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

29 NOVEMBER 2007

  Q20  Peter Viggers: We are looking specifically at households. Why do you think they have been so slow to reduce spending bearing in mind the rising interest rates?

  Professor Blanchflower: There are some signs that they have started to reduce their spending. I have made a couple of visits in the past month to Birmingham and Manchester. The story I hear is that from about the beginning of October the footfall started to decline quite a lot. I spoke to a number of retailers in large shopping centres in both Manchester and Birmingham. Yesterday people told me that in the past three weeks they had seen a significant decline and it was important to see what would happen this Christmas. That was the impression I gained from my regional visit which has not yet been picked up in much of the data. Literally, people have been saying to me that the past three weeks have looked soft.

  Q21  Mr Fallon: Ms Lomax, I come back to your comment that policy may now be on the restrictive side. I think you told the Chairman earlier that you were still waiting for business surveys and the like, but if there is now a downturn in the commercial property market, given what the professor has just said about high street spending, is it not fairly obvious that the economy is slowing pretty rapidly?

  Ms Lomax: There is not much hard evidence of that yet. So far the business surveys have been patchy rather than uniformly pointing to a sharp slow down. We had one month where we had quite a weakening in one of the important surveys, but recent surveys have suggested some bounce back. It is not yet a sustained picture even in the surveys.

  Q22  Mr Fallon: But at the end of your speech in Hull you said that we were facing either a force 6 or force 8. That rather implies you think that rates may already be too high.

  Ms Lomax: I put some weight on the forecast. We forecast a slow down and I still believe that is likely to happen but it is based on the implications of something which is very unusual, namely this particular event in the money and credit markets for which there is not much precedent.

  Q23  Mr Fallon: Governor, to put a more general point which is related to Mr Dunne's question, if the interbank rate has been so far out of line with the policy rate for so long and households now face the prospect of paying much higher rates for their mortgages, what do you say to the criticism that this short-term rate-setting is now becoming rather academic and divorced from events in the real world?

  Mr King: We have never set the interest rates paid by any individual borrower. Perhaps the best example of that is not what has happened in the past two months but the previous 18 months when we raised interest rates by a total of 125 basis points and on average only half of that came through into mortgage rates. The rest corresponded to a squeeze in spreads resulting from greater competition and keener pricing for mortgage lending. That is the result of the competitive market out there. Our job is to set bank rate and then competition and other changes, indeed the risk premium, will determine the interest rates that are actually charged to individual borrowers. For quite some years we have been through a period—this was really the story until August—when our concern in the central banking world was that the risk premia being charged in private financial markets had become excessively compressed. We were concerned that, although we were raising interest rates, those increases were feeding through insufficiently and risk premia had become too narrow. What has happened since then is part of a welcome re-pricing of risk. How far this will go is very hard to say, but our judgment—the forecast in the report is based on this—is that there will be some return of the high spreads we see at present but we will not go back to where we were at the very beginning of August. Some of the very narrow risk premia being charged in mortgage markets in particular but also elsewhere will be somewhat higher than was the case at that point. That will have a permanent impact on the link between borrowing rates faced by consumers and the level of bank rate that we set. There is no doubt that the level of bank rate we set does influence the interest rates charged by private capital markets, but it does not determine them uniquely; other factors such as risk premia clearly enter into it, and should do so.

  Q24  Mr Fallon: But it does not seem to have influenced them as directly and successfully as you might have wanted it to do so.

  Mr King: I am not sure. Typically, if we change mortgage rates by 25 basis points that will come through over the next couple of months, but if there are other things going on at the same time—over a three-year period we saw a significant and steady compression of spreads in the mortgage market—over a period the cumulative total of our change in interest rates will not map one to one the cumulative change in interest rates to borrowers. I do not believe there is any evidence that our policy changes are less effective than they were before; it is merely a reminder that changes in sentiment and the analysis and nature of the real risks out there will clearly have an impact on the terms on which private markets will make credit available. That is a very important part of the world. We cannot just wipe that out; it matters.

  Q25  Mr Fallon: I understand that. Do you reject the charge that you have lost control of rates?

  Mr King: I reject the charge that we have lost control of rates. We can clearly determine Bank Rate and, as I have said, I think that when we change bank rate that can be seen to flow through to the rates which are being set. I do not accept that we have lost control of rates, but I agree that we do not uniquely determine them and in circumstances such as the past three months what has happened is a big reappraisal of risks in particular kinds of markets, but not all. There has been very little change in observable risk premia in equity markets, although perhaps some in the past couple or three weeks. Before that there was no sign of a general re-pricing of risk in those kinds of markets, but certainly in the mortgage market there has been a very significant change.

  Q26  Mr Love: In the bank's November 2007 inflation report it states: "Although business investment growth faltered in the first half of 2007 investment intentions have remained relatively upbeat buoyed by the strength of corporate finances." You have been a little more pessimistic this morning about intentions. Why has your attitude changed in relation to that?

  Mr King: The background to the past three years is that corporate finances have been very strong and profits high. The balance sheets of the corporate sector have been very strong.

  The Committee suspended for a fire alarm evacuation from 10.24 am to 11.00 am

  Q27  Chairman: Governor, perhaps you would continue.

  Mr King: When we were thinking about investment earlier this year we contemplated a picture in which the corporate sector had made significant profits over previous years and had very healthy balance sheets. Therefore, the prospects for corporate investment looked fairly strong. That was backed up by the investment intention surveys. Since the beginning of August a number of things have crystallised: first, the financial turmoil has changed credit conditions so that the prospects for the cost of financing investment have altered; second, as Professor Besley pointed out earlier, there is a much more pervasive sense of uncertainty and so people may postpone investment projects; third, the world economy looks softer now than it did then; and, fourth, overall there is perhaps a sense of uncertainty affecting a range of different questions, one of which is clearly how the US economy will impact on the economy of the rest of the world and what will happen to the banking system. I believe those factors impact on our judgment about the prospects for investment in particular investment in property, be it residential or commercial.

  Q28  Mr Love: How much of a factor is tighter credit? Many of the companies that undertake investment are large ones with choices of investment strategies. Are tighter credit conditions and uncertainty really the main factor here?

  Mr King: It may be a little too early to judge at present. Certainly, when I have talked to representative of various trade groups in the CBI I have not gained the impression that the tightening of credit conditions or the financial turmoil has had a big impact on their decisions. I suspect that is because at least in part from their perception of the business conditions in which they operate—the real economy outside the City—there does not seem to have been a dramatic change. Therefore, they still see the same arguments for strategic investments and the need to ensure adequate capacity. I suspect that over time the impact of tighter credit conditions will show up as they ask questions about how much they would have to pay in order to borrow and how easy it would be to access credit. I do not think that so far there has been a big response by the non-financial corporate sector to the change in credit conditions. The real uncertainty is looking forward: how far will this eventually impact on investment? That is why at present we have put an enormous amount of weight not only on the surveys but focusing on the numbers and data. Where we are now is very much a quantitative judgment as to what we should do in terms of our policy response.

  Q29  Mr Love: Ms Lomax, you said that the surveys were key in the sense of looking forward. What about your regional agents? What role do they play? Are they becoming more and more important as you look at what is happening round the country?

  Ms Lomax: This is the sort of time when reports from our agents are particularly valuable. They are timely and you can also get behind some of the bare figures, unlike even the better known business surveys, because you can interrogate what the agents are being told. We have done some special surveys and we shall commission further ones with the agents to enable us to dig under the surface of what is going on. This is a moment when the agents are a very valuable resource.

  Q30  Mr Love: I should like to put a question to all the witnesses. Governor, earlier you referred to possible losses of $200 billion in the subprime market in the United States and said that it was a relatively small feature within the overall economy. Do you think there is any chance that the Americans are talking themselves into a recession and is there any prospect of it happening here in terms of the critical importance of confidence?

  Mr King: I do not think they are talking themselves into a recession. There is genuine uncertainty about the potential liabilities to losses of individual institutions, in particular the tremendous superstructure of financial derivative instruments built onto basic mortgage lending to subprime households. No one quite knows where that is and how big the losses will be. Since August we have moved from a period in which there was certainly a willingness—it may be a little unfair to call it hubris—to create instruments and to assume they could be sold on and not to look too carefully at what the lending was. Some of the lending decisions in the subprime market in the United States was quite extraordinary. We have moved almost in the opposite direction where people, perhaps having had a jolt to their belief that things will always be simple and work out well, really do not understand any of these instruments and are nervous about all of them. You see quite a disconnect between instruments linked to the housing market or structured credit products—that type of financial instrument—and normal corporate bonds, foreign exchange and the spot markets which work perfectly normally. There is an interesting difference between what has happened this year from August and what happened in 1998 which is the other example of a sudden loss of confidence in financial markets. In 1998 that was really spread right across all financial markets and liquidity dried up in all of them. This has not been true in all markets; it has happened in a particular set of financial markets. I suspect it will take time before the market recognises the true nature of these instruments and re-prices, restructures, and puts them back into a market setting where they can be traded again. I suspect that a lot of the activity in those markets will not resume. The model of securitisation will certainly resume but not in quite the enthusiastic form that it reached earlier this year.

  Q31  Mr Love: We may go into that more deeply when you come back to speak to us again. Professor Blanchflower, you were one of the two members who mentioned consumption as having critical importance in future. Obviously, confidence is incredibly important for consumption. To what extent do you think the framework in which we are discussing all these things—earlier the Chairman quoted eminent economists, all of whom said that recession appeared to be round the corner—will condition that confidence, and will that be important looking forward?

  Professor Blanchflower: Obviously, people's confidence is important. I do not think that anyone wants to talk it down. We face uncertain, difficult times. As an economist the way to think of it is that our experience of the recent past does not help us very well. People told me that central banking would be boring. It has not been. Experience over the past 10 years does not really help us very much. I think it is more an uncertain world than people talking it down. As to the sense in the US, there has been a change in my perception of confidence. The consumer confidence numbers are weaker there and so I have a sense that in the US confidence has changed. I do not have that sense here, although some data have started to look weaker. They are hard times and people are very uncertain and do not know what is coming. As an economist it is hard to forecast in this period.

  Q32  Mr Love: Governor, as to tighter credit conditions there seems to be a particular impact on small businesses. I know that they do not make up a large amount of overall business investment but they form a key sector of the economy. Are there real worries there about their ability to invest going forward?

  Mr King: You are certainly right that it is difficult for smaller companies, partly because they are often more reliant upon bank borrowing. In addition, they may well be perceived as the riskier types of borrowers and it is those for whom the credit spreads have risen most. That is certainly a factor. It is more difficult for smaller companies than many larger ones which may well have quite a large cushion of retained earnings to enable them, at least for the time being, to continue their investment plans until they have adjusted to the higher level of credit conditions in general.

  Q33  Mr Brady: Governor, earlier you said that monetary policy in the US was achieving its intended purpose, but obviously there is also an impact on the value of the dollar. Where do you see that moving in future and what is the wider impact of that on the UK economy and the eurozone?

  Mr King: As you know, I do not forecast exchange rates and do not know anyone else who can do so successfully, but what is interesting is that for a number of years people have anticipated a fall in the dollar, a rebalancing of the world economy and, within that, a significant rebalancing in the US economy as it moves to reduce its trade deficit and slow the growth of domestic demand. That is now clearly under way. Over the past three years the dollar has fallen in effective terms by between a quarter and a third depending on precisely how you measure it. Exports are growing very rapidly in the United States and for the first time they have just seen a positive contribution to economic growth from net trade—something that we have not managed to achieve in over 10 years. I believe that rebalancing is happening, but, as interest rates are cut and domestic spending weakens in the US, there is no doubt that the currency tensions we see are being exacerbated. In parts of the world, primarily Asia, where there is still a reluctance to see the exchange rate move markedly away from the falling dollar, that reduces the extent to which the world rebalancing can occur in a fairly manageable way. Obviously, it creates currency tensions for currencies like the euro in particular which takes the strain as the dollar falls. Here it depends markedly on the particular business you are in, because at the same time we have seen sterling reach the highest level against the dollar for over a quarter of a century it has fallen by 6% against the euro. Our effective exchange rate index, having been very stable for the past five yeas, has now fallen by just over 4% since August. We have also seen a fall in our exchange rate on average against other currencies but at the same time a very sharp rise against the dollar. These movements reflect not what is happening here but largely what happens in currency movements in the US, in the euro area and Asia. We cannot withstand those movements. We have seen big bilateral movements. Of the major currencies in recent years sterling has been far and away the most stable in terms of its average effective exchange rate, but we have now seen it start to weaken. It is impossible to know where that will go, but we still have a trade deficit.

  Q34  Mr Brady: How strong is the euro area economy and how well able is it to withstand the tensions and pressures of the current financial market instabilities?

  Mr King: Again, that is hard to judge and our colleagues in the euro area have expressed their concern about the higher levels of the euro which is dampening off one of the buoyant sources of demand in the euro area economy, namely exports. Their structural growth rate on average is not that high and they would think of something of the order of 2% as being the long run average growth rate they could achieve. Obviously, that can alter over time. They had been recovering quite noticeably over the past couple of years. There was a good deal of belief that perhaps they had never really recovered. Would domestic demand pick up? It did; we have seen a recovery. What is happening now has made life more difficult. All of us face concerns here and they are part of the world economy. This goes back to the discussions that the IMF tried to engender in its first multilateral consultation which included the euro area. What we are now seeking are very large current account imbalances exacerbated by very large current account surpluses in the oil-producing countries. That is a new factor in the past couple of years and it comes on top of the large current account surpluses in the emerging markets in China. This creates tensions among currencies. What is important is that the rebalancing of the world economy which is now visibly under way is accompanied by not just a slowing of the word economy but a rebalancing of domestic demand. Domestic demand is slowing in the United States and it will probably slow here. We need faster growth of domestic demand in the emerging economies of Asia so we see a rebalancing without a sharp slowdown in the world economy. That is not an easy thing to try to bring about when the flexibility of exchange rates is somewhat blocked by a reluctance by one part of the system to have flexible exchange rates at the same time as another part of the world economy does have flexible exchange rates. These are issues in which the new managing director of the IMF will want to engage quickly to see whether or not he can bring together people to find a way in which together they can plan and find a way through to a rebalancing of the world economy that does not involve a sharp slowdown.

  Q35  Mr Brady: In particular how vulnerable is the German economy to the current credit market turmoil?

  Mr King: I do not want to comment on individual countries; their own central banks will have views on that. Germany is a country that has seen a sharp increase in export growth and the high level of the euro will make that particularly difficult for Germany, though it has a very successful track record at exporting.

  Q36  Mr Brady: Earlier you made some interesting comments about the amount of liquidity that the bank had put into the market compared with the behaviour of the ECB and the Fed. Could I draw you as little more on your reasons for doing that and why you think it has been appropriate to behave in a different way from the ECB and Fed?

  Mr King: I do not think there has been a significant difference. All central banks when injecting liquidity have done so in order to maintain broadly the same amount of liquidity in each maintenance period, usually a month, as they were doing before. The Fed and particularly the ECB have been very clear that they have not increased the total amount of liquidity that they have injected into the banking system since this crisis started; it has remained constant. We have a slightly different system whereby we allow banks to choose their own reserves targets which they can change at the beginning of each month. If they say to us they would like to hold more reserves with the bank because it gives them more liquidity we supply the total amount of liquidity which banks in aggregate say they want to hold. That has resulted in our supplying almost 30% more than we did at the beginning of August in response to the banks' wishes. I think we have a very good system of money market operations. But what brings all the central banks together is their common objective to keep the overnight market rate in line with their official policy rate. We have been very successful in doing that. In the past two months we have been marginally more successful than the ECB. But we have been more successful at present than the Fed because, as its vice-chairman pointed out yesterday, it is constrained by laws that prevent it remunerating reserves with the central bank. That means their overnight rate has been much more volatile than that in either the euro area or London, but the objective of all three central banks is very clear: to keep the overnight rate close to the policy rate so that the decisions of the Monetary Policy Committee are implemented in the money markets. That is what we have managed to do. I believe that all three central banks are concerned that, as they get to the end of the year when all banks engage in what is called window dressing, there will be pressure on the demand for liquidity. We want to make sure that the supply is available to meet that demand. Basically, all three central banks have announced the same kinds of measures.

  Q37  Mr Brady: So, the difference is systemic, not policy?

  Mr King: There is no difference of policy; it reflects the different practical arrangements that the central bank has adopted.

  Q38  Mr Todd: I want to turn to the issue of projecting GDP growth and analysing data provided by the ONS for that task. In your latest report there is an interesting discussion of this. There is an academic article, which I confess I have not read, on presumably the methodological issues involved. The impression given is of a gentle disagreement between the bank and ONS on how to estimate growth. Is that a reasonable impression to gain?

  Mr King: I shall make one point and then ask Charles Bean, the world expert on this project, to discuss it.

  Q39  Mr Todd: I have seen his speech.

  Mr King: The speech is excellent. The article is also very good and would make an excellent Christmas present for those interested in such things. This is not a disagreement between ourselves and the ONS. I think the ONS sees its job as being to use all the methods at its disposal to acquire data on the economy and make estimates of what is happening to output and growth. Inevitably, data accumulate slowly over time. An obvious example is that one of the main sources of information for estimating growth and corporate profits is income tax data. There is quite a long lag between when the tax data are available to the ONS even in aggregate form and the period to which they refer. The ONS has adopted the strategy of saying that its job is to try to measure and record what has been going on. Inevitably, there is a lag between the time when you try to observe activity and the date when the data arrive. What we are doing is something rather different. We try to judge what is actually happening in the economy now, not record what data have arrived in the ONS. We have found that there are systematic patterns to the revisions that the ONS makes. There is nothing terribly surprising about that. Therefore, we try to anticipate when looking ahead in our judgments what revisions the ONS is likely to make. We also use business surveys which tell us quite a lot about what is going on. None of these things is perfect, but we use our best methods to try to bring together all this information to form a judgment about what we believe is most likely to have been happening in the economy with all the uncertainties around in the form of the fan chart.