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Bank of England
Quarterly Inflation Report - 12th November 2008
Page 2 Quarterly Inflation Report - 12th November 2008
Chris Giles, Financial Times: Governor, given that the broad shape of the Fan Charts are so different to anything we've seen before - and certainly three months ago - could you maybe outline the three most important things that the MPC have learnt about the way the economy works, how it's changed the way you think about things and how it will change the way you model and react to economic events in future?
Mervyn King:
Well I think the three most important changes are the ones I outlined in my opening speaking note, namely that we've seen a very sharp downturn in the short-run indicators of confidence and activity, orders and sales; secondly that we've seen an extraordinary banking crisis - unprecedented - the biggest certainly since the outbreak of the First World War, which has had a major impact on confidence and on the provision of credit supply, which has had a devastating effect on many companies. And third - and as a result of the fact that the first two occurred not just in the UK but also in the rest of the world - we've seen this feed through to oil and other commodity prices. So we've seen a most extraordinary fall in commodity prices - over a half now - in the space really of little more than two months.
Those three factors together add up to a very significant change in the outlook and has led the Committee, as a result, to make the biggest change in its inflation projection by a good margin in any Inflation Report that we have made since the MPC was set up.
Michael Wilson, Sky News: Governor, was last week's huge interest rate cut a tacit admission on the Committee's part that they should have done much more sooner than they did? And secondly, are you today effectively calling a recession for 2009?
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Mervyn King:
I think if you go back to the August press conference where we met then, at that point many of you were pressing us, perfectly reasonably, with the question - why should we believe that inflation will come back? Is it credible, given the actions you've taken or not taken, that inflation will actually come down at all from its present high level?
Since then the world has changed, and in response to that change in the world we have changed both our forecast that we present today and the level of Bank Rate that we think is appropriate. That's why we took the decision last week.
I think, in terms of the outlook, our forecast speaks for itself. It's almost certain I think that output will fall in both the third and the fourth quarters of this year. We don't know where it will go after that; we set out a balance of judgement as to where we think the outturns will be, and we'll monitor that month by month.
David Smith, Sunday Times: Governor, the Committee surprised everybody by cutting rates by 1½% last week. If one looks at chart 5.5 on page 38, doesn't that imply that you should have cut rates by a lot more than that to return inflation to the target over the medium term?
Mervyn King:
Well, it's certainly true that if you look at the chart for inflation, whether it's chart 2 or chart 5.3 which reflects the projection for inflation published today on the yield curve which held prior to our decision, that at that point it looked as if some further policy stimulus would be necessary. But that can come in a variety of forms.
We are certainly prepared to cut Bank Rate again if that proves to be necessary. There are many things that we will learn about
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between now and our next meeting. The yield curve itself has changed; the exchange rate has changed; asset prices have moved. We'll need to come back and look at that again when we come to our next meeting. We may or may not have seen some developments in fiscal policy.
One thing we will certainly learn is that the impact of the tax system in terms of effective tax rates is very likely to be different than in the latest published plans on which we condition this projection, because there's no doubt that the composition of output with less weight on asset transactions and on the financial sector is going to generate, almost certainly, less revenue per unit of GDP or income than was projected in the spending and tax plans published at the time of the Budget.
So even without any discretionary action, I think we're likely to see some revision in our own estimates for the impact of fiscal policy. But we will see when we see the Pre-Budget Report.
A variety of other things will change. We will take that into account. But certainly if it's necessary to cut Bank Rate again to ensure that inflation comes back to the target in the medium term, then we are quite prepared to do that.
David Smith, Sunday Times: Can you just be clearer on the constant rate assumption, not the market yield, the constant rate of 3%?
Mervyn King:
The same - the same argument holds because there isn't that much difference between the two projections. The yield curve as it stood before we announced our decision last week for the first year or so was not that different from a rate constant to 3%. But the same argument holds. Many things will happen. We'll
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learn a great deal over the next month, and we'll come back to our decision then.
Sam Fleming, Daily Mail: Could I ask on the inflation projection - there is at the bottom band a chance that it could actually slip into negative territory according to these projections. Are you concerned that there's an outside risk of deflation in the UK economy over the next couple of years? And as a related question, the banks have been signalling they're not willing necessarily to pass on further reductions in the base rate. Is there a concern at this point the base rate is becoming a less effective tool in terms of steering the economy? Thanks.
Mervyn King:
It's called Bank Rate, not base rate; if I could make a plea for everyone to try to remember that. Well on the first, there's obviously a risk of that happening - there are always risks of inflation being high or low, so that must be a possibility of that. I think it is very likely that RPI inflation will go negative next year. But that reflects now more the fact that we've cut interest rates significantly during the course of this year. So that alone would push RPI inflation into negative territory.
But again the target is to try to bring inflation back to the 2% target over the medium term and we will set interest rates in order to try to achieve that.
Will the changes we make be passed on? I think we've seen that the latest decrease by and large, for most people, will be passed on. But the channels of monetary policy are severalfold. We don't rely entirely on this being passed on through interest rates. It will affect the economy through changes in the exchange rate and also to some extent through movements in
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income as well as the interest rates that people face when deciding whether to borrow or to save.
It is important that these things are passed on, and there's no doubt that the spirit of the recapitalisation package which was announced on 8th October was to ensure that banks would be in a position to continue lending. And I'm sure that both we and the government will want to monitor that very carefully.
Faisal Islam, Channel 4 News: Governor, have you been briefed on any potential changes to the fiscal rules, and do you think - given this outlook - there's a case for a fiscal stimulus?
Mervyn King:
We haven't been briefed; we wouldn't expect to at this stage. We will find out before long I’m sure when the PBR will be and what it will contain. The Committee is usually briefed just before that.
In these extraordinary circumstances it would be perfectly reasonable to see some use of fiscal stimulus, provided I think two conditions are met. One is that it would be temporary, purely temporary, and secondly that it would be clear that there was a medium term plan to bring tax and spending back into a sustainable balance over the medium term.
Subject to those two conditions, it would be perfectly reasonable, in these circumstances to see some fiscal stimulus, and I believe that we are seeing that around the world.
Stanley Reed, BusinessWeek: Governor, you spoke recently about I believe a sharp fall in inflows into the UK banking system. I wondered if you could, you know, elaborate on that? And also with the government's
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financing needs clearly rising quite sharply, are you concerned that foreign investors will be, you know, reluctant to fund those needs and consequences of that?
Mervyn King:
Well I think the problems that are being faced here are very similar to the problems being faced around the world; we're not alone in this. And I think that will have - that's highly relevant; it's not a judgement here about the UK banking system, it's a judgement about banking systems in general. And I think that the model of wholesale funding which was used to fund a very high proportion of lending is one that will seem less attractive, not just here abut around the world.
Now to the extent that we did attract a significant proportion of that wholesale funding from overseas, we will need to find other ways to attract equivalent funding not in short-term wholesale funding, but longer term capital flows to compensate, if we're to avoid the need to make a current account adjustment equal and opposite to that of the change in the capital inflows. The bank recapitalisation programme offers a mechanism for starting down that road.
But these are problems and challenges which all banking systems are facing. The banking system, not just here but around the world, ended up in a position with an excessive degree of leverage and an excessive reliance on wholesale funding. And the adjustment process we're going through is to see a reduction in that degree of leverage and a reduction in the extent to which banks were relying on wholesale funding.
Larry Elliott, The Guardian: Governor, this financial crisis didn't start in the last three months; it started in August 2007. Yet previous Inflation Reports have actually shown little evidence of there being a recession. You
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go back to the Inflation Report of November last year. The recession is right off the bottom of the scale. So it was in February, and there was barely a chance of the economy having a recession according to the Fan Chart in May. In August, as I remember, I think you said there was a chance of a quarter or two perhaps of negative growth. Now we're talking about a monumentally big fall in output.
I think the man in - the public would want to know two things really. One - how is it that the experts at the Bank have got the economy so spectacularly wrong; how they've called it so wrong over the last year? And the second thing is - have you got anything to say to those people whose jobs are at risk and whose homes are at risk because you failed to cut interest rates quickly enough to avert the sort of downturn that we're now about to see?
Mervyn King:
I think if you go back to the August projections we discussed in this room, you'll see that the central projection for there did actually have a fall in output in the third quarter. The outturn was a bit bigger – it was a bigger fall than we'd expected. It wasn't a massively bigger fall than we'd expected. The world has changed in the past two months. We have seen the biggest banking crisis since the outbreak of the First World War, and arguably even bigger than that. And it's a global banking crisis.
So I think if you combine and look together at the three things I mentioned earlier: the biggest banking crisis since the beginning of the First World War and the effects that that's had on credit; the very sharp downturn in confidence measures, activity and orders; and the extraordinary fall in oil and commodity prices, which was not expected in August. If you go back to - there's a chart in here actually, page 31, chart 4.4. This shows the market expectations and the probabilities attached to different
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levels of oil prices in both November and in August. And the current level of the oil price - markets were attaching a probability of about 1% to oil prices being that low.
So we have seen a quite dramatic shift between then and now. And when you get a dramatic shift in the world, what matters and this is the message I would give to people - what matters is that we have the Monetary Policy Committee that sits down, analyses what's happened and in a thoughtful way decides how best to respond. And I think that one of the attributes of the Monetary Policy Committee is that we are prepared, when the world changes, to make big changes in Bank Rate in response. That's why we surprised people last week. I think many people, including many in this room, had not expected a change that big. But the facts changed, and the facts justified a big change in Bank Rate and we made it. That's what I think matters to people. They don't expect people to be able to prevent the world from changing; what they do expect - rightly - is that monetary policy will respond when the world changes. And it has, and it will continue to do so if we think it's necessary.
Larry Elliott, The Guardian: Can I just ask a follow-up, which is - you seem to have been caught somewhat unawares by the scale of the market turbulence in September and October; yet this didn't come as a bolt from the blue did it? We'd already had the collapse of Northern Rock here; we'd had the collapse of Bear Stearns; we'd had the problems of Fannie and Freddie in July, leading up to the August Report. And yet you do seem to have been caught with your pants down really over the scale of this turbulence and its impact on the economy. And I just wondered why that was really? I'm not sure you've completely explained why that was.
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Mervyn King:
If you think about what happened after the failure of Lehman Brothers, you will see - and the charts in here show it very clearly - equity prices fell very sharply after that - the biggest one month fall in equity prices since the 1930s. The increase in the spreads on investment grade corporate bonds rose by over 200 basis points, far and away - more than twice the biggest increase in spreads that we'd seen over any comparable period.
The increase in the LIBOR spreads; LIBOR spreads have come down. When we met in September, well after the last August Inflation Report, but at the September MPC the LIBOR spreads were about 80 basis points. They rose to well over 200 basis points. Fortunately they've come down to below 200 now, but they were well over 200 basis points.
An enormous number of things happened during that period, Larry. The failure of Lehman Brothers led to a period of 28 days between that and the announcement worldwide of bank recapitalisation which was an extraordinary period in the history of banking, not just in Britain, but around the world.
In the five weeks since the 8th of October, we have cut Bank Rate from 5% to 3% and announced a major programme to recapitalise the banking system. That's a pretty big response.
William Keegan, The Observer: In the 1980s during the monetary squeeze the Bank found itself having to help companies, serious companies which were quite threatened. Now we don't have a monetary squeeze, you're doing everything possible to ease Monetary Policy but there is a major question over the efficacy of Monetary Policy at this stage. Do you envisage that the situation is so serious that the Bank and indeed the Government may have to come to the rescue in some way of some British industrial companies?
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Mervyn King:
Well I don't want to anticipate what may or might not happen; I think that's extremely hard to anticipate. What we want to do and this is the major effort is to get the banking system back into a state when it can take advantage of profitable lending opportunities to the real economy. And the focus now and the test of the Bank recapitalisation package is when we can see a resumption of normal, in that sense, lending to the real economy. That has to be the objective I think rather than thinking about rescuing particular companies we should focus much more on using the banking system as the vehicle to get back to a state where companies can expect the same access to funding that they had before.
Brian Swint, Bloomberg News: Mr Governor to push you back to the risk of deflation, can you quantify that risk any better now - you know the Fan Charts have it that there as a risk but that's at the constant interest rate. Could you give us some sort of quantification of how great you see that risk after the move last week? And is the Bank prepared to push the Bank Rate all the way to zero to prevent that from happening?
Mervyn King:
Well on the first I think we say in the Report that in these circumstances it is actually extremely hard to calibrate the precise projections and the balance of risks. So I don't want to quantify it. I made it clear that for RPI, headline inflation as it's sometimes called, is very likely to go negative next year, simply because it reflects falls in mortgage interest rates. That's much less obvious for CPI inflation and our main forecasts don't have CPI inflation going negative, but who can tell?
Certainly we are prepared to use Bank Rate to move to whatever level is necessary to ensure that the prospect for CPI
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inflation is that it will return to the 2% target in the medium term. It will take time to get it back there but we will do that in the medium term.
Paul Wallace, The Economist: You've emphasised the importance of the banking crisis and the experience of other countries like Sweden that have experienced that, is that this brings about recessions which are long as well as deep. And yet your own chart shows a recovery occurring, so in other words a sort of short and deep recession rather than a long one. Could you perhaps set up how you think we'll emerge from recession, given the fact that this recession will be unlike previous post war recessions where the normal tools of economic policy have been more effective?
Mervyn King:
Well there are a number of differences from before, as you say it is not easy to make judgements about how the banking system will respond. I think the interesting contrast in terms of previous banking crises is between Sweden and Finland on the one hand and Japan on the other. In the former case action was reasonably prompt and hence the recession did not last for too long. In the case of Japan action was not prompt and indeed it was very striking that at the IMF meetings in Washington in the second weekend in October that the Japanese were unusually passionate about saying the lesson that we learnt, that we want to pass onto you is recapitalise the banks and do it now. And that was the major lesson that they took from that experience and I think we've learnt from their experience. So we have taken that action.
The forecast though for quarter growth clearly looks as if it's a sharp V and comes back. But the quarterly growth rates do take some time before they get back and we have falling output for around a year or so. But perhaps I can ask Charlie to talk a bit
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more about the length of the recession in the UK compared say with the Swedish experience?
Charlie Bean:
I mean the profile is actually not that dissimilar from the Swedish experience if you look at what happened there. The downturn really started in the second half of 1992. And as the Governor has already said the Swedish authorities moved quite quickly to essentially nationalise their banking system. And by 1994 the Swedish economy was recovering. So it was a reasonably significant downturn, but a reasonably short lived one.
As I say the profile we have is not that dissimilar in broad character from what was seen in Sweden. And I think our justification for that is essentially that relatively early action has been taken to recapitalise the banks, not just here but elsewhere.
Also it should be said there are other stimuli in the projection. We've had the best part of a 20% depreciation of sterling over the past year, which is pretty hefty. Now obviously the external climate has worsened, but that every considerable stimulus from the exchange rate should also help to pull the economy out of its slow period.
Ivana Stahasi, German Business Weekly Wirtschaftswoche: I was actually going to ask you about the fall in sterling, does it worry you?
Mervyn King:
Well clearly if sterling falls far enough this will be a concern and it will have an impact on inflation. I think it is not surprising that it has fallen over the past year. I think in the context of the banking crisis, we started remember going into this with a significant trade deficit. And now that the world is going through
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a rebalancing part of the changes that are happening is that we are seeing a rebalancing of the world economy. Just as the US dollar fell very sharply over a period it's not surprising that we're seeing some fall in sterling's effective exchange rate. And that can be a helpful part of the rebalancing provided it doesn't threaten our ability to meet the inflation target.
So it's something that we keep a very careful eye on and we certainly have no wish to see it fall particularly sharply. But I think we have to accept that some fall back from the level where it was at in the summer of 2007 is probably an inevitable part of the rebalancing that's going on.
Ivana Stahasi,
Could you just clarify when you would start to worry?
Mervyn King:
I think central bankers are paid to worry almost everyday. And I think I'm prepared for that.
Hugh Pym, BBC News: In terms of what households and businesses feel is there a possibility of a recession as severe as the early 1990s or even the 1980s?
Mervyn King:
I think that's very hard to judge and I'm not going to guess. The recession in the early 1990s in comparison with the early 1980s was seen as one that was led more by consumption and was less focussed on the manufacturing sector. Here too I think the impact is going to be very much on consumption, but we've seen it also affect investment. I think it is impossible to speculate on the precise size.
One of the big differences between then and now - between both of those recessions and now - is that because inflation has been kept under control and we have a Monetary Policy
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Framework which I think is credible that it is possible to take quick and substantial action on interest rates in order to ameliorate the effects of a prospective recession and to head off the worst outcomes. That wasn't always possible in the past because of concerns about inflation. It is now.
Hugh Pym:
How high could unemployment get do you think?
Mervyn King:
I'm not going to speculate on that, it's impossible to know.
Paul Mason, BBC Newsnight: I mean your own data show that in quarter three there was a sharp contraction going on - throughout quarter three. If you look at the Agents’ reports, if you look at broad money it's falling back throughout the year. So we're not just talking about the banking crisis that erupts in mid September, throughout quarter three there is a contraction. So basically you lost touch with reality and will you admit that you got the decisions wrong during quarter three on rates and will you apologise to the people who may be losing their jobs as a result?
Mervyn King:
I don't think you understand Paul; we had projected in August a fall in output in the third quarter. We hadn't lost touch with reality; we projected a fall in output in the third quarter.
Paul Mason:
It wasn't as big as what has now taken place.
Mervyn King:
No but it was a fall in output; we projected that in the third quarter.
Paul Mason:
So the rating decisions were …
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Mervyn King:
There has been a very significant change in September and October.
Paul Mason:
But the decisions were taken on the basis that there was wage push inflation, that there was a danger of inflationary expectations, these never materialised.
Mervyn King:
No, and we said there was a balance of risks. We didn't say what was going to happen; we said there was a balance of risks. And if you remember back to the August press conference in this very room several of you in that press conference pressed me very hard on why a reasonable person sitting on your side of the room should believe that inflation would come back from 5.2% or over 5% which we said - and we were the first people to say that inflation would go over 5% - why it was credible to believe that inflation would come back?
Paul Mason:
It's just Governor in terms of the response …
Mervyn King:
There is always a balance of risks.
Paul Mason:
In terms of learning the lessons and the responsiveness of the mechanism and the Committee is it not right to look back at that period and say that some of the reading of the data was just wrong and that decisions could have been taken earlier to cut rates?
Mervyn King:
Well of course - it is always possible to set policy with the benefit of hindsight. And if you cannot set policy with the benefit of hindsight better than you can with the absence of perfect foresight you shouldn't be in this business at all.
There is no way in which the Committee can always have perfect foresight. What it has to do is always, each and every
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month look at the balance of risks. We looked at the balance of risks. Now it was perfectly reasonable before September to say that you would take a different judgement on the balance of risk, a perfectly reasonable point. But the fact that there was a balance of risks was I think widely accepted up until when the world did change in September.
Chris Giles, The Financial Times: Just going back to fiscal stimulus very quickly, six months ago in May you sort of poured cold water on the effectiveness of fiscal stimulus and you said Ricardian Equivalence was the right place to start thinking about its effectiveness. Can you talk now given that there are credit constraints and this is one of the things that might make that different - whether the fiscal stimulus is more likely to be effective now and then what sort of size it has to be in order to have some meaningful impact on the wider economy to limit the recession?
Mervyn King:
Well I think there are two changes which mean that in these circumstances it is reasonable to think about Fiscal Policy as a compliment to Monetary Policy. One is as you said credit constraints on households, which make Fiscal Policy likely to be more effective, and secondly the fact that the transmission mechanism of Monetary Policy has been in part impaired through the banking crisis. And it's precisely in those circumstances as indeed was argued many decades ago that Fiscal Policy has a role alongside Monetary Policy. But it still has to be temporary and it still has to be consistent with the medium term framework which shows a sustainable path for tax and spending. If not the benefits can be lost in terms of higher long term interest rates.
Eric Albert,
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La Tribune:
At the centre of this crisis there is the fact that there was too much credit, too cheap, for too long. Do you accept that for the ten years - well that the Bank of England has been independent that actually interest rates might have been too low for too long a period, allowing this bubble to develop? And the other question I wanted to ask is also on the 15th of November in Washington there is this Bretton Woods II meeting what do you expect from not this particular meeting but what do you expect from the new worldwide regime?
Mervyn King:
Well I think these two questions are closely linked because whereas I think it's quite difficult to say to any individual Central Bank that they kept interest rates too low after all if that had been the case you would have seen signs of excessive inflation which was not seen in many countries around the world. What is clear however is that the international monetary system when taken as a whole did not lead to a terribly satisfactory outcome because it enabled a situation to emerge with very low interest rates which prompted the search for yield. But it was the search for yield rather than the level of interest rates as such. Now I think they are connected, but it was the search for yield which allowed the financial sector to be tempted down the path of excessive borrowing and leverage which we've seen has caused quite serious problems in the banking system around the world.
So there is an important point to ask about how can we think of reforming the international monetary system to make it less likely that this outcome will occur. And that of course does go to the heart of the questions that will be discussed in Washington at the weekend. And I very much hope that this will be the beginning of a process, because I don't think you can reasonably expect a two day meeting to achieve an enormous amount in itself. But what is important is that it's the beginning
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of a commitment to engage in a more serious discussion about the international monetary system than we've actually seen over the last ten years.
That may mean bringing more players into that discussion and being more open about the nature of the issues that need to be discussed and the role of the IMF. So I think this is a very important meeting, but what matters most is not what's in the communiqué as such at the weekend but that it is the beginning of a process in which all these countries together will agree to explore changes to the international monetary system.
Eric Albert, La Tribune: The process towards what - what outcome do you want to see say six months down the line or whenever there will be an agreement?
Mervyn King:
When Bretton Woods started the fear that the UK delegation expressed about the Bretton Woods International Monetary System was that it didn't put enough of an obligation on surplus countries. The fear was that this would be an asymmetric system that would have a deflationary bias because it didn't put obligations on surplus countries.
Now deflationary at that point was meant in terms of activity. As Bretton Woods evolved what became clear was that if a surplus country - the leading surplus country at the time wanted to pursue a policy of inflation - then with fixed exchange rates other countries were pretty well obliged to import inflation. That wasn't very attractive. So the fixed exchange rate element of Bretton Woods broke down and has been replaced by most countries by a flexible exchange rate, domestic monetary and inflation targeting which has worked pretty well.
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But we've seen more recently that a large part of the world economy has expanded rapidly by linking their exchange rate to that of the US dollar and that has created tensions. But the tensions are of exactly the same nature that were discussed at Bretton Woods itself. Namely, if you have countries with large current account surpluses and capital exports, are there obligations that should be placed on those countries to mirror the obligations which were placed at that time on the capital importing or deficit countries.
Now that is something which we need to revisit. I don't think there are any simple answers and I certainly don't want to give you a recipe for where we should end up. But that's the question I think that we need to focus on.
Natasha Brereton, Dow Jones Newswires: Markets are currently pricing at about 125 basis points of further cuts over the next six months. I was wondering if you see it as being a fair assumption that it's going to take us such a long time to get there?
Second question is a number of commentators have drawn on the idea of the UK entering a deflationary spiral like that seen in Japan. Would you say they are being over the top about that or is that a fair worry?
Mervyn King:
No I think that we've taken action much earlier than was taken in the case of Japan and I think you can see around the world there is a commitment to take the action that's necessary. We too will take our action in the monetary sphere to do what it takes in order to ensure that we bring inflation back to the target in the medium term. I'm not going to speculate on what that means for Bank Rate, the Committee will come back to that issue at successive meetings and we'll see.
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Marco Niada, IL Sole: You said that you are prepared to have further cuts if necessary in interest rates. I have two questions and this is the first one. I have flicked through the statistics of the Bank of England and I noticed that since 1694 interest rates never went below 2%, is that the reason, is it going below that? We know in Japan it was 0.3 but just for curiosity?
The second point is on asset classes, targeting asset classes for instance recently the General Director of the Bank of Italy started saying that in fact Central Banks are starting to regret that they should have looked more probably at asset classes in the past such as house prices and all that. What is your opinion on that?
Mervyn King:
Well on the first we will see what happens to Bank Rate, I'm not going to speculate on where it will go. But what matters is not comparisons between 1694 and now, what matters is the forward looking view of what do we need to do in order to bring inflation back to the target.
I think on asset prices, this clearly raises an important question. But it also I think points out that you can't expect to hit several targets with one instrument. Bank Rate is suitable for maintaining stable and low inflation in the medium term. And if you're concerned about the level of asset prices then I think the right question to ask is what other policy instruments can you think of using? And that immediately takes you to questions of counter cyclical capital requirements and other issues to deal with the regulation of the balance sheets - both capital and liquidity - of the banking system.
Ian King,
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The Sun:
At the bottom of page 3 you say that the MPC is assuming that there will be a 10% drop in domestic energy prices in spring 2009. I just wondered what were the assumptions underpinning that projection given that as you say at the top of page 31 most of the falls recently have unwound rises in energy prices over 2007 and first half of 2008?
Mervyn King:
Well it's based on a judgement about what you would expect from the level of wholesale prices, it's inevitably - we state it clearly the assumption we've made so that you know what assumption we've made, - it's not that we have any great confidence in this, but it's clearly a big turn around from August when we were expecting further increases. But perhaps Spencer would care to comment on the details of this.
Spencer Dale:
Certainly, on that same page on page 31 you'll see the chart 4.5 at the bottom and that shows you that in the past movements in wholesale gas prices have tended to have led movements in electricity and gas prices, retail electricity and gas prices. And so if wholesale gas prices do follow the path currently priced in by the futures curve shown by the dotted blue line that that sort of past relationship would imply that we would see a corresponding fall in gas and electricity prices. It's that past relationship and the fall in wholesale gas prices priced into the futures curve which underlined that assumption.
Ian King:
Okay one more if I may please? On page 34 you talk about the damage that's been done to corporate profit margins over the last few months, as I say if they have been unable to pass on cost increases. I just wonder what sort of assumptions the Committee is making going forward about when companies are going to be able to start rebuilding margins again?
Mervyn King:
Keep going Spencer.
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Spencer Dale:
I think we expect - we don't make precise judgements about exactly when margins may be rebuilt. We expect some squeeze in margins during this period. Typically we would expect that margins would tend to be squeezed during periods of relatively weak demand. And so over the next period of a year or so while demand is still growing very slowing we'd expect firms to take an increasing proportion of their costs in margins. But over time as the economy starts to pick up we'd expect to see some recovery in companies' margins.
Harry Wallop, Daily Telegraph: Two questions if I may? It's quite clear that the Bank Rate is being passed on by most lenders to their standard variable rate mortgage customers, but it's not yet clear whether it's going to be passed on to the great majority of consumers, 'cos only a handful of mortgage payers do in fact pay the SVR rate. How concerned are you that things like credit cards and other mortgage, new mortgage rates, may in fact not see that benefit of a lower Bank Rate?
The second question is about - you talk about the risk of real incomes actually falling. I mean how painful will that be for the average worker out there? And indeed when was the last time we saw real incomes in negative territory?
Mervyn King:
I'll ask Charlie to comment on the second one in a minute. On the first of course it’s not just mortgagors on the standard variable rate, it’s also people on existing tracker mortgages who will benefit from the full pass through of last week's cut in Bank Rate. So a considerable number of people will automatically benefit now.
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I don’t think it’s easy for the Bank of England or anyone else to tell the banks precisely what the pricing structure should be. What matters is that if we can ensure that the flow of lending is returned to more normal levels then we would hope that competitive pressure would enter and there would be profitable opportunities to enter and seek mortgage lending by passing on these cuts and attracting new customers. That has to be the right strategy.
So I think the two things go hand in hand, the cut in Bank Rate and the bank recapitalisation package and it’s important to see them as partners in the same policy response. So I think that deals with the first one. In terms of other sorts of interest rates that will depend very much again on competition in those markets.
Harry Wallop Daily Telegraph: But you're confident that your action will encourage greater levels of competition than we’ve seen over the last year?
Mervyn King:
I think the combination of the bank recapitalisation package and the cut in Bank Rate will help. And perhaps I could try and clarify one aspect of the recapitalisation programme which I think has not been well understood.
The aim of the bank recapitalisation is to get more capital into the banks. It is not to raise the required capital ratio of banks. Indeed in these circumstances going into a recession, the appropriate response is to relax the required capital ratios that banks have to hold as a minimum. So the minimum capital requirements should be going down at this stage in the business cycle. But what’s most important is to get more capital into the banks to ensure that the buffer between the capital that they have and the minimum capital requirement is as big as possible
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so that they will be able to continue lending to the real economy while still making provision for losses that may occur as we go into a recession.
So the aim of the bank recapitalisation is not to raise the minimum capital requirement of banks, far from it. That minimum holding of capital should be going down at this stage in the business cycle. The aim of the bank recapitalisation is just to have enough capital in the banks that they have a large buffer over and above the minimum requirement that they have to hold. And it’s that buffer that gives them the flexibility to be able to attract the funding from outside that they need in order to be able to lend it on to fund lending to the real economy, while at the same time making provisions for losses that may come over the next two or three years.
Charlie on real ...
Charlie Bean:
Real labour income. You asked how long is it since real labour income was in negative territory. Well the answer is actually not that long ago. If you turn to page 19 chart 2.3 you can actually see that real post tax labour income per head has actually fallen on a number of occasions in the last three/four years. And that's basically just the flip side of what’s been happening to commodity prices, the rise in oil prices, the rise in global food prices which have made a dent in the real living standards of households.
If you go back the decade or so prior to that, or much of the decade prior to that, you wouldn’t find periods like that simply because that was generally a period where we were benefiting from the terms of trade gain associated with the emergence of China and India producing low cost manufactured goods.
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I guess what is potentially painful about the prospect is that although global commodity prices have been falling, oil prices falling back, food prices falling back, with employment growth slowing that will nullify to a large degree the effect on average real labour income. So some households will be benefiting from the decline in inflation but clearly households where the employment falls back, where the head of the household loses their job or whatever, they would suffer a much more serious hit to their disposable income. So it’s different for different households looking forward.
Brian Swint, Bloomberg News: Governor your comments on the pound today reminded me of what you said in your last speech, that the depreciation of the currency is part of an adjustment and that the adjustment probably has further to run. Would you say that again today? I mean would you be surprised if the pound were to fall further? And related to that would you agree that the depreciation of the pound is in part due to a deterioration in the UK's fiscal position and is this then in turn an argument for some kind of caution when the government sets up its fiscal stimulus package?
And finally I wanted to ask you one more time, can you tell us today that you do not exanti rule out any level of Bank Rate as being too low?
Mervyn King:
I never rule out anything if that answers your last question. I’ll ask Charlie to talk about the impact of Fiscal Policy and the exchange rate. But I would have thought the one thing that surely nobody can do is to forecast where exchange rates will go. And if you can’t do that then you’re hardly likely to be surprised when you see where they do go. Charlie.
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Charlie Bean:
The thing that's fairly crucial in determining how the exchange rate responds to any Fiscal Policy action is how the Fiscal Policy action affects investors' perceptions of the medium term. So if you have a Fiscal Policy action which is expected to be relatively long lasting, it’s not clear how fiscal plans are going to be brought into a sustainable pattern further down the road, that's likely potentially to lead to concerns that eventually it might get monetised, that might put downward pressure on sterling - on the exchange rate. I mean this is something you've seen in emerging market countries in the past.
On the other hand if any fiscal action is understood to be strictly temporary, that there's confidence that in the medium term plans will be sustainable and fit together, the impact of that on the exchange rate you would expect to be far more muted. So a temporary fiscal action, I think it’s reasonable to expect to have relatively limited effect on sterling.
Daisy McAndrew, ITV News: Governor, in the last few weeks and months many people have been watching with mounting horror politicians and the markets and some bankers exhibit fear and confusion and a certain amount of panic, and so it’s not surprising that the public is now frightened and confused and wondering whether those in charge know what they're doing. Is there anything today you can say as the man in charge, the Governor, that can offer come sort of comfort or reassurance to the public?
Mervyn King:
Well we sit down, very carefully, we look at all the data, we publish this Report very openly so that you and others can comment on it. And each month we form a judgement, nine people round the table, one person, one vote, thinking about what is the right action to take. And if we think the world has changed, then we are prepared to make a big change in Bank
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Rate because that is the right thing to do and we will carry on behaving in the same way.
Daisy McAndrew, ITV News: So is the right thing also to send a message to the public today, a don’t panic message.
Mervyn King:
Well we are moving into very difficult times and people should be concerned that we are moving into difficult times. But that isn't to say that we won’t come through it. We will come through this and we are taking the policy action required to come through it.
Gary Duncan, The Times: Just to follow up on that question, Governor you referred to the fact that the Committee is prepared to take the action necessary but in the light of the criticism about the Bank allegedly being behind the curve in some sense and also your own comments about the sharp change in conditions over the last few months, in what way do you think the Committee will condition its response to developments in the next few weeks and months differently from how it has before if in any way?
And secondly you also said at the beginning of your remarks that you felt that the central projection overstated the decline in the economy that we can expect. Could you just give us an idea of how much you think that overstatement is given the change in the parameters that you also mentioned?
Mervyn King:
Well on that last point no because this thing varies from day to day amid the yield curve, asset prices, all kinds of things move. So this is something we’ll come back to at our next meeting and make a judgement.
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On the first one I'm not sure that the behaviour will be very different. As I said the way we respond to Monetary Policy hasn’t changed. The world has changed; we’ve reacted because the world has changed. But the way we go about setting interest rates hasn’t changed and I think it’s worked well and I think it will continue to work well.
Hugo Duncan, Evening Standard: On that matter of how you set interest rates, ahead of last week's decision was there any political pressure or even interference on the MPC to make the cut or was it a truly independent decision?
Mervyn King:
It’s a truly independent decision and I can say again as I've been able to say every single meeting since 1997, at no point has there been any pressure or any telephone call or message to say that Government would like the following outcome to be achieved. There has never been any pressure of that kind whatsoever. The Monetary Policy Committee has more than enough to take notice of and it reached its decision solely independently on the basis of the facts in front of it.
I think that's the great strength of the Monetary Policy Committee. The reason perhaps that people were surprised was that they were just looking too often at what happened in the past, what so called practical people said. Here was a group of people sitting down looking at the economic facts and saying there's been a big change since we last discussed this, we need to react to it. And so we did. And the independence of the MPC is what makes it possible to do that.
Jenny Scott:
Okay we're running out of time so last question, Faisal.
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Faisal Islam, Channel 4 News: The IMF forecast that came out last week suggested that Britain would suffer the worst contraction in all the advanced countries and it seems that your forecasts kind of roughly back up those numbers. I guess the question is we know that this was an internationally caused crisis but why is Britain suffering the most? It must suggest some failure of policy by someone?
Mervyn King:
Well we were growing quite rapidly before so to go from a period of steady growth for a long time we were the only economy in the G7 that had not experienced a quarter of negative output since the early 1990s. All the others had, we hadn't so it clearly will be seen to that.
I'm not sure that there is any really significant difference in the magnitude of the downturn that you would expect. We are a smaller economy, if you average across bigger economies you would expect probably to see a somewhat smaller fall in output. You've got the benefit of diversification in a bigger region. But certainly I would think that within economies of comparable size there will be others that would experience similar falls in output whatever that turns out to be.
But the most important thing, the thing I want to stress today, is that given the change in the outlook which is very marked since August, we have made a big change in policy and we are ready to make further changes in policy if that is necessary to bring inflation back to our target in the medium term because that is the diagnostic of our ability to maintain a balance between demand and supply in the economy as a whole. That's what Monetary Policy can do and that's what we intend to achieve.
Jenny Scott: END
Thank you all very much for coming.
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