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

26 MARCH 2008

  Q20  Peter Viggers: Looking at sterling, you have examined the factors which underlie the fall in sterling since November in your Inflation Report. Would you talk us through the key factors which have affected the price of sterling? How many of these do you welcome and how many are a cause of concern to you?

  Mr King: It is very difficult, even after the exchange rate has moved, to know precisely why it has moved. I think the first thing that is worth saying is that, although it has fallen quite significantly—it has moved around quite a lot, it is quite volatile, almost 10% it has fallen since this time last year—it is actually nowhere near as low as that relative to where it was two or three years ago. So, 2006 saw a rise in sterling which has unwound, sterling has gone a bit further than that, but, nevertheless, much of what has happened has been an unwinding of an appreciation which in 2006 we found very hard to understand. I think, inevitably, with the publication of larger trade deficits towards the end of last year, as the numbers came out it became more obvious that the factors that we had been talking about for some time, namely the need for a rebalancing, for a switch of demand away from consumer spending and towards exports and business investment, was going to be part of a readjustment, and I think that people in the second half of last year could see that the movements in financial markets were suggesting that, along with the problems in the banking sector, we were beginning to see some of the unwinding of the large international imbalances that we had seen build up over many years, and although there was an appreciation that these were not sustainable, no-one quite knew when the unwinding would begin. We are seeing a bigger appreciation of the Renminbi by China against the US dollar—they have allowed that appreciation to occur to a larger extent than I think many had expected—we are beginning to see the unwinding of the imbalances and I think people came to the view that, if that process was underway, it would not be surprising that the real adjustment in the British economy would need to be accompanied by some changes in relative prices, one of which would be a fall in the real exchange rate of sterling. I think that is the bigger picture analysis, but, clearly, we are not indifferent to the exchange rate.

  Q21  Peter Viggers: Some commentators have pointed out that we have stronger links with the United States than many of our European partners, that we are more closely linked with the housing market, housing is a more important element in our economy than in others, and, of course, we are more reliant on financial markets than many of our European partners. Does this make us more vulnerable than our European partners?

  Mr King: I think the housing market point has some validity, but I think it is easy to exaggerate that. The housing market is important, but I think its impact on spending in the economy as a whole is much more through its effects on confidence, expectations of what might happen to job prospects and incomes than it is directly through a change in prices. I do not think that the direct impact on the size of the financial sector is likely to be sufficiently substantial, apart from certain parts of central London, to be that significant. It is really the effect overall of the slowing of the world economy at a time when we need to adjust away from domestic demand to external demand. It is a difficult period for us to try and make that adjustment.

  Q22  Peter Viggers: How concerned are you about the widening current account deficit?

  Mr King: We have been concerned for some time. It indicates that a rebalancing is required. The data have been revised, which suggests that the current account deficit is worse than we had previously thought and there will be need to be an adjustment, but I think our central projection in the February report is quite consistent with that adjustment. In the retail sales figures we have not seen much slowing of consumer demand, but we would expect to see it through the course of this year as real income growth is held back by what is happening both on energy and food prices but also through the tightening of credit conditions.

  Q23  Peter Viggers: Could I ask each of you, as members of the Monetary Policy Committee, how many of you anticipate further declines in the value of sterling, and is this a matter of concern to you, perhaps causing inflationary pressures?

  Professor Bean: Perhaps I could start.

  Q24  Peter Viggers: The Chairman will insist that you are very brief indeed.

  Professor Bean: Yes. I would certainly say the risks are balanced to the down side, and that is something which is also priced into markets. There is a chart in the Inflation Report of so-called risk reversals—the price you have to pay for insurance against the appreciation of sterling or the depreciation of sterling in the financial markets—and the financial markets certainly are pointing, if anything, to the risks being to the down side. Given the size of the current account deficit, I would take the view that, if anything, the risks are tilted to the down side and in fact, of course, our projection is conditioned on the assumption that sterling continues to depreciate at a moderate pace over the forecast period.

  Dr Sentance: I would agree with that assessment. In my business life I used to say my exchange rate forecasts were always right but the timing was sometimes a bit awry. I think, over a period of time, for the reasons that the Governor has set out, you would expect to see some further decline in sterling. Predicting exactly what will happen over the next six to nine months, or 12 months, or couple of years is very difficult, but as Charlie said, the pressures seem to be in that direction.

  Ms Lomax: I would be very wary of forecasting the exchange rate at all. I think it is well documented as the most difficult, if not impossible, thing to forecast.

  Professor Blanchflower: It is hard to forecast. I agree with Charlie.

  Q25  Ms Keeble: I wanted to ask a bit more about domestic demand. What weight do you attach to the different components of aggregate demand in explaining the slow down in demand in the UK?

  Mr King: Let us hear from some of others. Charlie, why do you not start and then maybe Andrew or David?

  Professor Bean: The first thing to be said is that consumption is the biggest single component of domestic demand, so what counts for consumption is particularly important. So far, as the Governor has said, consumer spending has stayed remarkably resilient. Although it apparently slowed in the fourth quarter, that was after particularly strong growth in the third quarter. If you average the two together, the quarterly growth rate is a little bit above half a percentage point, so 2% at an annual rate, and retail sales growth has been relatively strong in January and February. Some of the other consumer spending indicators suggest a bit more softness, but no sign of it having decelerated sharply yet. But we would expect consumer spending to slow as we go through this year, essentially because real income growth is going to remain muted as energy price increases and food price increases, eat away at real purchasing power. On top of that, of course, there will be the impact from the reduced availability of credit also bearing down on consumer spending. Investment spending is a smaller fraction of overall demand, but it does tend to be more volatile. Quite often when you get sharp slow downs it is associated particularly with a turn round in investment—that, of course, was the case in the United States where the slowing in GDP growth last year was predominantly driven by a sharp decline in residential investment. Consumer spending stayed robust through most of last year, but there was a very sharp fall off in residential investment. We expect investment to ease, particularly in property, both residential and commercial. But to go back to an earlier question, whether we are just a few months behind the US, I think it is worth noting that investment in property in this country tends to be much less volatile than the US. That is a by-product of the planning system. Maybe, if you like, it is the silver lining which will probably help to limit any sharp downturn, but we do expect, as we go through this year, to see those components relating to investment in property particularly easing and also probably some easing of business investment as well.

  Q26  Ms Keeble: There are two points I want to follow up and one is specifically for the Governor. When we have talked previously about public response to some of the macro factors, you have been quite dismissive of them, in particular around impact on the housing market. All the commentators now will say that one of the factors in slowing down is public confidence, which is very nebulous. What regard have you had to public confidence in the economy and in financial stability? Have you given any consideration to the impact that that will have on overall economic performance?

  Mr King: Yes, and we look very closely at measures of confidence, but I think it is important to distinguish between what I described in my opening statement as confidence in the financial system from people's confidence in the economy and their own prospects for jobs and incomes. These are two very different phenomena. They may interact but they are reflecting different outcomes. So, we do look closely at confidence, and if you look at our projections for consumer spending which are embodied in our forecast for growth in the February Inflation Report, we have a pretty sharp slowing of consumer spending built into our central projection which very much reflects the fact that there is not only a squeeze on household real disposable incomes, which has already started and is likely to continue for another year, but also reflects the impact on confidence that that experience generates.

  Q27  Ms Keeble: Given John Thurso's point about public confidence in the financial systems colliding with the housing market, would you accept that what made Northern Rock turn from a problem into an unmanageable crisis, with knock-on consequences for public confidence in the system and the economy, was the queues forming outside Northern Rock, which nobody factored into the equation? I wonder now how much you factor the confidence factors into the on-going performance—

  Mr King: There is certainly no doubt that it was the queues on the street that made the story about Northern Rock a very prominent one. How far that impacted on consumer spending is very hard to judge. As Charlie said, if you actually look at the data, quite remarkably the figures on consumer spending on retail sales in January and February were surprisingly resilient, much stronger than we have embodied into our February central projection. That may well be very temporary, and we will have to look at all the data, but I think it is just worth looking at the numbers and seeing what is happening.

  Q28  Ms Keeble: One further question on the housing market. The Financial Times carried a story recently about the impact of the credit crunch on the availability of financing for new housing development, which is obviously a really big factor in house prices, not perhaps at the luxury end of the market but for most people that is a major factor. Have you looked at that and do you consider that to be a major threat to housing supply and, therefore, to house prices with knock-on consequences for a range of different factors?

  Mr King: Of course, if housing supply is restricted, then prices may rise more quickly, not fall, so those things go in opposite directions.

  Q29  Ms Keeble: Exactly. Have you given any assessment to that?

  Mr King: We certainly look very carefully at credit conditions, both to existing home owners or would-be first-time buyers, to see whether they can get access to credit in order to buy a house; and we also look at the access to credit of those involved in the construction of housing, yes. I would say that one thing that is a signal of slowing in the economy is that our survey of credit conditions shows a distinct tightening of credit conditions to all kinds of borrowers, and that shows up not just in the quantity of credit but also in the price. Broadly speaking, I think it is fair to say that the reductions in interest rates that we have made so far, the 50 basis point reduction, has offset the impact of the tightening of credit conditions on the cost of mortgages. Of course, there are many different mortgagees in different positions, and I do not want to deny that, but if you just average across all the mortgages, the average rate across all mortgages, the average interest rate paid on mortgages now is pretty much the same as it was last August. We have offset the tightening that would have taken place had we not acted by the 50 basis point reduction of bank rate that was made, broadly speaking.

  Q30  Jim Cousins: Professor Bean, we have now heard three times this morning the Governor saying that he does not think conditions in the housing market will affect consumer spending, and, of course, the Chancellor takes the same view and took the same view when he was in front of us, but your colleague, Professor Besley, appears to take a slightly different view and, in a very interesting presentation in the Bank's quarterly report, he drew the conclusion that, with credit conditions tightening, we might expect a significant reduction in consumption growth over the coming months. What is your view?

  Professor Bean: Can we separate two issues. The first is the impact of house prices on consumer spending, where I think you have slightly overstated our view by implying that they have no impact on consumer spending. We would certainly expect it to have some impact, and that is potentially embodied in our projections, but where we have departed from some outside commentators is that those outside commentators have often taken the view that there is a very strong link between house price inflation and consumer spending, whereas we have tended to think that when you look at that correlation in the past they are both reflecting a common third factor, which is basically optimism about future income growth. Having said that, there probably is a structural link between house price and consumer spending which comes through the availability of collateral against which to borrow. So were house prices, say, to fall sharply, that would limit consumers' ability to borrow against that housing equity. We think there is some mechanism there. Tim Besley's speech that you referred to, and the research that he has been pursuing, tries to focus more clearly on the mechanisms that are involved in determining the availability of credit from banks to households. In particular, were there to be a relatively sharp cut back in the availability of credit, then his work—and I think our view on the Committee—would be that that could translate into quite a strong impact on consumer spending. So there are two separate elements here: the impact of house prices and the impact of a reduced availability of credit.

  Q31  Jim Cousins: Professor Besley goes further than that, it seems to me. He clearly expects credit conditions to tighten and, therefore, also expects a reduction in consumption growth. Are you of that view?

  Professor Bean: Yes. We have a reduction in consumption growth in our central projection and also a downside risk that it may be even more steep than in the central projection. We certainly recognise that as a possibility.

  Q32  Jim Cousins: The Governor in his opening statement made it clear that he took the view that banks, so far as lending in the mortgage market were concerned, should, so to speak, bury their own dead. However, their dead are likely to be thousands of ordinary people who have real difficulty in financing their home loans or taking out new home loans to sustain the housing that they are in. Do you think special measures will be required to assist, not the banks, but the people faced with the difficulties to get them through that, that more policy measures will be required to help people?

  Professor Bean: I think it is early days to draw that conclusion. But in a situation where things get very bad—so with very high default rates and if unemployment has risen a lot—you may want to introduce additional measures. Certainly the Governor's earlier remarks about the banks burying their dead, I think his view was that the banks' shareholders should bear the burden of past mistakes in decision-making, not the customers.

  Q33  Jim Cousins: Professor Bean, we saw last autumn where all this talk about moral hazard gets you. Moral hazard is very fine, but when you are left with depositors who lose their savings, everyone runs away from the battlefield at that point: moral hazard is abandoned. Do you not think the same thing is true of the housing market? It is all very well to say the banks should bury their own dead and shareholders should bear the consequences, but at the end of it there will be thousands of ordinary people who cannot finance their existing home loans, and cannot finance new home loans, and cannot refinance the home loans that are coming to an end on the fixed rate deals, and cannot finance home loans to sustain the home they are in in terms of improvement and renewal. Do you not think special policy measures are required to assist that? I am asking Professor Bean.

  Professor Bean: It is a matter of balance between these two concerns. Where we are at the moment, repossessions are still at very low levels: I think that it is important to keep that in mind. House prices are flat: we are not in the position of a house price slump. Unemployment is at relatively low levels and has not risen. And the majority of households are not finding serious problems repaying their mortgages. So we are not in a position where any sort of special measures are required at this juncture. As we go forward in time, then the situation may well change. Policy-makers always have to balance off conflicting arguments. Moral hazard is an argument on one hand. The sort of arguments that you have been putting forward are arguments that go in the other direction. As conditions change, so the balance of those arguments may shift. But where we are at the moment is not in a situation of an extreme slump in either the housing market or the economy in general and special measures are simply not called for at this juncture.

  Q34  Jim Cousins: Governor, you told the Committee that you were operating on two fronts, which I well understand, that of policy interest rates and liquidity and the availability of credit in the financial markets, but at the moment you are losing the battle on both fronts, are you not, and people can smell it, and that is why confidence is going down in the economy?

  Mr King: I totally reject that. Let us take the two areas. We have a very difficult balancing act in order to set interest rates to meet the inflation target. That is the target that you in Parliament have voted for, your Government representing you have said that we should try to hit, and that is what we are going to do, Mr Cousins, and we are on track to do it. There is a difficult balancing act at present because there are big risks on either side and no-one can easily forecast the future. If the evidence moves in favour of one set of risks or another, we will respond—that is what we are doing—and I think most people's forecasts suggest that, far from panicking, people think there is plenty of scope for a difference of views about the right level of interest rates, that no-one is doubting that we are setting rates in order to meet our target. In terms of liquidity, as said to you before, there is concern and lack of confidence in all financial markets around the world, this is not a UK phenomenon, and all central banks are working together to deal with that. That fragility remains today, and we are continuing to work, working with the banks to deal with that problem. So, far from not having dealt with it, we are actively dealing with it day by day.

  Q35  Mr Love: Can I follow that up, Governor, by asking do you think, having accepted that there is fragility in world financial markets, that we have underestimated the impact of that on the real economy?

  Mr King: No, because I think at this stage, if the fragility continues and we cannot find a way of dealing with it, then the consequences would be more serious, but this fragility that has become serious in the last few weeks is quite different from where we were even in December. In December, when the central banks worked together and announced a series of joint measures to deal with the problem of liquidity, that action had a big impact and worked very clearly and brought down the spreads between inter-bank rates and the official policy rates quite markedly in all the major financial centres. In the last few weeks even the co-ordinated measures which the central banks took in March did not work, so there has been a much greater sense in the last few weeks of this lack of confidence, the fragility, and that is a matter for concern and it is a matter we are trying to deal with. What is so remarkable, I think, is the contrast between an objective view of what is happening now in the real economy and the concern in the financial sector. Of course there are links, but what is so marked is the difference in sentiment that you see between people running businesses and the outlook for their businesses at present and what is happening in the financial sector. Clearly, if we cannot deal with the problems in the financial sector, that might well have an effect that would jeopardise the future of those businesses, but it is our job to try to deal with that. At present what so is marked is the difference between the real economy and what is happening in the financial sector.

  Q36  Mr Love: One of the curious phenomena from past experience is that while you have put interest rates down twice, actually market rates are going up. What influence do interest rates today have when market sentiment out there is acting in reverse?

  Mr King: It certainly has an effect, and, as I explained just now, the cut in interest rates of 50 basis points that we have made offsets the widening in spreads charged by banks between the rates at which they can borrow and at which they lend. To some extent that is unwinding the compression in those same margins that occurred in 2006 and in the first half of 2007. When we were raising interest rates—not many people pointed this out—but when we were raising interest rates five times, the impact of that increase in interest rates, one half of that, was passed through to mortgage borrowing. Mortgage rates did not rise by the full extent of the increase that we made in bank rate. These differences will always occur, and they have always occurred in the past. We can only set the bank rate; it is the market that will then determine the rates on different kinds of borrowing. The massive expansion of securitisation and mortgage lending was on the back of a serious compression of spreads that was not sustainable and we are now in a position where those excessively narrow spreads are widening out, but I do not think that that means that changes in bank rate do not affect the borrowing rate. What that means is that you cannot assume that there is an automatic one-for-one link independently of the circumstances of the sector at the time, and we have to watch that and monitor it in order to work out by how much we should be changing bank rate.

  Q37  Mr Love: But in the current market conditions, does that not make the Monetary Policy Committee more predisposed to a cut in interest rates because of the attempt to decompress, as you have talked about?

  Mr King: Yes.

  Q38  Mr Love: It is interesting. Last week we interviewed Mr Strauss-Kahn of the IMF, who indicated that they had marked down world economic growth this year from 5% to 4%, and he said that the likely downturn would be longer and deeper than they had previously expected. What is your view of where the world economy is going, and are you tending towards the pessimism that I think was expressed by Mr Strauss-Kahn?

  Mr King: I do not think a down grading of a central view from 5% to 4% is wildly pessimistic, it is a modest reduction in the growth rate from the fastest growth rate of world trade in the world economy that we had seen in much of the post-war period, so we have been through a period of very rapid growth. It was not obvious it could be sustained. It might, Asia is still going growing pretty rapidly, but, no, we would expect some slowing of the world economy and I think that estimate is broadly the sort of figure that we would share. Who knows precisely? This is a slowing of world growth, but it is very important for people not to confuse a slowing of growth of that relatively modest kind with words like "depression, "slump", "falls in output"—they are a million miles apart—and it is the patient monitoring of what is going on month by month and the adjustment of policy to those changes that matter. As we said before, in the United States the conditions have deteriorated much more markedly than in other economies and, quite rightly, the Fed have responded to that. I think the way we react to these things is actually quite similar across central banks; what is different is the conditions that we face.

  Q39  Mr Love: Let me take out the hypothesis that either the United States is in recession or it is going into recession and robust action is, I think, an indicator that they may feel that it is moving in that direction. If that then has an impact on the European economy, if business investment in this country turns down because of the difficult financial markets, if net trade does not make up but consumption goes down as well, would that not have quite a dramatic effect quite quickly on the British economy?

  Mr King: Well, it would have an effect, whether I would use the word "dramatic" I do not know. For us, far more important than the United States in terms of the impact on demand in the UK is the impact on the euro area because they have a weight three times larger than the United States in our trade-weighted index, so what happens in the euro area is much more important to us directly than the US economy. Of course, that will undoubtedly make life more difficult, and I mentioned it in my opening statement, but it is factored into our central view in the February Inflation Report. These things have been factored in. We have quite a sharp slowing of growth in the UK in our central projections, so we do see a sharp slowing of growth, yes, but that will come and gradually we will move out of it back towards trend growth again. Our February Inflation Report was very clear that we would expect to see a period now when the economy would grow at a rate below its long-run average.