MR MERVYN KING, MS RACHEL LOMAX, PROFESSOR CHARLES BEAN, DR ANDREW SENTANCE AND PROFESSOR DAVID BLANCHFLOWER

26 MARCH 2008

  Q1 Chairman: Governor, good morning to you and your colleagues and welcome to this session on the Inflation Report. Can you introduce your colleagues for the shorthand writer, please? I believe you have an opening statement.

  Mr King: Indeed, Chairman. On my left is Rachel Lomax, Deputy Governor for Monetary Policy, on her left is Mr Andrew Sentance, one of the external members of the Monetary Policy Committee, on my right is Professor Charles Bean, the Executive Director for Monetary Policy, and on his right Professor David Danny Blanchflower, another of our external members. If I may, Chairman, I would like to make a short opening statement. The past week has seen significant volatility in financial markets, a further sharp cut in interest rates in the United States and at home the news that inflation rose to 2.5% in February. I would like to explain our own interest rate decisions. We have cut bank rate twice to its present level of 5.25% since the Monetary Policy Committee last appeared before you in November. Following increases in gas and electricity bills, consumer price inflation has risen. The central projection in our February Inflation Report is for it to rise further to around 3%. That pronounced pick-up stems from sharp rises in commodity prices around the world—food prices on world markets are more than 50% higher and oil prices two-thirds higher than they were a year ago. The time lag between changes in interest rates and their impact on inflation means that the MPC can have little effect on the short-term path of inflation. What is crucial is that the pick-up proves to be temporary, just as the rise in inflation last year was. Even if commodity prices remain at their present high levels in the face of a slowing world economy, our central projection is for inflation to fall back towards the 2% target, starting later this year. In judging where inflation is likely to settle, we have to gauge the balance of two risks. The first is that a sharp slow down in the economy this year, driven by the credit crunch, creates a margin of spare capacity that pulls inflation down below the target next year. The second is that rising inflation enters the expectations of those setting prices and pay and that, without some margin of spare capacity, inflation persists above the target. Our central projection in February was for economic activity to slow quite sharply this year as the world economy turned down and credit became less widely available, but we also judged that some slowing in the pace of activity from the rapid rates of last year would be necessary to make sure that inflation returned to the target next year. Surveys suggest that the economy has slowed but, so far, modestly. The world economy, particularly the United States, has weakened, but the recent fall in sterling should help to cushion the impact on exports, and the official data on retail sales show that spending has this year been surprisingly resilient. In contrast, both activity and prices in the housing and commercial property markets continue to weaken. That stems in part from the continued tightening of credit conditions, reflecting the turmoil in financial markets. The financial crisis has moved into a new and different phase. Across the world confidence in financial markets is fragile. It is not that banks, at least in the United Kingdom, have made loans that are likely to result in unsustainable losses. The heart of the problem is not in the real economy, it is in the financial sector itself. It stems from an overhang on banks' balance sheets of assets in which markets have closed. These assets cannot now be sold or used to secure funding in the market, they are difficult to finance and that has created uncertainty about the strength of banks' financial positions. These are the sort of circumstances I described in my statement to you in September as those in which central bank action is necessary to prevent a major shock to the system as a whole. I want to assure you that the Bank will provide the liquidity assistance that the system needs in order to restore confidence. Such lending can be only a temporary measure, but it can be a useful bridge to a longer-term solution, which is why the Bank expanded the range of eligible collateral to include mortgage bank securities in its three-month lending operations in December, January and March. I can confirm that the January auction will be rolled over on 15 April with the size of the auction to be decided in the light of market conditions nearer the time. It is unrealistic to assume that markets for many asset-backed securities are likely to reopen speedily or, when they do, to their previous levels of activity, so we are discussing with the banks how a longer-term resolution of the problem might be reached. It is too soon to say where those discussions will lead, but two principles would underlie any central bank role. First, the risk of losses on their lending should remain with banks' shareholders. The banks neither need nor want the taxpayer to insure them against these losses. Second, a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets. One of the lessons of this financial crisis is that providers of mortgage finance had underestimated the risks and, hence, the true cost of the securitisation process. Chairman, I am grateful for the opportunity to make those remarks, and now I and the other members of the MPC here today stand ready to answer your questions.

  Q2  Chairman: Thank you very much, Governor. I am interested in your opening statement where you used the phrase "credit crunch". Previous witnesses to this Committee, whether it be officials from Her Majesty's Treasury or the Chancellor, seem to have taken an oath not to use that phrase. When did you decide that this was a credit crunch?

  Mr King: We have set up, as you will have seen last year when we came to see you before Christmas, a special report that we publish regularly on credit conditions, and it has been clear that in the last couple of months there has been a further significant tightening of credit conditions both in respect of the margin which banks charge above bank rate in the interest rates at which they are willing to lend to the private sector and in terms of the quantity of credit which they are willing to make available as banks now look to slow down the rate of growth of their total lending in order to prevent the capital which they have proving inadequate relative to their total liabilities.

  Q3  Chairman: One of the newspapers today focuses on the continued hoarding by banks of liquidity. To what extent does such hoarding frustrate your attempts to provide extra liquidity to the market by your money market operations, and when the banks came to see you last Friday did you ask them the question why they were not lending to one another and make the comment that, if they did lend to one another, then a bit of the problem would go away, so may be the responsibility is not yours but theirs?

  Mr King: I do not want to say that people that decide at this stage not to lend to one another as an individual institution are behaving irrationally. I think collectively, clearly, it is not serving a common cause, but the problem we face is that people who supply funds to the banking system have become extremely cautious about the length of time for which they are willing to lend money (certainly on an unsecured basis) to another financial institution. This is not an issue only in the United Kingdom, this is right across the developed financial world. In all the major financial centres now there are very large spreads between policy rates and the rates at which banks say they may be willing to lend to each other but, more importantly, there is fragility: banks are unable now to finance themselves really anything above overnight periods. That is a situation of great fragility and it is one that we need to try and consider how we can best address.

  Q4  Chairman: I put this question to you, Governor, because it has been mentioned in the press and elsewhere that the actions of the Fed in aggressively cutting interest rates in response to concerns about the growing weakness of the US economy perhaps has not been replicated by the Bank of England. Should the Bank of England adopt a similar approach to the Fed?

  Mr King: No, I think there are two quite different types of policies and two different sets of circumstances. The first is the state of the economy and the outlook for economic activity and inflation, and the second is the fragility of the banking system as we currently see it. The second, the fragility of the banking system, is about the supply of liquidity. That is a problem which is shared by all financial centres and all central banks, and all central banks are taking steps to deal with that problem. In terms of the level of the policy rate, of interest rates, that depends on the outlook for inflation and activity; that varies quite markedly across different countries. Almost any dimension of the housing market that you look at is markedly worse in the United States than it is here. Even if you look at the latest data for the United Kingdom, you can see this very difficult balancing act that I have talked about before that we have to meet. On the one hand, there are signs that a tightening of credit conditions will depress the rate of the growth of spending—we see that very clearly in the housing and commercial property markets. On the other hand, in terms of activity, retail sales in January and February this year have been remarkably resilient. The latest growth rate in the official data, the post-war average rate, employment rising, unemployment falling: this is not an economy that has completely ground to a halt, but we are looking ahead and would expect some slowing that was spelt out in detail in our February Inflation Report. That is the activity side, and that will affect inflation further ahead. Complicating our problem is that in the short run we have already started to see (and we would expect this to continue) a pick up of inflation to a level who knows precisely where, but around 3%, well above our 2% target. We think in our central view that inflation is likely to come back to the target over the next couple of years; but that can only be a central view and it is absolutely vital that the course of interest rate setting that we pursue does nothing to undermine people's belief that we are prepared to take whatever action is necessary to bring inflation back to the target, and I can assure you we will do that.

  Q5  Chairman: Professor Blanchflower, you have the luxury of spending half your life in America and half your life here. Given your bird's eye view of what is happening in the United States, do you agree with the Governor's statement about the different policy approaches between the US and UK to stabilise the economy?

  Professor Blanchflower: Yes. Thank you, Chairman. Certainly I agree with what the Governor has said. The situation in the US is markedly different. There are some similarities, but the data now coming out of the US is substantially worse, especially in the last couple of days. Notably, the rapid decline in house prices in the US, the Shiller index has had the largest drop that has ever happened, we are talking about a national drop of about 11% in house prices and in some major cities 18% or so, as in Los Angeles. So, that is the first thing. I think the labour market data in the US are much worse, consumer confidence reports are much worse, so I certainly see that situation has worsened and I think my view over the last week is that it has fundamentally worsened and confidence is really at very low levels. I would say there are some similarities. Particularly, perhaps, if you look at the US some months ago, there are some similarities with where we are here, and certainly things look much worse there, but I am concerned that some of the soft survey data, particularly consumer confidence data, some of the surveys about the labour market here show some similarities to what occurred in the US some months ago. So, yes, there are some similarities, but I agree with the Governor, we certainly have not seen hard data of the kind that we have seen in the US, and that is why, I guess, my votes have been for small changes, small cuts rather than the aggressive cuts that the Fed has done and, in my view, probably had to do.

  Q6  Mr Todd: Can I follow up the question to Professor Blanchflower. You have been on your own this year in your voting on two occasions and with one other member on another, so you pursue a solitary path on the Committee. Could you explain your difference from your colleagues? Is it the American experience that you obviously have in much closer terms than the others?

  Professor Blanchflower: I would not call it a solitary path. Being an independent member, one tries to persuade one's colleagues, and certainly on a couple of occasions we have voted unanimously. I think my views have been well documented. I have obviously taken the view that the US was much more likely to go into recession. I said that on a number of occasions, I said that several months ago and that has been a concern to me, and I think my views have been about the degree of slack in the economy. There has not been a fundamental difference about how we operate policy, but in comparison to my colleagues, my view has been that the risk to the down side and to growth has been greater than they have felt. That has been my view and I have expressed it on a number of occasions. My views have been especially about what was going to happen to the labour market and whether wage growth was going to take off, and I have said it to this Committee on many occasions over the last year.

  Q7  Mr Todd: You have been right, by and large, on that, have you not? You have tended to counsel that expectations of wage inflation have been exaggerated and that slack within the labour market would dampen inflation expectations. Is that your perception?

  Professor Blanchflower: My view of the labour market is that it has been rather complicated to work out what is going on in the labour market. It has been helpful to be a labour economist to look at it. What happened a year or so ago about employment has been complicated: the role of migration and its effect on wage bargains has been complicated. It has been tough to call, but I guess someone who is a wage curve person, who tries to understand how labour market slack affects wages, was a good position to come from and it did not seem to me (and probably turned out to be right) that wages were going to take off, but it is a call that I made.

  Q8  Mr Todd: Ms Lomax, you have highlighted in your speech to the IEA that the fan charts of both GDP and CPI have broadened recently. Does that reflect, in your view, the increasing uncertainty of any predictions at the moment as to how this country's economy will perform?

  Ms Lomax: I have to apologise for my voice; it has completely disappeared. Yes, that is exactly right. We widened the fan chart in November precisely to reflect our uncertainty about the impact of the financial crisis: firstly, the duration of the financial crisis and, secondly, its likely impact on the economy. The other big uncertainty has been about the impact of another spike in inflation on inflation expectations.

  Q9  Mr Todd: This is parcel of energy prices and—

  Ms Lomax: That is right. The point the Governor made in his earlier remarks about the way in which it might affect the way that people perceive the credibility of the MPC.

  Q10  Mr Todd: We saw what happened with the last spike on energy prices, which had a rather lesser effect than people had expected, but that does not necessarily indicate what will happen in the future.

  Ms Lomax: I think inflation expectations did move up, but not dramatically. What I think is a little disturbing is that they did not fall back in the way that one might have hoped when inflation itself fell back. There is also the question of how many times can this happen before people begin to take a different view? I think it is beginning to get into the popular and political debate now, the concerns about inflation, in a way that we have to take notice of.

  Q11  Mr Todd: Dr Sentance, you are appropriately placed at the other end of the table to David Blanchflower!

  Dr Sentance: Do not read too much into that.

  Q12  Mr Todd: In terms of your voting patterns, and we will explore that, no doubt, later on this morning. You have pronounced that just at the moment the monthly frequency of the MPC has been extremely valuable in being able to respond to crises. You will obviously have noted the rather different and more emergency behaviour pattern in the USA. Do you actually incline towards the view that the MPC should meet more frequently than once a month, because you will be aware that many people actually suggested once a month as being too high a frequency in the past?

  Dr Sentance: Yes, I think my comments should be seen in that context. I joined the Committee after there had been a period of quite a degree of stability in interest rates, and I think that led to the view: is the Committee meeting too often? Should it have more flexibility? Over the period I have been on the Committee, over the last 18 months, we have seen an awful lot of change in the economy and we have needed to respond to that change. I went back and I looked over 18 meetings I have attended. We have changed interest rates on six of them, but there has been at least one vote for a change in interest rates in all but four of the meetings I have attended, and I think the monthly frequency that we have fits in with the monthly data cycle. I would rather we were meeting more often and then sitting there and saying the economy is more stable than we expected, rather than being in the position of often having to have emergency meetings, and I think the monthly meeting strikes the right balance, in my view.

  Q13  Mr Fallon: Governor, can I come back to the Chairman's question of the difference between the approach of the authorities here compared to the approach of the authorities in the States where Bear Stearns were sorted out within 48 hours. The Federal Reserve has been cutting rates aggressively and providing much more liquidity at a wider range of collateral. What is it about the United Kingdom position that makes your reaction so different? You said here that the crisis is now in a new phase. What is it that you are not prepared to do that the banks want you to do?

  Mr King: I do not think there is anything. We have had very useful discussions on that, but I think it is very important to distinguish between interest rates and the provision of liquidity. These two things are not the same, and it is absolutely vital to distinguish clearly between them. You will lose control of inflation if you are not careful to distinguish between them. In terms of interest rates, we have cut interest rates twice, the Federal Reserve has done it more often and by larger amounts, the European Central Bank has not cut at all. Those decisions reflect differences in the economies of those three areas. I think the broad approach to monetary policy is very similar in all three, so I do not think in terms of interest rates there is a real difference. Central banks are looking at the outlook for inflation in all three cases. In terms of the provision of liquidity, our system is much closer to that of the European Central Bank and in terms of the comparison between the ECB and ourselves, the response has been virtually identical. The total lending by the Bank of England to the banking sector now constitutes about 1% of the assets of the banking sector. That is exactly the same level of support provided by the European Central Bank. In terms of the proportion of the total liquidity that is extended by central banks to the banking sector, that is provided at three months or longer, longer-term horizons, to the full-term funding. The proportion provided in that way by the ECB is between 50% and 60% of its total lending. The proportion at three months and longer provided by the Bank of England is also between 50% and 60%. I do not think there is any significant difference at all. One of the reasons why this myth has grown up is because back in August and September a great deal of publicity was given to the very large injections made, particularly by the ECB, without anyone taking on board the fact that whatever money they put in with the one hand they have to take back with the other in order to maintain the total amount of money injected into the system to retain control of interest rates against inflation. The ECB have been very open about that—you explain that very clearly in your report—so I do not think there is any significant difference between the approach of the different central banks. The Federal Reserve in the last couple of weeks has taken particular action to deal with the failure of one of its major investment banks, and that was a series of measures which in many ways are not that dissimilar to the steps that were taken to deal with Northern Rock back in the autumn.

  Q14  Mr Fallon: But it is not working, is it? The inter-bank rate now is near 6%. Banks are not lending to each other.

  Mr King: It is not working in any financial centre, in the sense that there is still a sense of fragility, and that is why central banks need to be willing to provide the liquidity that is necessary—we are in that position too—and to monitor it, and, as I said, we are talking with the banks about possible longer-term solutions.

  Q15  John Thurso: Governor, in the November 2007 press conference on the Inflation Report you said you welcomed the cooling of the housing market. Does that remain your view?

  Mr King: I certainly would welcome a period of stability in house prices, yes.

  Q16  John Thurso: How long and how sharp do you believe the current slow down in the housing market is likely to be?

  Mr King: I think it is almost impossible to make any quantitative forecast of what will happen, but, as I said in the recent Inflation Report press conference, I would be surprised if in a few years' time house prices were markedly above where they are now. I would expect, without being able to forecast the short-term path that they might follow, that we will be seeing broadly stable house prices over the next few years. If that were to happen, then you would, of course, see quite a significant adjustment of the ratio of house prices to average earnings, for example. That ratio could come back to something much closer to what economists might think of as a normal ratio, with broadly stable house prices and the sort of rate of increase in average earnings that we have seen in the last few years.

  Q17  John Thurso: To what extent do you think over exuberance in the lending market has been a factor in the overheating of house prices and what lessons could be usefully learned for the future from that?

  Mr King: I think, undoubtedly, it was. As I said in my opening statement, I think that financial markets in general, house lenders in particular, underestimated some of the real economic costs associated with the securitisation process. Although that process does have real benefits, by ignoring the costs that came and looking only at the benefits, I think a good deal of mortgage lending at the time was under-priced. I think, if you look at the quite remarkable expansion of the issuance of mortgage-backed securities in 2006, to some extent 2005, but it is not before that—it is 2005, particularly 2006 and the first half of 2007—the very substantial increase in the rate of issuance of these securities which have turned out, in economic terms, to be much more costly than people thought at the time.

  Q18  John Thurso: You, rightly, made the distinction between what you call "the real economy" and "the financial sector", but house prices and that lending market are where the two collide, as it were.

  Mr King: Yes; exactly.

  Q19  John Thurso: Do you think that we should simply hope that the market has learnt its lesson and will behave better next time round or is this of sufficient severity and seriousness that we should be looking at something more than that?

  Mr King: I think you can probably rely on the fact that the pain that will be suffered by financial institutions this year will be enough to keep people's minds focused on it for a number of years. There will come a time, I am afraid, when the people actively involved will have forgotten what it was like, or will not have been working when these problems were experienced, and we will go through the same again. There are very many lessons to be learned from this episode, and I think the conclusions that will come out of this inevitably tend, in my view, in the direction of saying financial institutions will have to hold more capital in the longer run and that these activities will need to be monitored much more carefully. Martin Wolf's piece this morning in the Financial Times strikes a chord, and I think it is important that people reflect on that. There was a lot of hubris around in thinking that the expansion of financial services was a good in itself. It is not; it is a means to an end and there are a lot of lessons to be learned in what has happened in the financial sector, not just in the United Kingdom, but very much in the leading financial centres of the world. This financial crisis did not come from bad lending to, or by, Latin America, or an Asian crisis, or emerging markets in general, it arose out of the heart of the financial systems in the main financial centres.