Session 2010-11
Publications on the internet

To be published as HC 798




Treasury Committee

February 2011 Inflation Report

Tuesday 1 March 2011

Mervyn King, Charlie Bean, Paul Fisher, Martin Weale and David Miles

Evidence heard in Public Questions 1 - 77



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Oral Evidence

Taken before the Treasury Committee

on Tuesday 1 March 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andrew Love

John Mann

Mr George Mudie

Jesse Norman

Mr David Ruffley

John Thurso

Mr Chuka Umunna


Examination of Witnesses

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

Q1 Chair: Thank you very much again, Governor, for coming before us this morning. I am afraid it is a long morning, but we have just debated-

Mervyn King: I have brought on some substitutes at half-time to strengthen our team.

Chair: So have we, as a matter of fact, if you look carefully.

Mervyn King: Indeed.

Q2 Chair: The issue we are now debating is even bigger than the one we have just done in some ways. I do not know exactly how long this evidence session will last but I hope that we are over in time for some lunch at 1 pm. You said at the "Inflation Report" press conference that we are seeing, and I quote, "Very volatile short-run movements in inflation". How long does it take for such a series of short-run movements to become the medium term?

Mervyn King: It is impossible to say. It depends on whether people believe and expect that these movements will continue. Financial markets clearly do not believe that the rates of increase of prices that we have seen will persist, even if the levels will persist. I think the broad judgment of the committee is that the increase in inflation that we have seen in the short run would be expected to come back towards the target, and the debate on the committee is about not whether that will happen but the speed and extent to which inflation will fall back to the target and whether it will come back to target or below it or remain above it. It is that medium-term perspective that is the basis for discussions and differences of view and judgment on the committee.

Q3 Chair: How many letters do you have to write before you are writing these letters in a medium-term rather than a short-term framework?

Mervyn King: I would certainly expect to be writing letters through the rest of this year, because the measure that determines whether I write a letter is the increase in prices over the previous 12 months. The forecast that we produced, projections that we published in the "Inflation Report" a couple of weeks ago have the characteristic that the inflationary pressures are pretty much back to target by around the middle of this year, but of course that does not show up in the 12-month measure until well into 2012.

Chair: You have written five. Is there an infinite number of letters you can write before you have failed in your mandate?

Mervyn King: No, I don’t think that, and I think the question is whether the explanations we give are judged to be reasonable or not. We have never pretended to be able to forecast inflation remotely accurately. We went through a period of 10 years when inflation moved very little from its long-run, close-to-trend pattern, and that is because there weren’t very many shocks coming along, but as Charlie Bean wrote in a well known article before he joined the Bank, we would expect to be writing letters almost half the time given the normal pattern of volatility of inflation. We went through a period then in which volatility was much less than normal. Now we are going through a period when it is much greater than normal, and I think that is not particularly surprising given the shocks that have hit the world economy. I think that people will judge us as to whether our decisions, given the information available at the time, were reasonable and whether the explanations for what has happened seem reasonable.

Q4 Chair: What discussions have you had with the Chancellor about the relationship between his fiscal stance and monetary policy?

Mervyn King: Well, I don’t discuss the stance and monetary policy with him. I explain the views of the committee, but he doesn’t attempt to influence the decisions of the Monetary Policy Committee-his predecessors did not try to, too. Clearly the position we take is that the Government set out their fiscal policy and the Monetary Policy Committee takes that into account when it makes its decisions every month.

Q5 Chair: What do you take the Chancellor to mean when he says, "The Government’s commitment to delivering their fiscal consolidation plan continues to provide the MPC with the space that it needs to target low inflation."?

Mervyn King: I think that is a question you should put to him.

Chair: Well, you have had an exchange of letters. These letters are of particular importance to everybody. Do you have no view at all?

Mervyn King: I am certainly confident that he is not trying to hint to the MPC what we should or should not do. That has never been the case. Indeed, I think one of the great strengths of the regime is that through three Chancellors now there has never been any attempt on any occasion to influence the MPC into what decisions it should take.

Q6 Chair: It has been suggested that you might be running an accommodating monetary policy, so that deep fiscal adjustment can more easily be made.

Mervyn King: No. We are setting monetary policy in order to meet the inflation target, of course taking into account the fiscal stance and the consolidation of public finances that the Government have announced. It would be foolish not to take that into account, and we think that that fiscal consolidation over five years will have a dampening effect on the growth of demand relative to what would have been the case had that not occurred. We take it into account, and it influences the stance of monetary policy, but only insofar as any development in the economy that affects demand will obviously affect monetary policy. It is one of many things that we take into account.

Q7 Chair: Just to be clear, on this question of co-ordination of fiscal monetary policy, you have had no discussions with the Chancellor about this at all.

Mervyn King: We have certainly discussed the case for and against fiscal consolidation, and I have explained to him the stance that the MPC has taken on monetary policy to date, but he sees that through reports from the Treasury representative who comes to the MPC meetings as an observer.

Chair: But I am asking you about your meetings with the Chancellor.

Mervyn King: No, I have never discussed with him propositions of the kind, "If we tighten fiscal policy, will you loosen monetary policy?" That kind of conversation has never taken place.

Q8 Mr Umunna: I just want to follow up on the questions that the Chair has just asked and look at your options going forward. Most people think that the bank rate cannot possibly fall below its current level, given the forecast inflation this year. If inflation is as you forecast, how can rates possibly fall further?

Mervyn King: I don’t think it is likely that under any circumstances the committee would try to cut the bank rate below 0.5%. When we felt last year that we needed to loosen monetary policy further, we did so through asset purchases, not through further cuts in bank rate.

Q9 Mr Umunna: On that, obviously there was quite a bit of speculation before Christmas that the MPC may entertain a further round of QE, and I think that has receded. Under what circumstances would you entertain a further round of QE if growth remains sluggish but inflation remains high?

Mervyn King: It would depend. If we felt that the reason why inflation was high was temporary and inflation would come down and that the sluggish growth created a risk that inflation would fall below the target, and if we felt that risk was sufficiently high that the balance of risks to meeting the inflation target was that we thought the risk was on the downside rather than on the upside, then I think that would be the set of circumstances in which we would contemplate further asset purchases, but it would be entirely in terms of a judgment by the committee as a whole about the outlook for inflation in the medium term.

Mr Umunna: But that set of circumstances is not in line with what you forecast.

Mervyn King: We don’t forecast a single set of circumstances. Many things can happen in the future, and perfectly consistent with our projections are the possibility that we might either tighten monetary policy faster than people expect or indeed loosen monetary policy relative to the central view that the market holds. There is no unique part in it.

Q10 Mr Umunna: But, Governor, if you look at this year alone, you are not forecasting inflation to be to target until next year.

Mervyn King: As a central view, absolutely.

Mr Umunna: I am just saying, given what your central forecast is, I suppose my real question is how can you further loosen monetary policy in those circumstances?

Mervyn King: I think given the forecast that we published two weeks ago, those are clearly not the circumstances in which we would vote to exercise further asset purchases and that is obviously why we didn’t vote for that. But if circumstances were to change and if that led us to revise our projections so that we thought that perhaps because growth was sluggish, or for some other reason the outlook for inflation had the risks more on the downside than the upside relative to target, those are the circumstances where you would see it in our forecasts, and those will be the circumstances in which we will be debating again the question of whether we would engage in further asset purchases.

Q11 Mr Umunna: If your forecast turns out to be correct, and you have just said it is unlikely there would be a further round of QE in those circumstances, you have also just said that the bank rate really cannot possibly fall below where it is at the moment. What options are left open to you to stimulate demand in the economy if growth is continuing to be sluggish this year but inflation is as you forecast?

Mervyn King: If we felt that because growth was very sluggish that caused a downside risk for inflation in the medium term, then we could engage in further asset purchases, and I think we feel that would have some effect. You used the phrase, "If the forecast turns out to be correct"; we don’t see forecasts as being either right or wrong. They are entirely probability distributions; they are judgments about the balance of risks. The chance of our central projection taking place is close to zero.

Q12 Mr Umunna: Do you think it is about time, Governor, that we revisited the remit of the MPC? Currently you are required to keep inflation to target, and some would argue that if that was really the only target you would have increased rates some time ago. Don’t you think it is about time we made explicit what has been happening informally for some time and expand the goals that you were supposed to account for so that perhaps you operate more along the model and the goals set for the Federal Open Market Committee in the US, so it is more open and explicit what you are seeking to do and what goals you are taking into account?

Mervyn King: No, I don’t share that view, because I think the problem with the FOMC remit is that it can lead people to think that there is a long-run trade-off between inflation on the one hand and output and employment on the other. I do not believe that to be true, and I don’t think that’s the basis on which the FOMC is operating either. Indeed, it is interesting that members of the FOMC are moving much closer to our framework by adopting either an informal or a more explicit target for inflation.

Q13 Mr Umunna: But, Governor, with every quarter that you come back to us and say, "Essentially, this is a temporary blip", that argument in many senses becomes less credible. I suppose I am just saying can’t we get you, as an MPC, out of the hole where you are coming here and you constantly have to pretend this is a temporary phenomenon? With every quarter, that reduces in credibility as an argument.

Mervyn King: I think the actual remit we have now, which is the formal remit given to us by the Chancellor and approved by Parliament, already allows for that. It says, and I quote, "The framework is based on the recognition that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output".

Mr Umunna: But it said "on occasion". You have had to write so many letters to the Chancellor now about exceeding the target.

Mervyn King: I go back to what I said to the Chair: if people understand that the explanation we give is a reasonable one, namely that these movements in commodity prices and oil prices and food prices were things that certainly we didn’t expect to be the most likely outcome, they were part of the possible set of outcomes, and we acknowledge that in our fan chart, that these were not the central view and they certainly weren’t the central view of financial markets either. In the last three months alone food prices have risen by 20%, oil prices by one third, and none of these were anticipated as a central view by financial markets.

Q14 Mr Umunna: One thing you did not mention in that was the exchange rate, which is obviously going to have a material effect on prices. Is a weak pound consistent with an inflation target of 2%? Andrew Sentance gave a speech recently where he suggested that he didn’t really think that that was consistent with keeping to the 2% target. What do you think, Governor?

Mervyn King: I think if you look at the behaviour of the exchange rate over the lifetime of the Monetary Policy Committee, in the late 1990s sterling rose sharply, by over 20% in effective terms. We didn’t fully understand why that had occurred. I think you could make arguments to the effect that the new euro was an unknown currency and perhaps it wasn’t so surprising that people were unsure about it, but sterling rose. That led to the beginning of a trade deficit, which continued for quite a long while. After the financial crisis hit, markets re-evaluated the likely long-run strength of sterling and over the following 12 months sterling fell by 25% on average against other currencies. Since then it has been very stable for the past two years, so I think that is best understood as being very much a one-off re-evaluation of the likely level of sterling necessary to ensure that we can achieve a rebalancing in our economy. I think it is perfectly consistent to have that change in the level of sterling.

This is not a continuously declining exchange rate. That would be a source of greater concern, but we are not seeing a continuously declining exchange rate. We have seen a big movement in sterling, which in and of itself added six percentage points to the domestic consumer price level. Now, one has to ask the question: six percentage points on the price level spread over three years means that even if you hit the inflation target, domestically generated inflation has to be zero in order to be consistent with the target. Well, interestingly, domestically generated inflation has been around zero, and the excess of inflation above the target can be accounted for by the unexpected increase in world commodity food and energy prices.

Q15 Mr Umunna: Just one last question. You have mentioned oil. To what extent have you factored in what is happening in the Middle East currently, which is obviously quite unexpected, I think, for all of us? How is the impact on the oil price being factored into the forecasts that you are making?

Mervyn King: As I said, oil prices have risen by about a third since the November report. Half of that had taken place by the time of our recent February meeting. That was clearly factored into our projections. We assumed that oil prices would follow in our central path, the path implied by the market expectation of oil prices, broadly flat from then onwards. Clearly, it has risen since. An awful lot will hinge on how far this rise in oil prices persists or whether, as the political situation in the Middle East begins to become clarified, it falls back again. After all, whoever is in charge in the Middle East can benefit from the oil only at some point by selling it to consumers outside the Middle East. These are very uncertain factors and these are the things that do move inflation around, not just only up but sometimes down, too. After all, oil prices a couple of years ago were near $150 a barrel, then they went right back to almost $50 a barrel and now it’s back to over $100. These things are very hard to predict, and I don’t think it makes sense to have a policy framework that is based on the idea that we can predict it. We can’t. We should accept that. What we have to do is to react to it.

Q16 Chair: Do you agree that the absolutely crucial question with respect to whether interest rates need to rise-at least among a number of questions this is the biggest-is the degree of risk that inflation entrenches itself in the private sector wage round?

Mervyn King: Yes. I think we accept that the behaviour of wages is crucial to evaluating that medium-term outlook for inflation. That is why it is so difficult to form a judgment, because it is quite conceivable that people will say, "Well, yes, I expect inflation to be high over the next year, we’ve seen that, but the Monetary Policy Committee expect it to fall back." I don’t believe that we’ve yet seen significant evidence of a pick-up in medium-term inflation expectations, and we certainly haven’t seen much evidence of any significant pick-up in money wage growth. That remains muted, but it is reasonable to believe that if we continue to experience above-target inflation for long enough, there could be an upside risk to inflation expectations.

Q17 Chair: Have you put in place particular steps to monitor what is going on in the private sector labour market over and above what you normally do?

Mervyn King: Yes. We have a very careful survey carried out by the bank agents of the wage round and what is going on in wage setting. We have always done this. We have reinforced our efforts this year and we will carry it out at more frequent intervals. I think all of us on regional visits pay great attention to what we are hearing about the climate for wage negotiation settlements around the country and we feed that into our thoughts. That is important, and we also look very carefully at measures of inflation expectations. But I think these are difficult judgments and it seems to me quite reasonable for people to take different views about the strength of the risk to that looking down the road, because this is a judgment about what will be happening to wages 12 months or two years from now.

Chair: But the question was whether you have boosted your efforts to monitor this in the light of the particular importance of that question, and the answer is that in the 12 months you have boosted it.

Mervyn King: Yes.

Q18 Chair: Do you agree that a crucial aspect of any increase is more the signalling effect that it might have than the tightening it will have in terms of technical monetary conditions?

Mervyn King: I personally pay less attention to that, because I think the signalling is really given by our explanations and the reasons we give for why we think inflation is above target now and why we think that a reasonable view is that looking ahead some two years or so the balance of risk is evenly divided around inflation being above or below the target. I think that is what should influence people’s judgment about what will happen. If we on the committee genuinely believe that that is a true statement of the balance of risks, then to raise interest rates just to make a gesture or a signal is self-defeating, because we would then find ourselves below target looking further ahead.

Q19 Chair: So you disagree with the view that there is merit in sending a signal in order to try and influence expectations in the private sector labour market?

Mervyn King: If our own analysis says that it is sensible to keep the Bank rate where it is for the time being, given our own analysis, then to do something different from that in order to give a signal seems to me undermining the framework. The whole point of this framework is that we try to analyse; we don’t pretend to forecast the future. We set out the various arguments why you might believe that the balance of risks is either on the upside or the downside. Reasonable people can take different views on that, and our decision-making process is one in which we say, "No one knows the absolute truth. Let’s get nine people on the committee and take the view of the majority as the best guide to what we should do in practice". I think that has served us fairly well.

Chair: Yes, and of course they don’t all have the same view.

Mervyn King: Absolutely.

Q20 Michael Fallon: Let’s bring in some of the others. Charlie Bean, a year ago the bank forecast inflation would be 2% today. It is now 4%. What do you think you got wrong?

Charlie Bean: First of all-

Michael Fallon: You were party to that forecast.

Charlie Bean: Absolutely, and let’s emphasise you are talking about the central projection. As the Governor has reminded you, we forecasted distribution about terms, and inflation has clearly been in the upper regions of that distribution.

Michael Fallon: It has been double what you said it would be. What do you think you got wrong?

Charlie Bean: No, we did not say inflation would be 2%. That was a central projection with a distribution around it. On the key elements that have led to that relatively high outcome, I want to highlight two in particular. The first is the development of commodity prices over the past year, which have risen substantially between a third and 50%. As the Governor noted, futures prices for commodities such as oil and so forth were relatively flat. That reflected the market’s best expectations of where commodity prices were likely to go. In terms of the drivers for those commodity prices, there is a mix of elements. Part of it is the strength of demand, particularly in emerging economies, but part of it-this is particularly relevant to agricultural commodities-has been unusual weather conditions in a number of different parts of the globe, such as Russia, Eastern Europe and Australia, where there has been hot weather and/or floods. So that is one clutch of drivers.

The other, which is more down to our inadequate understanding of the dynamic forces driving inflation, has in my view been continued. It passed through from the depreciation of sterling back in 2007 and 2008, and it is somewhat larger than I expected. In assessing the likely impact of that depreciation, if you go back to its immediate aftermath, we had to a degree been influenced by experience during the 1990s and the early part of this decade, where there was a lot of evidence for this country and for other countries suggesting that the so-called exchange rate pass through had fallen. Now, we based our assessment on that evidence. As it has turned out, the degree of exchange rate pass through seems to have been rather higher and closer to the experience that we saw before the 1990s. On top of that, it is also likely that the degree of drag on inflation from the margin of spare capacity has been rather less than we expected. So a number of factors go into that.

Q21 Michael Fallon: Paul Fisher, what is your explanation? You were party to the forecast too. Is it the weather in Russia, or is it an inadequate understanding of the sterling pass through?

Paul Fisher: Both of those, but I would add another, which is the VAT rate. A year ago, we could not have assumed that the incoming Government would put the VAT rate up to 20%, and that is probably adding about 1.5% now to the level of CPI inflation.

Michael Fallon: Since January.

Paul Fisher: Since a year ago. The change came in in January and some of it was probably anticipated, but the current rate of inflation is probably about 1.5% higher than it would have been without a VAT rate change.

Michael Fallon: And you got nothing else wrong?

Paul Fisher: I agree with what Charlie has said on commodity prices and on the exchange rate.

Q22 Mr Love: Can I come back to this issue of inflation expectation, because on one side some members of the committee are pointing to 70% of wage settlement so far this year being above last year as an indicator, but other members are saying it is idle chatter to talk about inflation expectations coming up. Isn’t that the central issue between different members of the committee as to the stance they take as to whether the Bank rate should be raised or not?

Mervyn King: No, I don’t think that’s the central issue. The central issue that we are trying to form judgments about, and on which in my view it is reasonable to have different opinions, is what will be happening one or two years from now in terms of wage settlements and how far the experience of higher inflation will lead wages to pick up, as those deciding on wages try to claw back some of the squeeze on living standards-real wage resistance, as it is called in the jargon-and how far some of the higher inflation expectations will lead both companies and negotiators to agree higher pay settlements. That is a question for the future. It is difficult to form judgments about that and perfectly reasonable to have different views on it, but the big picture I think is one in which everyone is agreed, which is that we think the main cause of the higher inflation is likely to be temporary. It may not be. We just don’t know. If there are further increases in oil prices, food prices or energy prices, it will keep going up and we’ll have great difficulty. But I think a reasonable central view is that it is more likely that commodity prices won’t continue to rise at the rates at which they have in the past year.

In terms of wage settlements now, the latest figures were somewhat lower than we had expected. I think we haven’t seen yet the pick-up of wages that we have built into our central view and there is plenty of scope for this to surprise us on the downside, but it could surprise us on the upside as well and that is what we’ll have to react to. I think the important thing in this framework is not to pretend that anyone on the committee can foresee the future. We don’t have a crystal ball, but we make judgments and we are willing to revise those judgments month by month as new information comes in.

Q23 Mr Love: You have mentioned wage settlements in two years’ time. Taking on board the points I think that have been made around the Committee so far about the credibility of inflation targeting, you have given a proper explanation of why it is at 4% rather than at 2%. But as it has been there for some considerable time, aren’t you worried that in two years’ time, rather than looking at the inflation at that time, which you are forecasting will be back to 2%, people will be looking back to the inflationary experience that they are experiencing now and the basis of wage settlements, and that therefore they will be higher?

Mervyn King: A lot will hinge on what happens over the next six to 12 months. Remember, it’s only two years ago that inflation was 1.1%, having been 5.2% a number of months earlier. Inflation can move quite drastically in either direction, and if it moves again over the next six to 12 months then I think people’s concern about inflation expectations might well dissipate quite rapidly. But as I say, we will see when we get there. The important thing is not to prejudge that but to look at the data as they come in and be prepared to adjust one’s position according to what is happening. But so far I think it’s quite difficult to point to hard evidence of a pick-up of inflation expectations, or indeed wage settlements. Now, that isn’t to say that there isn’t a concern about that, because that could happen and that might push up domestically generated inflation. Indeed, part of that is in our central projection. We expect some of that, but if more of it were to occur than is in our central projection, then we would start to see that and we would have to adjust policy accordingly. The important thing about policy is not for people to take up fixed positions that they hold indefinitely but to recognise that we make a policy decision every month and when each month comes round, there is a new set of data and we have to look at the situation again.

Q24 Mr Love: Dr Weale, you changed your position at last month’s meeting. Tell me the reasons why you felt that it was necessary to have a tightening.

Martin Weale: As the Governor has said, it is a question of judgment about the balance of risks, and looking at the prospects for the next year and so on as we see it I think it is fair to say that I am more worried than some other members of the committee that the sort of expectation and effect that you describe may get built into the wage bargaining process and the price setting process and I therefore thought it would be prudent to have a modest increase in the interest rate at an early stage. But I would also make the point that the fan chart in the "Inflation Report" is conditioned on market interest rates and those do show an interest rate increase coming in any case at around the middle of the year. Now, one might infer from the voting on the committee that at the moment that not all of the members of the committee think that would be an appropriate thing to do, but at least relative to that change I must say I don’t think it is an enormous difference whether you have a quarter point increase now or whether you have a quarter point increase in the middle of the year. My sense is nevertheless that I would err on the side of caution to reduce the chance of the sort of expectational mechanism that you describe taking place.

Q25 Mr Love: I wouldn’t ask you, Governor, whether the committee is leaning towards a rate increase later in the year as the market is suggesting. I wanted to go on to the somewhat surprising ONS figure that output fell slightly higher than the original expectation, and to compare that. Some people are saying, "Look at the business side. They are telling us that output is going up, but the figures, somewhat delayed, have shown a different picture." What is the balance of judgment on the committee about where output is going over the next six months to a year?

Mervyn King: I think we all accept that output growth slowed in the second half of last year. It was very strong in the second quarter of last year. Some of that was the rebuilding of stocks and inventories that had been run down during the extraordinary downturn between 2008 and 2009. That impetus to demand has eased somewhat. Consumption spending is weaker. Consumption barely grew at all in the second half of last year, so it is clear that output growth slowed in the second half of last year. I think what we should think about very carefully is the balance between different sectors of the economy. Exports are growing rapidly; exports of goods are growing by more than 10% a year and manufacturing looks fairly strong. The surveys that we have for the beginning of this year suggest that activity did pick up in the first part of this year. Whether that applies to the economy as a whole right across the service sector-because it was the service sector that was weak in the end of last year-remains to be seen, and we await with interest the ONS’s first estimate of output in the first quarter of this year. But these are difficult judgments, because no doubt two or three years from now we’ll look back and say, "Gosh, the ONS estimates are quite different from those that they published initially", which is inevitable with the process of collecting and refining statistics.

It is very important not to put too much weight on any one number or any one statistic, but I think we have seen an easing in growth-there is no doubt about that-and we await with interest how far it will pick up during the course of this year. The nature of the recovery with the rebalancing going on means that it is quite likely that this recovery will be, in the phrase I used some months ago, "choppy", because in the sectors where growth is slowing, you can’t be sure that the bits that are expanding in exports will manage to expand at exactly the same rate or timing that consumption spending is slowing. So there will be a choppy recovery, but I think the big picture that we all agreed and signed up to was that we expect, as a central view, recovery to continue, not at a particularly exciting rate and not at a rate that is likely to use up a great deal of spare capacity, and it is for that reason that we think-overall, I think we agree-that the current level of inflation is likely to ease off, but there is room for a lot of difference of view about the precise timing when it makes sense to start to withdraw some of the very stimulatory monetary policy that we put in place.

Q26 Mr Love: A lot of people think that the critical issue here will be consumer sentiment, with some of the increases in unemployment coming along, reductions in public services and so on, that that is going to have more than a minor impact on consumer sentiment and people’s willingness to continue to spend. How far would output have to fall before it would start to trigger serious consideration of a further round of QE?

Mervyn King: That would depend on a whole host of factors, because ultimately it is not output that will drive the decision; it is the outlook for inflation. Obviously, if output growth slows, it would affect our judgment about the likely course of inflation, but it would be based on that medium-term path for inflation. I think it is certainly fair to say that insofar as we are looking at the impact of output growth on inflation, that the factor where there is most uncertainty, and I think probably the most scope for differences of judgment and view among the committee, is indeed the path of consumer spending.

Q27 Mr Love: Let me turn to Charlie Bean. A quick question and a quick reply. At the press conference, you said that the output gap in your measurement had gone down slightly. There has been some controversy among committee members about how important the output gap is and how accurate it is. What is your view about where we are with the output gap and how important is it in the considerations going forward?

Charlie Bean: The important thing to stress is the output gap is not something that we observe, so inevitably there is a huge amount of uncertainty, but it is an important latent driver of inflationary pressure that determines the output gap, or essentially spare capacity in the labour market and spare capacity within businesses. We have some proxy indicators for them, measures of capacity utilisation from business surveys and obviously unemployment vacancies in the labour market. We have slightly revised down our estimate of the margin of spare capacity in the light of some internal work we have been doing looking at the behaviour of productivity. We particularly need to take cognisance of the fact that this is in the wake of a very deep downturn associated with the financial crisis. The historical evidence from similar cases in the past suggests that they often have a significant impact on-

Mr Love: But that change will not make any essential difference to the judgments that you are making.

Charlie Bean: It is part of the inflation outlook. Since it is one of the drivers there, the revised view of the margin of spare capacity in the economy will have had an implication for the inflation outlook that we published the other day, and it is part of the reason why the growth profile is weaker. Inflation is still stronger, but that is reflecting a combination of adverse news from commodity prices and less downward pressure from spare capacity.

Q28 Chair: Dr Weale, you said a moment ago that a quarter point will not tighten much but that you were in favour of that rise nonetheless, because you wanted to be cautious about expectations. In which case do you agree with the Governor that signalling accomplishes nothing?

Martin Weale: No, sorry. What I was saying was that whether you start with a quarter point rise at the beginning of this year or whether you do it in the middle of this year doesn’t on its own make a very big change. I think signalling on its own wouldn’t achieve very much. I think that for a tightening of monetary policy to have some effect on people’s expectations, there would unfortunately probably need to be some impact on the real economy, but-

Q29 Chair: Why aren’t you arguing for a half point rise?

Martin Weale: At the moment, my judgment is that a quarter point rise would be adequate.

Chair: Even though it will not achieve very much and not tighten much?

Martin Weale: Well, a quarter point rise is a quarter point tightening. It is not as much tightening as half a point. My sense is that at the moment a quarter point is what is appropriate. Obviously, as the Governor has pointed out, we look at each month afresh, and when I have new evidence, I will look at it again.

Q30 Mr Ruffley: Governor, Project Merlin has seen an agreement with the big four banks and the Government for them to lend in 2011 £190 billion in gross new lending, and I understand that the Bank will be monitoring that. Could you just explain whether or not you are worried about the absence of a net measure, because that £190 billion is gross? Isn’t that something that might cause difficulty for SMEs, if quite a lot of that £190 billion does not take account of repayments?

Mervyn King: Let me make it clear we were not involved in the discussions on Project Merlin at all.

Mr Ruffley: But you are monitoring the £190 billion.

Mervyn King: We’re not monitoring. What we are doing is putting up on our website the data that banks submit after a fairly cursory plausibility check. We are not auditing the data that are submitted; we are monitoring and in a light sense. We are putting up on our website the data of the banks involved in the Project Merlin agreement, which involves the figures that they collectively in total for that group of banks describe as gross lending. Alongside that, we will also publish the Bank of England’s numbers for gross lending, which is a different definition, and we will also be publishing the figures for net lending according to our definition, so that you will be able to see the three different variables that have been produced.

Q31 Mr Ruffley: In basic terms, what are the main differences around the two definitions that differ from the Bank’s?

Mervyn King: As I understand it, the Project Merlin definition includes facilities. That is money that companies could borrow but have not yet borrowed, and our definition would include only loans that had been made-facilities versus actual lending. There is the difference between the two measures of gross lending, and of course then there is net lending, which at present to the corporate sector as a whole from the banking sector is negative. But you will see all three numbers go up, and we plan to put up the first set of data I think towards the end of May, which is when the first set of numbers would appear.

Q32 Mr Ruffley: Is it conceivable that the Project Merlin numbers see £190 billion in 2011 being hit, but on your measures it will not be hit?

Mervyn King: We don’t have a target for our measure at all. The numbers will be different according to the three series that we publish, and the difference in definitions will explain why they are different.

Q33 Mr Ruffley: Yes. It is quite an important point. I represent a middle England constituency in Bury St Edmunds, which is replete with small and medium-sized enterprise, and they are extremely concerned at the behaviour of the bank up until now and have some hope for Project Merlin delivering. The £190 billion figure in Project Merlin obviously has the rider, "Should sufficient demand materialise." It is a caveat of some significance. What are your regional surveys telling you at the moment of future demand for cash from the SME sector? Does it look as if it is buoyant? Does it look as if there is demand?

Mervyn King: I think there is no doubt that anyone who goes round the country and meets small to medium-sized businesses meets a lot of people who feel that they have been denied access to credit. I just find it very, very hard not to go round the country and get that impression. The figures for actual net lending are very clear. The UK banking sector is supplying a negative volume of net lending to the business sector as a whole and credit conditions have improved for bigger companies, but there’s no real sign that they’ve improved for small to medium-sized companies. I can understand why people running those companies still feel under great pressure.

Q34 Mr Ruffley: I know that this is not your direct responsibility, but you will have a view. On the £190 billion new gross lending figure, would you expect that to be met in 2011?

Mervyn King: I have no idea. I can’t judge that. We weren’t involved in the discussions, but I think that what matters is that you will be able to see the figure that the banks have lent according to the Project Merlin definition to see whether they have complied with that agreement or not, and you will also see the Bank of England’s number for gross lending and our figure for net lending. You will be able to draw your own conclusions as to whether you think the agreement was met and whether the agreement, having been met, has met the ultimate objectives of it. But that is for you to decide.

Mr Ruffley: Sure. I appreciate you telling us that you were not involved in Project Merlin at all, which surprises me somewhat.

Mervyn King: I find it very hard to judge myself as to the link between the two definitions of gross lending. I think we just have to see.

Q35 Mr Ruffley: That was going to be my next question. It is not your responsibility, you have made that very clear and it is very fair of you to point that out, but why wasn’t the Bank of England definition of gross lending adopted?

Mervyn King: I have no idea. I simply can’t help on that.

Mr Ruffley: Have you asked the Chancellor why?

Mervyn King: No. It was an agreement reached between the Treasury and the banks. I think a lot of negotiations went on. I don’t think it is my place to say why they didn’t reach a different agreement.

Q36 Mr Ruffley: Do you think you should have been consulted on Project Merlin?

Mervyn King: No. I see no reason why we should. This was a matter between Government and the banks and it had a great deal to do with lending and also compensation.

Q37 Mr Ruffley: My final question is that should the £190 billion target for 2011 of new gross lending not be met, obviously that is a matter between the Chancellor and the big four banks-you have made that clear-but if the Chancellor came to you and said, "Well, listen, this lending is not getting out to the SMEs in this country," could you tell him what other measures would be available to the Government to extend credit to SMEs? Are there any other tools in the policy locker? At the end of the day, you are the Governor of the Bank of England, and if there is a problem with the SMEs because of the failure of the big four banks, what would you suggest? What would you advise the Chancellor, or indeed this Committee?

Mervyn King: I can set out some options. They are the same options that I set out for the previous Government, and indeed for this Committee, which is that I think there are only three options. Either you are patient and wait for the banks to get back to a position where their balance sheets are strong enough for them to be able to lower the costs of funding, because one of the constraints on banks is that they can’t obtain funds themselves except at quite high premiums relative to bank rate. That is one strategy; that is, wait. The second is to use the state ownership in banks to direct them to take a different strategy towards lending. The third is to set up some taxpayer-funded scheme for supplying guarantees to borrowing by small businesses, small enterprises. Those are broadly the three classes of solutions. It is not my place to recommend which of those three is the most appropriate, but those are the three options. They were set out for the previous Government and explained to this Government, and Governments have to make their own judgment then as to what is the right thing to do.

Q38 Mark Garnier: Governor, in the past you and I have talked across this table about house prices and I think, if my memory serves me right, you said there was a possibility that we could see a further 20% or 30% decline in real terms in property prices. Do you still stand by that?

Mervyn King: There is always a possibility of many things. What I have also stressed is that, in my judgment, the single biggest factor influencing the upward movement of house prices in recent years was the move to very low levels of long-term real interest rates in the world economy, and hence in our capital markets. That meant that any asset price was likely to rise and house prices did indeed rise.

The interesting factor is that unlike the United States, which has particular problems in its own housing market of a structural kind, in our housing market there was, after 2008 and the immediate crisis in the banking sector, a 15% fall in house prices, since when house prices rose a bit and then they have been either static or falling back very slightly.

I think the influence of that low level of long-term interest rates is still very evident. The biggest risk to house prices, I think, is not so much developments in our economy but developments in the world economy that would mean that we suddenly move to a world in which real interest rates are very much higher. We all talk about the need for a rebalancing of the world economy, and I have talked about it more than most, but if it happened tomorrow and China suddenly decided to stop saving then real interest rates might well move up pretty sharply. Then we would start to see quite significant falls in asset prices around the world economy, and those would be major problems.

Q39 Mark Garnier: Is that a good thing?

Mervyn King: All these adjustments need to be carried out at a speed that is compatible with avoiding serious problems. That is one of the difficulties, not just in handling a national economy but also in thinking about the international economy and the imbalances in the world as a whole.

Q40 Mark Garnier: Have you done any work into the levels of people, numbers of households, in negative equity?

Mervyn King: Some work has been done, and no doubt in a minute Charlie will be able to remind you of the numbers that came out. What I find striking is that, compared with the early 1990s, the number of families who are in arrears on their mortgages, or the number of repossessions, is an order of magnitude lower now than it was then. It is much lower now than it was then. Part of the reason for that, of course, is that nominal interest rates have fallen, unlike in the late 1980s when nominal interest rates had to rise to very high levels to choke off what had become a domestically generated inflationary problem.

Charlie Bean: I don’t have a lot to add to that. That is the big point. The one thing that is worth saying is that this is not something where there are clear hard and fast numbers. You don’t know how much a household could sell its house for unless it tries to and the sources of information on this are twofold: there is information that the FSA has, connected with extension of mortgages, and you can make various assumptions about how house prices have evolved, post purchase and so forth. The other source of information is the survey that we carry out annually on household finances, where there is information from that that you can use to try and get a handle on whether households believe they are in negative equity or not. That second source of information tends to yield significantly lower numbers than the first.

Q41 Mark Garnier: Do you know what the numbers are, roughly?

Charlie Bean: I would have to go and look on the latest thing. There will probably be some numbers in the reporting for our survey in the most recent quarterly bulletin article. But the generic point that the numbers are much lower than we saw in the early 1990s I think is the key point.

Q42 Mark Garnier: That is very reassuring to hear, but it strikes me that there are a number of imbalances that are within the property market at the moment that are causing the problems. The first is there may well be a perception that a lot of people have negative equity. Negative equity doesn’t matter until you want to sell your house and if people believe they have negative equity and therefore they don’t want to sell their house then you are going to get a lack of movement of your labour market, in terms of going round.

I don’t think anybody thinks we are going to stay at this level of interest rate for very much longer, and obviously we were talking about this today, that in the longer term interest rates are going to go up. Clearly, what you are talking about, low interest rates supporting the property market, is also going to disappear slowly over time at the very least.

Finally, you have this other imbalance, which is first time buyers seem to be in their late 30s as opposed to in their early 20s when I first bought my house. This is restricting the ability of new buyers to come in at the bottom end of the market. All of these factors strike me as having to work their way through. I am very curious to hear your views on how these factors will work their way through, and if you also agree that it is ultimately a bad thing to have very high asset prices, for some of the reasons I have mentioned in terms of first time buyers. Contrary to that, obviously, is the movement of the labour market we discussed.

Mervyn King: The biggest threat in my view, as I said before, is how sustainable will this very low level of long-term real interest rates be. That is not something that is set in this country. It is a worldwide phenomenon and we have no control over it, although we can discuss with our colleagues in the G20 what the risks are.

I think at home there is no doubt that because of that the high level of asset prices relative to income flows has brought about a problem for people who want to get into the housing market, there is no two ways about it. There is an adjustment process then in which people have to save first to acquire the deposit in order to buy a house, which relative to income is much more expensive than it used to be. Of course, in turn, when they get to the end of their lifetime they will be bequeathing a much more valuable asset than they would have before.

In the short run, because we have not gone through a period when the mortgage rate dulled, then that has led us to a situation in which these problems of repossessions and mortgage arrears are much less severe than they were in the early 1990s. The point that I would make that ought to give us some comfort I think is this: one of the reasons why we cut bank rate to such a low level was because we knew that the banks would still be charging healthy positive rates to borrowers because they could not borrow at 0.5%. The banks were paying a hefty premium on bank rate to get hold of funds, so mortgage rates and borrowing rates in general did not come down anywhere near as fast as bank rate came down.

When we come to put bank rate up, at a point when we are wanting to move bank rate back to more normal levels, that is surely likely to be at a point when the banking system is in a healthier condition and can borrow at rates closer to bank rate, so that the increase in effective borrowing rates will not be anywhere near as big as the actual increase in bank rate, and that is-

Q43 Mark Garnier: So what you are saying is that you are adjusting the tilt of the short-term yield curve.

Mervyn King: It is the difference between the rates at which different categories of people can borrow, and rates to borrowers did not come down all the way to zero. Rates to savers did, sadly, but rates to borrowers did not. Equally, when it comes to putting up rates, we would be thinking that it was sensible to move rates up, in part because the borrowing rates would not go up one-for-one with the increase in bank rate. That is at a point we have not yet reached, where banks are able to return to more normal funding conditions, and we are still quite a way from that.

Q44 Mark Garnier: That opens a long philosophical question as to why you want to raise interest rates.

Chair: We are not going to get into that.

Mark Garnier: That we are not going to go into. I have one last question, which is do you think it is right that the Government should be stimulating the mortgage market and, if so, when the FPC starts its work in earnest how is the Government action to stimulate the mortgage market going to conflict with the FPC’s work to try and take the heat out of bubbles? Can you take heat out of bubbles?

Mervyn King: If the FPC feels that what action is being taken is causing a threat to the stability and resilience of the financial system and that that is posing a risk to the rate at which balance sheets and the real economy are rising, then we would have to use our policy instruments to try to offset that. Whether or not it is sensible for the Government to stimulate the mortgage market is, I am afraid, a question for you and this Committee. It is a political question, not for the bank to judge.

Q45 Mark Garnier: But you might have an opinion on that?

Mervyn King: Not as Bank of England. We try to stay out of politics as much as we possibly can. Even though you tempt us all the time to draw in, we are going to resist this temptation.

Mark Garnier: You are very resilient. Thank you very much.

Q46 Chair: Professor Miles has taken a look at this question in the past and your conclusion was that we should try and encourage more people to go on to longer-term fixed mortgages, wasn’t it?

David Miles: I would say that the conclusion that we had a few years ago was more that there were ways in which mortgages were sold in the UK that made variable rate mortgages look far more attractive, relative to fixed rate mortgages, than they would in a market that worked a bit more effectively. In particular, there was a structure of pricing where people were induced to take mortgages that looked very cheap, because you got a rate at the beginning of the mortgage that was very low relative to bank rate that the Bank of England set, and then some people would switch on to a higher rate later. These were discounted variable rate mortgages.

I think there are some problems with those products, partly because they were only sustainable for a while, because you were essentially cross-subsidising from people who had low mortgages and had been paying their interest for a long time.

Q47 Chair: Therefore, there is both the conduct of business aspect to this and a prudential aspect?

David Miles: I think there was. The world has moved on very substantially and now the structure of mortgage pricing I think is somewhat more sustainable. Those discounted variable rate mortgages do not exist to the same extent any more, and the degree of cross-subsidisation in the market to a large extent has disappeared. In some sense, we have a more sane structure of pricing in that people who are higher risk, have less good evidence of their income and want very high loan to value ratios, find it more difficult to get a mortgage, which is somewhat more expensive than for people who are very low risk. It is a painful transition to go through, but it is a transition that was absolutely necessary.

Q48 John Mann: Dr Weale, have you any evidence that real wages are increasing?

Martin Weale: In turn, if I could focus on the expectational effect. There is evidence from studies of a number of countries that that does start to bear on wages as a consequence of previous episodes of past inflation. On the issue of what real wages are doing at the moment, obviously a lot of people are finding real wages levels very squeezed. A lot of pay settlements have been under the inflation rate, which is unfortunately a consequence of having to pay more for raw materials than we used to. That makes the country as a whole poorer. It is also, of course, a consequence of tax rates going up, which some of them have, most notably the VAT rate.

Q49 John Mann: If real wages are therefore falling, considering what the Governor had to say about the criticality of real wages to real inflation, what basis can you have for presuming that this year they will increase?

Martin Weale: The expectational effect that I am concerned about could happen whether real wages are actually increasing or actually declining. One could have a decline in real wages if people got wage increases of 5% and prices went up by 7%. That would mean that inflation was well above target but real wages would, nevertheless, actually be declining. The concern I have had is that if expectations of heightened inflation become something of a norm then that can get built into the economy independently of what is happening to real wages. All the international evidence is that if that happens then the costs of bringing inflation down again, of squeezing out that expectational effect, can be rather high.

Q50 John Mann: Let’s look at the British evidence. What evidence do you have that expectations have increased so that there could be an upward pressure on labour costs this year?

Martin Weale: There is survey evidence-admittedly it is not terribly good evidence but it is the best we have-that does show some increase in expectations, and there is evidence that in the past that has fed through into unit labour costs. At the moment the link seems to be rather weaker than it has been in the past. I have to vote on interest rates on the basis of the way I see the balance of risks and it does appear to me that, after a sustained period of above average inflation, and indeed the risk that the inflation rate will rise further this year, that is more of a risk than it would be if the inflation rate had only just suddenly gone up to 4% after a period where it had been at 2%.

Q51 John Mann: I understand where your theory comes from but the evidence I have is that there is a wage freeze. For example, there is a wage freeze across most of the public sector. The evidence I have is that there is a wage freeze in the private sector and, therefore, real wages will decline this year. Have you evidence to suggest that I am wrong on that?

Martin Weale: In some parts of the private sector we are seeing a certain amount of wage buoyancy, but the point that I would stress once again is that the effects of inflationary expectations can be independent of what is happening to real wages. We had periods in the past when real wages were falling but inflationary expectations were built in and the inflation rate was much more rapid than it has been at the moment.

Q52 John Mann: But if there isn’t a wage increase then labour costs are not going to go up. I am going to ask Professor Miles, who has not had much opportunity this morning to speak. Professor Miles, what I see is that there is a freeze in the public sector. I am hearing repeatedly of no pay increase in the private sector this year. What I am hearing-and the agents of the bank must be hearing exactly this-is that there is going to be significant numbers of job losses in the public sector that haven’t really begun but will begin from April onwards. Throughout April through December this year there will be significant numbers of job losses and, interestingly, in some areas job relocations that could depress certain markets because the spending power of certain public sector workers will shift away, in particular from the market towns, tax offices moving and so on.

Isn’t it likely that what we are going to see this year is a further downward pressure, where people are not pressing for any pay increase because they are seeing jobs going? The feel in the local economy across the country is that we are in a recession and people ought to batten down the hatches, so there is going to be a downward rather than upward pressure on pay.

David Miles: I think you are absolutely right that right now wage settlements clearly are running at a rate, on average, in the economy well under the rate of inflation. Therefore, people’s real wages are falling and for many people that has been true for some years now. An awful lot of companies had a wage freeze last year in the private sector, and indeed the year before. We have seen some pick up in the average level of wage settlements in the private sector.

My own interpretation of that is not so much a reflection of a workforce that thinks inflation is permanently going to stay high and is pushing against a reluctant company that is giving in to inflationary wage settlements; my interpretation is a slightly different one, which is that many companies feel they are in a slightly better position now. They have got through an extraordinarily difficult couple of years, the workforce has stayed with them, they took the pain of wage freezes at a time when inflation was substantially positive, and this year maybe there is some scope for some wage increases, but almost certainly less than the rate of inflation. So I have a good deal of sympathy with your description.

Q53 John Mann: One of the differences with 10 years ago, I would suggest-and before then-is that the housing market is a lot less flexible in that 10 years ago you could buy a house in areas like mine for under £10,000. The same house now would be £70,000 to £80,000, the minimum level, and there is less supply of rented accommodation than there was. Therefore, the labour market is less flexible. How is that going to impact?

David Miles: I think on the flexibility point I would view things slightly differently. I think one of the extraordinary things we have been through-you would be very well aware of this-is how many firms got through this extraordinarily difficult period of the last few years without having to make huge redundancies, by sitting down with the workforce and saying, "Let’s try and get through this together. It’s going to be tough. Those people who are able to go on short-term working, let’s try and do some of that. We’ll have a wage freeze. We’ll try and get through it". In some sense, that has been an unusually flexible response to an absolutely extraordinary shock that hit the economy.

Q54 John Mann: Is it a question, Professor Miles, that perhaps the bank agents in the next six months, but particularly perhaps in the next three months, ought to be paying particular attention to what is happening with job losses and the factual situation in relation to what is happening with job losses and job relocations, so that that information is brought into proper account in terms of the decision-making on your committee?

David Miles: I think the agents are pretty focused on those issues right now. They certainly feed through to us a lot of valuable information about that and I am sure they will carry on doing that.

Q55 John Thurso: Governor, I want to ask you some questions about comments you made in the Q&A press comment following the report. Could I first, very quickly, follow up on some comments you made in relation to questions asked by both David Ruffley and Mark Garnier, which is the difference between the actual bank rate and the rates that banks are charging and the impact on small businesses. Your comments bear out what I am hearing, which is small businesses tell me, "When bank rate was 3%, I paid 5% or 5.5%. It’s now 0.5% and I’m paying 6% or 6.5%". It is not so much that they need the money to support the business, it is that they are dashed if they are going to borrow at that rate and pay bonuses to bankers, as they see it, and they are not expanding. Clearly, as bank rate goes up it is vital that the margins of banks come down or that investment will not be part of the recovery. Is that what I’m understanding from you?

Mervyn King: Yes, but I think it is not that banks set out to charge high margins, it is just that they can’t themselves raise money on the market at bank rate. They have to pay a premium over that to get hold of funds, which they then lend on. What I would hope is that as time passes the position of bank balance sheets will have improved; the degree of leveraging will have come down; markets will have more confidence in our banks; they will be willing to lend banks at something closer to the spread above bank rate, as they did before. At that point we can afford to raise bank rate without having a significant impact on effective borrowing rates. If we feel we need to time the policy further we can go even further.

Q56 John Thurso: The obvious question that follows from that is if you raise bank rate before you reach that point it is a fairly pointless exercise that just makes life tough for-

Mervyn King: It is not pointless, because if you feel that the balance of risks to inflation are on the upside, then by raising bank rate you raise the borrowing rate even further and that slows the growth of demand, which is the way in which monetary policy prevents inflation from rising. This is why it is uncomfortable at present because there is no magical way that you can simply bring inflation down. The only way we can bring it about is by slowing the growth of spending in the economy. That would lead to a slowing of output and a weaker recovery, higher unemployment and an even lower growth of wages. That is how monetary policy would bring about the lower inflation rate.

Q57 John Thurso: Turning to your comments, I was interested to see the exchange you had with Paul Mason of "Newsnight". In particular, when you were talking about rebalancing in our economy you made the point that people are suffering a squeeze on real living standards, but you said that it is going to happen one way or another and it is the price we are all paying for the financial crisis and the subsequent need to rebalance our economy. Do you think that people generally in this country understand how critical that rebalancing is, and what it is you are actually saying to them?

Mervyn King: I don’t know. All I can say is that I have kept repeating this point on many occasions. I have been talking about the need for rebalancing since 2000. If you go back to a speech I made in Plymouth in 2000, I talked about the fact then that the growth of domestic demand could not continue at the rate it had been without at some point requiring a difficult and painful adjustment in the future. Rebalancing has been on the agenda for a very long time and now the financial crisis has made it more urgent and very necessary. It is happening now and the fall in the exchange rate is the mechanism by which, in combination with the fiscal consolidation, those two key conditions for a rebalancing are in place. The rebalancing will take several years to achieve but I think it is in train.

The problem I suspect is that since the publicity about the damage of the financial crisis was focused on 2008 and 2009 when the whole episode appeared the most dramatic, that is when the banks were collapsing and had to be bailed out, the problem was that the cost of the crisis, the pain that will be suffered by most people, did not begin to be evident until much later. It is only now that the cost of the crisis is becoming evident to those that are suffering.

Q58 John Thurso: Do you think that the lower living standards that are clearly going through at the moment will remain as a result of rebalancing or that at some point living standards can begin to return to pre-crisis levels?

Mervyn King: I am sure that the growth rate of living standards will pick up after a period. Whether they will get back to the level to which they would have reached had the crisis not occurred-that is, if you were to extrapolate the pre-crisis trend-I think is a very moot point. We don’t know the answer to that because it depends upon whether you believe that the damage done by the financial crisis to the level of output and productivity in the economy is permanent, in the sense that it is there after 50 years, or it is merely there for a long time and it will take 25 years to get it back. We don’t know the answer to that.

The evidence in the past suggests that the impact of such crises persists for very many years. That is why the cost of a crisis like this is so high and why it is so important. This is what I have stressed from day one onwards that these kinds of crises are very, very costly. They are not like ordinary recessions where you lose output and get it back quite quickly. You may not get it back for very many years, if ever, and that is a big long-run cost to the living standards of everyone in this country. That is why it is so important to take the issues that we were discussing before the break, the issues that the Banking Commission are looking at, so seriously.

Q59 John Thurso: Do you think we in Parliament, in government and public life need to do a great deal more to explain what sounds like a rather dry technicality but is actually something that pre-dates the financial crisis and is a major underlying cause in what is happening? Should more be being done to explain that so that people generally understand it?

Mervyn King: It is hard to believe that you can ever do too much explaining and we have always kept on making explanations and giving explanations. We travel around the country. We give lots of talks to people to try to make these points and I think it pays off. Over time the number of people who have heard the explanation builds up, but one of the challenges that I am sure you all face-and we certainly face it-is that it is quite difficult to get significant amounts of time to explain to people. Even when we give a press conference, which lasts an hour, you might get 15 seconds as a sound bite on the television news bulletin. That is not long enough to explain to people the causes, the consequences of what has happened and why this is affecting people’s living standards. You can’t do it just in sound bites. We try in all kinds of ways to find opportunities to explain and these hearings are a very good opportunity to explain. You give us time to do that. That is very important, but I do think that some of the others around the edge here who are reporting on it, they could reflect on the need to give not just us but also you longer time to explain these things.

Chair: I was worried you might use the phrase "teenage scribblers" there, but you got past it in the nick of time.

John Thurso: I was just about to say I am delighted to have assisted you on this occasion.

Q60 Mr Mudie: I think we should press that a bit further, because I just wonder how many people when you go around the country you meet who are unemployed. I don’t remember any people in my estate saying they met you, or had the pleasure of meeting you, and were able to have firsthand reasons why they were unemployed.

Mervyn King: Well, I do meet groups of trade unionists and I am willing to meet anyone they wish to bring along to those meeting, and we are very happy to explain.

Q61 Mr Mudie: Trade union officials, I presume

Mervyn King: Yes, indeed.

Mr Mudie: But not unemployed people off the estate. So this is your chance. The Chairman did eventually get you to explain that you did have discussions with the Chancellor on both fiscal and monetary matters. When you had these discussions, did you discuss unemployment and falling living standards?

Mervyn King: Absolutely, and when I explained to him the position that the Monetary Policy Committee has taken and the reasons for its decisions, I explained to him the arguments that go into our discussions. If you look at the speech I gave in Newcastle in January, the absolute centrepiece of that speech was to point out that the consequence of the crisis and the need for rebalancing our economy is the biggest squeeze on living standards that we have seen for a very, very long time.

Q62 Mr Mudie: No, but can I just-because the time is short. We keep taking refuge in a word like "rebalancing". I am speaking about unemployment. I have a fellow who came to my house on Sunday night. Can you tell the Committee how much Jobseeker’s Allowance is, maximum contribution Jobseeker’s Allowance is?

Mervyn King: For someone who is in their mid-20s onwards, it is about £65 a week, not a lot of money.

Mr Mudie: It is £65.45.

Mervyn King: Sorry.

Mr Mudie: It is £3,500 a year.

Mervyn King: Yes.

Q63 Mr Mudie: It is £3,500 a year. I reckon somebody in your salary bracket would get something like £5,000 a week. You get more in a week, nearly double, 68% of what somebody who is unemployed gets in a year. Now, do you think rebalancing really gives them any confidence that anybody responsible for the economic affairs of this country understands what they are going through and their families are going through?

Mervyn King: If you would give me a chance to explain to them.

Mr Mudie: I will give you a chance. I have finished. Yes, take as long as you like.

Mervyn King: I do think we can explain to people, and it is very important that we do that. I am very well paid, I have never denied that, and being on unemployment benefit is a very difficult position. Unemployment has gone up by less than we feared it would. It has gone up and it has stayed up and it is not likely to come down easily or quickly, but one of the objectives we have is to ensure we can get back to the levels of employment we had in the past. One of the major contributors to that long period of high employment, and stable employment, was having brought inflation back to the target and kept it there. It was absolutely crucial that we achieve that because it was one of the building blocks to ensuring high levels of employment.

Q64 Mr Mudie: No, but that is where your discussions with the Chancellor are important. John referred to your comment to Paul Mason in the Q&A after the "Inflation Report", and you pointed out that he was asking you to deliberately raise interest rates by a significant amount, which would induce a much deeper recession, raise unemployment, to push money wages down, and you said "No" to that. Timing and depth, it was very, very important, and I applaud you. But you are on record as saying the Chancellor’s policies on the fiscal side are first class.

Mervyn King: No. Let me be clear about this. I have never said that the particular measures that are being taken, or the balance between spending and taxes, is the right thing. We have never commented on that. What I have said is to have a plan to reduce this enormous budget deficit over a period of five years is right, because otherwise we will all suffer if markets react adversely. At the time of the election and immediately afterwards, there was a real crisis of confidence in Government debt markets in Europe, which was at the peak of the Greek debt crisis. Since that point, the interest rate at which our Government can borrow-all of us can borrow on world financial markets, and we are borrowing an enormous amount every year-has fallen relative to German Bund Yields, which is the benchmark, whereas otherwise, if we had had no plan to deal with the deficit, it almost certainly would have risen.

Q65 Mr Mudie: You see, the lad on £65 a week now trying to raise a family won’t be very impressed with that, because one of the facts of life in Leeds, in Kirklees and Bradford last week, in Wakefield, in Hull yesterday, was that thousands of people were put out of jobs unnecessarily because of the front-ending-the timing of these cuts. If you are sitting unemployed you say, "Well, why does this have to happen?" and the answer is it doesn’t have to happen if the timing and phasing over the five years had been different. Now, in your discussions with the Chancellor, do you ever get around to that?

Mervyn King: Indeed we do, but I would point out that over the last year 300,000 new jobs have been created in the private sector.

Q66 Mr Mudie: Mr King, you and I know that this is going to be the worst year in the last three or four. The cuts, the real cuts-there were 6 million last year-are starting this year. Every council who made an announcement in West Yorkshire last week put hundreds or thousands of people on the dole unnecessarily. So it is not any comfort that last year some mythical figure happened in the private sector. It may happen this year, but it is a gamble-we are gambling, and the Government and yourself are gambling, with ordinary people’s lives.

Mervyn King: It is perfectly reasonable for you to point out that there is a better way to reduce the deficit. You could have argued not to reduce public sector jobs but to raise taxes on people like myself. It is a perfectly reasonable argument, and I have never got involved in that debate at all. What I pointed out is that, for the health of our economy, it was vital to have a plan over five years to reduce the deficit. How that is done is a matter for you and the political debate.

I have also argued that it was important that we had the fall in the real exchange rate to have this rebalancing. I am perfectly happy to explain to your constituents what that means in practice. It is a way of getting back to a position where we can once again have steady growth with low inflation, but all of us-all of us-are paying the price of this crisis in terms of a squeeze on real living standards.

Q67 Mr Mudie: Exactly. Mr King, that is exactly what you said. I applaud it and I tie it to those remarks. You said, "The vast majority of people in this country were in no way responsible for the events of the financial crisis."

Mervyn King: Yes, absolutely.

Mr Mudie: But it is the price we are all paying for the financial crisis-the drop in living standards and unemployment. Now, you implied that there are different approaches involving different phasing. In fact, on the Chair’s question about your co-ordinating monetary policy with fiscal policy, you are getting away with what you said there about not having high interest rates, because the Chancellor is doing the real dirty work and it is unnecessary. It could be phased differently; people could be in their jobs later for longer; and whether people lose their jobs would depend on the upturn in the private sector.

Mervyn King: I would put it rather differently. I would say that the squeeze on living standards is inevitable in aggregate because of what happened. We have to accept that squeeze, and we will find a way through it. The distribution of the burden of that squeeze across different families and different individuals, is what you are doing. It is the political choice, which is something that we shouldn’t get involved in, and we’re not. I have never said how that deficit should be reduced and the methods that should be used to reduce it. That is what the political debate is meant to be all about.

Mr Mudie: Thank you.

Q68 Jesse Norman: Governor, have you done any estimation of what the effect would be of having improved our monetary position relative to German Bund Yields? What is the spread reduction as a result of the policies that you or the-

Mervyn King: It is hard to know. You have to know a counterfactual, and if you look at the other economies with large deficits they have seen significant increases in their spreads relative to German Bunds, and we see a narrowing. It is not a particularly large narrowing, because it wasn’t that big to begin with, but we have seen a narrowing relative to that position at the beginning of May.

Q69 Jesse Norman: What is the mean spread difference between ourselves and the ones that have moved out?

Mervyn King: Between ourselves and-

Jesse Norman: The average of the spreads that have widened relative to Bunds.

Mervyn King: Several hundred basis points, but I-

David Miles: May I? This morning, if you take the yields on 10-year Government bonds, the average across Greece, Ireland, Italy, Portugal and Spain is a little bit less than 8%. The UK is 3.6%.

Q70 Jesse Norman: Right, but what is the widening since last year?

David Miles: A year ago, or at the beginning of 2010, the average of the five countries I mentioned was a bit under 5%. They have gone from a little bit under 5% to a little bit under 8%, so they have gone up.

Q71 Jesse Norman: If we track that, our rates would have gone up by something like 100 basis points perhaps?

David Miles: If we had risen in line with the average of those five countries our rates would now be 6% to 7% as opposed to 3.6%.

Q72 Jesse Norman: On a sump of debt of-?

David Miles: The net debt of the UK Government at the moment is 70%-odd of GDP.

Jesse Norman: So about £1 trillion? A little bit more, £1.1 trillion?

David Miles: Yes.

Jesse Norman: Times 70 basis points.

David Miles: Some £7 billion a year.

Q73 Jesse Norman: It would be £7 billion or £8 billion a year. Okay, so that is the measure. That is the economic benefit of the decision that was taken in May of last year. That is £8 billion a year. Is it a responsible policy for a Government to run a 3% budget deficit at a time when its growth is 3%?

David Miles: Sorry, got the decimal in the wrong place. It is much bigger than that.

Jesse Norman: I was waiting for you to say-

David Miles: The debt is 1,000; 1% of that would be 10. So 3% or 4% would be £40 billion.

Jesse Norman: So it is about £40 billion?

David Miles: If the yield on UK Government debt had gone up, because this is the yield on new debt so the existing stuff carries on paying what it would have paid. You exaggerate the size of the magnitude if you say all the debt suddenly has to pay different rates. That does not happen. It takes a long time for that to flow through. So it is a bit of a false calculation to do the multiplication.

Jesse Norman: One would have to look at the maturity profile, but the point you have made is that the cost of five to 10 of debt over the next year or two is not inappropriate. In other words, it is a substantial amount of money.

David Miles: I think the big issue-

Q74 Jesse Norman: Can I just come on to one other quick thing, which is is it a responsible Government policy to run a 3% budget deficit at a time when its growth is 3%, which was the position of this country in the years 2007-2008?

Mervyn King: I am not going to go back and comment on fiscal policy. I would like to make the one big point, which is very important, to try and bring you and Mr Mudie together, because I do believe-

Jesse Norman: We are together.

Mervyn King: No, no, we can do this. We can do this.

Mr Mudie: You are an optimist.

Mervyn King: No, no, no, we can do this. I would like to persuade you all of two propositions. First, it is very important for the United Kingdom to have a plan to reduce our structural deficit over the next five years. Without that I think we would have risked our credibility in international financial markets, and you can see that in the yield. Secondly, that the real cost of this crisis is being borne by people who were in absolutely no way responsible for it. In the past you could look at recessions in the UK, and we could have said in the past, "Look, some of the jobs are in unsustainable industries being supported by taxpayers, nationalised industries that shouldn’t be in this business". There were inefficiencies; there was weak management; there were trade union restrictive practices.

Most of the downturns in the past, in the post-war period, we could genuinely say that the downturn gave an opportunity for creating greater efficiency in our economy and there were some benefits we might get from it. None of that applied on this occasion. We had had a much more flexible labour market; management had been improved. Most of the structural weaknesses of the UK economy over the previous 30 years had been eliminated, I think, by Governments of both major parties making changes over a period of years. We had reached a position where we had quite a successfully operating economy, but the people whose businesses went out of existence, the people whose jobs were destroyed, were in no way responsible for the excesses that we saw in the financial sector and the causes of the crisis.

I think that is a very difficult point to get across and it is why I have every sympathy with Mr Mudie’s constituents who cannot look at this and say, "Okay, I accept that something was wrong and needed to be put right, and this is the price of putting it right". They are paying the price themselves and they are people that don’t get bonuses of the scale that people in the financial services sector get, they are on much lower incomes and they are paying the price. I think this is a big political problem for you, because the cost of this crisis is only now beginning to be felt. It may have been 2008 and 2009 when the headlines and the television bulletins were full of stories about the financial crisis, but now is the period when the cost is being paid, and I am surprised that the degree of anger hasn’t been greater than it has been.

Q75 Jesse Norman: Every MP feels the same way. A final very quick question for Professor Miles if I may, which is in your excellent speech here, Mr Miles, you point out that this economy is very unlikely to return-as one might expect-to a trend extrapolated from previous growth. In other words, the concept for a growth strategy has to be moderated in one’s mind by the question of whether any growth is essentially on the table, given the nature of the recession that we are in.

David Miles: I think it is very unlikely that we get back to a trajectory that we might have stayed on if we had not got into the financial mess of 2007-2008. I don’t think that means we can’t hope and expect to get back to a growth rate that looks fairly average and normal in the longer context of history, but I think we have had some lasting damage on the economy and that is a reflection of just how damaging a financial crisis can be.

Q76 Mr Love: This is to the Governor and it is responding to the debate that has gone on for some months and has just been commented upon by Mr Mudie. How do you respond to the criticism that by commenting on the framework for reducing the deficit-that is you talk constantly about five years-implicitly that assumes that you will eliminate the deficit within those time periods by commenting on that? I understand why you would be drawn into that debate, but by commenting on that you crossed a line in commenting on fiscal policy, because there is some concern about that.

Mervyn King: Clearly, some concern has been expressed. I don’t believe it is crossing a line. I have gone far less far than any of my central bank colleagues internationally. Ben Bernanke in the States has been speaking out forcefully on the need for the United States to introduce a deficit reduction package. Jean - Claude Trichet talks about the need for fiscal consolidation in 17 countries, not just one. I have gone far less far and I have been very careful to avoid saying anything about specific measures. The question of how the deficit is to be reduced and upon whom the burden falls is rightly the subject of what political debate should be all about, and I have been very careful to stay out of that.

Q77 Mr Love: But my understanding is that in Toronto at the G20 what they concluded on how far and how fast the deficit should be reduced was very different in terms of looking across all of the countries who had similar problems. We have chosen one method to do that; others have chosen others. By implicitly ticking the box for what has happened in the United Kingdom, aren’t you criticising the other alternatives that were talked about and agreed at Toronto?

Mervyn King: No, I don’t think so. I think you can see, from the words that are being used by the American Administration, that time has moved on and they have backed away from some of the things they said in Toronto. This debate carries on but, as I say, I don’t think we should try to get fixated on this. We have now a plan to reduce the deficit over five years. We have the biggest peacetime fiscal deficit ever. There is perfectly reasonable scope for debate about the precise timing or the measures, absolutely, but we needed to demonstrate to the world that there was a plan to reduce the deficit, that we weren’t proposing just to keep this going indefinitely and leave it to the next administration to deal with. I don’t think that was a plausible alternative.

We have that in place now. There is plenty of scope for you and others in Parliament to debate on the precise way in which this should be implemented. You will all have views on that and we don’t. It is not our business to get involved in that.

I joined the Bank of England 20 years ago today. When I joined it I never imagined that we would ever face a financial crisis of the kind that we have been through. I don’t intend to leave until I get to the point where I can try and reassure this Committee that we have in place a framework for policy to make it very much less likely that any of us have to go through this again, and especially Mr Mudie’s constituents.

Chair: Thank you very much for those last words. Happy 20th anniversary at the Bank of England. You have shown some skills that are associated with politicians today, the skills of a reconciler on our behalf on the Committee, but not strong enough yet to bring the MPC together to all agree on what to do on monetary policy. This is the biggest challenge you are facing and probably you have faced or will face with the MPC, and it is very important that a full explanation is given for the decisions that you are taking. Thank you very much for coming.

Mervyn King: Thank you for inviting us.