Bank of England November 2010 Inflation Report - Treasury Contents

Examination of Witnesses (Question Numbers 1-65)

Mervyn King, Paul Tucker, Spencer Dale, Dr Adam Posen and Dr Andrew Sentance

25 November 2010

Q1   Chair: Good morning, Governor. You have a statement here that you would like to make. Could I ask that we receive these 24 hours before the hearing in future if possible? We got this at 8.30pm last night.

Mervyn King: Yes, indeed. We will make sure we do that, Chairman.

Chair: Unless there are market-sensitive aspects to your opening statement, in which case I'd be grateful for a call beforehand.

Mervyn King: Absolutely. No, indeed. And good morning, everyone.

Together with policymakers overseas, the Monetary Policy Committee responded quickly to the financial crisis, cutting Bank Rate almost to zero and injecting additional money into the economy through our asset purchase programme. This unprecedented response did stop the fall in output in 2009 and over the past year has generated the beginnings of a recovery. Output has grown by a little more than its long-run average and close to the centre of projection made by the MPC a year ago but, given the scale of the falls in output during the recession, the level of output remains well below where it would have been had the crisis not occurred. And, inevitably, there is considerable uncertainty about the future path of demand and output, making the task of controlling inflation more challenging than during the decade prior to the crisis.

Over the past year output growth has been supported by a turn round in the stock cycle, clearly only a temporary stimulus. The economy will need to find more sustainable sources of demand if the recovery is to be maintained. For that, demand needs to rebalance away from domestic consumption and towards net trade. This will be a major change for the UK economy, requiring resources to shift from those sectors that have served domestic consumption towards sectors providing goods and services to customers overseas and substituting for imports.

The necessary pre-conditions for that rebalancing are in place. The Government has set out a credible plan to close the fiscal deficit, and UK businesses are now benefiting from a real depreciation in the value of sterling. The real exchange rate is around 20% below its level in mid-2007 and, partly as a result, UK goods exports have risen by over 10% in the past year. As we saw in the figures released yesterday, the net trade position is improving. In the Inflation Report published two weeks ago, the projections of the MPC implied that over the next three years growth was a little more likely to be above than below its historical average. But there are risks, and we are particularly dependent on prospects in the rest of the world. A healthy European recovery is important to the ability of the UK economy to rebalance.

The change in the exchange rate since mid-2007 has been one of a series of factors that have pushed up on CPI inflation. That, together with the increase in the standard rate of VAT and the boost from commodity price rises, explains why CPI inflation is 3.2% at present. The forthcoming increase in VAT and further pass-through from import prices are likely to mean that CPI inflation remains elevated for another year or so, but the key question is what is likely to happen to inflation in the medium term. If the MPC took strong action to offset temporary fluctuations in inflation, then we would risk generating undesirable volatility in output, as referred to in our remit. And in the medium term, there is no reason to expect that inflation will be significantly affected by further movements in the exchange rate, taxes or commodity prices. So these factors, while very important in explaining why inflation is high at present, are not the most important factors driving the inflation outlook in the medium term. Instead, at that point the risks are dominated by whether the effect of spare capacity in the economy will pull inflation below the target or whether the prolonged period of above-target inflation outturns will push up on inflation expectations, keeping inflation above target.

The range of views among the MPC about which of these risks will come to dominate is wider than usual and that explains why different members have drawn different policy conclusions in recent months. That difference of views, and the healthy, open policy debate that accompanies it, is something to be welcomed. Overall, a majority of the MPC have concluded that the risks are, at present, broadly balanced but we all stand ready to adjust policy, in either direction, should the outlook for inflation demand it.

With that, Chairman, I and the other members of the MPC here today stand ready to answer your questions.

Q2   Chair: Governor, you say in your statement that the Government has set out a credible plan to close the fiscal deficit. For that to mean anything, you must be prepared to come before us one day and tell us when a Government doesn't have a credible plan.

Mervyn King: If we feel at some stage that is the case, then indeed I will be prepared to say that, but, as you know, I've been reluctant to be drawn into too many debates on fiscal policy and I will do that when and only when it is relevant to the outlook for inflation.

Q3   Chair: You also say if the MPC took strong action to offset temporary fluctuations in inflation then we would risk generating undesirable volatility in output, as referred to in your remit. Do you interpret your remit on growth in exactly the same way now as you have throughout the period that we've had the Bank of England Act?

Mervyn King: Yes. The actions we've taken are those that we foreshadowed in various speeches in 1997 and 1998 when we said then that if there were shocks to the economy that temporarily pushed inflation away from target that were the result of what we then called supply shocks—that is shocks that have a temporary effect on inflation—we would look through that and set inflation to ensure that in the medium term it was on track to meet the target. I think what we've seen in the past two or three years is an example of that.

Q4   Chair: And you are confident that these are temporary shocks?

Mervyn King: One can never be certain about anything. That is clearly not true and we know there is a risk that they may not be. That is why there is an upside risk to inflation. But against that we have to balance the downside risks and I think the challenge facing the committee is to recognise that there are risks in both directions.

Q5   Chair: Could I ask Dr Posen about the article in the Financial Times on 10 November that said, "Some senior staff at the Bank of England are uncomfortable with Mervyn King's endorsement of the Government's spending cuts, suggesting he has overstepped the line separating monetary and fiscal policy. People familiar with the monetary policy's deliberations have told the FT that Mr King's support for the Coalition's aggressive fiscal tightening is not fully shared by all members of the nine-person committee." When you read that, what action did you take?

Dr Posen: Well, first, Mr Chairman, I was a little annoyed and upset that somebody was talking to the FT about such a thing at this date. I don't know where that came from and I don't know why it appeared there. Secondly, on the facts of the matter—as was, I think, reported subsequently in the next day's newspapers and as I believe the Governor said at his most recent press conference—there was a difference of opinion at the MPC, in particular in the May meeting, over a particular paragraph in the report that was talking about the need for a particular speed with which to deal with the fiscal policy.

A number of people in the committee, myself plus at least one other—I'm not going to identify how many or who; it's up to other members to decide if they wish to identify themselves, but more than just me and fewer than a majority—were concerned that that statement could be seen as excessively political in the context of the election and the discussion that had gone on. We expressed that point of view. We offered alternative language. The majority of the committee decided that they were comfortable with the language that appeared in the report. Appropriately the minutes and the Inflation Report are statements of the general opinion of the committee. I happen to dissent from that opinion but it is entirely appropriate and right that the Inflation Report or the minutes reflect the general opinion of the committee. It is factually correct, however, that at least one other member plus me were concerned that that language was too political, too much of a statement. That's my personal opinion.

Q6   Chair: And was prejudicing the impartiality of the Bank of England?

Dr Posen: Yes. These are lines to draw. Clearly, as we've seen in Ireland right now, there are situations where the central bank does have to talk about fiscal policy, but my strong bias is that, except for those very rare occasions and particularly in election cycles, we don't. But the committee, in good faith, decided at that time they wanted to say that and that's their right.

Q7   Chair: And that the Governor crossed the line. Did you discuss this with other independent members of the MPC?

Dr Posen: Yes, I did.

Q8   Chair: And you got support from one other but not from two more?

Dr Posen: It's not a question of my getting support. There were a number of us who were concerned. It wasn't that I personally was leading this. Secondly, as I said, I am perfectly willing to be accountable for my own views. I'm not going to out other members from private discussion. It was more than just me and one other person; it was fewer than five people.

Q9   Chair: And you took those views informally to the Governor or you only raised them formally?

Dr Posen: We took those views informally by email to many of the colleagues sitting to my left and then we openly discussed them in the closed MPC meeting, discussing that document.

Q10   Chair: And you're now confident that this issue is closed and that any threat to impartiality has been handled appropriately?

Dr Posen: I am confident that no one has said anything since that time that I would object to, in terms of biasing their views about policy or about the overall fiscal picture. As the Governor just said, and as I've taken advantage of, I think it is right for us to talk about how fiscal policy affects the forecast in light of our remit. It's not right for us to talk about what is the goal to fiscal policy in a long-term sense. As is sometimes invoked, I guess it's the loss in role, the idea that monetary policy should be about demand management, fiscal policy should be about the long term. As long as the Government is not messing up current circumstances by really, really, really strange fiscal policy, it is not our place, in my personal opinion, to talk about it.

Q11   Chair: Before we move on, have you anything you want to add, Governor?

Mervyn King: I don't think so. What the Inflation Report says is always the view of the majority round the table. Everyone round the table, every one of the nine members, is asked whether they approve the wording that we see in front of us and the majority clearly agreed that. There are times when a Governor is asked to say something as Governor. I was asked after the election—and I should point out the Inflation Report appeared after the election—and I commented as Governor. Most of the comments I've made on fiscal policy, indeed almost all, apart from the statement I made in the May Inflation Report Conference, which was in response to a direct written request from the Government to make a comment, were in response to questions by this committee.

Q12   Chair: I am specifically referring to the rebuke or to the shot across your bows that was given by the independent members of the MPC. Do you want to add anything to that?

Mervyn King: No. I mean the—

Chair: If I may just finish—particularly in view of your sensitivity on this issue in the press conference that took place where you said, "Perhaps we can move on to a serious question about the economy", after this was asked of you. I'm sure you understand that, for a committee such as ours, the safeguarding of the Bank's impartiality is also important.

Mervyn King: Of course it is. And I would emphasise that I have never spoken, ever, about the balance between spending and taxes, let alone about any of the individual measures. I have merely commented about the outlook for the UK economy of the largest peacetime fiscal deficit ever. Now, I think most central bank governors around the world have spoken far more often on fiscal policy than I have and I reserve the right to make those comments if we ever again have the largest peacetime fiscal deficit ever.

Q13   Mr Umunna: Thank you, Chair. I'd just like to follow up on a response that Dr Posen gave. Obviously we're not in an election cycle now and you did just mention that one wouldn't comment on these things unless the Government was pursuing quite an exceptional fiscal policy. The current deficit reduction programme that is being pursued by the Government has been described, given we're still recovering from recession and the outlook is so uncertain, which is something one really picks up in the report, as the biggest macro-economic experiment in any advanced country in a generation. Now, would you say, Dr Posen, that it's correct to say that no fiscal contraction of this order has been attempted at this time with an economy recovering from recession?

Dr Posen: Thank you for the question. I will just stick to the facts as I understand them from studies and cross-national research of the history that all members of the committee have been talking about. My understanding is that this is rare in two senses. It is rare that an austerity programme is this large—although, of course, if you look across the Channel or across to our neighbours in Ireland it's not as unusual now as it was in the past—and that it is unusual for an economy to be contracting this much when it is not yet under crisis.

However, it is fair and reasonable and factual to say that the idea of this programme is to prevent such crisis pressures from happening. It's not for me to say whether that's right or wrong but it is certainly a legitimate concern on the part of any Government to say, "We want to get ahead of events". It has to make a judgement call that's above my pay grade, as we say, but that is a legitimate concern. The only comment I would make—and I hope this is responsive to your question—is I believe it is my job and the job of other members of the committee to talk about what impact this will have in the short-term forecast of two to three years when we're supposed to try to hit the inflation target, and that I'm happy to talk about.

Q14   Mr Umunna: Okay. Just moving on, obviously if the outlook is as uncertain as it is, if growth remains sluggish, the Chancellor has been very clear that he doesn't and will not alter fiscal policy, which means, to the extent there is any plan B, people will be looking to the MPC and monetary policy to address that. Now, obviously the foot is firmly on the floor insofar as interest rates are concerned, which leaves us with quantitative easing as being the remaining lever to pull, which you would be very much involved with. I know there's a difference in views here, and I'm sure it's very coincidental that you are sitting at the opposite end of the table to Dr Sentance, but would you say—and I address this to the Governor and the two MPC members—there is any signs of fiscal contraction in the current climate that couldn't be compensated for by quantitative easing?

Dr Posen: What order do you want us to respond in?

Mr Umunna: Well, we'll go with you first.

Dr Posen: Thank you. The first point I would make is that it is my personal assessment that the short-term effects of the Government's fiscal plans will be quite contractionary. That is why, in my statement to the Committee and in the last minutes of the Inflation Report, I differed from the majority forecast of the committee. That's not the only reason. There are other reasons but that's one reason. Could monetary policy fully make up for this quantitative easing? Probably but not certainly. We all have different choices about where we think the uncertainty lies. I'm probably, and possibly foolishly, more confident about thinking where the forecast is going to be and I am less certain than some of my colleagues about the impact of quantitative easing. I believe it is helpful but I do not have full confidence that, if we go full bore from here on, it will be as effective as it has been in the past or will necessarily be enough.

Mr Umunna: Thank you. Governor, do you agree?

Mervyn King: I have as much confidence in the impact of asset purchases as I do in interest rate changes; that is, there is an enormous amount of uncertainty around either instrument and that has to be borne in mind. What matters is the outlook for the economy as a whole. What we need in the next five years is a significant rebalancing of the economy. Some components of spending have to slow; consumption is one of them, both public and private. We need net exports to pick up instead. We are beginning to see that. Over the past year, as I said in my opening statement, we have seen growth just above the long-run average. We need more of that, but we are seeing growth from one component and we are about to see a slowing in the other. So, what matters is the net balance between the two. So far so good; we will see as we go ahead. But I think most forecasters, not just the MPC and every member on it but almost all outside forecasters, have, as a central view, neither particularly rapid growth but neither no growth at all. It is modest, moderate growth and that is the central view over the next few years.

Mr Umunna: Before I ask just one last question, Dr Sentance?

Dr Sentance: Yes, just to make a few points on this. One is I think that in some of the media coverage on the fiscal tightening some of the comments that you were quoting to us have been, to my view, slightly overstating the intensity of it. And I've made the point in a number of speeches that the tightening, if you look at it as percentage of GDP, is broadly similar to what we saw in the mid-1990s and the restraint on public spending is not that dissimilar. Public spending is still set to rise on the broadest aggregate in cash terms, even though slightly below inflation. So I think the private sector and the business side of the economy can help drive the economy forward in this environment.

The other point I would make, it is not just monetary policy that acts as an offset here. We already have, in my view, quite a loose monetary policy with very low interest rates and a very large injection of quantitative easing. It is also the growth of the global economy and the support provided from the international environment. Over the last year we've seen non-oil export volumes grow, of goods, by 15%, which shows that the world economy is already providing the UK with quite a lot of support. And my expectation is that a relatively strong global economy is going to be one of the major factors that will help us continue to grow while the fiscal tightening is going on.

Q15   Jesse Norman: Thank you very much indeed, Chairman. This is a question to Dr Sentance, Mr Tucker and Mr Dale. Dr Posen has already shared with us his concerns about the line potentially being crossed over fiscal policy by statements of the Monetary Policy Committee. Would you be able to tell us how you came out on that issue within the committee?

Dr Sentance: As an external member, perhaps I can kick off. I remember us discussing the paragraphs in the May Inflation Report and I think we considered various forms of drafting. I think, on balance, what I recollect is the majority of the committee were comfortable with it and, in terms of the general points that the committee has made in its Inflation Report on fiscal policy, I've broadly been comfortable with the view that has been put across.

Q16   Jesse Norman: But did you support Dr Posen's position?

Dr Sentance: I'm not quite sure I recollect there were positions being taken. We discussed drafting of the Inflation Report, particularly the overview section and section 5, and there were sensitivities at that time about how we should communicate the view that the committee wanted to get across because we were just immediately post an election. We'd moved the date of the committee because of the election. So I remember that discussion. But in terms of the substance of fiscal policy and its impact on the inflation outlook, I think I've made my views fairly clear, that even though we do have a very significant fiscal tightening, I think the economy will continue to grow and my concern is the risk that inflation will continue to persist higher than the target and higher than we would ideally like, even though we have a very significant fiscal tightening.

Q17   Jesse Norman: We're very short of time so I just want to focus, if I may, very quickly with Mr Tucker and Mr Dale as to whether you supported Dr Posen in his concerns or not?

Paul Tucker: I did not think the line was crossed. If I had thought the line had been crossed I would have gone to the Chairman of Court, I would have come to you if necessary and, before all of that, I would have gone to the Governor. This is my 30th year in the Bank of England. The circumstances in which this debate took place were the most extraordinary precarious position in the financial markets with a chain reaction, which we can still see playing out, where this country needs to put itself beyond harm's way. And I think we would have said those things to any Government of any complexion, of any combination, in those circumstances.

I think it was an absolutely legitimate thing for the Governor to do and, had he not done so, I think you would have been concerned the other way around, which is why wasn't the Governor of the central bank issuing some kind of warning in order to ensure that this country took the action that it needed to take in order to stay on a stable course? That's a legitimate thing for the central bank to do in such extraordinary circumstances and it's legitimate for a monetary policymaker to do in those circumstances because you cannot operate monetary policy in any sensible way without a framework of underlying stability that comes from Government and Parliament, as well as from our mandate.

Jesse Norman: Thank you very much.

Spencer Dale: I was also comfortable with the drafting in the report. I just wanted to make one other point in case you get the impression that we spend most of our time on the committee worrying about drafting rather than about economics. The vast majority of the time during that May Inflation Report when we were discussing the budget wasn't spent on detailed line drafting, but on the question, "What impact will this fiscal package have on the economy?" On that I think there was pretty much agreement. There were differences in terms of the precise scale but I think all of us agreed that the impact to the fiscal policy would produce our central projection for growth. But also it would reduce some of the downside risk to growth since it took away or lessened one of those risks, that we'd see a very sharp rise in real interest rates associated with a loss of confidence in fiscal policy. The majority of the time we spend as a committee we're talking about the economics, not about line drafting in the Inflation Report.

Q18   Jesse Norman: Thank you for that. You've made very clear that the Bank reserves the right to comment on whether or not a fiscal tightening is credible or not, Governor, because you've made that comment today and Mr Tucker has previously robustly defended the independence of the Bank in these issues. Why then did you not raise a similar concern in 2007 and 2008, let alone last year, when the Government's fiscal policy was described by the previous Chief Secretary to the Treasury and Cabinet Secretary as "hit and hope economics" to this Committee?

Mervyn King: In answer to a question of this Committee in June 2009 I made exactly the comment that I've made subsequently. That's when I raised it. I didn't raise it, you asked it and I gave a straight answer to a straight question. It was made clear then. So I said it well before the election.

Q19   Jesse Norman: You mean that you didn't regard the Government's policy as credible at the time?

Mervyn King: I said very clearly to this Committee in June 2009 that the United Kingdom needed a credible medium-term fiscal plan, by which I meant that the markets would expect that at least after the election the details of such a plan were made clear quickly so that it would be credible and that it needed to be somewhat more ambitious than the plans that existed at that time.

Q20   Jesse Norman: Thank you. Final question, if I may. On page 7 of the Inflation Report we have a CPI inflation projection that has a fan of outcomes that look as though they're taking us into deflation in the middle of 2012, on a central reading.

Mervyn King: No, that's not—

Jesse Norman: Have I misread that?

Mervyn King: Yes, I think you have.

Jesse Norman: Thank you for that.

Mervyn King: If you look at the scale on the right-hand side, you'll see that in the central view it is somewhere between 1% and 2%.

Jesse Norman: Sorry, you're right. So you come down to round about 1%?

Mervyn King: It's above that. It's between 1% and 2%.

Q21   Jesse Norman: Right. Do you think that there's any case for discussing again with the Government whether or not the mandate that the committee has is correct, given that inflation has been so high for so long?

Mervyn King: No, I don't. I think it is very important that we stick to our 2% inflation target, that we explain why it is that we think inflation has been above the target. I think it would have been wrong to have raised interest rates markedly over the past year, deliberately in order to create a deeper recession in order to bring down inflation that was the result, primarily, of what we believed to be temporary shocks. At some point policy will need to be normalised. There is no question about that. But the judgment of the Committee on Monetary Policy has to be a question of balancing risks; it always is. But I see absolutely no case for changing the remit. It's in fact the opposite. It is very important now, in these circumstances, that we stick to it.

Q22   Jesse Norman: Just for the avoidance of doubt, there's no implication that interest rates should be raised in my question. My statement was about the relationship between Government and the Bank as to the communication of monetary policy.

Mervyn King: Well, the Government sets the remit. That is for the Government to set. It renews it each year.

Q23   Michael Fallon: Dr Posen, the minutes record your concern about the weakness in productivity growth has been based on international evidence, whereas Dr Sentance, in his Belfast speech, points to previous UK evidence of the strength of the recovery in the mid­1990s. Why is he wrong?

Dr Posen: Well, Dr Sentance as a person may not be wrong but on this point of view I personally believe him to be wrong, and let me give my view why. As I tried to say in a speech I gave in October in Hull, you are always trying to figure out whether short-term movements in data are meaningful or not. And so one can look at the last six months or eight months of UK data and say, "Oh, things are going up", and one can look at them, as Dr Sentance and others have rightly pointed out, and say "Oh, things have gone up better on exports than we would have expected". But you have to make sense of the data. Is this just a fluctuation? Is this just random? Is this going up in a different way than what you would expect?

If you look back just at UK experience, you're basically left with only one or two examples you can go to and, to me, that can be misleading. The way I illustrated this was in this chart I used in my October speech in which I showed that, yes, in terms of money growth or output growth, the recovery right now is doing better than the previous recovery in the early 1990s in the UK but it's also doing worse than the Japanese recovery in 1993, and we all know what happened in Japan following 1993. That doesn't mean it will happen here but it's meant as a check on the idea that you can just plot recent data and say, "That is sufficient to explain what is going on".

So I would turn around the question. We know, unfortunately, there have been dozens of financial crises, not just in UK history but in other advanced economies' history, and so the question is why is the UK different? And there are some things that are different. We had a more aggressive policy response. We have had more pressure on our banks to behave. We have more flexibility in various parts of our economy than some of the other economies. So there are reasons to think, as I and I think all the committee think, why things are, as the Governor said, maybe slow growth but probably not disastrous. But there isn't enough reason to think that the UK should be totally different from all other advanced countries and, on average, things look pretty bad at this time.

Q24   Michael Fallon: But what about his other argument that you're going to have to raise rates at some point? If you delay raising them, this could well be quite a shock to the economy, quite a lurch in policy. It would be better to raise them more slowly now rather than suddenly jack them up in a year's time.

Dr Posen: There are three reasons why I differ from that point of view. The first is I think it would be, frankly speaking, much more of a shock to the economy to move policy in the wrong direction than to worry about policy path over a long period of time. And I think markets would look at us very strangely as to what it is we think is going on were we to do that.

The second reason I would suggest that it is, in my opinion, not right to do that is that—sorry, I have to take a second to figure out how to phrase this properly—markets in general and citizens in advanced economies don't require central banks to move slowly. They require central banks to move correctly, on average. There has been a lot of talk for many years about the idea that central banks smooth interest rates. You don't want to surprise the markets unduly, but that's very different from saying you always have to do rate hikes or rate cuts in very temperate small steps. There's no evidence to suggest that that's necessarily right. So there's no advantage to it.

The third reason why I would say that I would be against raising rates in that fashion is because it's a question of what it is you think you're getting ahead of. As is stated in the chart that we just looked at, thanks to Mr Norman, the central view of the committee is that inflation will be under target in two years' time. Now, the central view of the committee is if it's close enough to target and there's enough risks on the upside, they don't wish to react. To me, because of my forecast, I believe the central view is below that and so it would be just an outright mistake to move policy in that direction.

Q25   Michael Fallon: We've been told for some time now that inflation was going to be back below target in two years' time. Are you not concerned about inflation expectations getting out of hand?

Dr Posen: I am concerned and that's certainly a concern shared by members of the committee and, if anything, if you read our last minutes or our last Inflation Report, as you have I'm sure, there is discussion of that fact. Speaking for me personally, I am not as concerned for two reasons; always a list. Reason one is if you look at the behaviour of financial market futures and longer-term household surveys, they've barely moved up or have not moved up at all. There are only one or two short-term surveys that indicate rises in inflation expectations. Therefore, it seems to me that the inflation expectations are well-anchored.

The second point I would make is there is no precedent—again, I look at international comparisons, not because everything is like the UK but because we have to try to draw conclusions from what is reasonable—for a country with an independent central bank seeing, as Mr Umunna raised, an austerity programme in the fiscal policy, with an inflation target, with wage growth at 2% or less, having a sharp sustained rise in inflation. So, is it a legitimate concern to worry that if we've made repeated mistakes, or we continued to, that inflation expectations might creep up? Yes. Is it in magnitude enough to keep me from voting for doing the right thing on policy? No. Do I think that there is a real threat that inflation will stay up? Not really. My expectation is that, just as inflation expectations in the household followed inflation developments up, they will follow them down in due course as the economy turns.

Michael Fallon: We'll see.

Q26   John Thurso: I'd like to try and get three questions in, in the short time available, all based on your wonderful reports. I'd start, please, with Dr Sentance. In your report you note the worry that the credibility of the MPC's commitment to keeping inflation on target risks being undermined if the committee does not respond to persistent above-target inflation. The other side of that is if you are persistently forecasting differently to all of the rest of the committee, does that not go to the credibility of your forecast?

Dr Sentance: I'm not forecasting persistently differently from the rest of the committee. As I made clear in my report, in relation to the forecast in the November report I wouldn't have the downward skew on growth but I think the central forecast on growth is realistic, and that has growth in the 2.5% to 3.5% range over the next two to three years, which is above trend growth for the UK. And the inflation forecast shows that the central forecast and the balance of risk is to the upside in the short term. Yes, we do expect inflation to come down in that forecast, but I'm less confident about that and I think the forecast itself shows a lot of uncertainty. So I think there's always going to be slight differences of emphasis in terms of the committee on the forecast.

The concern that I would have is not that it isn't appropriate at times, when you get one-off shocks to inflation, to allow those to feed through and then allow inflation to return back to target. But we've had this happening on a persistent basis and some of these shocks I would see slightly differently from the way the Governor described them in his opening comments. For example, the upward pressure on energy and commodity prices is associated with the strong growth that we're getting from the world economy at present and that strong growth in the world economy, as I've already pointed out, lifts UK exports and lifts the UK economy and that's a demand-side influence that the MPC needs to respond to.

The other issue I think that I would highlight is the level of the exchange rate, where the pound has fallen very significantly from its level three years ago and it's a well known transmission mechanism, monetary policy, through the UK exchange rate and the UK is more open than many other major economies to imported price inflation. So I think in those areas we need to take perhaps a different view of some of the pressures that are causing inflation to be higher. And coming from a level where we have relaxed monetary policy to such a degree in very different circumstances, I think it's becoming increasingly difficult, in my view, to explain to the public and the business community that we're not responding in some way, given that we have an inflation remit, to the fact that inflation is persistently above target.

Q27   John Thurso: Thank you. Dr Posen, can I come to you? In your report you mention QE. In particular you say that how large and lasting the impact of QE proved to be, beyond it being broadly simulative, would inform how you would vote and you go on to say, "I came to believe as well the expansionary impact of our QE policy was insufficient and diminishing over time", and later on that you voted for a £50 billion increase in the programme. Are you concerned that QE is not delivering sufficiently?

Dr Posen: I'm concerned that, given the forecast I have, the policy setting is insufficient, yes. Mr Thurso, the issue is sort of in line with what Dr Sentance was saying. There are several steps of the forecast and policy setting, most of which we agree on, and so what I tried to do in my statement was highlight those particular areas where I was differing. And so my concern is that on quantitative easing, we have to make a guess or better than a guess; thanks to Spencer and the staff at the Bank we have to make a very educated guess as to what we think the impact of additional purchases would be.

My taking that into account is that if I was setting an interest rate—I differ from the Governor in that I have a little more confidence in the interest rate setting than I do in the quantitative easing in terms of impact, although he is right, interest rates are not certain either—of minus whatever, minus 4%, minus 6%, I don't think we are at the equivalent of that. I also think there is reason why additional QE at this point is probably useful, because I don't think the impact of QE is as strong now—I'll be very brief, I'm sorry—for two quick reasons.

First, part of the benefits of QE that the Bank rightly undertook in 2009, before I joined the committee, is to deal with panic in markets and to deal with lock-up in markets. Thankfully we don't have that now but, therefore, you don't have the benefit of that. Secondly, because of the panic going away, thanks in part to the Bank of England policy, the amount of desire people have for gilts versus other securities goes down, or rather they're more willing to substitute other things for gilts. And the power of QE, as explained in speeches by Spencer Dale and by my colleague David Miles, is in part when you think that there's an imperfect substitutability, that your buying people really want to hold gilts, and so when you buy gilts from them it causes a lot of changes to their portfolio. Now that we're in more normal times there's more substitutability. So, to me, the mechanism is less potent than it was, say, a year and a half ago.

Q28   John Thurso: A quick question to the Governor. In your report, Governor, you highlight the concern that net trade may not coincide with slower growth in the domestic economy, and you spoke about it in your opening statement as well. If that were to be the case, what is the monetary policy response and how quickly could it take effect?

Mervyn King: It would depend in which direction this happened. If fiscal demand were to grow faster than the slowing of domestic demand, so we felt the economy would be—

John Thurso: The assumption I'm asking on is that net trade has not replaced the domestic demand.

Mervyn King: Has not grown as fast. Well, there are two obvious consequences of that. One is the automatic stabilisers, which would lead to a change in the level of a fiscal deficit. So they kick in and they're quite powerful in the United Kingdom, with high marginal tax rates. Second is monetary policy where we could engage in further asset purchases, were we to think that necessary to keep inflation on track to meet the target.

Q29   Andrea Leadsom: Being fairly new to the Treasury Select Committee, I'd like to ask just a couple of quick questions about the role and purpose of the MPC, bearing in mind the financial crisis and so on. So I'm going to pick my victim on each question, rather than ask everybody each question. So, first of all, Paul Tucker, would you say that quantitative easing is scope creep for the MPC? Obviously it was given this tool at a time of financial crisis. Do you think it is now adequately monitored by Parliament? Are we still in control? Are you in control? Do you know exactly what happens with quantitative easing?

Paul Tucker: I don't think it's remotely scope creep. The essence of a central bank is that our liability is our money and interest rate setting is just putting the price on our money. When our price gets close to zero we can't go negative because, for a start, we can't put negative interest rates on pound notes, but we can do something else. We can increase the quantity of our money out there and that's something that our predecessors 30 or 40 years ago would have regarded as a fairly normal instrument. What isn't normal is the circumstances in which we're applying that instrument, not the technique itself.

If anyone were to suggest, and I know you're not, that we shouldn't be in control of the size of our balance sheet, that would be a very great concern indeed about whether we could get up in the morning and be the nation's central bank. In terms of whether it's effective—just picking up a couple of points that Adam makes—it does work through destabilising, if you like, the portfolios of long-term investors. It was quite deliberate that we have executed quantitative easing, not by lending directly to the banks but by buying gilts from the long-term investment institutions. As they try and replace those gilts, they go into the corporate bond markets and that has helped the recovery of the corporate bond markets in this country, which has been an unambiguously good thing for the outlook for domestic demand.

My two points: that as the financial markets work better, the markets are more efficient and so the impact would be smaller. That's true. That's what Adam alluded to. On the other hand, the more gilts we take away from the long-term institutions the greater the effect would be because the marginal value to them of losing the duration, the interest rate exposure of long-term gilts gets greater. If you buy £1 million worth or £1 billion worth of gilts off the long-term institutions, you don't do very much. If you buy a vast amount you do more and that would continue. And so we're at the stage now where, to be perfectly honest, we can't tell which one of those factors dominates. But do I believe that quantitative easing would still help to stimulate demand if we found ourselves wanting to do more? Yes.

Q30   Andrea Leadsom: Thank you. Governor, since the MPC was established we haven't seen a period of raging inflation. Do you sometimes lie awake at night wondering if that tiger is there somewhere in the background? Dr Posen mentioned just now that there is no precedent for our current economic factors to lead to inflation. Nevertheless, the point about crises surely is that something unexpected happens, like, for example, an oil shock or something like that, that has the impact of creating inflation. Do you think it's reasonable, bearing in mind your core target of 2% inflation, to simply keep writing to the Chancellor rather than addressing it, even though your central view is that it will right itself in the medium term?

Mervyn King: I think it would be going against the remit to take actions that were not consistent with meeting the inflation target in the medium term if that is our view. And I think what we have to do, what we're paid to do, is to take that difficult judgement about where we think the outlook is likely to be in the medium term, to balance both the upside and the downside risks and to tell it how it is. My view is just to keep it as simple as possible. Each month we make a judgment on monetary policy. We don't have to decide now what interest rates will be in one year's, two years' time. We do it month by month.

If we think the right level of interest rates or the right level of asset purchases today is the one to keep inflation on track to meet the target, that's what we do and we're prepared to change it any month, in either direction, if our judgment about the future changes in response to news. Our job is to communicate that and to explain it and we try and do that a great deal. You'll see that all the members of the committee here today and the other four have all been out and about around the country explaining the balance of risks that we face, why it is a difficult judgment but this is where we've come out.

Q31   Andrea Leadsom: Thank you. And, Dr Sentance, a final question. When you're having your discussions or when you're discussing in front of the mirror with yourself your own views, do you take into account, in your own mind, the socio-economic impacts of monetary policy, albeit that it's not part of the brief? Do you worry about the effect of low interest rates on savers or, conversely, the risk of raising interest rates and the impact that might have on mortgage owners?

Dr Sentance: I think we try and take into account things that are material to the outlook for the economy and its impact on the rate of inflation, and I think the way in which interest rates affects savers are clearly relevant to that. I think the way in which we look at it, however, is in relation to the outlook for growth and the inflation target. I think one of the issues that has been flagged to me in some correspondence from people who are concerned about savers is that the picture in terms of consumer confidence is quite complex at the moment, and I would also say in terms of business confidence as well. Yes, low interest rates are obviously helping people who have mortgages and help to maintain their confidence but then for a lot of people who have seen their savings income drop, their confidence has been reduced by a reduction in interest rates. So the notion that a rise in interest rates will, of itself, hit consumer confidence is a more complicated matter, and also I believe for business confidence.

I'm giving that as one quite important example of the way I might take it into account. And what I've stressed in terms of my view on interest rates, particularly on the business confidence side, is that I don't want the Monetary Policy Committee to pursue a policy that is going to cause big shocks to consumer confidence or business confidence. But I worry that there could be a greater risk of a shock further down the track if we don't begin to move interest rates gradually and move policy gradually in the right direction in these current circumstances.

Q32   Mr Mudie: Mr Tucker, one of the matters raised in the reports is the funding gap, and it's put in the Stability Report at £750 billion to £800 billion. Now, in the Inflation Report you seem fairly relaxed about it but I've always assumed that the unwillingness to lend to small businesses and so on has been the fear by the banks of the knowledge they have to meet this funding gap. Am I mistaken? Do you have any worries about it? Do the banks have any worries? Is it as under control as you suggest in the report?

Paul Tucker: There's good progress that has been made. There's more to be done, rather like the position of the economy as a whole. I think had we known a year ago that we were going to get this far by now we would have settled for that on this issue and more generally. Is there still more to be done? Yes. Is it probably contributing to tight credit conditions for small and medium-sized firms? Yes. Does that remain a worry? Yes, it does.

Q33   Mr Mudie: So when we keep beating the banks over the head, we politicians, to get them to lend, the answer we got from the Chancellor last week was, "It is a complex matter". Is it simply or largely because of this funding gap?

Paul Tucker: It's not entirely to do with the funding gap at all. It was also to do with the weakened capital position of the banks and perceptions of the weakened capital position of the banks. The cost of funds to the banks has gone up a lot compared with not just immediately before the crisis, but a decade ago; they pass that on to their borrowers. We should expect that to happen. They're also trying to rebuild their capital; so they've widened their margins as well. Also in conditions on the other side, on the demand side, when the bankers say the demand for credit is low, there's unquestionably something in that because the economy is still fairly weak but recovering. So it's a combination of things. I think the point to get across is not that we're now in a position that is satisfactory—we're not—but that the banking system is repairing itself. Reasonable progress is being made with that.

Q34   Mr Mudie: Governor, you announced the stopping of various things in the asset programme but you announced a new departure to put money, not direct, into firms, smaller firms as well as those with a lower credit rating. How much are you intending to do through this facility, when will the criteria be published, who will take the decision on whether an applicant meets the criteria, and why are you doing this through an American firm and what part are they playing?

Mervyn King: This is not a large-scale facility. It's one, in fact, that has been in the making for a long time. It's not designed to have a large material impact. It's designed to offer a small-scale facility.

Q35   Mr Mudie: How small then?

Mervyn King: Very small. I've no idea of how big, because the size of it will depend on the demand, the people who come to us. Each of our facilities in this area was designed merely to overcome what we thought were temporary problems in the liquidity in that market, our corporate bond facility and our commercial paper facility, which we're now going to wind down because the liquidity in those markets has returned. It should not be confused in any way with our major asset purchase programme, which is on a scale of £200 billion; a large amount of money to go out there in order to boost the amount of money in the economy. These are very small-scale programmes, designed to improve liquidity.

Q36   Mr Mudie: Okay. When will the criteria be known, who will decide, where is the decision-taking centre for whether an applicant—

Mervyn King: I will ask Mr Dale to talk about the criteria. We can send you a paper on it. We have published on the screens already the principles of the scheme but perhaps Mr Dale could comment on it.

Spencer Dale: Yes. The criteria for the secured paper facility have been public knowledge for some time now. The development that has changed is we have announced that a particular programme has now passed those criteria and so is eligible to start operating that facility. Just to explain the key aim of that facility, the—

Mr Mudie: No, before you do that. You can see the aims, but if I were a small firm and I was applying for this, who takes the decision on whether I meet the criteria? Is it the Bank, is it an American firm or is it what?

Spencer Dale: The way the small firm will get access to money is not by directly borrowing from us. The nature of the facility is similar to what we would call a supply chain finance facility. Large companies at the top of the supply chain, like a supermarket, owe lots of bills to many of their suppliers. What this facility is explicitly designed to do is to allow that large supermarket to borrow from us with the explicit intention of then using that money to pay its suppliers earlier. So the small farm at the bottom of the supply chain doesn't borrow directly from us but they get funding more rapidly, their bills are paid more quickly, through the use of this facility.

Chair: Drop us a line on how the small firms get their claws on the cash. I think I have a pretty good idea but I think it would be helpful for the Committee to have something on paper. David Rutley.

Q37   David Rutley: Just building on that point, this is a subject that's close to the heart of George and many other people here on the Select Committee. Last time we discussed the challenges of funding for small businesses you stated to me, I remember very clearly, that you felt MPs should be doing more to raise the profile of these issues and you inspired me. I've worked hard locally to try and raise the concerns of businesses in Macclesfield and I'm sure Members opposite will be doing the same for Retford, which we've heard much about in recent meetings. But do you feel, based on the conversation so far, that you've done enough? What have you done since we last met a couple of months ago to help the particular cause of SMEs?

Mervyn King: It is not for the central bank to take on responsibility for that. That is a matter for Parliament and the Government.

David Rutley: No, but you said to me, I remember distinctly, that MPs should be doing more to raise the profile. We've been doing that. What have you been doing to raise the profile?

Mervyn King: It's not our responsibility to do it. I'll be very clear on this. The central bank is designed to be in charge of monetary policy, to ensure the economy as a whole has enough money, to make sure it runs smoothly with inflation close to the target. It should not be for the central bank to decide which individuals and which sectors of the economy have access to finance. That is a political matter; it is for Government. If you feel there is a need for a special facility for small businesses, then it is for the Government to put that in place. We can play a role in advising the Government, in helping the Government to put that together and, if necessary, to operate it as an agent of Government. But it should not be for the central bank to take the initiative in deciding how to allocate credit within the economy. That is for the market first and, if the Government wants to intervene in the market process, that has to be the responsibility of the elected Government.

David Rutley: Given your stated concern at the last meeting, I feel disappointed that you haven't sought to use your influence more.

Mervyn King: I talk regularly to the Chancellor about this and I have made clear to him what the issues are, but this cannot be a matter for the central bank.

Q38   David Rutley: In your statement today you expressed your concerns about net trade and how we need to improve in that situation. In fact, on 10 November in Q&A on the Quarterly Inflation Report you expressed concerns about net trade again and noted that 7% of our exports go to Ireland, a country that's in the news at the moment. And, in fact, we're in a situation where more exports from this country go to Ireland than to China, India, Russia and Brazil combined, which is staggering. Given the growth in emerging markets over the last decade, do you feel that being in this situation is a dereliction of duty or a missed opportunity by the previous Government?

Mervyn King: I don't think Governments can decide to which countries we can export. That is a functioning of the economy itself and the Government's responsibility is not to tell firms which countries to export to, in the same way as it can't tell other countries to buy British goods. What we have to do over a period of time is to ensure that we have an economy that works effectively and efficiently—there are many aspects to that and they certainly aren't for the central bank to determine—so that we have an economy that can flexibly respond to changes in demand. And you rightly point to the fact that over the next few years we do need in this country to expand our net exports, not just exports but production to substitute for imports, in order that we can accommodate the slowing in domestic demand.

David Rutley: Actually, it's not my opinion. I'm looking at your opinion in Q&A in the Inflation Report.

Mervyn King: Well, I hope you'll share it because it's a very important challenge that we've taken on.

Q39   David Rutley: I'm pleased that's the case, but what should have been done over the last 10 years? You have an opinion that we're in a difficult situation now, given the balance of our exports. What should have been done more over the last 10 years?

Mervyn King: The most important thing was that at international level—no one country could have affected this—the problem of the imbalances was discussed endlessly and in the end nothing was done about it. And the denouement of this, I think, led directly to the financial crisis. What matters now is how we get out of it. As I said at the same press conference, it is very important for the major countries in the world, the G20 or a subgroup of the G20, to recognise that what they have is a common interest in finding an agreement on the path of adjustment of these imbalances, because countries that were formerly deficit countries, and to some extent still are, cannot continue to borrow from the rest of the world. Their borrowings are going to have to decline. We see that in every country facing financial problems now.

If that is going to be the case, we need the surplus countries to expand their domestic demand, because they will not able to export as much as before. There are several ways in which this could come about. One is a disorderly process, perhaps involving protectionism, perhaps just involving deep recession in a number of countries. It is far better if we can reach a common agreement on the strategy that we'll all follow to ensure that the rebalancing that is necessary in this country, more importantly in the United States and a number of other countries, can be matched at world level by an expansion of domestic demand in the surplus countries. Without that, then I fear we will have a bumpy ride over the next few years. It's not easy, but I think the first step is that recognition of a collective interest in the process.

Q40   David Rutley: In your conversations with the Chancellor then about what more could be done, there have been delegations to China and to India. What else will you be saying in your conversations to the Chancellor about what else the Government should—

Mervyn King: I think the UK is playing a very constructive role in trying to bring the major players together in order to recognise that collective interest.

Q41   Mark Garnier: Broadly speaking, my comments are addressed to you, Governor, but if anybody else wants to leap in, please do. Just an incredibly simple question, and I hope we'll get an incredibly simple answer; I'm just looking back to kind of when quantitative easing first came about. As I remember, one of the key points about QE being quantitative easing and not printing money was that QE needs to be unwound at some point in the future. Is that right?

Mervyn King: Yes.

Q42   Mark Garnier: Okay, brilliant. So what that means, and the point of this £200 billion we have in QE right now, is that markets need to be confident that at some point, even though we may introduce more QE—another £50 billion, £100 billion or whatever in the future—that will go back to zero. Have you any sort of idea of a timescale for that?

Mervyn King: No, we can't, because that is a statement of what monetary policy will be in the future. At some point we will do it. Over what time horizon, I don't know, and it would be foolish to judge that now, because it must depend on the state of the economy as it unfolds.

Q43   Mark Garnier: Which I absolutely accept, and a very wise answer. The question, however, is that there's a lot of discussion now about protectionism and in terms of countries using QE in order to promote their trade advantage, and clearly QE, depending on how much money you're putting into the system, can determine what your exchange rate is going to be. Obviously we've seen, as you say in your statement earlier, a 20% reduction in the UK's exchange rate, which has put us in a much stronger position. You also say, and I quote, "There's a world of difference between deliberately intervening in order to lower or raise the exchange rate or setting domestic policy and then letting the market determine that exchange rate." How can the market be confident that it's policy and not the actions of the MPC, particularly through quantitative easing, that is determining exchange rates?

Mervyn King: We can give you an absolute assurance that we have not intervened in the exchange market, and if we were—

Q44   Mark Garnier: No, no, but I'm talking about the secondary element.

Mervyn King: The quantitative easing is a form of monetary policy. It's a form of monetary policy with a very old pedigree. Go right back to the writers on monetary policy in the past; this was a standard form of monetary policy. As Paul explained earlier, this was used by Governments in the past, in the 1980s. The language was different; over-funding and under-funding were discussed a great deal at that point. Arcane language maybe, but very similar in principle. But the real point is that countries that set their monetary policy, if they accept the consequences for that in the foreign exchange market and do not intervene, other countries should also accept that. If they don't like the consequences for the exchange rate, it's in their own hands. No one has to accept or import US monetary policy. If people don't like American monetary policy for themselves, they should let their exchange rate move. No one is forced to accept that.

Q45   Mark Garnier : I just want to quickly check on one particular point, on the point of unwinding QE. Can you define absolutely clearly for the record what that means?

Mervyn King: Unwinding our asset purchase programme would mean to sell back into the market the gilts that we had purchased in the process of doing our asset purchases.

Paul Tucker: And withdrawing the extra central bank money that we have injected.

Q46   Mark Garnier: Which means that at some point in the future, you can be in competition with the Government in issuing gilts.

Mervyn King: In terms of selling it into the market, obviously yes, but in the same way we are buying gilts now, we will be selling them in the future. These are standard monetary policy operations that can be carried out in other directions.

Mark Garnier: Yes, sure. I appreciate that.

Paul Tucker: Can I add one other thing? We were buying gilts in the market before this.

Mark Garnier: Yes, but not with—

Paul Tucker: Not on the same scale, but we were buying gilts in the market before, and I have no doubt that we will be buying gilts in the market when this has passed. What will be withdrawn is the extra central bank money we've put out there, over and above what the banking community would spontaneously demand at the level of interest rates that we set.

Q47   Mark Garnier: Just going back to you, Mr King, you're very clear in your statement about the fact that we have to rebalance this economy away from domestic demand to international demand, we have to boost our trade, and I think all of us would agree that that sounds the right way to do it. But what I'm concerned about is that other countries are going to be looking towards you much more now, as the MPC, to see what your actions are going to be in the future. Are those actions going to be deliberately made in order to follow what you've said in this statement, that is are you going to be sitting there making a policy among yourselves to boost UK trade? Very helpful though it may be, the international markets might be quite worried about that.

Mervyn King: No, I think we've been very clear on this, and we will continue to be clear. That's why I said earlier this is certainly no time to change the inflation target. Our remit and our objective and the objective to which monetary policy will be devoted month in, month out is to meet the inflation target. That is what financial markets all want to know.

Q48   Mark Garnier: At no point do you ever discuss the exchange rates? You're not considering exchange rates?

Mervyn King: We discuss exchange rates a great deal, but not in order to do that.

Mark Garnier: But in the context of what you're trying to get with an outcome.

Mervyn King: No, absolutely not. Anyone who decided to set an exchange rate as a target would surely be aware of the difficulties that that has created in the past. We have a very clear set of instruments and a very clear target. The challenge is not to know what the target is or the instruments; the challenge is to work out at what level to set the instruments in order to meet the inflation target, and that's what we spend all our time discussing.

Q49   Chair: Paul Tucker, if cranking up QE can be seen as a substitute for the fact that we can't lower interest rates any further, would you agree that unwinding QE may come to be seen as a substitute for not raising interest rates?

Mervyn King: Not a substitute for it, no.

Chair: I did ask Paul Tucker.

Mervyn King: I'm sorry, I didn't hear that.

Chair: That's all right. By all means, I'll let you have a go in a moment.

Paul Tucker: I'm pretty sure we're going to give the same answer, actually.

Mervyn King: Probably will.

Paul Tucker: I think it was in your Mansion House speech, Mervyn, that you said after discussion among us that, depending on the circumstances, expectation is that when we come to withdraw the monetary stimulus that we would do it initially by raising interest rates and then eventually by selling back the gilts. Why is that? Because in those circumstances, the interest rate is the easier tactical instrument, if you like. This is just common sense.

Q50   John Mann: Governor, you have cited the June 2009 Treasury Select Committee and your responses to show how much you warned of the necessity, but that's not what you said, is it, in June 2009? Indeed, in June 2009, you never mentioned structural deficit, implied or explicitly, in any way. What you said was that that the deficit would have to be dealt with when the economic conditions were improved, and you said that on three occasions.

Mervyn King: I did.

John Mann: You made no other statement whatsoever in that meeting in response to the questions in relation to the deficit.

Mervyn King: I said the scale of the deficit needed to be reduced on a more ambitious timescale.

John Mann: No, you didn't. I have the transcript here, and what you said in that meeting was "dependent on the economic circumstances" and you were questioned by three members of the Committee. In your opening statement, you never mentioned it once. What you said in your opening statement, if I quote, as the important factors, the first was about broad money, which was the moment of the day, and the second imperative you said was to reform the international monetary system.

Mervyn King: Indeed.

Q51   John Mann: When you were questioned on the deficit, the issue of structural deficit, implied or explicitly, in that language or any other, was never raised by yourself in any way, in any context whatsoever. So the issue of the deficit you defined, again quoting directly from you is, "One of the points that does not attract sufficient attention in the public debate is that the speed at which the fiscal stimulus should be withdrawn has to depend on the state of the economy."

Mervyn King: Absolutely, and I have said that since.

John Mann: You were consistent in saying that.

Mervyn King: Yes.

Q52   John Mann: But that was your response then. We've talked about the May Inflation Report, but let's look at the November one, "'Austerity cuts will not derail the economy' said King", that is your good self, and—

Mervyn King: I did not say that. That is clearly not a point from anybody at all. Is that your local newspaper or some other?

John Mann: Well, you did say, "It is clearly feasible and not at all unreasonable to see a shift in employment between the public and private sector. It can be done."

Mervyn King: It seems a rather different form of words, if I may say so.

John Mann: Well, that's not how The Times—

Mervyn King: Indeed, it's exactly what has been happening, actually.

Q53   John Mann: The Times newspaper is popular probably in my area. But this question of you commenting on fiscal policy and not, I don't recall when I sat on this Committee you ever raising the structural deficit with us, conceptually or using that term, on any occasion. I wasn't at the June meeting, but I was at all the others. I have the transcript from that meeting I didn't attend, which all the way through it—

Mervyn King: Absolutely, and I have—

Q54   John Mann: I am not critical, but I'm pointing out there is a dilemma in you having to work with Government, and I want to raise something you said this morning in this context. While it may sound a criticism, this isn't a criticism, because this is a dilemma that you and anyone in your position will always have in terms of not being accused of talking down the economy, by talking down what the Government is doing. I understand, indeed I appreciate that dilemma and that problem. But today you used the term "rebalancing" and you were very clear what you meant by rebalancing, but rebalancing has become a political term. Rebalancing in the political context in this country at the moment, as used by us and the media, is about rebalancing between public sector and private sector. You're now using the term "rebalancing", rebalancing "away from those serving the domestic economy". Isn't there a danger with language that things could be implied, having the support of yourself and the Bank with that term rebalancing, that in fact it's not what you mean but gives the politicians—not least the Chancellor—much more leeway in how he uses the term rebalancing?

Mervyn King: I have always been very careful in the way I have used the word rebalancing. It is the conventional economic use of the word, to do with imbalances in the international economy and trade deficits. I've always used it in that way. I have never, ever commented on the appropriate balance between spending and taxes as a way of reducing the deficit.

Q55   John Mann: No, but you have, in response to questions on 10 November, when you stressed in response to a question from another journalist that the job losses in the public sector are going to be front-end loaded, rather than back-end loaded. Is that what your agents are telling you is happening out there?

Mervyn King: No, I did not say that. What I said was that the plans, as reported by the OBR—it's not our judgement, the OBR—is that the loss of public sector jobs will be back-end loaded, not front-end loaded, and that over the past 12 months we have already seen 250,000 net new jobs created in the UK economy.

Q56   John Mann: Just one final question, because it is the key one in this, and it is on this question of rebalancing. What you're saying is we need to move away from those serving the domestic economy?

Mervyn King: Private or public. That is not for me to say.

John Mann: That's where the jobs are being created. The new jobs that are being announced are precisely the supermarkets, the food industry, rather than the FTSE 100 exporters. So the new jobs coming in are those that are serving the domestic economy, but you're suggesting a policy objective of trying to change that to exporters, where in fact of those FTSE 100 exporters in the last five years there are less jobs being created. That's taking the Bank into some interesting policy areas for Government.

Mervyn King: No, don't put words into my mouth. I have not talked about a target for jobs in any particular sector. I have talked about the need for total demand to shift away from private demand, away from final demand, domestic demand into net export demand. That is already happening. We saw yesterday the first set of numbers published by the ONS that show that that is beginning to happen with a positive contribution from net trade. It's the pattern of demand that is crucial to our analysis for inflation and is something we're clearly entitled to talk about. We have no target for employment in different sectors at all.

Q57   Mr Love: Chancellor—sorry, Governor. I have Chancellor on my mind, as it happens. It's a slow start. Governor, some months ago when there was a lot of speculation that the Monetary Policy Committee would be engaging in further quantitative easing, the Chancellor—and that's why it was in my mind—was asked about this and he said he would follow the exact same procedure as that of his predecessor. We know that there's an exchange of letters, and that happens following the decision, but what is that procedure in advance of a decision of the Monetary Policy Committee regarding quantitative easing?

Mervyn King: I think both ends of town know that if the Monetary Policy Committee wanted to engage in further asset purchases then that is something that we would ask the Treasury to confirm that we have the authority to do that, with the indemnity. I will be very surprised if the Chancellor were to deny the right of the Monetary Policy Committee to carry that out. He has the right to do so, but we have the right to say that that's what we wanted to do. So that will become a matter of public knowledge. The exchange of letters takes place after the Monetary Policy Committee has decided what it wishes to do. So far that has not been necessary in recent months.

Q58   Mr Love: Let me very clear about that. Are you saying that there will be discussions before between the Bank and the Treasury? Are you saying that the Treasury's representative at the Monetary Policy Committee would be asked specifically on that? How do you know that you will get a green—is it just that the damage to the relationship would be such that—

Mervyn King: Yes. We can't know and I don't know when I see the Chancellor what the committee will choose to do, and I cannot tell him, "Well, next month we're going to vote for this". I have no means of knowing that. So the decision by the committee is something that will be observed by the Treasury representative, and he will be able to communicate very quickly with the Chancellor to get a quick answer. Everyone knows that the question may or may not be posed and therefore presumably knows what the answer will be. This is something we can deal with very quickly if we have to.

Q59   Mr Love: The Chancellor was asked about this when he came to us, but of course he came on the day the Monetary Policy Committee was meeting so he was somewhat coy about what he would say, naturally enough. I don't think anyone—

Mervyn King: Indeed. There's no point in answering a question if it hasn't been put to you.

Mr Love: No. One could understand why he was a little coy. But the reason the question was put was some concern that there had been statements, particularly from the Prime Minister, suggesting that they would be unhappy, or are unhappy with quantitative easing and further quantitative easing, because they believe it will be inflationary in the longer term. Does that concern you, and have you had discussions with the Chancellor in relation to their commitment, should you desire it, to go for further quantitative easing?

Mervyn King: I'm quite convinced that if we felt that it was appropriate to do it, the Chancellor would allow us to do it. I can't commit him, clearly, but he certainly hasn't raised any objection in principle with me at this stage, but he has the right not to give an indemnity if he so chooses. That must be his choice, but I think it would be hard to believe that he would deny the right of the MPC the authority to carry out I think what we all accept to be a conventional monetary policy operation.

Q60   Mr Love: Thank you for that. Can I move on now? In your statement this morning you made a very important positive remark, which was of course that the net trade position is improving, which I think we would all welcome, but there are indeed considerable clouds on the horizon. We have Ireland, we have Europe where—I won't go into the word contagion—further difficulties may arise, particularly in southern European economies. The American economy may struggle a little bit. I noticed in the press conference you had after the Monetary Policy Committee you said that the balance of demand was absolutely critical if the private sector was to mop up the unemployment that would be created from the fiscal constraint. How confident can you be, with those dark clouds, that we'll get that rebalancing that will allow the private sector to do that?

Mervyn King: We can't be confident in terms of timing, clearly. The next few years will require, as I said before, a significant rebalancing. The precise time profile of that is hard to judge. I'm sure that we'll be going through some turbulent waters. There will be gusts from time to time that blow us a bit off track, but eventually I think we'll get there, because the significant real depreciation of sterling is a very significant factor. Past experience would lead one to expect that eventually, over a time period that's hard to judge, that will clearly feed through, and I think we're beginning to see the results of that. You see it clearly on the data on goods exports; you see it in the contribution of net trade in the numbers published yesterday; you see it in the report of our agents; you see it in some of the strengths in the manufacturing sector. So I think it will be a strange view not to believe that at least some of that will come through. How big it will be is hard to judge, and I think you point to what, to my mind at least, is the single biggest uncertainty facing us, which is the strength of the export markets into which we will need to sell.

Q61   Mr Love: Let me press you further. If there is continuing weakness in the euro economy as a result of what has been happening recently and that has an effect on the exchange rate of the euro, if as a consequence of quantitative easing—I know there's a debate about the impact of quantitative easing in the United States in relation to the exchange rate of the dollar—in terms of trade weighting, the pound was to appreciate in value, how much would that threaten the rebalancing?

Mervyn King: That depends on how far it goes. I think what we've seen so far is that between the second half of 2007 and the end of 2008, early 2009, it was almost a step jump down in the level of sterling. It has been pretty stable since. But I think what you point to is the fact that we all have a strong collective interest in seeing a healthy European recovery. That is very important. Three quarters of our exports go either to Europe or to the United States. The strength of the world economy, to which Andrew referred, is seen more obviously in the other quarter, the emerging market economies. Now, of course it feeds through indirectly. Germany is expanding quite quickly, in large part because of the strength of the emerging markets to which it is selling engineering exports, and that will help the demand by Germany for goods produced in the UK. So there are indirect effects too. But the most important thing—and it goes back not just to the euro area, but to the imbalances that I mentioned earlier—is that we all have a strong collective interest in a strong world economic recovery. If we don't get that then undoubtedly we, along with everyone else, will suffer.

Q62   Stewart Hosie: Governor, you said today we need to shift away from domestic demand, this rebalancing; twice today you've said consumption must slow. But Charlie Bean, one of your deputies, said, "What we're trying to do by our policy is encourage more spending". He went on, "Ideally, we'd like to see that in the form of more business spending. Part of the mechanism that might encourage that is having more household spending, so in the short term we want to see households not saving more but spending more", which presumably would stoke consumption, domestic consumption, and run contrary to what you've said earlier. Where is the balance and the timeline on the shift away from domestic demand?

Mervyn King: What Charlie was referring to—and he explicitly quoted this in the full comments that he made—was what I referred to in an earlier speech as the paradox of policy; that is, what you feel you need to do in the short run is the opposite of what you know you have to do in the longer run. In the longer run as an economy, we need to save more, export more and consume less, relative to GDP as a whole, a share. In the short run, we need to maintain levels of demand in order to prevent a deeper recession, and there is that conflict between the short-run imperative and where we need to get to in the medium term. We're beginning now to move away from the short term towards the medium and longer term.

Q63   Stewart Hosie: On the issue of saving more, obviously the savings ratio forecast is down every year in the CSR period, and we know there's huge pressure on mortgages, and there's a direct correlation in terms of mortgage availability with more savings deposits with a higher savings ratio. How important do you feel the mortgage market, the property market and construction are to the overall health of the economy generally? How do you look at that when you're looking at the forecast—

Mervyn King: I don't want to exaggerate. It's clearly important, it's a major factor in people's decisions, both in terms of house purchase, ultimately the construction of houses, and the form in which they allocate their wealth. But the biggest impact of the housing market in the last decade has really been an intergenerational shift, with the younger generation coming into the housing market and taking on a large burden of debt, which has been mirrored by an acquisition of financial assets by the older generation, the retiring generation. It didn't in itself result in a significant impact on consumption, but it certainly had an impact on the intergenerational distribution of financial assets and liabilities.

Q64   Stewart Hosie: In terms of housing then in relation to inflation, because we know property inflation has been significant, the Consumer Prices Advisory Committee have recommended that ONS look at what they call owner-occupier housing cost indices so they can more accurately measure the value of inflation and overall inflation indices. Do you think we should move to these separate indices quickly, or do you think we should do something more sophisticated with the CPI measure?

Mervyn King: I think it would be a mistake to jump into anything, for two reasons. First of all, for many years, well over a decade, the Bank has made quite clear that it thought that ultimately we should have a better measure of the impact of the rising cost of owner-occupied accommodation entering into the consumer price index. This has been something we've discussed for many years and I've referred to at this Committee for a very long time. The question is how you do it, and for a long time we've been waiting for a common European approach to do this. Whether we get one or not quickly, I don't know. They seem to be moving in a direction that may produce some results but, unhappily, perhaps not in the right way, according to our judgment. The important thing now is that the ONS is focused on this question, and there now needs to be quite a long period, I think, in which people can experiment with different ways of incorporating the cost of owner-occupied housing to see whether we think these measures are sensible or not.

There's no need to rush into this, because the second reason why I think it would be a mistake to change quickly is that at a time when there is concern about inflation being a target, understandably, I think the last thing we want to do is to be seen to be moving the goalposts at a time when others might believe that it was convenient to do so. It's very, very important we don't do that.

Q65   Stewart Hosie: I appreciate that. This a final question—I know time is short—to Dr Sentance. You had said earlier obviously you have to take account of all the things that are material to the economy and for inflation, so it's basically the same question. How much weight do you give to the issue of housing costs and housing inflation when you're looking at the forecast for the economy?

Dr Sentance: I think it's probably better to talk about the housing market more generally. The housing market does have a bearing on consumer attitudes, consumer perceptions of wealth, and the house price movements are an element of that. It's one of the areas that we look at, but I wouldn't say that it has been sort of dominant in my thinking in recent terms. If I had to pick out an area that has been most significant in the impact on the real economy, it was the one that we were talking about just now, which is the global economy. I think the housing market came back a bit during 2009 and there has been more uncertainty this year about its progress, but the area that I think has most significantly affected the UK recovery has been the rebound in the global economy. As we discussed earlier, I think the prospects for that are probably the most significant thing affecting the UK outlook at the moment.

Chair: We have found that extremely valuable and informative and a demonstration of how an independent institution can be made accountable to Parliament. Thank you for your evidence. We are now going to take a five-minute break and then resume with a session on the regulatory side. Thank you, Governor.

Mervyn King: Thank you.

Chair: Thank you, everybody.

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Prepared 17 January 2011