansion House speech, we are setting up a process for when it comes to the point of tightening policy we would expect interest rates to be changed first and then we would announce a programme of sales of the assets to take place some time shortly after that over a period of time to give the market some certainty of the pace at which we would sell off the assets.

Q19 Andrea Leadsom: Presumably that is regardless of the impact on the public purse whether it is profits or losses that are gained as a result?

Mr Fisher: I do not think we are completely indifferent to the public purse in the following sense: that the Government’s debt market is very important to the UK economy and we would not want to do something which caused unnecessary volatility to the gilts market, so we will be conscious of that and we will be talking very closely with the Debt Management Office about exactly how the gilts are sold back. The impact on the economy comes primarily through the impact of QE itself and the benefits that has to generating the right level of inflation for the economy consistent with the target rather than from the notional gains or losses on the actual gilt sales themselves.

Q20 Andrea Leadsom: Yes, sure. Governor, are you concerned about the lack of specific parliamentary scrutiny over this enormous and costly programme which is essentially an experiment that we have undertaken in our economy?

Mr King: No. There is a great deal of scrutiny by you. We come to you and you can quiz us on any aspect of this.

Q21 Andrea Leadsom: But not in the sense of your actions, not in the sense of the commitment you are making to the public purse, the potential profits and losses and so on?

Mr King: I think there is a misunderstanding about the nature of profit and loss. When we buy government bonds, the bonds are an asset in the Bank of England’s balance sheet and a liability on the Treasury’s balance sheet. I think the taxpayer should look at the combined effect of those two taken together; they wipe each other out. At one level this is a perfectly standard monetary operation. We are injecting money into the economy. It is unusual and unfamiliar because for most of the postWar period central banks have spent their time trying to reduce the rate at which money was growing in order to prevent inflation rising. This is the opposite to that. We are trying to prevent inflation from falling too far by injecting money into the economy. That is what it is about; it is a monetary policy operation. I would say two things. One is there clearly has to be scrutiny to ensure that the assets are handled properly within the Bank of England and that we do not lose them. We have a very strong Audit Committee of professional outside people who are the nonexecutive directors of the bank. They take their duties very seriously. We have outside auditors in addition so there is a very clear scrutiny process for how these are actually managed. In terms of the policy judgments I really think that is for you to hold us to account. If I may say so, we have been held to account by your predecessors on this and no doubt you will be in future.

Q22 Jesse Norman: Just to follow up on that question, do you think that either through the operation of quantitative easing or through the expectations that that creates the danger of stoking up longterm inflationary pressures in the economy?

Mr King: With any monetary policy action if you go too far there is a risk that you will generate higher inflationary expectations and that will lead to higher inflation. That is why it comes back to the overall judgment of the stance of monetary policy. Our view so far has been that these quite extraordinary actions were necessary in the face of a very big deflationary shock hitting the economy and, in particular, the very substantial contraction of the balance sheet of the banking sector which was itself pulling down the growth of broad money in the economy. I think I would be more concerned with it if I felt there were a sign that the amount of money in the economy was growing at a rate that threatened our mediumterm inflation outlook, and I do not think that is the case. However, we are prepared to adjust the monetary stance in any month in order to keep that mediumterm inflationary outlook in line with our target.

Q23 Jesse Norman: Is there a danger of a risk on two sides? One is that you leave quantitative easing in place for a while because to withdraw it would have potential adverse effects on the economy in the way that was hinted at by Mr Fisher but to leave it in place would be to continue to encourage inflationary expectations?

Mr King: No, I do not think so. I think inflationary expectations will reflect the overall stance of monetary policy taking bank rate and the stock of assets together. The reason why we would begin with bank rate and then move on to a programme of asset sales is because we do not think it would be sensible to make discretionary decisions on the level of asset sales monthbymonth £30 million this month compared to £127 million next month. When it comes to selling assets we must ensure that for the successful operations of the Debt Management Office they know the programme of sales that we want to make, but we should not begin these sales until we are in a position where we are fairly confident that we want to embark on this degree of tightening over, say, the following six months, so we would have a programme of pre-announced sales, say, over a six month period. That is the way in which we would envisage the sales whereas bank rate is an instrument where everyone is used to there being changes up and down from month to month.

Q24 Jesse Norman: On a different topic, are you happy with the policy of the bank levy that has been imposed? Is that too high and therefore potentially undermining bank lending activity or do you think there is scope for it to be raised?

Mr King: I think that is a matter for you and the Chancellor to debate. That is a tax matter;, not for the Bank of England.

Q25 Jesse Norman: It obviously has an effect on bank behaviour and therefore on monetary policy.

Mr King: I would say the principle of the bank levy as a medium to longterm instrument seems to me sensible because what it is trying to do is to provide an incentive for banks to use fewer of the risky kinds of finance that got us into trouble and to rely more on the longterm sources of funding which provide stability to the banking sector’s balance sheet. It is one of many instruments. There is a whole programme of reform underway to try to shift the risks the banks are taking; this is one of them.

Q26 Jesse Norman: One final question really for the two independent economists, if I may, about house inflation. Do you think that the country is addicted to house inflation? Should it be an aim of government policy to be moving us away from a situation in which so much saving and so much reliance is placed on house inflation?

Mr Miles: I think there is a problem in trying to change the target of the Bank of England to include a wider range of asset prices in general, but I think there is one point about house prices which is that it makes sense that some element of house price changes should enter a measure of consumer prices. "Anomaly" may not be quite the right word but the CPI measure we use at the moment does not really reflect the costs to owner-occupiers of housing which is a substantial cost in people’s overall cost of living.

Q27 Jesse Norman: That is quite a serious technical defect in some respects, is it not, when you think of how much reliance is placed by consumers’ own behaviour on their house values?

Mr Miles: I think it would be an improvement ultimately to have a measure of the costs of owner occupied housing entered into the measured level of prices that the Bank of England targets.

Mr Sentance: I am quite cautious about the way in which we might do this if we are going to bring owner-occupied house prices into the inflation measure. The way in which you do it is quite important. Housing is an investment activity as well as a consumption activity and you have to get the balance right. I have been quite surprised by how much house prices have bounced back last year and so when we see house prices flattening off now that is not altogether surprising. The surprising thing is that they bounced back so strongly last year.

Q28 Mark Garnier: I want to talk about interest rates and a lot of what we have been talking about recently. Governor, getting back to something you said in response to the Chairman’s earlier questions when you said you saw QE very much as one of the tools of the MPC and you have talked a great deal about how it affects money supply. However, what there has not been a great deal of conversation about is how it affects interest rates and the bond market. Clearly with £200 billion-worth of bond portfolio, of which, if I remember rightly, £150 billion is UK gilts, your interventions either one way or the other is going to have a direct effect on bond yields and that are going to have an effect on business, and it is going to have an effect on the ability of the Government to raise money. Can you talk a little bit about how you see your interventions using QE as affecting interest rates in addition to your setting of interest rates with the bank rate?

Mr King: Yes, I think that the initial immediate impact of our asset purchases is to increase the amount of broad money in the economy. How that affects the economy goes through a variety of channels. It can lower the yields on a variety of assets. It can raise asset prices as those who have got the money and who sold assets to us diversify into other assets. They might, for example, be buying corporate bonds which would lower the yield on those bonds hence lowering the required rate of return on companies financing themselves and stimulating investment. In terms of longterm interest rates what I would expect is through our activities in buying bonds, when we would be raising the price and lowering the level of longterm interest rates, this can be seen as a natural counterpart to the impact of lowering shortterm interest rates through changing the level of bank rate. It has probably affected the yield curve further along the maturity spectrum than conventional monetary policy actions would have implied. Quite how much and how far is hard to judge. We have just published a working paper on this which contains some attempt to estimate the importance of this, but these are bound to be very uncertain estimates. It is out there for people to read if they want to look at it. One way asset purchase would work is to lower longterm interest rates. That would affect a whole variety of financing costs which depend ultimately on the level of longterm interest rates in the market.

Q29 Mark Garnier: Sure. Interest rates are of course incredibly important to millions and millions of householders out there and I am interested in the two comments from David Miles and Andrew Sentance about using house asset prices in the measure of inflation. I was very interested years ago when they moved from RPIX to the CPI which took out house prices. There is £4.2 trillion of personal debt out there of which £1.2 trillion is mortgages. Interest rates are incredibly important for millions and millions of householders out there. How concerned are you about the sensitivity of households to rising interest rates?

Mr King: I think one of the things we should draw great comfort from in this recession as compared say to the early 1990s is that households by and large have been able to service their mortgages in a way which was more difficult in the early 1990s when interest rates went up to very high levels. It is very striking the contrast with the United States that in this downturn, which is far and away the biggest downturn we have experienced since the Great Depression, the level of mortgage repossessions and mortgage defaults is not only much lower than it was in the early 1990s but is actually at present falling. I think that is because this downturn has been accompanied by a fall in interest rates as we responded to it rather than was generated by a massive rise in interest rates which resulted from a failure to control inflation before the downturn.

Q30 Mark Garnier: One of the interesting dynamics of the last 10 to 15 years is this tendency for households to opt more for interestonly mortgages as opposed to repayment mortgages which are perhaps more traditional for the older generation. People are not saving in terms of buying their house and paying off their mortgages. We are going to see people in a few years’ time retiring still with quite substantial mortgages on interestonly mortgages. Do you see this as a problem for the future?

Mr King: That is hard to judge without talking about all other aspects of personal savings and finance and, in particular, how it links to people’s expectations of pension income. I certainly do think that the issue as a whole, which is are households planning and will they be able to build up a level of savings appropriate to the length of time which is reasonable to expect them to be in retirement, is a very big question, but the decision about what you do on your mortgage cannot really be determined in isolation from your expectation of how long you expect to go on working, what pension you expect to receive in that period, and I think you need to look at them in the round. It is a big question because there is no doubt that one of the problems in this area is that you cannot try it and if you get it wrong do it again. It is not like buying something and if you do not like it buying something different the next week. These decisions about pensions and mortgage finance are ones that people are stuck with for a very long time. It is certainly a big question but I do not think it can be answered satisfactorily by looking only at the nature of mortgage finance.

Q31 Mark Garnier: My final question talks about business investment. Clearly business investment is going to be very crucial to rebalancing the economy which is important and obviously interest rates are very important within that, et cetera, but when you look at smaller businesses, no matter what the banks say, the evidence on the ground is that small businesses are still finding it incredibly difficult to get hold of financing, to get loans, overdrafts, whatever it is. Do you see first of all any impact in this blockage of the banking system at a lower level? Secondly, to what extent do you think that is going to affect the recovery of the private sector of the economy?

Mr King: I accept your description of the state of access to credit. I think it is a particular problem for SMEs. This downturn was driven by investment, a very sharp 20% fall in investment, unlike the 1990s where the downturn was driven by consumption. There is no doubt that this is in part because of the difficulties which the banking sector has in trying to reduce their balance sheets quickly in order to improve their capital positions. They are reducing both sides of their balance sheets. That is bound to restrict lending. Much of that has occurred in lending to the financial sector but there has also been a spillover knockon effect on restricting lending to the private sector. Large companies have been able to deal with this in part by issuing bonds or equity to the market as a whole; in other words they have been able to go round the banking system. Indeed, many companies are in better financial shape than the banks from which they were used to borrowing. It is a particular difficulty for those small and mediumsized enterprises for whom there is no real easy alternative than to go through the banking system. How far this will slow the recovery is a moot point. The work that we have looked at suggests that in the past a sluggish growth of credit is not an impediment to recovery in part because such a large proportion of the total investment is carried out by big companies. I do not think it is something that we should think of as a major concern about recovery as a whole but it is something we should worry about in terms of what it means for those small and mediumsized enterprises that are finding it difficult because if their competitive position is undermined then that will have effects that we really will notice in years to come and I think it is therefore quite a significant policy challenge.

Q32 Mr Love: Governor, what are we to make of the fact that last week in an article in the Financial Times the President of the European Central Bank rather trenchantly called for fiscal tightening the day after the Chairman of the Federal Reserve had said that shortterm fiscal support was necessary? Is that just the peculiar circumstances being different in Europe and in America, is it the unusually uncertain times in which we live or is it something much deeper?

Mr King: I think you have touched on exactly the two reasons. The positions in Europe and North America are very different. In Europe there are clearly many sovereign states that do not have the luxury of the United States, which has the ability to borrow from the rest of the world for a much longer period than other countries before markets start to question how safe it is to allow the level of debt to rise, so I think there is a real difference between them. There is also a real difference in terms of uncertainty. I think however that what is very clear, and all central governors agree on this, and both Chairman Bernanke and President Trichet have made this point is that all countries need to have a credible mediumterm plan within which they can demonstrate that they will get back to a position in which structural deficits are eliminated and there is a sustainable path for the longterm public finances. There is plenty of room for debate about over what period you spell out that path but not spelling it out is, I think, a problem.

Q33 Mr Love: I would like to press you on something that the Chairman asked earlier and it is really to find out who your Mr Trichet is and who your Ben Bernanke is in the Monetary Policy Committee because I was very struck in the minutes of the Monetary Policy Committee that although it was not put to a vote you did go so far as to say "a further modest monetary stimulus would act to offset …" which seems to me to be flagging it up, if I may say so, without actually voting on it and therefore I assume that there is a trend of opinion amongst some Monetary Policy Committee members that this may be an action necessary to take. Would I be right?

Mr King: No. Obviously Andrew has suggested that he feels that now is the time to ease gently off the accelerator but still maintain a high degree of monetary stimulus. The rest of the Committee so far have decided neither to expand the stimulus nor to withdraw it. That has been our position so far. Whether it will be true at the next meeting or subsequent meetings time will tell. We have not made up our minds yet. The Monetary Policy Committee has never played the game of trying to signal in coded language what it has already decided to do at a subsequent meeting. That simply is not the way we behave.

Q34 Mr Love: Could I ask Mr Miles, whilst I accept what you said earlier about you did not think that it was appropriate to have a vote on the matter, would it be right to say that you have certainly raised those concerns at the Monetary Policy Committee?

Mr Miles: I think we are all aware, to be honest, on the Monetary Policy Committee that there are big risks on either side of the most likely outcome as a central forecast and some of those risks, if they were to crystallize, if demand were to become much weaker, inflation pressures were to drop off very substantially, would mean that it would be appropriate, I think, to loosen monetary policy, but they are risks. I do not think that is where we are at the moment. That is why I voted as I did in the last meeting.

Q35 Mr Love: I was struck by something Mr Trichet wrote in his article in the press giving a reason why fiscal consolidation was necessary and I will quote it: "In extraordinary times, the economy may be close to nonlinear phenomena such as a rapid deterioration of confidence among broad constituencies of households, enterprises, savers and investors. My understanding is that an overwhelming majority of industrial countries are now in those uncharted waters, where confidence is potentially at stake." Do you recognise that in the UK?

Mr King: I think it is fair to say that we are all in uncharted waters.

Q36 Mr Love: Would you go as far as to say confidence is potentially at stake?

Mr King: I think where business confidence and consumer confidence will go is uncertain. I do not think I would have used the same form of words but then no two individuals ever would. I certainly share the view that we are in uncharted waters and there is uncertainty about where confidence will go. The key point behind this is a point that Professor Rogoth made and one that was brought home so vividly in the weekend immediately after the general election here (coincidence as it turned out) and that is if Greece had taken action a lot earlier it almost certainly would not have been required to do as much as it had to do in the end. That is sad and unfortunate but I think it is true and I think therefore the risk is to get behind the perception that you are on top of fiscal issues. I think people looked at the UK and said in the real world we do not expect to see many convincing statements about fiscal policy before the election but afterwards we do expect to see something, whatever the result of the election. I think that we were given that grace and that opportunity but after the election it was clear that markets were looking for action to spell out, not immediately (and there are no proposals immediately to eliminate the deficit) but gradually over a period of time to get back to a point where it was possible to say that on a plausible central view as judged by the OBR that the ratio of debt to GDP would begin to fall back again. I think that is a sensible position to aim toward and I think that general strategy applies to all countries.

Q37 Mr Mudie: Governor, I would like to take you back to the answer you gave to Mark on bank lending to businesses. You particularly highlighted the small and mediumsized businesses. In my city the three big employers are probably all in the public sector - the hospital, the council, the universities - and the majority of employment elsewhere is in small and mediumsized businesses. I note in your report that you accept the weakness of bank lending in the past year. I note in your report you are saying there is uncertainty about future supply and the price of credit in the future. Am I being unfair in saying, or do you share my disappointment that this seems to be only reporting a situation and being almost fatalistic about it? Are we waiting for the market to sort it or is there anything you should be doing or the Government could do  and the same applies to you "could do" to actually get this going because if we are going to rebalance the economy this is a key part of the rebalancing of the economy. If we are going to lose public sector jobs and have them move across to that sector of the economy it is important we get the investment, and the banks clearly are not playing their part.

Mr King: I share your concern. I think you have put it very, very clearly. I do share that concern. I do not think there is a monetary response that we can make that helps the particular challenges facing the small and mediumsized enterprises; it is a matter for government. Overall we can provide a degree of monetary stimulus which helps in aggregate and that is exactly what we have been doing. As you point out, while the banks are restructuring there is a real adjustment going on which monetary cannot influence. The banks will have to adjust their balance sheets. I think there are two things to be said about that. Firstly, and it is something that we have stressed in this debate on Basel III, we think it is sensible to bring the new capital requirements in only with a fairly long transition period. I do not think we should weaken the standards that banks have to reach at the end of it but I do not think it makes sense to push banks to adjust too quickly. That will then make it more likely that they will be able to finance lending. The points that I have made to the Government, and I think it is for them to think about it, and they have issued a consultation document and we will see what comes out of that, are, one, and this is true of our publications in general, at a time when banks feel the need to slow their balance sheet growth and to build up capital, paying out large amounts in dividends or compensation to employees is neither helping lending nor getting them to a point where their balance sheets are stronger. It would seem to me it would be better for all concerned if there was less emphasis on distribution, whether in dividends or compensation, and more on building up the balance sheets so the banks will be able to get back to a point where they were again willing to lend on reasonable terms.

Q38 Mr Mudie: When we were in the middle of helping the banks survive, I was under the impression that we signed an agreement with the banks that they would lend at given levels. I was always sceptical about this and I think the Committee were sceptical about it and when we pressed the banks they said they were doing it and when we pressed the Government they said they were sure the banks were doing it. It was clear there was an agreement signed but nobody knew what the hell was in the agreement. They were too busy with other things. Do these agreements exist? Is there scrutiny? Does your organisation have any part in the scrutiny or any knowledge of the scrutiny because if we have rescued these banks and put a great deal of taxpayers’ money in them and we ask them to do one particular thing and it is clear that it is not happening to the extent that you and I would like, and it is affecting people out there in the street, is there a way that we can actually put some pressure on the banks not out of goodwill but out of an agreement they signed to do something about this?

Mr King: You are certainly right that the agreements were not effective in achieving the objective that was set out for them and, in particular, the agreements which, as far as I can see, are now specified in terms of gross lending, are not going to be effective because what matters is net lending, so I do not think the agreements are being effective. What can we do? We have to understand the pressure that the banks are under. I do not think the banks are deliberately trying to be difficult. Banks have weak balance sheets which means it is expensive for them to borrow money in order for them to lend on. I think we need to understand that the banks do need to improve their balance sheets. That is one thing. I also think we should try to encourage new entrants into the banking system because they will not have the same problems of legacy balance sheet difficulties. I think we should try to explore new ways of transferring savings to investment by going round the banking system. In the long run that would increase competition to the banking system which is desperately necessary. There is plenty of scope for a range of longterm reforms. In the short run it is very difficult. As I have said before to this Committee I think, my own view is that in the short run if you want to achieve anything then the only instrument at the disposal of the Government is to ask itself what is the role of stateowned banks. We have one bank which is 84% owned by the taxpayer and another which is roughly halfowned. They are in private management and they are behaving, understandably because that is the instructions they have been given, in a way to try to shrink their balance sheets. If we do not want that to happen and if we want to use the state ownership then there would be a way of doing it. It is not without cost and it may well affect the way people see these banks in the long run. I think that is the only other instrument I can imagine. Otherwise I think we need a panoply of instruments and to put them together, a range of things to encourage new entrants into banking, to encourage competition to the banking sector as well as within it, and to think of new instruments whereby the Government might be able to offer support to the SME sector. I have great sympathy with the point that you make because we do need a rebalancing and that rebalancing will require in the end a shift of jobs from the public sector to the private sector to those small and mediumsized companies that are going to be providing the investment and exports upon which our economy will depend.

Q39 Chair: There is strong support round this table for increased competition in the banking system and, as you know, we are beginning an investigation into that shortly. You said that the only instrument available to the government apart from treating stateowned banks differently was to act on them. Therefore presumably you are ruling out the threat of a profits tax as an alternative route?

Mr King: It is not for me to comment on that at all. That really is a fiscal matter for you to take up with the Government.

Q40 Chair: So there are other instruments but that is the only one you think useful.

Mr King: I do not persuade or encourage the banks to change their judgments about the amount of money which they are willing to lend at present. I think when it comes to analysis of taxes I am happy to leave it to you to pursue.

Q41 David Rutley: Not only is there support for increased competition, just going to the point, there is also a lot of support around the table to ensure that banks do the job they set out to do, to lend to SMEs, so I am going to return to that theme. George made some passionate points along with Mark. The thing that worries me is that it is not only about gaining access to new funds; increasingly, as I speak to people in my constituency more generally it is the existing client relationships that have been in place for decades which are now coming under scrutiny. The screws are being turned very hard often without any notice at all and we are all agreeing violently around the table that this is a concern for new funding; do you share the concern as well about existing relationships?

Mr King: Absolutely. Every month I try to get out of London and go to a part of the country and see what is happening. I meet many people who run small and mediumsized enterprises and the thing that really makes them angry is that having built up a business, often over many generations, where they have tried to establish the idea of longterm relationships not just with their workforce but with other companies with which they deal, and they have had the same banking relationship for 60 or 80 years, then suddenly out of the blue comes a letter churned out by a computer which says "the terms of our relationship have changed" and they simply do not think that that is a sensible and fair way to operate the relationship. I see many of these. For the banks to say there is no demand for credit is not an adequate response to what is happening. I understand the problems banks face. They are facing problems because, frankly, their balance sheets have been in a mess and they are having to adjust. We should not stop them adjusting, they have to adjust, but I think they need to understand what is being done to client relationships. The only way that we can respond to it is not to prevent those banks that need to adjust from adjusting but to make sure that we find ways of encouraging new banks and new sources of finance that will pose a competitive threat to those banks. If people want to jeopardise client relationships they will just lose business. We have to make sure there are other sources to which those SMEs can turn for finance. It is heartbreaking sometimes. It is a lot harder to run a business out there than it is to sit in London and trade away and make what appear to be millions one day and minus millions the next. It is a very tough job to build up these businesses and I do think that we need a pattern of finance that respects the need for those longer term relationships.

Q42 David Rutley: I agree it is heartbreaking but I think we do need to call for some sort of action. The conversation we will have later on about regulation may help but while we are sticking on this particular situation, is there any evidence base that can be brought together or data that would help support the issue and, if it is difficult for you to put any instruments in place or any regulation, just having some transparent evidence of what is going on can help shame the banks into understanding and the public to understand the situation to put moral pressure on the banks to do this?

Mr King: You get letters from your constituents and your contacts and you could put them all together and talk about it, but to go to the structure of it, what can we actually do, I think increasing competition within the banking sector, promoting new entry, thinking of alternative sources of finance, these are things where if there are impediments in the current regulatory system that apply then we should do our best to try to find our way through it so new banks can start quickly and get going.

Q43 Stewart Hosie: Paul, I think these are really questions for you in terms of economic growth and what happens next. Is there a clear pattern now in terms of emerging economies growing more quickly with the more developed economies being more sluggish? Is it as simple as that? Where is the shape of the world economy just now?

Mr Fisher: You would expect always an emerging market economy, a less developed economy to be growing more quickly in a phase of catching up, with faster productivity growth in countries in Asia and Latin America for example. That would be the natural order of things. It was quite remarkable when the crisis hit at the end of 2008 how almost every country in the world seemed to suffer a lapse in confidence at the same time and some of those emerging market countries at the time fell even more sharply than Western economies, places like Singapore, but they also rebounded very sharply and have since been sustained in their own growth. There really is something of a difference now between what is happening in Western Europe and what is happening in the emerging market economies. They have not had quite the same problems with their banking sector this time round that Western economies had; they had those problems at the end of the 1990s. At the moment the Asian economies in particular are quite a strong driving force in the world economy and a lot of that of course is centred on places like China and India which are very large countries growing quite quickly, and that looks pretty much set to continue.

Q44 Stewart Hosie: Except in the minutes of the 7th and 8th it described that some surveys had weakened a little in June in both India and China, possibly reflecting the impact of tighter monetary policy, so the picture is not consistent even terms of India and China.

Mr Fisher: Each of these countries has its own individual situation. India for example has been getting quite worried about inflation and wanting to tighten policy to keep its own economy under control. China is a much more direct command economy and has a different range of problems.

Q45 Stewart Hosie: I am trying to understand the combination of that growth, strong or weak, plus the difficulties in the euro area, plus the fact that the first quarter growth in the United States was less than anticipated. If we are to move to an export-driven recovery, do you see problems in that as a strategy?

Mr Fisher: The problem for the UK is that typically the areas which have been growing very quickly are the areas to which the UK has its major exports. Particularly strong export markets for the UK are places like Spain and Ireland which have been at the forefront of the recent problems, and around half of our exports go to Continental Europe in the euro zone, and so we have not typically had as strong a presence in places like China and these emerging market countries. That is an opportunity for British business which it needs to look to take up.

Q46 Stewart Hosie: It is an opportunity but of course part of it is going to be predicated on the strength of sterling, and we have seen sterling down against major currencies for two and a half years. What is your view on when the impact of sterling’s devaluation will fully impact on the ability of the UK to export more?

Mr Fisher: It tends to take time and the lags are quite uncertain. Two to three or four years would not be unusual. We had the reverse situation in the late 1990s and in 199697 we had something like 29% appreciation of sterling and it took many years before you could really see that having a negative impact on UK exports. Often the impact comes through quite late, partly because it is so difficult to measure trade properly. I think we should be starting to see an effect now. Particularly in the initial downturn in demand that was not the time at which UK companies would be trying to maximise the benefits of weaker sterling but as demand kicks in in their export markets that is the time they should be trying to take full advantage, and that applies particularly to places like Europe.

Q47 Stewart Hosie: Just a final question in terms of exchange rate fluctuations, businesses that are growing and exporting seem to be taking much of that margin. What needs to be done, perhaps in policy terms, to encourage businesses to reduce the price to export more rather than simply to take the devaluation as a margin?

Mr Fisher: It is for them to maximise their profits and it should be up to them to take profit maximising solution there as to how much they can reduce their margins in order to gain the extra share.

Q48 John Thurso: Governor, the Chairman has told me we are running behind so I have got to move quickly and I do not expect you to answer this, but I must make the observation that your comments on banking reinforce my judgment that splitting retail from investment banking is the only course to get us all back on track. I will not ask for a comment on that but that is my observation. On page 45 of the Inflation Report, which was published at 10 am on 12 May, which is of course before a Government was formed, it states: "A more detailed and demanding path for fiscal consolidation than set out in the March 2010 Budget may therefore be needed in order to avoid unnecessary increases in the cost of issuing public debt." On 23 June in the House of Commons at Column 3.11 the Business Secretary, that noted economist Dr Cable said: "The leader of my own party talked to the Governor and I have talked to him since. The advice that I received, uncompromising and unequivocal, was that the incoming government, whoever they were - we did not know who they would be at that time - would have to act immediately and decisively on the budget deficit because there was a serious threat to this country. I took that advice ..." Do you think your advice has achieved the desired result?

Mr King: I am not quite sure I entirely follow the question. The advice I gave was in public at the Inflation Report press conference. Three days after that I had one conversation. That is all I have ever said on the subject. I cannot judge who decided when about their attitudes to fiscal policy. I think only you can; you will have to ask people about that. I made one set of comments at a press conference in response to a public request from the new Government as to say what advice would I give. I had one conversation after that and that is all I said on the subject.

Q49 John Thurso: But my question remains the same: do you feel that that advice that you gave in public is having the desired effect?

Mr King: I feel there is now a path for fiscal policy that is set out clearly and before the end of the horizon to which it refers which demonstrates how the ratio of debt to GDP on a central path would begin to turn down.

Q50 John Thurso: You have got your foot on the accelerator and the Government has its foot firmly on the fiscal brake, which could result in us going round in circles, but leaving that vehicular metaphor aside, what do you think the impact will be of the fiscal consolidation on the private sector and how fast will the private sector be able to recover to replace the public sector stimulus?

Mr King: I think you will have to wait until August for our judgment about the overall outlook. The OBR forecast does not seem an unreasonable position that they have taken, which is that growth will be positive, it will not be particularly exciting, it will not be that far away from our long-run trend, but it will take a long time to use up the spare capacity that exists at present. I think the reason for that in a fundamental sense is that there is a real adjustment going on, by which I mean not something that monetary policy can prevent. The rebalancing of the economy includes many parts. It is a switch from consumption to exports and investment. It is also the reduction of borrowing and the reduction of debt. Experience suggests that after the sort of financial crisis that we have experienced it takes many years of relatively slow growth before you really get back to normal. I do not see any reason to suppose that we will deviate from that historical experience. Indeed, in many ways what is striking is how close the recent path has been to the average of previous financial crises. I think we are in for a long haul and I do not think we should expect a great deal of excitement.

Q51 John Thurso: Paul Fisher, could I ask you just one question. In a recent speech you noted that estimates of the output gap are extremely uncertain at the current juncture. Why is the estimate so uncertain?

Mr Fisher: We know what has happened to demand. Clearly it has fallen a long way. We think it is now somewhere around 10% below where it would have been if it had carried on growing at the same trend as before. It is very difficult to know what has happened to the supply side of the economy. We clearly do not have an output gap of 10% because that would imply much lower inflation and much lower unemployment than we have currently, so it appears that the supply side has adjusted and yet it is very difficult going round the country to see whole factory estates having closed or shopping centres having completely closed down, so it is very difficult to assess exactly what has been happening on the supply side.

Q52 John Cryer: This is a question primarily directed at David Miles. You said in a speech earlier this month that wage pressures may build significantly over the next year or so. How concerned are you about wage pressures?

Mr Miles:I think the worry is, and it is not the most likely outcome, that having been through a period where inflation has been above the target level by quite a substantial amount for quite a long time now, that may get built into people’s expectations about what the future might look like and that will then be reflected in higher wage settlements and become selffulfilling and selfreinforcing. I think it is a risk. I do not think it is the most likely outcome. I think we have been through a period where, despite inflation having moved above the target, actual wage settlements have remained at a pretty low level on average across the economy, running at 2% or less. If that were to continue I think it would be one reason for thinking that inflation will move back towards the target level. I do not think the most likely outcome is that wage settlements will accelerate sharply but it is a risk in a world in which inflation has been above the target for quite a while now.

Q53 John Cryer: Going back to what the Governor said earlier on in his opening statement if inflation becomes ingrained in people’s expectations it will be very hard to remove. Wage inflation is going to be a very key part of that if that were to happen.

Mr Miles: Absolutely, and a bad situation and a difficult situation for us setting monetary policy and a difficult situation for the country would be one in which people came to believe that inflation was going to persistently sit above the target level. That then gets built into wage settlements and becomes almost selfreinforcing. I do not think that is the most likely outcome but it is a risk on the MPC against which we need to guard.

Q54 John Cryer: This is a side issue but say if immigration were to fall, which might happen, then presumably there would be more upward pressure on wage settlements?

Mr Miles: I think the question would be why is it that immigration was falling, and one factor might itself be a reflection that there is a degree of slack in the labour market greater than was true 18 months or two or three years ago. It is not quite so obvious that immigration being lower than you might have thought a few years ago means wage settlements need to be high. I think it is actually responding to the slack in the labour market.

Q55 John Cryer: At the moment you do not see any kind of legislative intervention in labour relations being necessary?

Mr Miles: I do not think that is really a question for the Monetary Policy Committee, to be honest. What I would say is that the labour market in the UK in some ways has worked pretty well over recent years because we have seen a rise in unemployment in the UK which is probably a lot less than most economists would have expected given how much output actually fell. There has about a degree of flexibility. One thing I have been struck by talking to companies around the country is how many companies said that when the downturn was at its most severe, late 2008/early 2009, they and their workforces were able to manage their way through it without the scale of redundancies you might have expected given how severe that downturn was, by agreeing on flexible working and temporary wage freezes.

Q56 John Mann: I smiled when I heard the new emerging markets of China thrown in there earlier. In your opening statement you said the biggest single cause of the crisis is imbalance in global demand. Is not the single biggest imbalance the imbalance in trade with China and is there not a danger that all of us are overlooking the conundrum of China in terms of a command economy with this huge world trade imbalance to it?

Mr King: I would not single out China. I think there are a number of economies, three of the biggest four in the world, Germany, Japan and China, all of which have been running very large trade surpluses. That requires somebody else to run a trade deficit. That has fallen largely on the US and UK and countries like Spain. That cannot go on. We cannot borrow from the rest of the world in the way that we have been doing. We are adjusting. If they try to continue growth based on the export model there is an inconsistency there and one way to reconcile it is to have a weak level of world demand overall or there will be conflict again. We cannot allow these imbalances to continue. I think one of the biggest challenges facing the G20 is to face up to the fact that unless there is a genuine acceptance around the table that rebalancing applies to all our economies, not just some of them, we will end up in the end with a very weak rate of world growth. This is a major challenge and I do not see any solution to it at present but I am hoping one day we will get there.

Q57 John Mann: Just changing tack, going back to the labour market, the OBR’s forecasts on wages and salaries are a dramatic increase from minus 1.0% last year to a 1.2% projection this year to 4.9% and 5.3% in 201314. That is a very huge and significant increase in wages and salaries and of course the reduction in the structural deficit is predicated partly on the tax revenues that that tax increase will bring in. How realistic is it that inflation will be kept at 2% with that projection on wages and salaries going up to 5.3%?

Mr King: They obviously think that it is because that is their own forecast and you will have to put the details to them. Certainly when we started the regime in 1997 we were talking about the inflation target being completely compatible with rates of growth and nominal earnings increases of 44.5%. What has been interesting is how low earnings increases have been recently and there is no immediate sign of their picking up. You could imagine ways in which very healthy financial positions of many companies, particularly big ones, could be used to bid up wages but quite why that would happen at present is not entirely easy to see short of a generalised rise in inflation expectations, which I do not think there is enormous evidence for at this stage but we will have to be very careful in looking for it. I myself would be sceptical that this is a period in which you would expect to see a very significant pickup in nominal wages and salaries. You cannot be certain about it. We will have to monitor it very carefully.

Q58 John Mann: Obviously the growth in fiscal revenues is predicated partly on the projections. Presumably in terms of your remit with inflation and with them predicting such a high increase, you are going to have to put increased attention into monitoring both trends in the labour market and trends in immigration because exactly who is taking the new jobs is going to impact on whether these are accurate or not.

Mr King: Indeed, and one of the difficulties we have had in recent years has been the inadequate data that we have had on migration both in terms of when numbers were coming in and linked to the labour market. One of the explanations for why unemployment has risen much less than we had expected when we saw the scale of the downturn in output may well be that many of the migrant employees who came into the UK have now returned home and are no longer working here, but it is very hard to judge. The data I do not think are at all clear on that front. We have been genuinely surprised by how muted has been the response of employment and unemployment to the downturn in output, particularly when you look at the United States where the opposite has occurred where employment and unemployment have responded much more than you would previously have expected, and I do not think it is easy to find explanations which are compelling at this stage. You can find rationalisations, but I think it is something we will have to look at very carefully because it will determine how far we would expect to see a recovery in the future leading through to increases in employment.

Q59 Michael Fallon: Andrew, the Chief Economist to the Bank last week said that since the spring of 2006 inflation has been above target for 41 out of 50 months and for two years it has averaged over 3%. He said, "Now we can come up with all sorts of clever and real reasons to explain our view, but at some point people will say that inflation just seems higher than it used to be, and that is a very substantial risk". Do you think we are at that point, or past it?

Mr Sentance: Well, I think that is a risk, that people continue to experience above-target inflation and that begins to feed through into some of the underlying processes that drive inflation in the future, including wage increases. Now, the Governor pointed out that wage growth has been subdued so far and it has been held down by the recession, but that will not necessarily go on for ever. We are at the point where we have to try and think one or two years ahead and balance those risks. There are risks that the economy could be weaker and we will have further shocks in the international economy, but I certainly feel that people’s experience of inflation is a very important factor in influencing their judgments about the credibility of policy and the future path of inflation, and I think we need to take that risk seriously.

Q60 Michael Fallon: So what is the answer to my question then? Are we at that point, are we even close to it, or are we beyond it?

Mr Sentance: The point?

Q61 Michael Fallon: The point at which, in Spencer Dale’s words, people will say that inflation just seems higher than it used to be.

Mr Sentance: Well, I think observing, looking backwards, they can fairly make that observation. It has also been more volatile, but the question is: how is it going to affect the behaviour, going forwards, in inflation expectation? Now, so far, what we have seen is that inflation expectations were pushed down by the initial shocks that we saw last year and they have come back to much more, looking at all the various measures, normal levels, but the trajectory of inflation expectations has been upwards, so we do have to take that seriously, and that is one of the reasons why I have argued that we need to begin now to gradually tighten policy so that we do not get in a position where we have to tighten policy more aggressively into the next stage.

Q62 Michael Fallon: Charlie Bean, if the Bank has consistently underestimated inflation for so long over the last four years, how can we be confident that you are not also underestimating the inflationary effect of quantitative easing in the medium term?

Mr Bean: Well, we cannot be confident about anything. As you correctly say, inflation has surprised us on the upside fairly consistently in the recent past and some of that has been because there have been unexpected events, like the oil prices are substantially higher now than they were two years ago, but there are other aspects where basically our initial judgment about the inflation process turned out to be incorrect. In particular, it looks as if the effect of the depreciation in sterling two and a half years ago or so, down 25%, has been rather larger and faster than we were expecting, and obviously we formed our judgment on the basis of recent experience in the 1990s, but one could well argue that large movements in the exchange rate people expect to see as likely to have larger effects on inflation, so that certainly, we think, is one of the reasons why inflation has turned out stronger than we expected. However, we are in a world where there is a number of factors that drive inflation, and I have already mentioned the exchange rate, but also the amount of spare capacity which, as earlier discussion touched on, is uncertain and could be very large, given the scale of the fall in output. Even getting the estimate of the responsiveness of inflation to the output gap and the exchange rate movement wrong by a relatively small amount can lead to very large errors on inflation because the movements in them have been so big, so we certainly cannot be confident, looking forward, about exactly where inflation is going to go, and that is reflected in the fact that our fan charts are wider now than they have been, say, during the period of the so-called ‘great moderation’.

Q63 Michael Fallon: But again can you answer the question: how can we be sure that you are not underestimating? Are you measuring the inflationary effect of quantitative easing two, three or four years out?

Mr Bean: We cannot be sure. When you say how can we be sure, there is no way we can be sure in this game. All we can do is make a judgment on the basis of the best information available about the effect of our policy actions, and obviously we are monitoring as best we can the impact of quantitative easing, the impact on yields that we talked about earlier, we put out the working paper that the Governor referred to, providing our assessment of the impact, and they looked to be broadly as we expected when we embarked on the process. However, in terms of the ultimate impact on nominal spending in the economy, which is what we are trying to effect by the monetary relaxation, it really will be some years down the road before we can be sure about what the impact is, and in fact even then we will not be sure because we do not know what will have happened in the absence of quantitative easing.

Chair: Thank you very much, Governor. The fact that we have overrun, please take as a reflection of the importance of some of the things that have been said and the interest for us as in this Committee.