UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 989

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

TREASURY COMMITTEE

BANK OF ENGLAND FEBRUARY 2013 INFLATION REPORT

TUESDAY 26 FEBRUARY 2013

CHARLES BEAN, PAUL TUCKER, PROFESSOR DAVID MILES and IAN MCCAFFERTY

Evidence heard in Public Questions 1 - 114

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1

Oral Evidence

Taken before the Treasury Committee

on Tuesday 26 February 2013

Members present:

Mr Andrew Tyrie (Chair) Mark Garnier Andrea Leadsom John Mann Mr Pat McFadden Mr George Mudie Jesse Norman Mr David Ruffley John Thurso

______

Examination of Witnesses

Witnesses: Charles Bean, Deputy Governor, Monetary Policy, Bank of England, Paul Tucker, Deputy Governor, Financial Stability, Bank of England, Professor David Miles, external member of the Monetary Policy Committee, and Ian McCafferty, external member of the Monetary Policy Committee, gave evidence.

Chair: Thank you very much for coming before us this morning. As you probably know from experience, the acoustics of the old part of Parliament is not quite as good as the rest, so we would be particularly grateful if you can speak up for us. I hope that you can hear us, Charlie. Can you hear? Charles Bean: I am fine, thank you, just.

Q1 Chair: You can hear only just, okay. Perhaps I can begin with a question to you, Mr Bean. What do you think the essential ingredients of a banking union are and do we have one at the moment in the eurozone? Charles Bean: Okay. I think I would identify five components. The first is a common supervisory mechanism—regulatory arrangements—and obviously there is discussion taking place at the moment between members of the eurozone, and some other countries for that matter, on how to set that up and operate it, and they are some way down that road.

Q2 Chair: Is that a necessary condition? Charles Bean: I think so. Obviously, when you ask about what is necessary for a banking union I am assuming you mean a banking union that we think is durable and works reasonably well. Some of the items I am going to give you you may not have, in which case you run more risk that the banking union may not function well. Chair: That is fine. I was just trying to check that we are not talking about what is desirable; we are talking about what is essential. Charles Bean: I think they are sensible ingredients for a durable banking union. Chair: I would like to talk about what is essential for a durable banking union, only that. 2

Charles Bean: Yes, okay.

Q3 Chair: We need a single supervisory mechanism? Charles Bean: Single supervisory— Chair: Do we have it at the moment? Charles Bean: No. As I say, that is the thing that the primary discussion within the eurozone is about. The plan is to have something in operation probably towards the end of this year, beginning of next year, with the ECB taking the primary role in supervising systemically important financial institutions. Chair: Okay. You have four more. Charles Bean: Okay. The next four are all going to be dealing with what happens when things go wrong. The second one would be a supplier of liquidity to banks that get into difficulty, a lender of last resort, and that clearly you do have in the form of the European Central Bank and the constituent national central banks. That is in existence.

Q4 Chair: What about the transfer of losses? What happens on the fiscal side? Charles Bean: Let me just go through the list and I think you will see how everything fits together. As far as lender of last resort goes, central banks when they are providing support lend against collateral so there should not be any losses associated with that.

Q5 Chair: Sorry, before we go any further, what do you think about the quality of this collateral across the eurozone at the moment? Do you have any views about the quality of that collateral? Charles Bean: I think it is reasonable to think that the collateral has certainly been impaired, say, in the periphery countries and that is an issue obviously that a central bank always has to take on board when it decides whether to provide support to a bank that is in difficulty. Essentially, will it get its money back? Inevitably, that collateral, as I say, is going to be impaired in some countries at the current juncture. Chair: So that is the lender of last resort. Charles Bean: Lender of last resort. The third ingredient would be a suitable resolution regime for handling failing banks, winding them down, restructuring them or whatever. Now, the Financial Stability Board has identified key attributes that you want in a good resolution regime. I think it is fair to say, although Paul may correct me because he knows more about this than I do, that it is not true to say that all countries in the eurozone presently have resolution regimes that are consistent with those key attributes, but they are in the process of implementing them.

Q6 Chair: Just to be clear, we do not have that either, yet? Charles Bean: Not yet, no, but that is in train.

Q7 Chair: So, so far three essential ingredients, none of them in place? Charles Bean: No, the lender of last resort is.

Q8 Chair: You have not explained how this collateral is going to be made effective in the periphery. Charles Bean: Well, that is not a problem about the lender of last resort not being—

Q9 Chair: Who is going to pick up the tab, Mr Bean? Charles Bean: Okay, let me get to that in a minute. The final two I think do connect with your concerns. The fourth item that I would identify is a common deposit insurance, and 3 here you may need the ability to bring in funds from outside a country. A country that is in fiscal difficulty may not have the wherewithal to provide the support to depositors unless the deposit scheme has been prefunded.

Q10 Chair: I am sorry to keep interrupting, but just for clarity—these are only questions for clarification—what we are really talking about here is northern tier countries insuring Greek bank deposits? Charles Bean: In all likelihood, yes, or Cypriot bank deposits or whoever it may be. If the liabilities associated with the banking system exceed the capacity of the Government to pay them, to make the deposit insurance scheme credible and, therefore, discourage depositors from withdrawing their money, people need to think there is a backstop there, which in this case, as you say, would need to be probably the northern countries. The final ingredient would be a mechanism for injecting fresh capital into banks that have failed and need recapitalisation. Just as with the deposit insurance scheme, you may need a source of funds outside for that if the country in question is in fiscal difficulties.

Q11 Chair: Do we have that? Charles Bean: No, certainly not at the moment, although there is the suggestion that the European Stability Mechanism should be able to provide that in the future. Governments, particularly like Germany, have been keen that those injections should not take place until other elements of the banking union, like a supervisory scheme, were in force. We are short of that at the moment but, in principle, you have a facility that could provide that.

Q12 Chair: The one item that was identified in a recent IMF report on this subject that you have not mentioned is a common macroprudential regime. You are thinking of that as something that is perhaps desirable but not essential? Charles Bean: Certainly, the way I would think about a banking union is to do with the micro supervision, the micro arrangements for the banking system. A macroprudential overlay would be highly desirable. The idea of macroprudential policy is it takes on board systemic financial concerns, but it is not something I would regard as essential; desirable but not de rigueur.

Q13 Chair: What we have here is five essential requirements of which four and a half are missing? Charles Bean: Well, I am not sure I would say the half. I think the lender of last resort— Chair: Of which four are not yet in place. Charles Bean: Not yet fully in place, some of them in progress, but clearly well short.

Q14 Chair: When Mario Draghi says he will do whatever it takes to protect the eurozone, there is a touch of the “wing and a prayer” here, isn’t there, because he does not have any tools? Charles Bean: Well, his comment was particularly in connection with the heightened concerns in financial markets that some countries would leave the eurozone so that you were getting what is referred to as a redenomination risk into those countries’ bond yields. Because if, say, a country like Greece exited, it would be highly likely that the new currency there would depreciate sharply, and that extra premium would be built into the associated bond yields. Mario’s remarks back in the middle of last summer were particularly directed at saying, “The euro is for keeps. We will do what is necessary to take that redenomination risk off the table”. 4

Q15 Chair: Do you think that a banking union is an essential part of bringing stability to the eurozone? Charles Bean: I think it is desirable. Where we are at the moment, there is— Chair: But not essential? Do you think that the eurozone could be stabilised without a banking union? Charles Bean: Well, I would say it is very highly desirable. It would make it much easier to stabilise it. The reason for that is that there is a strong symbiotic relationship between the fiscal position of the periphery countries and the position of the banking systems so that the banks often hold a lot of the sovereign debt of those countries, so if the sovereign goes bust those banks go bust. Equally, if the banks get into trouble, the sovereign has to provide the extra capital and so forth to restart the banking system. Somehow or other you want to try to break that “doom loop” between the two of them. One way of doing that is a banking union where there is the possibility of some injection of funds from outside that country.

Q16 Chair: You are saying it is very highly desirable but not essential that we have a banking union in order to stabilise the eurozone? Charles Bean: Yes, very, very highly desirable.

Q17 Chair: Now, we are not members of the eurozone, obviously. The reason that I am asking these questions is that the Bank of England has identified the eurozone as a key risk to UK economic growth and recovery. Given what you have said here, that a banking union is highly desirable to stabilise the eurozone and that four of the five necessary ingredients for a banking union are missing, despite your natural sunny disposition, Mr Bean—not always in evidence from the Bank of England—you would have to come round to the view, wouldn’t you, that you are a bit on the pessimistic side about its prospects? Charles Bean: Well, not necessarily because, as I have said, these countries are on the route to creating a banking union, putting resolution regimes in place. The supervisory mechanism discussions are taking place with the aim of putting that in place by the end of the year. They are on track to do these things and clearly the sooner it is done, the better. Chair: It sounds like a race against time. Charles Bean: Well, the nature of the problems in the eurozone is that these are not things that are going to be solved overnight. This is a long haul back, but the sooner the preconditions are put in place, the more likely we are to get out the other side without major disruption.

Q18 Chair: Now, the body language of your three colleagues, two in particular, has struck me while you have been giving your very straightforward answers. I would particularly like to give Mr Tucker an opportunity to say something, since he is at least as responsible for this area as any of the four of you. There was a grimace at one point from Professor Miles, so I am going to give him an opportunity; then I am going to pass the questioning to Andrea Leadsom. But first, Mr Tucker. Paul Tucker: Charlie has summed it up. I think your line of questioning is over- pessimistic about the determination among these countries in the monetary union to develop a banking union. That is reflected in our view of the fact that threats from the euro area to the UK have receded somewhat. As Charlie said, and I would underline this, there is a directive in an advanced stage of preparation on resolution that so far is extremely good; it could get worse but so far it is extremely good. They have announced that once they have got that through, and that applies to all 27 member states, including us—the Chancellor talked to you 5 about this in your other Committee yesterday afternoon—they will launch proposals for a single resolution authority and so on for the banking union. Why do I emphasise that? Because all roads lead back to what happens when banks fail. Even with fiscal transfers, there are bank failures that would stretch the monetary union just as bank failures here have stretched the fiscal position in this country. A necessary condition for a successful monetary union is a banking union with a really good resolution regime. More broadly, I would say strategically, monetary union will not be sustainable in the very long run without a high degree of economic union. The reason I think the markets have taken some reassurance since the announcements about the banking union is that the markets take it as a signal that the members of the monetary union are prepared to take steps, and more steps, towards fiscal union.

Q19 Chair: Okay. David Miles? Professor Miles: I am not sure what I was grimacing at, but I do— Chair: Do you have something you particularly want to say? Professor Miles: Well, I do have one, but I merely— Chair: Okay, otherwise we will move on. Professor Miles: Well, let me say one thing very briefly. I do think this is a tall order. If it is the case that the banking union requires the provision sometimes of outside capital to the banks of one country from some central pool, and if it requires a single deposit protection scheme, which necessarily might involve big cross-border transfers of funds, I think that is a big ask.

Q20 Chair: Okay. What I have been trying to explore is the bank’s overall view of the depth of risk associated with the eurozone that you have identified in general terms in your quarterly reviews and in other publications and, indeed, in speeches. I think we have some feel for this, but I am going to— Paul Tucker: It has receded somewhat but it is still there. Chair: I am going to hand over to Andrea Leadsom.

Q21 Andrea Leadsom: Mr Tucker, it does seem to me that it is extraordinarily complacent the way that the bank for the last couple of years has always had a little rider with its inflation comments that this is all, of course, subject to the problems in the eurozone, which are not going away. There has been a complete failure on the part of the bank to give any scenario analysis, in spite of the attempts of this Committee to persuade you to do so. A very direct question to you: you are saying that the eurozone has gone off on the right path towards European banking union. Isn’t it absolutely inconceivable that German taxpayers will truly undertake the deposit insurance for Greek depositors or, indeed, the bailout of Spanish banks should it come to that? Isn’t it absolutely politically inconceivable? Isn’t that the sort of analysis that you need to be doing, as to how on earth they are going to make that happen? Isn’t it the case that the European banking union is only limited to a single supervisor because that is the only bit of European banking union that is politically acceptable within the eurozone? Paul Tucker: You are probably better equipped than me to make the political judgments about— Andrea Leadsom: No, but the impact on the British economy is fundamental. Paul Tucker: I am going to answer your question. I think you are better equipped than me probably to make judgments about political preparedness in Germany. What I would observe is that they have already shown some willingness for transfer payments. How far that goes, who knows? I think on the banking union they have announced that they are going to do 6 more than the single supervisory mechanism. They are planning to introduce a resolution regime for the banking union, which will go further than the 27 member state thing. On what you say about the Bank, I do not think—colleagues will want to come in—at all we have been trying to hide the risks from the euro area. On the contrary, the Financial Policy Committee has taken a tough stand over the past year in saying to banks, “You must build up your capital and your resilience against the tidal wave that may be coming our way from the euro area if it unravels”, which looked to be a tangible probability in the middle of last year and somewhat beyond. As Monetary Policy Committee members, can we put numbers on that and incorporate it in our fan charts? I think we would find that very hard to do. I think anybody would find that hard to do. What we have been clear about is that we are not going to go for spurious accuracy in our forecasts. Rather, we are going to say this is a major threat, it is not certain to crystallise, and we are doing things elsewhere with our regulatory instruments to try to protect the UK against those threats. I think that including numbers in the fan chart—I doubt whether they would have satisfied you because you would have said we were making them up.

Q22 Andrea Leadsom: Okay. Mr McCafferty, what do you think about the argument that it is impossible to disalign the politics of the eurozone with the economics of the eurozone? Arguably, the survival of the eurozone is about politics, not economics, because it is whether there is the political will for the northern European countries to bail out the southern European. In the end, if the markets push them to test that point, then we will find out, but that has a very profound impact, doesn’t it, on Britain’s economy? We are already seeing that the strength of the euro is actually having a chilling effect on the eurozone’s economic recovery, which in itself has a chilling effect on the UK’s economic recovery. Isn’t it the case, therefore, that in this particular area the Bank of England simply cannot hide behind the idea that, “This is politics and we don’t do politics”? Ian McCafferty: I do not think we are hiding behind the fact this is as much a political as an economic question. On Paul’s point about putting numbers to political questions, that is extremely difficult and is, as it were, at the extreme edge of the risk fan chart that we put around the central projections. But I would also agree with him that I think the risks of an immediate break-up have receded over the course of this year as a result both of the actions of the ECB and of the manifest choices of the political parties and their electorates across Europe. It is clear that the German electorate has been more willing to countenance some fiscal transfers than was perhaps expected, certainly in this country a year ago. I think that does mean that the immediate risks of break-up have receded, albeit that, as we have seen overnight, politics is difficult to predict, certainly with the case of the Italian election, and as a result risks still remain.

Q23 Andrea Leadsom: Mr Tucker, what analysis have you done on the politics—for example, the forthcoming election in Germany—and the impact that that might have on policy that in turn affects the economy? What I am trying to get at here is, to what extent can you simply say, “This is a major threat” and leave it at that, “but we are not going to put numbers on it because it is too difficult”? Or, to what extent does the Bank feel it ought to have a contingency plan in case the politics overtakes the economics? Paul Tucker: This idea that we have done nothing is nonsense, with respect. We have been absolutely clear with the regulators that they need to ensure that the balance sheets of UK banks are strengthened to make them as resilient as they can be against an Armageddon in the euro area without in the process making the path of recovery in this country worse. If the euro area falls apart, the most direct, unpleasant channel to this country would be from a collapse of the euro area banking system cascading into the UK banking system. The UK 7 banking system has made itself somewhat more resilient and we wait to hear from the regulators in March at the next FPC meeting. If the premise of your question is, we have said all this is terribly risky and we have done nothing, that could not be further from the truth. The other thing I would underline is that, compared with five or six years ago, when we would not as an institution have had the instruments to say to the regulators, “You must do something about this”, this is an example of the new regime announced in 2010 being used. On your question about the extent to which we follow the politics of this country, one of the things we have done—I have certainly been involved in leading this, as has Charlie—is make greater use of the Foreign Office than perhaps we did five or six years ago to ensure that we can track the views of various different potential outcomes in these countries. I do not think any of you, with respect, would be able to predict either the makeup of the German coalition, assuming there is a coalition after their election, or indeed the commitments that may be given during the election campaign in Germany. Do we think the German election will be tremendously important? Yes, I think it will be very important indeed. I hope it gets the coverage that it warrants in the UK media.

Q24 Andrea Leadsom: Okay. Mr Bean, one final question. Dr Carney wrote to this Committee saying that the Bank will need to support the Government as it engages in efforts of the euro area to re-found the European monetary union. What do you think he means by that? How do you interpret that? Charles Bean: I should imagine that he means by that that we play a full part in the European fora in which we are represented, although we interact with other European countries. Obviously, the Financial Stability Board and the Basel Committee is one forum where we are represented and we interact, and Paul can expand on that if necessary, but also in fora like informal ECOFIN meetings and things like that. We are one of the people at the table and we can encourage our European partners to move faster in what we think is the right direction.

Q25 Andrea Leadsom: Do you think he is right to be calling for increased German private sector wages to ease the balance of payments problem? Charles Bean: Well, I was not aware that Mark had called for actions in other countries, so you will excuse me if I am not aware of that particular—

Q26 Andrea Leadsom: But is it appropriate for the central bank in one country to be calling for action to be taken in another country? Charles Bean: It is perfectly reasonable, I think, for people to point out the consequence of imbalances. We have imbalances at a global level between some of the emerging markets and the deficit countries like the United States and so forth, and we have imbalances within the eurozone. One of the problems if you focus excessively on austerity as the solution to the countries that were in deficit and have fiscal problems is you end up with insufficient demand overall. A sensible thing is also to look for an increase in demand in the surplus countries that have more room to manoeuvre. There are various ways that you might decide to go about doing that. I suspect the quote of Mark Carney that you are citing had something to do with the desirability of realising that you need a two-handed approach here to dealing with imbalances. It is not a case of putting all the weight on the deficit countries doing the adjustments. That same argument applies at the global level, where the imbalances that we had before the crisis, which were partly drivers of that financial crisis, are still with us. They have narrowed to a degree, but that in my view largely reflects cyclical developments and the fundamental problems still need to be addressed. 8

Paul Tucker: In this world of a single supervisory mechanism centred on the ECB, we think that that provides a good basis for really good co-operation between the Bank of England as supervisor and the ECB as supervisor. Big picture, in the western world there are going to be four big supervisors: the Federal Reserve, the ECB, the Bank of England, and the Swiss. That is a somewhat simpler world than at the moment, and we also think that with supervision moving to the Bank of England and supervision in the banking union being centred on the ECB, we will be able to draw on excellent relations with the ECB to improve supervisory co-operation. Mark may have had that in mind, too.

Q27 Chair: Before I move the questioning on to John Mann, is there anything you want to add to that, Professor Miles? Professor Miles: Just one thing on the eurozone situation. I think in some sense the risk of things going badly wrong in the eurozone has absolutely crystallised. Many of the economies are going backwards at a rate of knots. Overall growth in the eurozone over the last year or so has been close to zero, so I do not think this is a case of, “Well, it could go wrong”. It has gone wrong. I think the projections that we have made in the Inflation Report are really based on the assumption that growth remains very weak and anaemic throughout the next few years. Paul Tucker: That is in the fan chart. It is the tidal wave Armageddon risk that is not in the fan chart.

Q28 John Mann: Mr McCafferty, we have learnt that you are not a hawk and you are not a dove. I wondered whether you are a flexible inflation-targeting man. Ian McCafferty: I am an inflexible or flexible? John Mann: Flexible. Ian McCafferty: I think I, along with the rest of the committee, am a flexible inflation targeter. I think the bank and the MPC has been a flexible inflation targeter since its inception nearly 20 years ago now. From that point of view, I think I would refer back to some comments that have been made in the past by both the current and previous Governor of the Bank of England. We have to deliver over the medium term a low and stable inflation rate, but we have to be mindful of the fact of causing undue volatility in output in the short term at the same time. I think the issues are probably more acute, as we speak, than they have been for much of the history of the MPC. The circumstances are more difficult. Both inflation and GDP growth are more volatile currently than they have been for much of that history. As a result, I think the Bank has had to exercise that flexibility probably more explicitly over the course of recent years than it perhaps did five and 10 years ago. But I think the Bank has always seen the mandate as one in which it delivers stable inflation over the medium term but without delivering undue volatility. That, to me, is the definition of flexible inflation targeting.

Q29 John Mann: You have fitted into the MPC’s consensus very quickly since your appointment. Before you were on, when I questioned the current Governor at this Committee there was no ambiguity when I raised precisely this issue. The current Governor was adamant that there should not be a flexibility. There was a target and it was right that the target should be set. Ian McCafferty: There is a target and we are operating to that target, but the speed with which we bring inflation back to that target and the timeframe over which we bring inflation back to that target provides an element of flexibility.

Q30 John Mann: Are you in favour of German wages increasing? 9

Ian McCafferty: It depends for what reason German wages would be increasing. If they are increasing because German productivity has increased, then I think it would be a very good thing. If it were simply to introduce inflation into the system, then no, I would not be.

Q31 John Mann: What is your attitude to the labour market constraints in this country? Do you think that the labour market here is sufficiently flexible? Ian McCafferty: Sufficiently flexible for what purpose? John Mann: Sufficiently flexible for growth into the future. Ian McCafferty: Yes, I do. In terms of the legislative and regulatory framework, I think we have a very flexible labour market and I think that has been demonstrated by its performance over the course of the last decade or more. What I have suggested in my recent speech is that there may be some changes in the behaviour of individual companies who are perhaps more mindful now of the value of individual workers and the skills that those workers can acquire over the course of a long period with an individual company, which makes firms reluctant to part with labour even when demand is weak. I would not necessarily say that that is a significant reduction in overall flexibility. That is probably a good thing for the long-term health of the economy.

Q32 John Mann: Do you think it would be a problem for the approach of the Monetary Policy Committee if the labour market here became less flexible? Ian McCafferty: To the extent that it would increase the national rate of unemployment and, therefore, worsen the trade-off between the level of unemployment and the performance of the labour market and the prevailing rate of inflation, yes.

Q33 John Mann: That answer is predicated on a British labour market, but of course, as we have seen repeatedly, large numbers of the new jobs being created have been filled flexibly by the European labour market. Can you conceive of economic problems should we move out of the single European market, in terms of labour mobility? Ian McCafferty: On balance, I would argue that that freedom of movement across borders over the course of the past few years has been beneficial to the UK economy in allowing new skills and filling jobs where there has been demand. I think, yes, were we to move out of that degree of flexibility cross-border, then I would be concerned.

Q34 John Mann: If we were to pull out of the single market, the more than whispers we hear from American and Japanese business people is that they would look at investments here. That is one issue, but labour market flexibility is another. There is the political issue of whether we are in the European Union, but the European single area is a separate factor—i.e., direct access to the single market. Can you conceive of a situation where we could leave both the European Union and the European single area and, therefore, be outside the single market? Ian McCafferty: I am not quite sure what you mean by can I conceive of this. Clearly, that is a political decision on the part of both the electorate and the elected Government and I am not going to comment on that as a hypothetical future solution. I think that, to the extent that we have that flexibility in both our employment market and in the extent of investment flows, these are both of benefit to the UK economy.

Q35 John Mann: How would you summarise the impact, were we to be outside the single market—in other words, outside the EU and the European single area? What is the economic impact of that happening within what would be the end of the current economic cycle, 2017? 10

Ian McCafferty: I am not going to speculate on any timing of any change in our relationship. As I have said, I think that the benefits both to the labour market and to the flows of FDI are beneficial.

Q36 Chair: Professor Miles, could we have your views on flexible inflation targeting? That flexibility, reflected in the timeframe over which inflation has been brought back to target, has always been interpreted under cross-examination before this Committee as two years, partly on the grounds, no doubt, that that is the time it takes conventional monetary policy to feed through, or most of it to feed through. Do you think that it is still two years as interpreted now, or should we think of this as a longer timeframe? Professor Miles: I am not sure the two-year horizon has ever been quite so clear. It certainly is not part of the remit. Chair: I do not have the quotes in front of me, but I can assure you Mervyn King has given statements to this Committee to that effect. Professor Miles: Well, the remit, which I do not think has changed materially—maybe not changed at all in the relevant parts of it—has always said that if inflation moves away from the target level because shocks have taken it either above or below, then it would not make sense for the Monetary Policy Committee to try to come back to target in the shortest possible period because that could involve enormous swings in monetary policy, which would generate enormous swings in the real economy. There was never in the remit any statement about, “And two years is the appropriate horizon”. I think I am right in saying that until about 2004, it was the case that the fan charts in the Inflation Report tended to go two years ahead. I think from 2004 that was extended out so that we showed three years, but even that was not a sign that somehow the right horizon moved from two to three. I think it is a matter of judgment what the trade-off is between trying to move inflation back in a very short period, as opposed to over a slightly longer period. It depends very much on the reason why inflation may have moved away from it.

Q37 Chair: Okay. What is your judgment on that question? Professor Miles: At the moment, the central forecast is that inflation is near the target level, somewhat above it two years ahead but pretty much at it by the end of 2015, and to my mind that is consistent with the spirit of the remit. Now, if you focus just on the two-year- ahead horizon—so, the first quarter of 2015—the single most likely outcome is that inflation, from memory, will be 2.3%, 2.4%, something like that. Although there is a chart—I have it here—on page 41 of the Inflation Report, chart 5.5, which shows the probability that inflation is above or below the 2% level of different horizons. If you take the two-year point, roughly speaking, it says that our judgment is that there is about a 55% chance we are above 2% and 45% chance that we are beneath 2%. So it is not 50:50. That does not happen until a little bit further down the road. My own interpretation of that chart is that that profile is consistent with the spirit of the remit we have been given. Charles Bean: Can I—

Q38 Chair: In a second. I just want to clarify what Professor Miles is saying. You are implicitly saying there has not been any change in the interpretation of the horizon over which inflation is to be brought back to trend, as far as you are aware, since 2004? Professor Miles: That is correct. I just speak for myself. Having looked carefully at the remit, I have not changed my interpretation of what that made acceptable and unacceptable.

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Q39 Chair: Therefore, when we hear all this talk about flexible inflation targeting, there has been no background briefing going on to the press and this has all just been a bit of a press storm in a teacup? Professor Miles: I have always thought that the remit defined flexible inflation targeting and that remit has not changed.

Q40 Chair: You are answering yes to that question of mine? Professor Miles: That there has not been a change? Chair: That the press talk about all this was a storm in a teacup? Professor Miles: I think so, yes.

Q41 Chair: Okay. Now everyone seems to want to chip in. Quick remark from Mr Bean and then Mr Tucker. Charles Bean: Let us get this absolutely clear. The notion of flexible inflation targeting has been around a long time, right since pretty much the birth of the inflation target regime. The Governor in his speeches often talks in terms of constrained discretion but it is essentially the same thing. The idea is present in the academic literature from the 1990s describing how to operate an inflation targeting regime. The two-year thing I think really came about almost by accident because in the early days of the regime we wanted to emphasise that there was very little we could do to affect inflation today. You could only affect inflation further down the road because it takes time for monetary policy to affect demand and then for the changes in demand to feed through into inflation. Now, if you just have one-off cost shocks, they have typically passed through the system by a couple of years. The circumstances at the moment are slightly different because some of the cost shocks that we are being subject to, and particularly in this area of administered and regulated prices, will take longer to pass through because they are not just applied to this year. We know they are going to recur next year and possibly a little bit beyond. So it makes sense to be thinking about bringing inflation back rather longer. Certainly, I have never subscribed to the view that there was something magic about two years. The whole reason that we introduced the extra year on to the forecast back in 2004 was precisely to try to get people away from focusing rigidly on where our central projection was, two years out. In a number of speeches before the financial crisis, I talked about whether monetary policy should lean against the wind of a building credit asset price bubble, and made precisely the argument that it may make sense consciously to undershoot an inflation target if it improved your chances of hitting it further down the road.

Q42 Chair: That is another big question but— Charles Bean: It is a very big question. Chair: —just to be clear on the first point, you are saying there was always two to three years since 2004 built into this? Charles Bean: Yes. Chair: That has not changed a scrap— Charles Bean: Yes, and actually— Chair: —and therefore, you are agreeing with Professor Miles that all this press talk is a storm in a teacup? Charles Bean: Yes. The one rider I would add is that you can have a legitimate question, and this is a policy judgment, about how much flexibility you want and what sorts of shocks you might be willing to accommodate. That is a real issue.

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Q43 Chair: We may well come on to that in just a moment, but Mr Tucker was particularly eager to get in. Paul Tucker: The 2004 change, which I was part of, was significant. We wanted to disabuse the world of focusing overly on two years. My recollection is that sometimes, inflation was projected to be a round target of two years but the slope was upwards or downwards. Well, of course, that means that the horizon was not two years because we were effectively projecting that it was going to depart from target off-screen, as it were. The 2004 change was very significant. I was particularly keen on it to get away from any obsessive thing. This point about being flexible inflation targeters has to be repeated over and over again, and the language changes from one generation to the next. The way Eddie George put it was in terms of not being inflation nutters. The way Ben Bernanke and Mervyn talked about it was in terms of constrained discretion. Today the popular language has become flexible inflation targeting. Do not get seduced that there is anything significant going on. The third point I would make is that, far more significant than what we are projecting now in taking roughly three years, we allowed inflation to go to 5%. We could have squeezed that out of the economy by pushing the economy into a deeper recession. I said to you before, this was the biggest judgment I think we have made since the committee started and it should assure everybody that we are in today’s language flexible inflation targeters but without ever, ever taking our eye off medium-term inflation expectations. None of this, I trust, is resiling from a commitment to sound money and that is the thing of which you need to be repeatedly assured.

Q44 John Thurso: Can I come to you, Mr Bean? I particularly want to ask a couple of questions on your annual report, but I will start—because we have just brought it up—with the point that you made: “Inflation has been subject to further adverse shocks, including much larger than expected contributions from university tuition fees and from other ‘administered and regulated’ prices.” Were you surprised by those changes to these prices? Charles Bean: Which ones particularly? John Thurso: Well, either or all of them. Charles Bean: Okay. As far as the university fees go, the effect turned out to be bigger than we expected. Now, we obviously knew that the tuition fee increases were coming in, but what we did not know was precisely what the mix of the student population was going to be between different fee categories.

Q45 John Thurso: How far apart was the reality from what you were estimating? Charles Bean: It first came in around November, I guess, so, corresponding to the September RPI—but that was significantly higher than we had expected. As I say, it was not down to not knowing what the levels of tuition fees were, but we did not know what the student mix was going to be until actually the students turned up.

Q46 John Thurso: With regard to the administered and regulated— Charles Bean: There are a number of things there, like sewerage services and so forth, but I think the one that has, if you like, been news to us recently has been energy and utility prices. Obviously, we have had bigger increases than those in the past, but that has generally been driven by the wholesale price of energy—oil and gas—on the world market. This time there were also other increases, things like the cost of transmission networks, distribution networks, which are contributing significantly. From what we have been told, they are going to continue to contribute over the next year or two. As I say, that is news to us relative to where we were six months ago. 13

Q47 John Thurso: These are all things that from the outside one might say had a degree of predictability, in the sense that we knew tuition fees would have an impact but, as you have explained, it was the degree of it that was the surprise. But we know about the work that has been done on transmission charging and the upgrading of the system and so on. The question that is behind that is, to what extent do these things come as a shock and to what extent should we actually be looking to say there are always going to be things like this? Does this not call into question the fundamental forecasting? Charles Bean: Well, first, you do not know how the energy companies are necessarily going to respond to that increase in cost. Even if you know something is going up, they may well absorb it in terms of lower margins. Now, we talk to the energy companies so we get intelligence from them. As soon as we learn something from them we can incorporate that in our forecasts. Obviously, the staff try to keep ahead of the game on these things as much as they can, but one has to admit that there are times when we find out something and think, “Oh, maybe we should have discovered that a little sooner”.

Q48 John Thurso: The reason I raise this is, if you take your paragraph about the picture generally as it starts off, there is this one sentence that really picks out these things: “further adverse shocks, including much larger…” Charles Bean: Well, that is because it is relevant at the current juncture. It is not as big a disturbance, obviously, as those huge movements in oil prices that we have seen. The price of oil during the last five years has been between $35 a barrel and $145 a barrel. Sterling has fallen 25%. That is a huge shock. Now, the administered and regulated price bit is not the same order of magnitude. Normally, these components of the basket, which are about 16% of the basket, would contribute something like half a percentage point, maybe a little bit less, to inflation. Over the next year or two we expect they are going to be contributing about one percentage point, so that is half our target. It is a reason why you will expect inflation to be running a bit above that target. It would not be a justification for inflation being 5%.

Q49 John Thurso: We have heard I think every year since I have been on this Committee something of that nature. I just wonder, if I can ask the Michael Fallon question, at what point do we arrive at the point where you are saying, “Well, actually, there are these changes every year and, therefore, we ought to say it is not a medium-term but a long-term problem”? Charles Bean: The unfortunate thing about the last five years is that the shocks have been predominantly in the upward direction. It is perfectly reasonable to think there are times when we are going in the other direction, and some of the shocks within this period—the original cut in VAT, the start of the financial crisis and when oil prices collapsed in 2009— obviously go in the other direction. Overall, the last five or six years have tended to be characterised by a sequence of different upward shocks. I think where you get into difficult territory is if you have a shock that you know is going to keep on recurring year after year. Arguably, we did have a shock of that variety in the pre-crisis period that is still having some effect, and that is the downward pressure from access to cheaper manufacturers from the emerging markets, especially China. The question then comes in the central environment regime we have; if you have that repeated shock, should you be saying, “I am going to keep on looking through it” or should you say, “Well, actually, in these circumstances I should be aiming to hold inflation at 2% and ensure the other wages and prices adjust in the economy appropriately”?

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Q50 John Thurso: Can I turn to the second question I wanted to ask you, which comes from your last paragraph explaining monetary policy? In May last year you made one of your speeches that was entitled, I think, “Pension Funds and Quantitative Easing”. You were really seeking to address the question of whether QE is having a negative impact on pension funds and broadly you came to the view that it is not. We have recently had considerable evidence from people representing pensioners complaining fairly bitterly about the impact. Do you think they are wrong to be complaining to us about that? Charles Bean: First, I should clarify what the conclusion of that speech was. One of the things I wanted to do in that speech was draw attention to the fact that QE affects both sides of the pension fund balance sheet. John Thurso: Yes, you made the point that where you start from has a big impact on where you end up. Charles Bean: Absolutely. There is no dispute that for a pension fund that is in significant deficit, the downward pressure on yields that has been associated with quantitative easing will have worsened that deficit. Basically, those pension funds are short of the assets that they need. They have to pay more to purchase those. I want to stress I was not disputing that fact and the sort of numbers that I came up with are in the same ballpark as the National Association of Pension Funds, but I think it is very important to try to unpick movements in deficits that might be associated with quantitative easing from movements in deficits, say, that might have resulted from the big collapse in stock prices that happened around the start of the financial crisis.

Q51 John Thurso: Among the pensioners rather than pension funds, of course, the complaint is that the particular problems arise when you are converting to an annuity at this time because you will get a particularly bad rate. We now have far more pensioners than we have ever had before and they were until five or six years ago a major boost to the economy. People in marketing were writing books about the grey panthers and the amount of money they had to spend. That is a consuming force that is being quite severely constrained. In the light of that, should we not have some concerns about the suppression of that purchasing power? Charles Bean: First of all, the bulk of pensioners were already retired. They will be drawing their pension already and in some cases they will be holding assets—bonds, equities—which would actually have gone up in value. They could actually have been made better off. The group you might have more concern about are the people who started drawing their pensions during the last couple of years. You are exactly right, their annuity rates are lower. Whether they are made worse off or not depends on how they had invested the assets that they are converting into an annuity in the first place. If they had been invested in a mix of bonds and equities, roughly speaking the two effects offset. That is, broadly speaking, what our estimates suggest. Now, most pensioners drawing the annuity probably do not really associate the movement in the value of their pension pot with our monetary actions, but they do associate the declining annuity rate, so they see one side of the picture and not the other.

Q52 John Thurso: The final point, which is slightly off piste but is along the same lines, concerns the concept of financed fiscal deficits, obviously relating to Adair’s speech last week, which I read with great interest. To what extent ought we, instead of trying to stuff string up a pipe with QE, actually start pouring money down the pipe with helicopter money? Charles Bean: I think there is some woolly thinking in this territory. I am not suggesting Adair was one of them but— John Thurso: I am quite happy to admit to woolly thinking. I have done it all my life. 15

Charles Bean: No, helicopter money was an intellectual experiment that Milton Friedman introduced to make a theoretical point. In practice, if you wanted to do helicopter money in the real world, an increase in tax allowances would be the natural way of doing it.

Q53 John Thurso: This would be the personal tax allowances? Charles Bean: Yes. Basically, you have to get the money to— John Thurso: Well, we have started, have we? Charles Bean: But that is the way you get it there, and then you can envisage this as being, okay, the first leg of that is financed by selling some Government bonds. Then we go and buy the Government bonds on the secondary market in exchange for the money that we create. We are exchanging bond liabilities for monetary liabilities of the state, essentially. Any action of this sort you can always split into what is essentially a fiscal action and a financing action. We do the financing bit with QE and, if you like, you can think of a large chunk of the deficits in recent years—there has been some temporary monetary finance that has gone along with it but which we will unwind in due course. But the real issue for you is, do you want to do the first leg and, if so, is an increase in tax allowances the most sensible thing to do? One of the things that we know is, if you have a temporary increase in people’s income, they tend to save most of it. It is probably not a very effective way of getting the economy going, but the question of whether there should be more fiscal action, that is up for you and the Chancellor to decide.

Q54 John Thurso: This is what I am afraid of. Helicoptering money would be a Treasury call, not a Bank call? Charles Bean: Yes, absolutely. The first leg of it is the Treasury’s. Chair: The King helicopter then is still under— John Thurso: Is an Osborne engine.

Q55 Mark Garnier: Mr Bean, if I can carry on with interest rates and just start very quickly with this Moody’s downgrading that we saw on Friday. Just prior to the downgrading the 10-year bond yield was 211 basis points and obviously it has now been downgraded and the market is suggesting that we are now actually at 201 basis points so, in fact, the bond yield has gone down arguably on the back of this. What are your thoughts about what is going on? Charles Bean: The downgrade is largely a reflection of the economic developments in the economy. I do not regard it as being a great deal of news in and of itself. It is obviously significant in the political sphere, but in the economic sphere the impact of disappointing growth, a slightly worse fiscal position than the Government expected and so forth—that was already being gradually discounted into Government bond yields. The markets largely have been expecting a downgrade and possibly other ratings agencies may follow suit. This is, of course, just one notch; there are a lot more notches to go. But the actual downgrade itself from an economic perspective I do not see as adding anything new.

Q56 Mark Garnier: In itself. I am just slightly more interested in the fact that we have seen a 10-basis point fall in the gilt yield in a day and a half. Charles Bean: Basically, gilt yields and the exchange rate have bounced around in the last couple of days. After the Moody’s announcement yields went up and the exchange rate fell. Just today on the back of the Italian elections it has all been reversed.

Q57 Mark Garnier: No, fair enough. Just getting back to the low interest rates and the effect of QE, Dr Ros Altmann recently came before us and she was arguing that the effect of QE is to reduce the risk-free rate to next to nothing, thereby inducing people to make fairly 16 peculiar decisions as to what is a good return and possibly go into quite risky assets in order to try to seek yield. Do you think she has a point? Charles Bean: She has a point in the sense that that is how QE works—the whole idea.

Q58 Mark Garnier: But is it artificially adjusted risk? Charles Bean: I would not say artificially. What we are doing is changing the composition of the state’s liabilities in a way that drives down long-term interest rates and encourages investors of all sorts to move into riskier assets. What we have at the moment is, if you like, excessive risk aversion, so by undertaking QE we are leaning against that. Now, it is quite reasonable to have concerns. You do not want to push it too far and end up generating something that creates problems when it unwinds, so that is obviously something we look at very closely. Also, you would get very worried if it was generating a build-up of leverage as people were trying to exploit yields elsewhere. We have not seen that. What we have seen so far, we think, is largely a plain vanilla switch into riskier assets. These are things like corporate bonds. We do not have any really risky assets, but corporate bonds, equities. It reduces the cost of finance to businesses and that is how you are trying to stimulate demand in the economy.

Q59 Mark Garnier: Okay. You are encouraging people to try to look for riskier assets? Charles Bean: Yes. That is how it works.

Q60 Mark Garnier: She also argued that—Paul Tucker, I am quite interested in your views on this—because you have this artificial depression of yields at the moment, when it goes back to a period of normalcy, if you like, it is more likely to snap back rather than go back in a controlled sort of way. Given the fact that we have £1.46 trillion, I think, of household debt, clearly that is going to have a very severe impact on households. Again, what are your thoughts about how things are going to go back to a period of normalcy, if you like, and do you think that there is significant risk for households? Charles Bean: On the final point about it having a large impact on household debt, that is not so obvious because most households are not borrowing over 20 years. Their interest rates are determined by the much shorter end. The generic point here about what happens as we move towards withdrawing the stimulus is an important one. All central banks that have been making these large-scale asset purchases are aware of the risk of getting a sharp snap- back in the yield curve. The example that is regularly given is what happened in the United States in 1994. What that means is that we will need to try to manage that process carefully to avoid the markets overreacting. It is likely that we will unwind our purchases over a relatively long period. We are not going to try to sell all the gilts back within the space of three months or anything like that. It will be over probably an extended time period.

Q61 Mark Garnier: None the less, if the market perceives you as being in the process of unwinding QE, then it will try to predict it and that— Charles Bean: Indeed, and that is why our communication and our messaging will be very important leading into that, in that we will need to signal clearly to the markets when we are moving in that direction, giving clear signals about the pace at which we expect to do this. You are absolutely right that there is an issue here that we will have to deal with.

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Q62 Mark Garnier: Of course, not only will you be competing with the markets that are going to be trying to predict what you are doing, you are going to be competing with the Government, who also have to go into the gilt markets. Paul Tucker, do you want to— Paul Tucker: You are absolutely right. The lesson from 1994, which it should be remembered not only caused a dislocation in bond markets but almost caused some of the largest financial institutions in the world to fail—not on this side of the Atlantic—is a salutary tale. The lessons are, as Charlie said, to communicate clearly so that people do not overreact. We can make errors the other way as well. Looking back to a decade ago, if one signals that one is going to move in super slow motion when the economy warrants something else, one can store up trouble as well. The other substantive thing I would add to what Charlie said is that the supervisors are going to have to be aware of what interest rate risk positions the banks and the other key players have. That was the thing that should have been understood in 1994 and it was not.

Q63 Andrea Leadsom: I just wondered, Mr Tucker, what you would say to Dr Ros Altmann’s assertion that according to surveys of the over-50s, QE’s impact on them has been to persuade them to save rather than spend. Is there a risk, or have you ruled out the risk, that QE has in fact stifled consumption in some way? Paul Tucker: I think that without QE in 2009, the economy would have sunk away in a desperate way and that would have been hugely damaging to savers. I think QE has helped over the past couple of years as well. It has brought down the cost of capital and it has underpinned wealth, and net, that has been a positive thing.

Q64 Andrea Leadsom: But we need consumption, don’t we? Paul Tucker: We do need consumption, but we also need net trade as well, even more. The most obvious reason for arrested recovery is where you began, which is a huge threat during last year from the euro area that diluted the traction that monetary policy could have. We were affecting the financial markets in a powerful way. That was not being transmitted into spending. Why not? All monetary policy, every instrument we have, is trying to get somebody else to spend: households or businesses. If they, to use slightly extravagant language, think that the world might be about to come to an end, they squirrel some money away or defer investment. I think, as I said in my annual essay to you, that with the euro area risks having receded somewhat, the QE we have done can gain traction and help a recovery in spending. I wrote that, of course, before the Italian election results and we will have to see just how potent an effect they have on markets and on sentiment.

Q65 Chair: Just on a very closely related point, what are the risks of a currency war, Mr Tucker? Paul Tucker: We must avoid them. We must avoid slipping back into protectionism. We must avoid balkanisation in global finance. We must avoid beggar thy neighbour policies generally and, as Mervyn has said overnight in Tokyo, we can avoid all of these things as long as central banks around the world—and other policy makers—stick to their domestic price stability objectives. The most important choice about monetary policy in this country over the past 20 years has been to have a domestic price stability objective, rather than an external anchor. That is what we did when we came out of the ERM. That is what we have been given to do and we must do that and nothing else. When you ease monetary policy, when you are expected to ease monetary policy, that will have an effect. There is one other thing that is tremendously important and that I fear has had some effect—modest—over the past few weeks, but which we must be very careful about. If either we or other central banks signal that we are going to tolerate a higher level of inflation 18 permanently—if we were to somehow lead the markets to think that we like 3%, and that is what it is going to be—then yes, you will find a fall in the exchange rate. But it will be a fall in the nominal exchange rate only. It won’t be a fall in the real exchange rate and it will do absolutely nothing for the recovery in that trade. Our ability to conduct monetary policy in a way that is helpful to the economy and helpful to the recovery depends absolutely on our commitment, and belief in our commitment, to sound money, which means a 2% inflation target over the medium run, and we need to be immensely careful when we talk around the world about these things that that is not put into question.

Q66 Chair: So, just to be clear, there is no tacit policy or acceptance of a real sterling devaluation? Paul Tucker: No, no. What there is is that, on the one hand, we say, as a matter of analysis, that we believe that the real exchange rate needs to fall compared to where it was a few years ago to get the necessary rebalancing in the economy. As a matter of policy, when we set our instruments we are trying to achieve a 2% inflation target over the medium run, without exacerbating the recovery in the near term.

Q67 Mr Ruffley: I would like to begin by asking two clarification questions. The first relates to QE and is for Mr Tucker. To your knowledge has any member of the committee advocated cancelling the gilts that you bought under the asset purchase facility? As I understand it, the reason that would not work is that, were you to cancel those gilts that you hold, rather than unwind the position by selling them back, you would reduce the tool for tightening monetary policy; and secondly, you would still have an ongoing liability to pay interest on the reserves that had been created. That would logically mean you either hold the interest policy rate at zero—not very likely—or you have to create more electronic money to satisfy the interest you owe to the banks in question. Paul Tucker: That is right, yes. Mr Ruffley: I understand that, but has anyone on the committee ever articulated that as a way of easing policy into the future? Paul Tucker: Not that I recall. I stand subject to correction by others, but not that I recall. I think it would be a stunt, and, for the reasons that you say, if you did it on a grand enough scale we would go bust. Mr Ruffley: Yes. That is why it was a clarification question. Paul Tucker: Which on the whole would be a very bad thing. Mr Ruffley: Yes. Charles Bean: I have certainly put exactly the argument that you have just made in one of my speeches. Mr Ruffley: Yes, on 31 October, I remember. Charles Bean: Yes.

Q68 Mr Ruffley: The second question is for you, Professor Bean. It concerns the point you raised about helicopter money. Am I right in thinking that, to your knowledge, neither you nor any other member of the MPC has discussed the fiscal proposition which would be part of a helicopter drop? That is to say, have you spoken to Ministers or are you aware of anybody speaking to Ministers about that fiscal part of the equation? Charles Bean: I certainly have not. Mr Ruffley: You haven’t. Charles Bean: I can only obviously talk from my own personal discussions. Others here may meet people. They may have had discussions. I somehow doubt it, but— 19

Q69 Mr Ruffley: Perhaps just very quickly, because we have just under half of the MPC here. Have any of you, other than Professor Bean, discussed helicopter drops in the terms that Professor Bean described it: that there would have to be a fiscal judgment to cut taxes, which is clearly nothing to do with the Bank? Have you aired that, Professor Miles, with current Ministers? Professor Miles: No, and I completely agree with the analysis of Charlie Bean on what helicopter drops mean. I did talk about it at some length, actually, in a speech I gave last year at the Scottish Economic Society lecture in the middle of the year, and pretty much said what Charlie just said. I quite agree with his analysis on this. Mr Ruffley: Yes. Any discussions with Ministers about— Paul Tucker: If I may say so, on the one hand it is important that analysis of all kinds is out there. On the other hand, I think we need to make it clear that we are committed to sound money, and the reason I say this is as follows, and this is consistent with what Charlie said. One version of helicopter money is—well, the core idea—the Government pursues a fiscal expansion and we finance it with the printing of money. So the important question is: who decides what? If the Government decides on a fiscal expansion—any Government—and orders us to print the money, then that is abandoning the current monetary regime, and do not expect the markets to react pleasantly. That will be taken as an abandonment of sound money. The alternative political economy outcome is a Government wants to undertake a fiscal expansion and have it financed with the printing of money, and we say, “Oh, we’re not going to print that money. We’ll only print it up to, such and such” and everybody feels that that is the Bank of England telling the Government what its fiscal strategy is. The final thing I would say—and I think it is tremendously important—is that things have to get much, much worse before any of these ideas are even remotely serious, and before that debt financed fiscal expansion would be contemplated by almost any Government, rather than printing money to have a fiscal expansion. I am not advocating that that should be the case now—I want to make that absolutely clear—but in the interests of filling out the analytical space, there is a risk that the market and you, as Parliament, and the public are misled as to where the policy debate is and should be at the moment.

Q70 Mr Ruffley: That is very helpful, and for the avoidance of doubt neither of those two positions on cancelling gilts or helicopter drops are positions I advocated. I said they were clarificatory questions, and your responses have been useful. Could I turn to credit flows to the economy and funding to lending, and perhaps I could stay with you, Mr Tucker? Do you think all credit is equal or do you think business lending has a greater stimulatory effect than mortgage lending? Paul Tucker: I don’t know. I think both matter enormously. Households and consumption is the biggest part of spending in the economy. Small and medium-sized businesses are the lifeblood of the productive side of the economy. I am worried, as are others, that our current battery of credit policies may not be reaching as far into the SME sector as they might, and I should make clear that in saying this I am speaking for myself. I think we need to be watchful of two things: the first is not all lending to small firms and medium-sized firms in the economy comes from banks. It also comes from non-banks. At present the FLS is for on-lending to households or on-lending to firms. We should have a think about this. I am neutral about what the outcome should be, to be clear with you. I think we should have a think about whether we can harness non-bank lenders in some way, possibly via the banks. The second thing—and I talked about this in a speech in late spring of last year—is I find it regrettable that the markets for working capital finance in this country are not as 20 healthy as they were a generation ago. Now, in old-fashioned speak this was the bill of exchange, and I do not want to be represented or represent myself as saying, “Let’s go back to the bill on London; 1870 was absolutely tremendous”. But I do think—and I called last spring for bankers and corporate treasurers to work on this—that the authorities and the Bank could play a role in that. The lifeblood of working capital finance to medium-sized firms, at least, for around a century was a trade finance instrument that was transferrable and marketable, and that we would buy. There is so much debate about the Bank of England not being prepared to lend to companies. That is not true. We are lending to companies via the FLS. I would simply like to explore whether or not some kind of working capital finance instrument could be rejuvenated. I do not have a plan in my pocket for how this should be done. My years of being the markets director are behind me. But I would like that to be debated.

Q71 Mr Ruffley: It is a very interesting answer, because what took my eye in the February minutes was exactly this point: that consideration of measures to support the flow of credit more broadly, including from non-bank lenders, was also warranted and it seems to me— Paul Tucker: That is a reflection of something I said. Mr Ruffley: But I just want to clarify it. Paul Tucker: Absolutely. I am not just saying this to you.

Q72 Mr Ruffley: But these are in the minutes, rather than it being a personal and brilliantly articulated view. But what more work is the Monetary Policy Committee going to do in relation to that, perhaps, Professor Bean? It seemed to be an MPC view that this should be explored—consideration of measures. Charles Bean: No, it was part of the discussion. We had quite a wide-ranging discussion of various options, in the course of which Paul said pretty much what he has just said to you now. The question then is: can we come up with a scheme that looks like it might be attractive, that might work? These may not be things that we alone can do, but this is something we need to put some thought into and that is basically Paul’s point.

Q73 Mr Ruffley: I think this is helpful. When will you be in a position to let this Committee know, or is research being done on this? Charles Bean: It is something we will work on inside the Bank to see if we can come up with something. It is obviously an area where the market side has a particular role. Mr Ruffley: Yes, but in the fullness of time— Charles Bean: In the fullness of time, we may decide there isn’t anything useful we can do in this sphere, but Paul is perfectly reasonably saying we should think about this.

Q74 Mr Ruffley: This is very useful and, with your permission, Chairman, just one final and brief question. The funding for lending initiative is currently controlled, as I understand it, between your executive and the Treasury. Given that the role of the FLS is to plug a gap in the transmission mechanism of the Monetary Policy Committee, is there scope for it to become more closely controlled by the MPC as an MPC tool, and what is the dynamic with HMT? Charles Bean: First of all, we operate the FLS, we do all the mechanics of it and so forth. The bank staff monitor the collateral and all that. The other thing is it is not a scheme that lends itself to continuous tweaking in the same way that you might with bank rate or the quantity of asset purchases. What the FLS does is basically supply banks with funding cheaper than they can get in the market. The reason we introduced it was precisely because 21 funding costs had been rising through last year, partly on the back of what was going on in the eurozone, and we were worried that would lead to a credit crunch, and there were signs that that might be starting to happen. So the primary aim was to work against that and, indeed, funding costs have come down very substantially—more than 100 basis points. So it has achieved what it set out to in that regard, but we also put in these extra incentives to encourage banks to lend more than they otherwise would have done to the real economy—the way the scheme is priced. Now, as far as the banks are concerned, they want some certainty about the pricing of the scheme in deciding where they are going to take advantage of it, how to extend their lending and so forth, and it would not be constructive of us to be continually tweaking the parameters from month to month. If it was clear that we had got the calibration of the scheme wrong and it wasn’t having the effect we thought it was going to, then we would obviously need to think, “Do we need to change something?” But frankly, the way it is working at the moment is pretty much as we expected it to. We have seen the effect on funding costs that we wanted to see. That has largely passed through into the rates that are being charged, certainly on household mortgages, and the availability of finance for larger companies. There is less evidence so far of the effect that we would like to see for smaller companies, but certainly they are the group that have less access to alternative sources of finance.

Q75 Chair: Larger businesses are okay already. Charles Bean: Yes, yes. Chair: Many of them are cash rich. Charles Bean: Yes; that would not necessarily be true of all businesses, but certainly many of them. But we did expect it to take more time to feed through to the smaller company end of things, where it is more heterogeneous and so forth. Chair: We will keep an eye on it. Charles Bean: But we are keeping an eye on it.

Q76 Chair: Mr McCafferty and Professor Miles, you have been virtually spectators for the last 20 minutes or so. I just want to give you an opportunity to add anything—first Mr McCafferty and then Professor Miles—to what you have just heard. You do not have to, but do you have anything you want to say? Ian McCafferty: The only thing I would add at this stage is in answer to Mr Ruffley’s question. I have not spoken to Ministers about fiscal issues. I agree with everything my three colleagues have said about the analytics of the issue, and I do think one of the most important elements of the current QE programme, which we would lose with either helicopter money or with the cancellation of gilts, is that ability to reverse the policy. I think that is to our credibility. Chair: Professor Miles? Professor Miles: Coming back to the impact of QE, I agree with something Ros Altmann said—to this Committee, I think—which is that one of the side-effects of QE is that it generates a search for yield. As Charlie said, actually that is a good thing. That is not a bad thing, and I think one side-effect of search for yield has been the knock-on impact in the corporate bond market where yields have come down over the period when we have been buying gilts very, very substantially. The number of new companies that have not issued in the corporate bond market before has increased. I think part of the helpful side-effect of QE is to increase somewhat the universe of companies that now think about using the corporate bond market. Now that doesn’t stretch all the way down to small companies, but it begins to stretch down to some of the medium-sized companies, and that is exactly one of the beneficial side-effects of QE. 22

Q77 Chair: That is a helpful illustration or guidance on yield compression and it is not all necessarily bad. You have to be very quick, Mr Tucker, you have had a good innings so far. Paul Tucker: I absolutely agree with what Charlie and David have said about search for yield, but I would hate it if in five to 10 years time we have it quoted back to us: “Oh, the Bank of England was encouraging a search for yield blind to the risks that could build up in the financial system”. The whole point of giving us both functions—I have said this publicly, and I am sure you have—is we need to have two sides to our brain: while monetary policy might desirably stimulate risk-taking, we have to make sure that that risk is taken in places that can bear the risk, if and when it crystallises, rather than blowing up the world again. Chair: Yes. We will settle for two sides of one brain rather than two brains.

Q78 Mr Mudie: Mr Tucker, paragraph 36 of the minutes in the Monetary Policy Committee opens, “The committee discussed the appropriate policy response to the combination of the weakness in the economy and the prospect of a further prolonged period of above target inflation”. It deals with the latter—inflation—for the rest of the paragraph and then finishes with an intriguing, “The committee also agreed that it stood ready to provide additional monetary stimulus if warranted by the outlook for growth and inflation”. You have dealt with inflation, and I am surprised and saddened that there seems to be no appropriate policy response regarding the outlook for growth and the business that is warranted by it. If you have spotted growth in the last two years, Mr Tucker, I would be glad if you pointed it out. Why did you and the other members of the committee, excluding Professor Miles, think there was no need for this—that no policy response for growth was warranted? Paul Tucker: I would say three things. First of all, we wanted to make clear in the last sentence that nobody on this committee thinks that QE has reached the end of the road and it is not a useful instrument any more, and we stand prepared to do more if we judge that necessary. Given speculation about whether we do think that QE has reached the end of the road, it was important to make that clear. Secondly, in my own case—as I make clear in my annual essay to you as well—I think that the QE that we have already done is likely to gain more traction now that the headwinds from Europe have receded somewhat, subject to Italy overnight, on which one cannot yet form a judgment. I think this is a really important point, Mr Mudie, at least for me. We did this QE last year. It affected financial market conditions. The impact on spending was effectively switched off, for the reasons that I have described earlier, because of the huge uncertainty and threats coming from the international environment. As those recede, I would expect the effects of the existing QE on financial market conditions to start to affect the economy. That weighed with me. The third thing I would say is, I think we are absolutely conscious of trying to support growth and recovery, consistent with maintaining inflation conditions. We are not inflation nutters. I promise you that if it became perceived that we had given up on inflation and that we were only going to support recovery in growth, what we would find after a few quarters was that we couldn’t provide that support for growth because the bond markets and everybody else had reacted adversely. It is only by maintaining our commitment to sound money that we can do what you personally most want us to do. Now, will we get that absolutely right every month or every quarter? Of course we won’t, but I do not think you should take away from this any lack of willingness to support growth. By letting inflation go to 5% on a judgment that perceptions of our commitment to price stability were not diluted, we were doing that precisely so as to support growth.

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Q79 Mr Mudie: But that is not a choice that is necessarily on the table, is it, letting inflation go to 5%? Paul Tucker: No.

Q80 Mr Mudie: But it is interesting, Mr Tucker, that you responded only on QE, as though that was the only— Paul Tucker: No, it is not. No, no. Mr Mudie: No. It was an appropriate policy report, but it was not specifically about QE. Paul Tucker: Yes.

Q81 Mr Mudie: Two of your three points were on QE and the other was on inflation, which you dealt with without any warning of a 5% inflation rate. Let’s come to paragraph 33— Paul Tucker: Can I just say on that, Mr Mudie? Mr Mudie: Yes, go on then. Paul Tucker: I answered the question in terms of QE but, as I said to Mr Ruffley earlier, I personally have been raising questions and promoting ideas about— Mr Mudie: Mr Tucker, that is the next question. Paul Tucker: That is where you are going? All right.

Q82 Mr Mudie: In paragraph you 33 state, “The Committee reviewed the range of possible monetary policy instruments”. You list some of them, and then you say the ones you list all had drawbacks, and these drawbacks remained and excused you from accepting any of them. “The committee would nevertheless continue to examine all of the policies potentially available to it”. What are the drawbacks that you have experienced with the purchase of alternative assets, and what are the other policies available? Paul Tucker: I will come to the purchase of other assets. I have talked about FLS already. We touch on in this paragraph reducing the Bank rate or the rate paid on reserves from 50 basis points, say, to zero. One possible risk of doing so is to make life even harder for some of the building societies and small lenders, particularly— Mr Mudie: No, I haven’t raised that issue. Paul Tucker: Specifically, can I— Mr Mudie: No, Mr Tucker; I am sorry but time is very limited and I am asking specific questions. The question is on the alternative asset purchases: what are the drawbacks? Secondly, what are the other possible measures that don’t have drawbacks that you have admitted to putting on the table for consideration? Paul Tucker: On the second question, I have raised the question of what the limits would be to setting— Mr Mudie: No, Mr Tucker; again, I am asking you specifically about your minutes. There were other measures. Can you tell us what others were on the table that did not have drawbacks, but you have decided in the fullness of time—to take Mr Bean’s phrase—you will come round to. Paul Tucker: We are going to continue to think about these. I hope we will think about whether there are constraints to setting negative interest rates. This is an idea that I have raised. This would be an extraordinary thing to do and it needs to be thought through very carefully. On the purchase of other assets, I have absolutely no theological or religious principled objection to our buying non-gilt assets. What I would say to you is there are 24 practical considerations that deserve weight. The main classes of assets in this country are equity and land. This is not like the United States of America where there is a wealth of other assets denominated in sterling. There aren’t tradable pieces of commercial loans. We are lending against commercial loans and in my judgment, for what it is worth, lending against commercial loans and buying commercial loans is more or less the same thing, in terms of its economic effect and the help that it can provide.

Q83 Mr Mudie: What are the other ones that are not mentioned here that you are potentially looking at? Paul Tucker: I think we have mentioned the FLS things. That is a— Mr Mudie: That is in operation now. Paul Tucker: No, in answer to Mr Ruffley I talked about possible extensions, which I have aired, which would be quite significant, in terms of lending to non-banks or lending via non-banks, and also trying to revive a market and working capital finance where we could once again buy pieces of working capital finance paper—the old bill on London. I have said that publicly.

Q84 Mr Mudie: I am not getting personal and I am interested in your views, but I am really interested in what alternatives were on the table when you had this broad discussion. I would welcome you sending the Committee a list of other items that are not mentioned here— Paul Tucker: These are the main items that we discussed.

Q85 Mr Mudie: That is not how the minute reads. These were some of them and they were ones with drawbacks, so they are mentioned as though they are already dismissed. If you have dismissed these, I am simply asking what other monetary policy initiatives you have up your sleeve if we have this sad position with growth and we need to get some monetary help. Paul Tucker: First, I do not believe these are dismissed. When we say we are leaving them on the table and continuing to consider them—[Interruption.] I have mentioned to you this morning the negative interest rate. That is a pretty radical idea, and not something anyone should clutch on to as the answer to the question of the universe. In terms of credit supply to the economy—which matters so much, given our beaten up banking system—in response to Mr Ruffley I have amplified on what is stated very briefly here, and I hope that is helpful to you.

Q86 Mr Mudie: I have a final question, on paragraph 35, which states: “It seems possible that a further broad based monetary stimulus would on its own be insufficient.” We accept that. You continue: “The committee also discussed other potential measures that the bank together with other UK authorities might deploy” and you finish by saying, “A number of more targeted interventions to boost demand and the supply capacity of the economy and to facilitate rebalancing might be entertained, but many of these fell to other UK authorities.” Can you list them? Paul Tucker: The thing that lies within our competence is to try gradually to improve the performance of the banking system, and the FPC is doing that by— Mr Mudie: No, no, again, Mr Tucker— Paul Tucker: I am sorry. Mr Mudie: This is the minutes of a meeting and the minutes say there were a number of more targeted interventions but many of these were in partnership with other authorities. I 25 am simply asking: could you supply the Committee with a list of these other possible interventions, albeit in partnership with other UK authorities? Can you also identify, when you pass us this note, the other UK authorities? Paul Tucker: The main area is supply-side policies. We do not have a detailed list of that. It is not within our responsibility and it would, I think, be wrong for us to carry around a specific menu. The broad point in economics that we have made is that things that could improve—

Q87 Mr Mudie: With the greatest of respect, your minute says, “In that context the committee also discussed other policy measures at the bank together—”; so you discussed it but you don’t have a list of them? Paul Tucker: Perhaps we should have included the words “in broad terms”. I wish following this exchange that we had. If you have taken away from these minutes the idea that there is a— Mr Mudie: That you are working on something. Paul Tucker: —specific list of things on the supply side which calls for the competence of Government, there is not.

Q88 Chair: That is very helpful clarification. We have had a lot of clarification today. We have a couple of colleagues who want to come in, but I just want to ask you—not now, but perhaps in writing—if you could set out the extent of your thinking, and it may be only very sketchily developed, on how you would go about putting a floor to negative interest rates. Paul Tucker: That is a good question. Chair: That is why we are asking it and we look forward to your answer.

Q89 Mr McFadden: I would like to return to this issue of the pound and the exchange rate. The new incoming Governor of the bank has said that the UK’s export performance is the worst in the G20. That is despite devaluation of around about 20% or more in the last four or five years. Let’s start with you, Mr Bean; why do you think the UK’s export performance has been so poor relative to other countries, and why have we not seen more benefits to exports from this devaluation? Charles Bean: There is a box in the inflation report in chapter two, which I think is quite useful at this point. If you have it. Mr McFadden: Yes, I have it here. Charles Bean: It is on page 24. Chart A just shows the extent of the sterling depreciation, 25% since the beginning of the crisis, so a large depreciation, no doubt about that. First, I think it is worth saying that there are two elements that work pretty much as we expected, so the behaviour of imports has been in line with past experience and if you look at chart C, which shows our share of exports in an appropriate global measure of trade, as far as goods are concerned, that share has been falling and since the depreciation that has levelled off. In pretty much—

Q90 Mr McFadden: Levelled off—but it has not. Charles Bean: This is a share and the overall market size might be getting bigger. So the puzzle lies in what has happened to exports of services. That is the big puzzle. If you notice in that same chart, that was where we had been increasing share during the years leading up to the crisis and, if anything, you might have hoped the depreciation would have allowed that to keep on carrying on. It hasn’t. It has flattened off and fallen back. Some of 26 that is down to exports for financial services, and it is obviously connected with the financial crisis. But there is also a wider weakness in business services more generally. What is not clear to us at the moment is to what extent we can expect that unexpected weakness, particularly in those categories, to come back, or is it something we have lost permanently, like a permanent adverse shock to our ability as a trading nation? You might think that some of this might be relatively persistent—the bit that is connected to exports for banking services. If that is the case you might take the view, “Well, we need an even bigger depreciation to make our exports of goods and other services more competitive and to lean even more against imports”.

Q91 Mr McFadden: Is that your view? Charles Bean: I am not convinced that we necessarily need a nominal depreciation to get that. One of the things that chart A brings out is the fact that measures of the real exchange rate have been appreciating recently. The one that I look at most often, and I regard as the most useful thing to look at, is the yellow line, which is based on relative unit labour costs between countries. You can see that line has come back quite a lot. We have lost about half of the gain that we got. That reflects the weak productivity performance in the UK. So the crucial question here is: do you think that weak productivity performance is actually something that would solve itself as the economy picks up?

Q92 Mr McFadden: So in simple terms you are saying that this line shows that by keeping people in work we are increasing our unit labour cost and perhaps making life more difficult for ourselves when it comes to exports; is that what you are inferring? Charles Bean: It means that the competitive advantage to businesses is less than it might otherwise be. That is not to say they should sack everybody, because there are obviously advantages to keeping people in work. It helps to keep demand up. But if as the economy recovers businesses find they can utilise their labour more efficiently, you will find that productivity improving naturally. That is the argument that David was making earlier on this morning. The other thing that is worth saying is that it may well take time for exporters to respond to the change in the profitability that the depreciation has allowed. If you are someone who is thinking about getting into foreign markets— Mr McFadden: This depreciation, most of it happened in 2008-09— Charles Bean: But it is not just that. It is also the conditions in the foreign markets themselves. It is not straightforward to suddenly start exporting to China or into bits of the eurozone that you haven’t targeted before, and in an environment where there is a lot of uncertainty you are probably pretty cautious about some of these things. So it may well be that some of this is just taking time to see some of the benefits. I should say I was on a visit to the north-west last week, visiting businesses. One business told me that they were consciously switching more of their sourcing to UK suppliers of clothing. This was a mail order business. Another one told me they were on-shoring their call centre, which they had previously off- shored to India because it was now cost-effective for them to do that. So we do hear stories of the mechanisms working the way they are supposed to, but it is fair to say we have been disappointed about not getting more of a kick to the recovery from net exports. Mr McFadden: That is what I am getting at. Charles Bean: No, absolutely. There is absolutely no doubt that we have been disappointed relative to our expectations.

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Q93 Mr McFadden: If someone had said to you four or five years ago, “We are going to have a depreciation in sterling of about 20% to 25% relative to other major currencies” you would have expected more of an effect? Charles Bean: Yes, absolutely. Mr McFadden: Does anyone else want to come in on this? Paul Tucker: I agree with what Charlie has said. The only thing I would add is quite an important question in the years ahead will be whether exports of financial services increase again. Whether we like it or not, this is a significant part of our economy. It has been a significant part of our external trade in the past. My personal expectation, for what it is worth, is that as the world heals—assuming it does heal—exports of financial services will pick up again. But I would add that we need our external trade to be more diversified geographically, which is the point that Mark has made about the Far East and Mervyn has made in the past as well. We can no more afford to rely on just exporting financial services than we could rely 25 years ago on just exporting manufactured goods.

Q94 Mr McFadden: But even in terms of your point on goods, this chart on page 25 shows a flat picture for the last six years. Paul Tucker: That is the geographical point. Charles Bean: Are you talking about chart C here? Mr McFadden: Yes, chart C. Charles Bean: Yes, and remember this is just a share of the market.

Q95 Mr McFadden: Yes, but it is relative to other currencies that we are talking about. That should have helped us. Charles Bean: Yes. This has helped us. It would be nice to see this red line going up instead of being flat.

Q96 Mr McFadden: That is what I am driving at. Let me ask you then about the future, if that is the past. In your MPC deliberations do you take a view on this currency question? Is that a central part of your thinking? Is there an MPC view on the currency, where you would like to see it go? Charles Bean: No. The exchange rate is obviously important to the outlook for both inflation and output. When the currency is weaker that tends to push up import prices, so it raises the inflation profile. It has a two-edged impact on activity. On the one hand the higher import prices reduce the real incomes of households and that tends to dampen consumer spending. But on the other hand we hope that it has some beneficial effect on exports, and we still think that net, the effect is probably expansionary from an exchange rate depreciation. So where sterling is, and where it is likely to go, is very important to us in forming a judgment.

Q97 Mr McFadden: That is what I am trying to tease our of you— Charles Bean: Yes, I know. Mr McFadden: —whether you have a desire for the direction of travel. Charles Bean: No, absolutely not. The markets will take the exchange rate where it will and we do look at issues such as, do we think the risk to sterling might be in one direction or another? For instance, if we are running a current account deficit—as we were for the decade before the financial crisis—we did repeatedly say that at some stage we thought there would need to be an exchange rate depreciation to rebalance the economy and eliminate the current account deficit.

Q98 Mr McFadden: But rebalancing has not happened. 28

Charles Bean: There has been some rebalancing but not anywhere as much as we would like to have seen.

Q99 Mr McFadden: Professor Miles, you voted with the Governor to have more QE at the last MPC meeting. When the minutes were published the markets were somewhat surprised by this division in the MPC on this issue, and one of the quick consequences of that was downward pressure on the pound. Did you regard that as a fairly benign if not desirable consequence? Was that part of your thinking? Professor Miles: I am not sure about benign and I am not sure how long lasting it will be. We have very few reliable models of the exchange rate, so it wasn’t certainly part of any strategy to try and get the exchange rate to move. I think the exchange rate is pretty much unpredictable, and when we produce our own forecasts we use as the least bad forecast simply what the market expects the exchange rate to be. It always turns out to be wrong but it is probably the least bad forecast. So I don’t think there was any expectation that there would be some reliable movement in response to the way the voting went. I hadn’t changed my vote, as you will know. I have taken a view for quite a long while that stronger growth in the UK would be very welcome—I think we all believe that—but also consistent with inflation gradually moving back to the target level, and I felt having a slightly more expansionary monetary policy would make that growth more likely, and partly for the reason that Charlie mentioned a moment ago, which is the likelihood that some part of poor productivity just reflects weak growth in itself. If you believe that, as I do, that would mean that stronger growth would improve productivity, would be consistent with inflation pressures probably no higher and, therefore, would be a welcome thing. So that was my thinking behind continuing to vote for more expansionary policies.

Q100 Mr McFadden: Let me just finish with this. I am conscious of time. Under the heading, “The Bank of England does what it does not what it says” James Mackintosh wrote in the FT the other day, “Perhaps Sir Mervyn’s vote”—and by implication yours, Professor Miles—“was merely part of his ongoing effort to talk down the pound. If so, it worked.” Professor Miles: That wasn’t my motivation for voting the way I voted. As you will know, I have voted this way for some months now. It was based on an assessment of the likelihood of growth falling in different ranges—my assessment that stronger growth would be more likely to come if monetary policy was more expansionary. I also take the view that quantitative easing and more asset purchases are likely to increase the pace of growth in the UK, not particularly through the exchange rate, which I think is highly unpredictable, but through some of the other channels we were talking about earlier. We talked about the search for yield, making investment in corporate bonds, in equities, more attractive, and that having a positive impact on demand.

Q101 Mr McFadden: Mr Tucker, you earlier said that this was the kind of road to hell, this competitive currency devaluation. The G20 Finance Minister has issued a very pious statement saying this would all be bad, but talk is cheap, isn’t it? The actions of us here and other states will speak louder than G20 finance statements. Paul Tucker: I think I have used the words “sound money” three times this morning. I do not believe for a second that David or Mervyn’s or Paul Fisher’s vote was motivated by trying to manipulate the currency, and if they tried to I think they would fail. Monetary policy has an effect on currencies. We need to stick to explaining what we do, in terms of the mainstream effects, and be careful about what we say. At this point of an economic cycle, where—big picture—I think we have to be patient, it is very important not to lose our nerve and talk in ways where we can be misunderstood. Because it is not just actions 29 that make a difference; in the short term talk can make a difference too and I think the G20 and the G7 have sensibly been trying to row back their talk and to bring it into line with the actions, and I welcome that.

Q102 Chair: Very quickly, bringing us back to an earlier point that was made about labour hoarding, Mr McCafferty, do you think there is a lot of labour hoarding going on and do you think that is retarding recovery? Ian McCafferty: Chairman, I am not sure I like the term “labour hoarding” because it makes it sound like it is a very negative concept. What I said in my speech was that I do believe that the nature of the way in which employers and employees work together within the labour market has changed, and that one of the values employers are increasingly recognising is of the longevity of some of their employees, that they gain productivity and they gain skills through working with individual companies over a longer timeframe, which makes employers reluctant to lose those employees, simply because short-term demand conditions are less than they would like, or certainly deficient in this case. So from that point of view I think, if you want to call it “labour hoarding”, there is some degree of labour hoarding. It is clear from the statistics that employment growth is relatively strong at this stage in the cycle, whereas output growth is particularly weak. By definition, therefore, we have to have some form of labour hoarding in that sense. It can be explained, as I say, because I think there are firm-specific skills that employees can gain that are increasingly important in maintaining competitiveness for many firms, which leads them to be reluctant to lose those employees. Firms are able to maintain their labour force in this particular recession, which I think is a contrast to previous recessions, because of the less difficult financial conditions that they face: the very low interest rates; the use of QE. The fact that firms went into this downturn in a better financial position than previously means they are able to maintain employment in a way that firms weren’t in the 1980s and the 1990s, for instance.

Q103 Chair: You are portraying it as a good thing. They are hanging on to people they are going to need when the upswing comes and, therefore, you are partly answering Mr Bean’s question about the yellow line in chart A, page 24, by saying you are optimistic that is going to go in the right direction. Ian McCafferty: Yes. I think that as the recovery gains some strength, we will see productivity naturally recover as people work more intensively than they are having to currently.

Q104 Jesse Norman: Mr Tucker, you have raised the very interesting and controversial idea of negative interest rates. You are going to write to us, kindly, about how a floor could be set for such. Could you also include in that any thinking you have done on current mechanisms for how it would be implemented? I am grateful. You remarked about the importance of the banks staying out of the supply side of the economy, and I hope it would not be facetious to point out that you have an extraordinarily large influence over one aspect of the supply side, which is the supply of money. It would be nice to think that as the Bank takes over more responsibility—proper responsibility for the banking system—it could be gently guiding the large banks towards a proper recognition of the function of banks to supply working capital to industry, and to get out of the business of principal trading and punching their own treasury operation. I hope you will pass that message on in the supervisory role that you increasingly exercise. Paul Tucker: I think that the first step is to gradually restore these banks to health. I have talked about that on other occasions. The other thing I would say is it is not just a matter of exhortation. The changes made and the regulatory regime in Basel, which, for 30 understandable reasons, do not get a huge amount of prominence here, will tend to tilt the allocation of capital away from trading towards real economy provision of credit, and that process is not yet finished. If you asked me, “How much?”, my answer is I don’t know because that work is still ongoing. But this crisis was a long time in the making, and some of the details of regulation can affect incentives in the financial sector in a very potent way. But we are trying to design an international regulatory framework—and I know that Mark talked about this when he was here—that both underpins soundness and unwinds some rather unfortunate incentives.

Q105 Jesse Norman: Thank you. Mr Bean, you will recall that European Monetary Union was dogged from the outset by an inability to maintain countries within the framework of the spending and growth requirements as set by the European Commission. You have just described, fairly eloquently, why a banking union that is required to make European monetary union work effectively is going to take, at the very least, many more years to implement. Would it not be your view that these should have been foreseeable in advance and, therefore, the implementation of EMU has been a fiasco? Charles Bean: I think it is fair to say that there were plenty of commentators, academics and the like, who did suggest when monetary union was first mooted that it needs to be associated with a degree of fiscal union and so forth. The route chosen to deal with the fiscal issues was, as you say, the Stability and Growth Pact, which turned out not to have teeth. Also I think insufficient attention was given to the question of how you deal with heterogeneous developments in different parts of the community, and the problems that that might lead to. I don’t think people did realise, though, that one of the consequences of monetary union was going to be to encourage capital flows into the periphery and the build up of financial imbalances that was obviously connected with the wider development in global financial markets. But that exposed I think the issues in the structure of financial markets, banking union territory, in a way that I think it is fair to say most people had not really anticipated. Although with hindsight you can see the issues. But certainly—

Q106 Jesse Norman: Greek interest rates falling as quickly as they did might have encouraged people to— Charles Bean: No. There were people who identified that that would have some consequences, but I don’t think anybody can really claim to have said, “Oh this will lead to a build up of financial imbalances that will eventually unwind in an unhappy way”.

Q107 Jesse Norman: Because I am sweeping up a whole bunch of things, I want to keep moving if I may, and I take your point. What is your central guess, Mr Bean, for how long a proper banking system will take to put into place; a banking union if you like? Charles Bean: It depends whether you want all of my five items.

Jesse Norman: You have to have five because you said they are necessary. Charles Bean: I said, for a durable one— Jesse Norman: Let us have one that works. How about that? How long will that take? Charles Bean: I suspect you will have the supervisory mechanism in operation by the beginning of next year. That is clearly the roadmap that our European partners have put out for themselves. The timeframe for the resolution— Paul Tucker: I hope the directive is done before the summer, and then they have they have said that they will announce their plans for a banking union resolution authority before the summer. Once the ECB have responsibility for supervision, without the other pieces that Charlie described being in place, they have a hell of an incentive to push for further steps. 31

One of the great lessons for supervisors in this country is that being a supervisor without an adequate resolution regime is a pretty stupid place to be. I think that we will find over time that the ECB end up being a voice to push along the line that Charlie has described. Whether they will succeed, I do not have the faintest idea.

Q108 Jesse Norman: Is it five years to get all these five? Is it longer? Some people say it is a decade. What is your best guess? Charles Bean: I do not think you can necessarily easily set a time limit because the last two steps are connected with the politics of this and whether there is the will for the north to provide the back stop. Paul Tucker: It goes back to Ms Leadsom’s question. Jesse Norman: I am fully aware of that. Paul Tucker: But we think you are better equipped to make judgments on that than us.

Q109 Jesse Norman: In your view at the moment, there is no guarantee it will happen at all, is the point you are really making. Nothing, or very little, has changed in the eurozone economically. That is to say, the European Central Bank is now supplying a limited liquidity, but the fundamental economics of productivity imbalances has not really—I think I am right in saying—changed. What risk do you think—any of the panel really, but I suppose in particular Mr Bean—there is at the moment to a balance of payments crisis within the eurozone? Charles Bean: Within the eurozone? Jesse Norman: Either within or without. Charles Bean: Personally I think there has been some improvement relative to where we were in the middle of last year and, in particular, the ECB’s declaration that it is willing to undertake these so-called outright monetary transactions, buying the short-term debt of periphery countries in receipt of a support programme.

Q110 Jesse Norman: How does that actually improve the fundamental economics? The productivity— Charles Bean: I am going to work through this. There certainly has been an improvement there, which has brought down yields very significantly for countries like Italy and Spain. That means it is easier for them to finance their fiscal deficit. That is a real improvement. You shouldn’t underestimate that. It is also played more generally in the improvement in financial markets around the world—a sense that they are heading in the right direction. Where you are absolutely right that there is still a long way to go is in the underlying real problems of those countries, in terms of indebtedness and competitiveness. I would emphasise the competitiveness part because countries like Italy, Greece and Spain lost quite a lot of competitiveness relative to Germany in the first years of monetary union, and they now have to get that back and increase net exports, as we were discussing earlier. But of course they can’t do that by changing the exchange rate. They have to do it either by changing pay levels or somehow bringing about a big improvement in productivity. So these are big challenges they still face, and there is a long way to go. I think it is fair to say that some of them are making significant steps though, and if you look at a country like Spain, its trade performance has actually been really quite strong, despite not having access to the exchange rate. Professor Miles: I would say one thing which I am sure is a minority view and it is a view that does not affect my thoughts about UK monetary policy. I think the view that you can only make a monetary union work with fiscal union is profoundly wrong. That is my own 32 assessment. I think the reason why there was such a problem in the eurozone was that there wasn’t a recognition early on that bonds issued by different entities in the same currency had very different risks. People took the view that as long as a bond is issued in the same currency by a Government that was in the eurozone, it had the same risk as the least risky Government in the eurozone, and that is a mistake that I suspect people will not make again, at least for a very long time. Charles Bean: So the challenge is to make no bailout credible. Paul Tucker: Yes. In a strict sense David is right, but you do then need to make the no bailout credible. If it is not credible then you need mechanisms for transfers. Chair: Did you want to say something else, Professor Miles? Professor Miles: No, that was all.

Q111 Jesse Norman: Dr Carney has noted what he called an underlying sickness— that is, a balance of payments crisis within the currency area. Do you think that is a mistake? Paul Tucker: No, that is the imbalances that exist at the moment. Jesse Norman: That was the question I originally asked. Charles Bean: My remarks about competitiveness were precisely a response to that.

Q112 Jesse Norman: You do not think there is a likelihood of having a balance of payments crisis within the currency area? Charles Bean: There is one within it. Ian McCafferty: You could say that, yes, there is one. Jesse Norman: So there is one. Paul Tucker: Yes, there is one. It manifests itself as vast balances in the so-called target system where the German banks are effectively lending money via the Bundesbank and the Nederlandsche bank to the southern countries.

Q113 Jesse Norman: I think we are where we should be, which is, we have a balance of payments crisis in the eurozone. That was my original question and we are now, five minutes later, there. Good; I agree. You did not answer the questions put to you, Mr Tucker, about the currency war. What is the actual risk of having a currency war at the moment? Paul Tucker: If everybody conducts themselves in the broad way I have described, I think it is low. Jesse Norman: Yes, but what if they don’t? What is your— Paul Tucker: They all have domestic price stability objectives. I don’t see any evidence that any of them are departing from trying to pursue their own domestic mandates. That is not a recipe for a currency war. Where there is a degree of tension is between the big G7 countries and other countries who link themselves typically to the dollar, and they become concerned about importing US monetary policy and the capital flows that go with that, and as those economies become bigger that does pose questions about the design of the international monetary system. But that is quite separate from questions of a currency war among the big countries; I do not see that that need happen. People would have to try quite hard to make mistakes.

Q114 Jesse Norman: You are saying not only does it need not happen, but you don’t see any signs of it actually happening now? Paul Tucker: If you go back a few weeks, I certainly saw signs that the markets were worried about it. I think the officials of the G7 and G20 have responded in a sensible way. Jesse Norman: Thank you very much. 33

Chair: You have been extremely helpful this morning, which has now become this afternoon. Thank you very much for coming in. We have picked up a great deal about your messaging, about some keys facts in a number of areas; clarity has been brought to policy, and we will be following up a number of points that you have raised in writing. Thank you very much indeed.