MR MERVYN KING, MS RACHEL LOMAX, MR CHARLES BEAN, PROFESSOR TIM BESLEY AND PROFESSOR DAVID BLANCHFLOWER

29 NOVEMBER 2007

  Q1 Chairman: Governor, welcome to you and all your colleagues. We are here to discuss the November 2007 inflation report. You have kindly agreed to come in December to answer questions on financial stability and transparency, but today we will focus on monetary policy and the real economy. I believe you have an opening statement. Will you first introduce your colleagues?

  Mr King: On my right is Mr Charles Bean, chief economist at the bank; on his right is Professor Tim Besley, one of our external members; on my immediate left is Rachel Lomax, deputy governor for monetary policy; and on her left is Professor David ("Danny") Blanchflower, also one of our external members. I am grateful for this opportunity again to explain the reasons for the decisions on interest rates by the Monetary Policy Committee since its appearance before you in December when, understandably, your main concern was about matters other than monetary policy. Bank Rate stands at 5.75% where it has been since July, although market expectations of where it will stand at the end of the first quarter of next year have fallen by 75 basis points over that period. In recent months the near-term outlook for both inflation and growth has become less benign complicating life for the Monetary Policy Committee, but the committee remains focused on meeting the 2% inflation target. Since March, when it reached 3.1%, CPI inflation has fallen back to around target as the committee had expected. In August, the committee judged that some slowing in the pace of output growth was necessary to meet the inflation target in the medium term. Although the official estimates of output still indicate firm growth, surveys suggest that the economy is starting to slow. Recent economic news has been dominated by the continuing turmoil in global financial markets which has led to a tightening of credit conditions particularly for the most risky borrowers. In the United Kingdom the consequences are difficult to assess and are likely to be evident first in the housing and commercial property markets. With borrowing more expensive and less easily available the personal saving rate is likely to rise, leading to slower growth of consumer spending. Abroad, the rebalancing of the world economy proceeds and the main news since the November inflation report has been a further weakness in the US housing market and continuing strong growth in Asia. At the same time, world energy and food prices have risen sharply and the latest data on earnings growth look somewhat less benign than before, so the short-term outlook is rather uncomfortable. The committee's current judgment is that the most likely outcome is that output growth will slow and inflation will rise at least for a period. The central projection further ahead is for growth to return to its long-run average rate and inflation to the target, but the outlook is also highly uncertain which makes the task of navigating through the next few months far from straightforward. Despite the accumulation of significant amounts of liquidity by many of the larger banks, markets are fearful that further falls in asset prices might impair the balance sheets of many banks. Although that fear has so far run well ahead of realised losses, it has the potential to lead to a further tightening in credit conditions. The bank will continue to assess how these developments will impact on the outlook for inflation. Given the continuing fragility in the banking system, there is a risk that money markets will tighten over the end of the calendar year which is the end of the accounting year for many banks. This could cause overnight market rates to rise relative to bank rate. To reduce that risk the Bank of England has talked with all of the reserve system banks about their reserve targets for the maintenance period that begins in the first week of December. To assure banks of liquidity over the year end the bank will be offering a substantial proportion of the reserves it supplies in the form of a five-week facility that will extend to the end of the maintenance period in the second week of January. We stand ready to take further measures in order to keep the overnight rate in line with bank rate, and this is similar to the measures announced in recent days by both the Federal Reserve and the European Central Bank. We are keeping money markets under constant review. The challenge for the Monetary Policy Committee at present is that inflation may rise in the near term and pose a risk to inflation expectations, and that it may fall below target further ahead in the event of a sharp slowing in output growth. We shall return to the question of what all that means for interest rates at our meeting next week. Chairman, those are the remarks I would like to make this morning and I and the other members of the committee here today stand ready to answer your questions.

  Q2  Chairman: That is as global a statement as you normally provide, particularly your comments about navigating the next few months. This week comments were made by Larry Summers and Peter Sutherland. Larry Summers said: "Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth." However, he says that, "The odds now favour a US recession that slows growth significantly on a global basis." Peter Sutherland, chairman of Goldman Sachs and BP, said: "I think we are going through next year, certainly the first half of next year, with considerable traumas, and it is a dangerous period for the world." Do you agree with the sentiments of both those experienced individuals?

  Mr King: I am not going to make a judgment about the probability of recession in the United States. My colleagues on the Federal Reserve Board are much better placed to form their judgments. They stress that, as yet, much of the slowing we have seen and the problems are focused on the housing market not elsewhere in the US economy. I stress that this is a risk rather than something that has yet happened. Nevertheless, what we see, not just in the subprime mortgage market, are market fears about the possibility of further movements in asset prices which impair the balance sheets of the banking system in the United States and that would lead to a classic credit squeeze. The real risk is that there would be a contraction in the amount of lending available to household and corporate borrowers in the United States that had an impact on their spending, both consumption and investment, and might slow the rate of growth of output pretty sharply. Certainly, my colleagues in the US would say that the real focus of concern is whether the developments that might occur in the future will lead to a sharp credit squeeze. Of course, they have cut interest rates quite noticeably already in order to offset the increase in spreads charged to borrowers to ensure that borrowing costs really have not moved too far, but that is the big risk. I do not think you can say that what has been seen so far adds up to a major shock; it is the concern about what might lie ahead that impacts on the banking system. Some now put the scale of the losses on subprime mortgages in the United States at $200 billion; others put it as high as $400 billion, which is 40% of the total risky lending to the subprime mortgage sector and for that to be wiped out would be an extraordinary rate of default. Although $200 billion is an enormous amount of money it is no more than the equivalent of the loss of wealth that would result from a fall in the US stock market of about 1½%. That represents a bad day on the US stock market. It is hard to believe that that alone would cause a major slowdown. I think it is the fear and sheer uncertainty out there that that drives the risk that there might be a more substantial credit squeeze. It is that which would cause the downside risk to output in the United States.

  Q3  Chairman: Mr Bean, you said in an interview in the Liverpool Daily Post that only a relatively small fraction of the likely losses associated with the subprime issue had been declared by the banks. How likely is it that persistent financial market instability will lead the February inflation report to include a further downgrade to growth expectations?

  Mr Bean: Obviously, we will have to wait until our February round to form that forecast. What I was concerned to draw attention to in that remark was the fact that there was still a lot of uncertainty about where the losses associated with the US subprime market lay. Only perhaps 20% of the likely losses have so far been declared by banks and other financial institutions. So there is likely to be a continuing period of uncertainty until there is greater clarity about who actually bears those losses. As long as that uncertainty persists, it is likely that financial institutions will be reluctant to lend to one another for anything other than rather short periods and obviously that may have spillover effects onto their lending to households and businesses, which is where it starts to impact on the real economy and inflation prospects.

  Q4  Chairman: If I am correct, during the November inflation report press conference you referred to the likelihood of a recession in the UK.

  Mr Bean: It was in the context of a question about the fan chart. If I remember rightly, it was Evan Davis who said it seemed to imply that we put a very low probability on a recession. I drew attention to the fact that the fan chart was for growth over four quarters, whereas people often use the term "recession" to refer to two successive quarters of falling growth and the likelihood of that was somewhat greater than the fan chart might appear to imply. There is a lot of uncertainty about growth prospects. Although our central projection incorporates a slowdown, it is nevertheless a relatively benign outlook. The slowdown is relatively mild and is of the same sort that we saw in 2004-05 and growth then recovers. But that is just a central projection. Certainly, encapsulated in that fan chart are significantly worse outturns that involve slower growth over a somewhat longer period. Equally, there are outturns that are less worse than the central projection.

  Q5  Chairman: Professor Blanchflower, can you explain the reasons for your vote in the November inflation report?

  Professor Blanchflower: In some sense it follows on from a number of comments that have been made. My view is that the fear of a recession in the US is perhaps greater than I thought it was a month or so ago and greater than others think. Having spent time in the US, my sense is that in the past month or so confidence has declined somewhat. Bob Schiller has been talking about how important that is. A number of commentators—Goldman Sachs and others—have said that the probabilities of a US recession have increased. There is also the latest evidence from Fannie Mae, Fannie Mac and so on. I think confidence in the US has slipped somewhat and the implications of a recession, which now have perhaps 50:50 probability in 2008, are greater than in the past. The implications for the UK economy in my judgment are greater, that is, at least a two-quarter set of negative growth. My first view of the US economy was perhaps more to the downside than others and concerns about the extent of monetary tightening that had gone on in the UK economy was somewhat higher than I had expected. I also had the view that there were interest rate increases still to come through. Therefore, those factors together seemed to suggest that going forward the potential for the downside was greater than perhaps my colleagues thought. I had also taken the view that there was more slack in the economy already than others had thought, so it seemed to me that the potential risks on the downside were substantial and we should act. That was why I voted the way I did knowing that in our inflation report reductions are built in based on market interest rates, but my judgment was that it was time to do it and get ahead of the curve rather than wait.

  Q6  Chairman: I should like to bring in Rachel Lomax. What economic indicators will you be paying most attention to in the coming months given your brief in the bank?

  Ms Lomax: I think I will be looking very closely at the business surveys because a lot of the concern about the impact of a credit crunch is in the forecast rather than the data. The surveys will give us a timely read on where business confidence is going. We are also looking very closely at any indicators of credit. We recently published for the first time a credit conditions survey and there will be another one in January. That will be a very good sign of how far these troubles in financial markets are feeding through. On the inflation side, which we have not talked about much so far, what is happening to commodity and oil prices is a big concern at the moment. And we are coming up to a big season for pay awards. We are very conscious that the RPI still has not fallen back in the way the CPI has, so we are looking very closely at what is happening in the labour markets and on wage settlements.

  Q7  Chairman: You said in a speech to Hull Chamber of Commerce that current interest rate levels may be on the restrictive side. How great is the danger that that will turn out to be the case?

  Ms Lomax: It is a very broad assessment. What is the neutral level of interest rates? Clearly, we are in a different place from where we were when interest rates were around 3¾% or in the low fours. Above 5%—at 5¾% or 6%—it is difficult to argue that interest rates represent an accommodative monetary policy, but how restrictive they are depends on quite a lot of things about what is happening on the supply side of the economy and so on. It is not a precise statement, but we are starting from a position where interest rates are high relative to recent experience and to other countries of the G7.

  Q8  Chairman: Professor Besley, following those questions what is your current view of the UK economy?

  Professor Besley: If we go back to August and think about how things have evolved since, a number of us thought then that it might be necessary further to tighten monetary policy in view of the low levels of spare capacity in the economy that we saw with fairly strong growth. It is important to benchmark what we are now seeing against the position in August. We see some slowing, but it is the kind of slowing so far that we would have been expecting in the August inflation report. To some extent, what has gone on in financial markets has done the work that monetary policy might have had to do in terms of tightening. I agree with the broad assessments of my colleagues about the kinds of factors that will be relevant going forward, but at the moment the measures we have suggest that there is still relatively limited spare capacity and therefore the kinds of things that might weigh against inflationary pressures from commodity prices and other sources mean that there is still a fair amount of potential inflationary pressure out there. We will have to see to what extent events going on in the real economy weigh against that and mean that the increase in inflation we see does not become embedded in expectations and wage settlements in the next quarter.

  Q9  Chairman: What is the balance of risks in the growth of inflation?

  Professor Besley: If I was called on that I would say it would be slightly to the upside on inflation and slightly to the downside on growth.

  Q10  Mr Dunne: Governor, in the inflation report you draw attention to the cut in interest rates by the Fed of 75 basis points. Normally, you would expect other corporate rates and so on to follow by a similar amount but that did not happen between November and June. Investment grade debt is down by about 25 to 28 basis points and mortgage rates have barely moved. Therefore, are interest rates in the current difficult credit environment an effective tool of monetary policy?

  Mr King: Are you referring to the United Kingdom? You mentioned the United States at the beginning of your question, but you meant the United Kingdom.

  Q11  Mr Dunne: You referred to the cut in interest rates in the US in your inflation report and I am illustrating that cutting rates by 75 basis points has not had the normal reaction in the markets; it has not reduced the real interest rates that the corporate market and individuals pay.

  Mr King: It has offset many of the rises in interest rates that would have resulted from the tightening in credit conditions and so it has achieved its desired effect, namely to keep borrowing rates where the level of demand that would flow from corporate and household spending is broadly consistent with the Fed's judgment as to where it wants to go. I do not think it means that monetary policy is less effective in any sense.

  Q12  Mr Dunne: If we look at your chart 1.2 which shows the three-month LIBOR rate in the UK, you were anticipating a steady decline to a more normal level of spread of 15 basis points or so by the summer of next year. Yesterday the spread hit 90 basis points so instead of declining the spike has started to move in the other direction. It is not quite at the levels achieved in August and September but it is heading in that direction. Is that not a very worrying signal that we are about to hit the same conditions in the market that we had a couple of months ago?

  Mr King: I think the conditions are different, and it is certainly a matter of concern. The expectations that spreads would eventually come down were not ours but those of the market at the time of the inflation report. There are three interesting aspects of the change in spreads. First, they have moved very similarly in the dollar, euro and sterling areas. This is a judgment about what is going on in the banking system of all the major developed economies. Second, if you look at the forward spreads the peak of over 90 basis points is very much concentrated at the end of the year and the beginning of the next. If you look at the six-month LIBOR spread that comes down quite markedly in the market's expectations. Therefore, there is concern about what will happen at the turn of the year and that is partly why all three central banks are taking action to deal with liquidity at the end of the calendar year. The third matter is in many ways most interesting and perhaps takes me back to what I said at the very beginning in my first answer to the Chairman. We have a technique which tries to disentangle whether these spreads result from concerns about liquidity on the one hand and credit risks about other banks on the other. It is quite clear that in August and September the sharp rise in the spreads was the result of concerns about the shortage of liquidity. All the banks tried to accumulate large amounts of liquidity. The major banks now have very large stocks of liquidity. The rise we have seen in the past two to three weeks is the result of concern about credit risk. I believe that reflects the point I made at the beginning, namely it is not so much that people are worried about the magnitude of the total losses in the subprime loan market; they are worried about where they are. First, there is enormous uncertainty as to where those losses are to be located. Second, there is great concern that in the future there may be further falls in asset prices that would impair the capital cushion of leading banks around the world. It is that concern, fear almost, that has been driving up the spreads. It is indeed a matter of concern, but it is what economists call a real phenomenon, not a monetary phenomenon; it is not to do with insufficient liquidity but genuine concerns about what might happen to the capital position of the banking system. I think the most welcome developments in this area have been the examples set by some of the large banks both in the US and here in terms of greater transparency about where losses have occurred and how big they are and the willingness to take on board and inject additional capital into the banks to restore that capital cushion faster than might otherwise be the case. The action of Citibank a couple of days ago is a good example. It is those developments as a means of bringing down those spreads to which we should look forward over the next few weeks.

  Q13  Mr Dunne: You mentioned liquidity. If any other major banks suffer a liquidity crisis which leads them to seek the lender of last resort facility—you—does the bank's existing facility to Northern Rock constrain its ability to provide liquidity to the banking system?

  Mr King: No.

  Q14  Mr Dunne: Therefore, you will be able to provide facilities?

  Mr King: I am certainly not going to imply that that is remotely likely, but what we have done so far does not constrain our ability to provide whatever liquidity we think is necessary.

  Q15  Mr Dunne: In relation to the impact of credit tightening on the real economy, have you seen any signs of contagion from the financial markets into underlying credit availability to the corporate sector?

  Mr King: In terms of corporate ability to obtain funds from the banking system, clearly there is a sign of a tightening of credit conditions in terms of both higher borrowing rates and, for the riskier borrowers—the non-investment grade corporate borrowers—tightening in the availability of credit. So far the surveys carried out of businesses do not suggest that this tightening in borrowing conditions is having a very big impact on investment spending or intentions, though one would expect that to come through in due course and that a tightening of credit conditions by the banking system would feed through to weaker spending. That is in our basic forecast. On the household side so far there is not a great deal of evidence of it apart from riskier borrowing, which in this country is described by the rather inelegant phrase "adverse credit borrowing", where for those kinds of borrowers who already have a history of poor credit repayments, clearly conditions have become much more difficult in terms of both availability and a substantial increase in spreads, but for ordinary mortgage borrowers, whether floating or fixed rate, there has not been a significant change yet in credit conditions.

  Q16  Mr Dunne: You do not regard the 37% reduction in mortgage advances in October as a significant sign of tightening?

  Mr King: That is not necessarily a sign of tightening; it may be due to a reduction in demand, but certainly loan approvals have fallen. That is something which reflects in part demand and not just the supply conditions. If you look at the interest rates at which people are able to borrow there has not been a major change; there has certainly been a fall in the demand for borrowing.

  Q17  Mr Dunne: Has there not been a significant fall in the loan to value ratios applied by mortgage lenders?

  Mr King: Loan to value ratios have already been much lower than they were in the late 1980s and early 1990s. I do not believe that is the constraint. There is more of a constraint on loan to income ratios which have been higher than in the past. I am sure lenders will feel constrained because their ability to fund mortgage lending has become more expensive. I would expect to see that feed through. What I am saying is that if you look at the rates currently available there does not seem to have been a significant impact, but again we would expect to see this flow through; in other words, at present our judgment in the forecast is that, in the banking system clearly there has been a tightening in credit conditions both in terms of banks being willing to lend and the price at which they will lend. In terms of the borrowers, we do not yet see a major impact, but we do not expect it to continue. We would expect to see both on mortgage borrowing and corporate borrowing some impact. It is worth pointing out that even in the United States, when the Federal Reserve was asked whether it was still possible for investment grade corporate borrowers to obtain funds the answer was, "Yes, absolutely." This is something that is still very much focused on the housing market.

  Q18  Peter Viggers: In its monthly bulletin the European Central Bank talks about a number of additional open market operations with varying maturities being made available. Press comment has talked about the Bank of England's reticence in providing three-month liquidity and other liquidity. There is less emphasis in your inflation report on market operations and yet your statement to us today says that your operations are similar to the measures announced in recent days by the Federal Reserve and European Central Bank. Would you please compare and contrast your attitude to providing funding with those of the European Central Bank and the Fed?

  Mr King: I think actually they are all remarkably similar. One of the points most people fail to understand, perhaps quite reasonably since money market operations are a relatively arcane part of the central banking arena—many in the City often have difficulty understanding it—is that the European Central Bank has not increased the amount of liquidity at all since the beginning of August. It has redirected some of the liquidity that it would have done at one-week term to three-month term, but the total amount of liquidity that it extends to the banking system is absolutely the same now as it was in June and July before the turmoil began in August. That is not readily understood by many people. The amount of liquidity that we are extending to the banking system is almost 30% higher. I do not put enormous weight on that. I think what we have is a system, which I prefer, in which the banks can choose their own reserves targets. If they say they would like to hold more reserves with the Bank of England we readily supply it on demand. That is why we are supplying 30% more now than we were. Equally, the Federal Reserve has not raised the total amount of liquidity very much. There is a certain myth in all this that goes around and we take our share of the responsibility for not explaining it properly, but it is not easy to get across these points. I have tried to do so in the past two or three months, but understandably most people have more interesting things to worry about than the arcane matter of liquidity and money market operations. In terms of what the three central banks have announced in the past week—who work closely together—basically we are all doing the same thing, namely to ensure that in the maintenance period which spans, say, December into the January/New Year period, banks that are concerned about obtaining liquidity at the end of the calendar year will be able to lock into that liquidity at the beginning of the maintenance period by borrowing for a longer period that goes across the end of the year. That is something which all three central banks have done and what we are announcing today. We announce it today because this is the date of our weekly money market operation statement. The announcement went out on the wire services at nine o'clock this morning.

  Q19  Peter Viggers: To switch to a different area, considering the components of the bank's gross domestic product forecast such as consumption or net trade, perhaps each of you would say which would have presented the greatest risk in September and how that situation has changed through until November. Professor Blanchflower, perhaps you would start.

  Professor Blanchflower: Obviously, my concern has been that output will decline more to the downside than perhaps others have thought. At the moment the difficulty lies in forecasting exactly where it would be. My concern is that consumption will drop, but it has held up somewhat stronger than I would have thought. My concern is that the housing market declines and there will be declines in consumption. Therefore, my concern has been on the downside in both consumption and output.

  Ms Lomax: I would give a very similar answer. The big area of risk in my mind is consumption. It was so in September and it still is. It is by far the most important component of demand and one that is most likely to be impacted by a tightening in credit conditions.

  Mr King: You asked about September. I would say that what most likely concerned me then was investment in housing and particularly commercial properties. I would put the focus back on investment given that is where we see the figures change in credit conditions and where in the United States it has been the main cause of the slow down in that economy. There has been a sharp fall in residential investment. Our housing market is very different, but I think the commercial property sector has the possibility of generating a sharper fall in investment and that is where I see the main downside risks.

  Mr Bean: I have some sympathy for that view. Ms Lomax is obviously right about consumption being the largest component, but various elements of investment tend to be particularly volatile. As we go into the new year, the places where we might see particularly sharp contractions in demand are more likely to be associated with the investment part of demand.

  Professor Besley: I agree with that. In the near term I am particularly concerned that with a much more uncertain macro-economic outlook there may be a tendency to postpone investment projects, so it is not coming through so much as a change in the cost of capital through the credit markets but more as a general sentiment that people will postpone particularly investment projects over the near term.