Good morning, my lady. Can you see us and can you hear us?
I can. Thank you very much.
My lady, the first witness this morning is Lord King.
Thank you.
To stand and take that repeat after me. I swear by Almighty God.
That the evidence I shall give.
That the evidence I shall give.
And nothing but the truth.
To take a seat.
Thank you for coming to help us, Lord King.
Pleasure to be here, my lady.
Lord King, you are the former governor of the Bank of England and you were in post between 2003 and 2013. Is that right?
You have provided a witness statement to the inquiry with reference number INQ0000656310. You are here to give evidence today primarily about monetary policy and the actions taken by the Bank of England during the pandemic. Yours is an outside view of what was happening because you were of course not in post at the time. Is that right?
Lord King, we are planning to structure your evidence in two parts today. The first is to give an exposition of some fundamental principles related to both the bank and monetary policy. And the second is to take your perspective, perhaps a critical outside perspective, on the actions taken in respect to monetary policy by the bank during the pandemic. The first question I have for you then as a building block: the Bank of England is an independent central bank. Why do we have one?
It is independent in respect of the decisions it takes on the operations of monetary policy. It's not independent in respect of its objectives. Those are given to the bank by parliament after decisions by the chancellor. So for example in monetary policy the government sets the inflation target, currently 2% a year, and then the monetary policy committee takes decisions to set interest rates or engage in quantitative easing to achieve that target. The reason for having that split between the objectives given to the elected government and the operational decisions given to the bank and its committee is to ensure that decisions on interest rates are taken out of day-to-day political flux and pressures. And before the bank was made independent, there were examples where governments would change interest rates perhaps just before a by-election or reward itself after a budget that it felt went pretty well. But there was skepticism in financial markets that the real motivation for those decisions was economic as opposed to political. And I think that after the experience of high inflation in the 1970s and 1980s, that politicians came to feel that actually there was nothing to be gained by having day-to-day control of interest rates because they would simply end up being blamed for the vicissitudes of inflation. And everyone had something to gain by handing control on the day-to-day decisions on interest rates to an independent central bank.
How does the nature of the relationship then between His Majesty's government and the Bank of England operate in practice?
Well, in practice, the government will set the target for the Bank of England. There will be regular communications. I used to meet every couple of weeks with the chancellor and we talk about what the Bank of England was thinking about the state of the economy and in turn the chancellor would be talking about his thoughts about how fiscal policy will evolve. But there was a very clear division of labor between the two. And at no stage since the Bank of England became independent in 1997 and when I left in the middle of 2013 was there any pressure from a politician of either major party to push interest rates in any direction that they wanted to see. They respected the independence of the bank.
Internally and externally, what is the role of the governor of the Bank of England?
Well, the governor leads the institution. He sets a strategy for the institution. He has to explain that internally and also externally. He's chair today of the three major committees that set policy in the bank: the monetary policy committee which sets interest rates and decides on quantitative easing; the financial policy committee which engages in what's called macroprudential regulation, deciding on how large are the amounts of equity which banks have to issue in general; and then the prudential regulation authority is now inside the Bank of England and that body regulates individual banks.
There are some words in there that may not be entirely familiar to everybody. What does macroprudential regulation mean and how does it contrast with microprudential regulation?
Well, it's a good question because it's a relatively new concept. Essentially, the idea was to take a view of the financial system as a whole and try to identify various risks. That's one part of the work which the financial policy committee does. But then the question is what do you do about it if you think there are big risks? It can offer advice to the prudential regulation authority about whether or not they ought to be tougher in forcing individual banks to issue more equity so they have bigger buffers to absorb losses when they see that their loans go bad. And they do have specific powers also to mandate banks to limit the scale of lending to domestic or commercial property by ensuring that they can't lend for example if the loan to value ratio, the ratio of the mortgage to the value of the property, rises above a certain level. These are new instruments. I think they're still fairly controversial, but they have been used by the Bank of England in order to try to moderate the degree of risk in the financial system as a whole. Microprudential regulation is the remit of the prudential regulation authority which sets the regulations for individual banks and they will say for example to Barclays or to Lloyds either that the amount of equity that you've issued is not high enough or you need to take some other action in order to reduce the risks that you're taking with your balance sheet. That's to do with individual institutions. And of course, they also have to decide on whether new institutions can be admitted to be regulated banks.
And I think it's important to recognize that though your evidence today will focus on monetary policy and the decisions of the monetary policy committee of the bank, there are a larger suite of measures that were undertaken by the bank during the pandemic which perhaps fell under the umbrella of the financial policy committee and the prudential regulation committee.
Yes, I think certainly the financial policy committee changed its view about the amount of equity capital which banks had to issue. It relaxed that so that banks would find it easier to keep lending to businesses that were under pressure and required more lending. Actions of the prudential regulation authority are ones that almost by definition we as outsiders don't get to see. And there were no obvious bank failures during that period. So that is not something that I have to contribute on, but it's become a major part of the work of the Bank of England. If I could just illustrate with one number: when I left the Bank of England, just before I left, before we were once again responsible for regulating banks, there were fewer than 2,000 people working at the Bank of England, primarily on monetary policy and also on the financial policy committee was up and running at that point. Today it's over 5,000 people, more than two and a half times as large, which shows the sheer burden of work which has been created by adding the regulatory responsibilities to the bank and of course that adds enormously to the workload of the governor himself.
Thank you. To now move closer towards the meat of your evidence today, I'm going to ask you to explain some things about monetary policy. Firstly, could you do your best to give us a brief overview of what it is, monetary policy? What should we understand by that term?
Well, it's really all about changing the interest rate which the Bank of England sets. But I'll come back to that in a minute. The idea really is that in the economy there is a certain amount of total willingness to spend. It's called aggregate demand. And there's the value of the ability of the economy to produce potential supply valued at the desired price level given by the inflation target. Ideally, you want these two things to be pretty equally balanced. In that situation, there's no upward pressure or downward pressure on inflation. Now, occasionally things change. Either people become very optimistic and decide to spend more or pessimistic and decide to spend less. And in those two situations, what the Bank of England can do is to try either to slow down the speed of spending or to accelerate it. To speed up spending, then the idea is you cut interest rates in the economy. And to slow it down, you raise interest rates. How does the bank do that? The bank controls one interest rate only which is the interest rate at which it lends to or pays interest on deposits which the commercial banks hold with the Bank of England. So very large amounts of bank reserves are held by the Bank of England but they belong to the commercial banks. We are the bank, we have the bank account for the commercial banks. So if an individual deposits their money at a commercial bank, similarly a commercial bank will deposit its money at the Bank of England.
And if that interest rate changes and the Bank of England announces that, which is called bank rate, if that changes then the commercial banks know that if they wish to, if bank rate for example goes up, if they want to carry on lending to the private sector then they really need to charge the private sector a bit more in order to compensate for the interest rate that they're going to be having to pay to obtain money, either from the Bank of England or indeed from other providers in the money markets in London, hedge funds and others. So bank rate does lead to a pretty much automatic pass through to very short-term interest rates in the economy. Of course, mortgage rates and longer-term rates which are charged by banks, if a bank makes a loan for say five or 10 years, how do they decide what that rate should be? Well, they have to look not just at bank rate, but where they think bank rate will go over the next 5 or 10 years. And that is reflected in the curve in financial markets where people out there are lending and borrowing money at 5 years or seven years or three years and you can see in those markets where people believe bank rate will go. Of course, when banks lend on mortgages or commercial property or even more so when they're lending to business ventures, they won't want to lend just at bank rate or where they think bank rate will go. They want to add a risk premium to that to reflect the riskiness of the loan that they're making. So that matters too, but that's a factor which the commercial banks have to decide for themselves.
Could you just explain what you mean by risk premium please? So if for example you said to me that you were starting a successful new business, you decided to abandon this inquiry, you had a great idea for a new business and you were going to start next week and you didn't want money for very long, just for 3 months. I wouldn't want to be willing to lend money to you just at bank rate over the next 3 months.
I'd say well, sounds a pretty good idea. I can't be sure. There's some risk you won't be able to repay the money. So, I'm going to charge you a bit more interest so that as you keep repaying it, I'm being compensated for the risk that I'm taking. And the whole spectrum of interest rates in the economy will reflect people's judgments about how safe it is to lend to various people.
And there's no point taking a risk if there's no potential reward.
How is monetary policy, in as simple terms as is possible, different to fiscal policy?
So monetary policy operates really through both the interest rates which borrowers and lenders face in the economy but also directly through the amount of money in the economy. And the amount of money in the economy really comprises two parts. Some part is just the amount of banknotes that exist out there that people hold. That's only about 5% of the total broad money supply. That is the money held by businesses, families, individuals right across the economy. People who go out and spend.
So the pound coins, the five pound notes, the 50 notes, all of that together comprises only 5% of what you're terming broad money in the economy. And the rest is primarily bank deposits.
So you and I have bank deposits with our commercial bank. We can make payments out of that. It's accepted as a means of payment. That's the other 95% of money in the economy. Now when interest rates go up and up or down, that leads to banks being willing to either lend a bit less if interest rates have gone up. People don't want to borrow as much. So the amount of lending by banks to borrowers goes down.
And the reason presumably people don't want to borrow as much when interest rates are high is because there's more risk to it. They have to pay more back.
And when interest rates go down, it's cheaper to borrow. If the prospect for borrowing, whether it's to buy some equipment for a business or whether it's to buy a new television set at home, it seems more attractive because the cost of paying for it has gone down. In that way you can affect spending directly. But what also happens is that the amount of money in the economy, 95% of which is reflecting bank deposits, is affected by the amount of lending that banks do because most of the lending that banks do comprises the assets of the banking system. The loans that they have made are their claims on other people. It's their assets. When they make a loan to someone, so to a business, if I make a loan to you, then I'm going to open a bank account for you with my bank and I'll credit you with the amount of the loan. That increases your bank account, your bank deposit. So, when lending changes, bank deposits go up and down as well.
So, I would take on debt perhaps.
You would take on debt as a liability to you. To me as the bank, it's my asset. Your asset is the bank deposit which I've created for you.
So that's the money I've gone and put in the bank and that the bank says we're holding this for you. It's available to you when you want it.
Yep. And you can spend it whenever you want it. And that is a liability to me. It's your asset and my liability. And that affects the amount of money in the economy directly. Now why does this matter? Easier to explain that in terms of quantitative easing which we can come on to.
But when you change bank rate which has been the normal method by which central banks influence monetary policy, they do so in order to either speed up or slow down the amount of spending by the private sector.
And is it right for us to understand fiscal policy as decisions made by the government on public spending?
Yes. So fiscal policy is decided by the central government and it's done by direct transfers of income essentially. I mean the government can spend directly itself as it would say through NHS or through defense or some other form of spending directly by government.
Or it could be transfers of income in which it would either lower taxes or raise taxes or say to people in this context of the furlough scheme, we will transfer money to you the employer. So you can reimburse your employees even though they're not turning up to work because we don't want to break that relationship between the employer and the employee because we think that the break is purely temporary.
The reason I'm asking really is that your evidence today is going to focus on monetary policy. And so to draw a distinction in our minds between monetary policy on the one hand and fiscal policy on the other. The inquiry understands that they largely operate separately and should be thought of separately but I think it's right to say that it's important for one to be aware of the other.
Absolutely. And that is always true whether inside the pandemic period or outside it. So each responsibility, the fiscal authority the treasury and the monetary authority of the Bank of England take their own decisions using their own well-defined monetary and fiscal instruments. But in order to set their, make their decisions they need to take into account what the others are doing. It became, you know, trickier during COVID because in normal times the fiscal authority sets its budget once a year and the monetary policy committee says okay that's what the government's doing in fiscal policy. We will meet once a month or every six weeks and we will set monetary policy in the light of the fiscal policy that's been set.
Which is relatively constant.
Yeah. Only changes once a year. Now clearly during COVID...
For one moment please. I can see that the screen has gone blank.
Sorry. Don't worry. I just dropped something.
Thank you, my lady.
I've done it before.
I'm sorry. Lock in. I interrupt. Did you...
We were talking about the separate responsibilities but it was vital that each authority understands what the other's doing.
And that fiscal policy during the pandemic was relatively inconstant compared to how it is usually.
Yes, exactly. Fiscal decisions were being taken understandably, if not daily but certainly they changed at regular intervals. That required obviously close cooperation, perhaps cooperation is the wrong word, but information sharing between the chancellor and the treasury and the governor and the bank. And as far as one can tell, that worked extremely well.
The next large concept is inflation. Broadly, what is inflation and why does it matter to individuals and businesses on a daily basis?
Inflation is a rise in the price of goods and services which we all face from day to day. Things don't all go up at the same rate, but on average if they're going up at a rapid rate, you can tell that pretty easily. And all the evidence we have is inflation is pretty unpopular.
Love it, loathe it, or enjoy it in moderation.
No. Why is the inflation target 2% rather than zero? Well, there's nothing magic about the figure of two, but there are two good reasons for thinking of 2% as being a good target, and it's one that's been chosen by almost all industrialized countries around the world. The central, well, the Office for National Statistics and statistical authorities around the world do their very best to measure the rise in prices of goods and services month by month. And they go into shops and supermarkets and measure the price. The difficulty is that quite often the quality of what you're buying improves from year to year. This is particularly true in the case of durable goods like motor cars or computers. And the ONS and others do their best to try and capture that, but they can't capture it all. And most of the studies that have taken place would suggest that at least 1%, maybe 1 to 1.5% a year of measured inflation actually corresponds to a genuine improvement in the quality of those goods and services. So a measured 2% inflation may correspond to a real inflation rate of between a half and 1%. If you're going to make monetary policy work, it's quite important and we spent much of the time in the bank doing this, to explaining to people what we were doing. The idea of explaining to people we're aiming at 1.73% inflation clearly doesn't make any sense. 2% is good enough provided you stick to it. You can explain it and you can try to meet it and it provides a very good benchmark by which whenever we went to House of Commons to a select committee and were grilled on why was inflation different from your target, the benchmark was there that we had to explain why it was above or below 2%. And I think therefore having a very clear numerical target for inflation helps a great deal. It said this is what we're trying to achieve. We never hit it exactly spot on although in the 25 years after it was introduced inflation pretty much was an average of two or 2.1%. So I think it's just the right target to hit. But of course there is nothing specially magic about two rather than 1.6 or 2.4. But there is something seriously better about two than say four because the people who advocate allowing the inflation target to go up tend to do so only when inflation happens to be above the target and it's convenient then to say well perhaps we don't worry about that, we'll let it go up.
Whatever the target is, what are the downsides to inflation being above it? Can you help us with some practical examples?
Well, I think it's quite tricky for inflation just to, I mean take suppose that the government said well we're going to, it's a bit of a hassle to get down to 2%. You know, it means maybe unemployment stays a bit higher for longer. So, let's just accept four. Well, then people notice, okay, it's going to be four, right? So, they then start to say, well, in that case, we need a higher wage increase this year. And people selling things in shops or in businesses say...
And presumably you need a higher wage increase because the goods on the shelf cost more than they did last year.
But once you start to go up like that, where's it going to end? And people may say to themselves, hm, if they were quite keen to go to four from two, you know, maybe at some point could go up further and you can quite rapidly get into a situation where inflation starts to accelerate away. That's really what happened in the 1970s, late 60s right through the 1970s. So actually being serious about the inflation target and trying to meet it is very important because once inflation starts to rise then it becomes very difficult to know what is the right price or what is the right wage that I should be paid because you start to see that people who get a wage increase in June as opposed to November, you know, there's quite big jumps in their relative position and it becomes much harder for people to judge what is the right price or wage to pay for something. There is no benefit to allowing inflation to rise without limit.
What are the downsides of inflation being below target?
If inflation goes too far below target, then the risk is that what it's reflecting is that you're moving into a depression. Not just a recession where output falls, but a depression where it falls substantially and stays there for a long while. The 1930s. And that can be self-fulfilling because if prices start to fall, then businesses that have borrowed money, say they borrowed so many pounds, thinking that they can sell their products for an appropriate price in pounds. If the value of that pound is, if inflation is negative and you start to get into negative territory then the real burden of that debt in terms of the goods that you've got to sell becomes bigger and bigger. So if I bought a microwave for £100 planning to sell it for 120 but now it's actually worth 90, that's a problem for me.
And then you can't repay your debt and you may have to sell something else.
So you contract your production even further and you get into a self-fulfilling downward spiral. And that would be, you know, very damaging. So stability of the price level, price stability is the phrase that central banks use all the time. Keeping inflation close to the target has enormous value.
You have explained how bank rate works. Comparing it with quantitative easing which we will come on to next. What are the relative strengths of using bank rate to influence the economy?
Well, for a long while, bank rate has been the favored method chosen. It's a relatively recent idea that we should always and only use bank rate. Quantitative easing is a phrase that was introduced during the financial crisis.
I'll explain quantitative easing in a minute. The financial crisis by which crisis 2007 to 2009.
2008-9 when the banking system in the western world basically collapsed.
The phrase it was introduced then but essentially it's where the central bank buys government bonds. We can come back to how that works in a minute but that was something that central banks have always done and in the 1980s it was called underfunding. The government was not selling as much debt to the private sector as it needed to finance its spending. The central bank was buying it instead. And so it's not something we should think of as necessarily an instrument introduced for the first time in the financial crisis in 2008. It had existed before.
And the strength of bank rate as compared with quantitative easing.
Well, quantitative easing is directly affecting the amount of money in the economy. Bank rate is directly affecting the interest rates which lenders charge either to people to borrow from them or to deposit money with them. But they have the very similar effect. What happens is they both of these channels feed through to affect spending. So if interest rates go up, spending slows down. If interest rates go down, spending speeds up. And quantitative easing, the central bank buys typically from financial institutions like pension funds, hedge funds, insurance companies, and others buys government bonds. When they do that, they give that institution a check for the amount of money they're paying to buy the government bonds. Now...
Could I just pause you there one moment?
Because I think we're now moving smoothly, if I may say so, into quantitative easing.
Government bonds is an important concept within quantitative easing. Could you unpack that first before you go on to explain the way that it operates?
So, the government finances its own expenditure in two ways. One is by taxes, raising taxes directly, income tax, VAT, many other taxes, which we've learned to hear about, if not love, in recent weeks. But it also can finance itself by borrowing. And by borrowing, it issues bonds. It sells bonds to the private sector, both in Britain and overseas. And these bonds offer the buyer an interest rate every year until the bond matures which can be either one year down the road or 30 years down the road or in some cases longer. So the government can borrow money and it issues those bonds and they're typically known as gilts because when they were first issued they were literally gilt-edged around the edge. Sadly, we can't afford now to have our bonds edged in gold. But they were gilt-edged bonds, gilt government bonds.
Could you provide us with a brief explanation of how quantitative easing affects the real economy? And if you could, could you please explain some of the channels through which it operates, particularly in so far as they were relevant during the pandemic?
Yes. So quantitative easing is where the Bank of England buys government bonds from the private sector, hedge funds, pension funds, insurance companies and others. When it does that, it has to pay those institutions for the bonds which they give the Bank of England. And it does that in the form of a check, typically a digital check which the institutions can then deposit into their bank accounts. So if a pension fund sold gilts to the Bank of England, they would be able to deposit a check drawn on the Bank of England into their bank account, say in Lloyds. That means their bank deposit will go up. Lloyds would then take that check back to the Bank of England and say, 'Here's a check drawn on you, the Bank of England. I'm going to deposit into my bank account with you.' So Lloyds' bank reserves with the Bank of England will also go up.
So Lloyds Bank increases the amount of money in its own bank accounts and then in the same pipeline way we discussed earlier, it deposits further money with the Bank of England. And so the Bank of England's balance sheet, its deposits go up as well.
Yes. So you've got the increase in the bank deposits of the private sector that sold the bonds to the Bank of England. That means that total bank deposits go up. Broad money supply goes up one for one with the scale of the action for quantitative easing.
And you've already explained the amount of money in the economy that is comprised of bank deposits, 95%.
And so it's much more impactful one might think than simply printing money in physical form.
Yeah. Though it is printing money in electronic form, it's adding to the deposits, the bank account deposits one for one with the scale of QE. Now that's how it works in practice. So what's the impact of that?
So the institutions, pension funds, hedge funds and others that find that they've sold bonds to the Bank of England, they got much bigger bank accounts now. They don't really want to hold a lot of extra money in their bank account. So what are they going to do? Well, they'll buy other things. They're likely to buy some more government bonds to replenish their holdings of government bonds. In turn, that's going to push up the price of those government bonds and a rise in the price of a government bond is going to push down the effective interest rate or yield on that bond. So...
Just pause for one moment. The reason I think that the price will go up is because there is greater demand or competition for the same asset.
So, we price it at a higher level. They'll be going into the market to buy government bonds which have now become more prized than they were before. And we don't need to go into the mechanism of this because it can be quite complicated. So suffice to say the assumption is if the price of a bond rises the yield or its interest rate falls.
That means that people borrowing at longer-term interest rates will find it cheaper to borrow.
So they're more inclined to borrow long-term to finance investment. Investment may go up. Other kinds of spending may go up. But the institutions may not buy government bonds. They might buy equities. If they do that, correspondingly the price of the equity goes up and then the yield on the equity or the cost of capital goes down. It's cheaper then for companies to issue more equity to finance investment. So they may invest more. Or the institutions might buy overseas assets which would push down the value of sterling make exports a little more competitive. Our export demand may go up. But in exactly the same way that boost in the total amount of money in the economy is likely to be expansionary. And if you do the opposite which is what the bank is doing at present.
What do you mean expansionary?
More spending. And if there's more spending but no change in the supply in the economy that's likely to push inflation up. Now that may be a good thing to do if the starting point is where the amount of demand in the economy has fallen below the potential supply.
Mhm. So if you started in a situation where people suddenly became very pessimistic about the future and didn't want to spend then it may make sense either to cut bank rate or to do quantitative easing in order to encourage people to spend more. Could you briefly explain the way in which quantitative easing can impact on addressing market dysfunction perhaps with an example from your time as governor?
Well, I don't think in my time we ever did QE in order to deal with market dysfunction. This clearly was an issue that came up in March 2020. It may be helpful to discuss it precisely in those circumstances. Yes, in March 2020, some people said the government bond markets were becoming dysfunctional. I think what they meant by that was that prices were moving very rapidly by large amounts, unusually large amounts. I don't regard that as remotely surprising. In March 2020, the world learned that we were in the middle of a global pandemic. That was bound to lead to very big changes in prices of financial assets reflecting relative profitability of different countries, different businesses and so on. No one really knew what the effect of COVID was going to be on individual businesses or indeed individual governments. And in that situation, excuse me, there's so much uncertainty that there's a price discovery process. How do we know what's the right price to pay for a government bond? Well, initially you're very cautious. So, you try not to do too much buying and selling. You stay out of it for the moment. Activity falls. You watch what other people are willing to pay. That tells you something. And gradually over a period of weeks, this process of toing and froing establishes a new price for government bonds. Indeed, a price for many other things in the economy. Now if that volatility is thought to be, you know, too damaging and I'm not sure that I would have concluded that but if you do conclude that one way of going into that market is to say okay we better go in and buy these bonds ourselves to establish a floor price give people confidence that there is a value in these bonds.
And so into the market and so somebody wondering whether to buy those government bonds would see the Bank of England buying them at price X and think the price is probably around X then.
Yes, exactly. Now, of course, the consequence of that and that was the main justification provided for much of the QE in March 2020. But the logic of the argument is that once that dysfunction disappeared, which it had done within two or three months, you would then reverse those purchases of government bonds and unwind your holdings.
I don't want to unduly cut you off. We very much will come to that aspect of your evidence. I want to first reverse slightly and set the scene for the important principles in decision-making that the bank has to be aware of when there is a large-scale economic shock. Presumably it's crucial for the bank as well as other economic actors to accurately assess both the nature and the scale of the shock that is being faced. Could you help us with why it is important if you agree that it is to understand the nature and separately the scale of the shock?
I think this is the main job of the monetary policy committee. The broad principles about keeping demand in line with supply are very clear. The real challenge is to work out what's happened to both demand and supply and so that you can decide which action is appropriate to bring them back into balance. And that requires monitoring both demand and supply in the economy. Most of the data and statistics that we have relate to demand. Fewer data refer to supply. But the challenge always is to think about both demand and supply. And indeed I would say even more importantly to ask the question what is going on here to really understand the nature of the events that have occurred since the last decision was taken on interest rates or quantitative easing. What has happened since and what do we need to do now? And really to understand, create a narrative of what is happening in the economy.
And presumably on the basis of what you've just said, the really crucial thing to do is whatever data you have or don't have to conceive of it in the right way to make an assessment of the data, interpret it and calibrate a response accordingly.
Absolutely. It's not a case and I know we've heard other evidence in relation to science in this inquiry. It's not a case of follow the numbers.
Is it more a case of make an accurate assessment on the basis of the numbers you have?
That is absolutely crucial. It's making a good judgment of what the numbers mean. And I think the way I used to describe it is every three months the Bank of England would produce a new report which was a narrative about what is going on in the economy, what we'd learned since last time. Have we changed our view on any element of the interpretation? But that judgment is about the nature and the scale of the difference in the balance between demand and supply.
Do you agree in principle that this shock was one that was particularly unfamiliar in both nature and scale?
Oh, absolutely unprecedented.
And so with that in mind, can we examine some of the decisions taken in March 2020, June, and then November 2020. In March 2020, actions were taken in relation to monetary policy in relation to both the bank rate and asset purchases or quantitative easing. In respect of the bank rate, on the 11th of March, the monetary policy committee voted to reduce the bank rate from 0.75 to 0.25%. And then again as things became somewhat clearer on the 19th of March they reduced it from 0.25 to 0.1%. The inquiry understands that this is termed as the effective lower bound in respect of bank rate, i.e. as close to zero as one can get. Could you explain for us why in your view the bank would take an approach of reducing bank rates before it considers other monetary policy interventions?
Well, of course, the change in bank rate was followed fairly quickly by a significant degree of quantitative easing.
Yes. Why, I mean I suppose it was just very easy for them to decide as a committee to go down with bank rate. It may be that the bank had wanted to talk to the treasury to reaffirm the arrangements for quantitative easing which you know there was a guarantee from the treasury to the bank that may have been just an operational issue but I regard these things as essentially having been taken together in economic terms.
And I think what surprised me was that the judgment of the monetary policy committee at the time as revealed in the minutes was that they felt the impact of COVID would be a much bigger shock to downward shock to demand than to supply. I found that puzzling at the time and I find it even more puzzling today. And I think there's been a recognition around the world that maybe central banks jumped too quickly to the conclusion that trying to boost aggregate demand was the right response. I understand that central banks felt that in that situation there was enormous pressure on them to do something. They were a public body. This was a major economic shock. They had to do something. The trouble is that it doesn't follow that if there is bad news that every bit of bad news justifies a monetary policy response. There may be other things or in this case it was for the government to take the appropriate actions through for example the furlough scheme and other schemes and the bank did contribute with the term funding scheme. All of these things made sense but a general monetary policy easing I think was not easy to understand either at the time or subsequently.
We know Lord King that in March of 2020 the bank undertook 200 billion pounds further of asset purchases, quantitative easing. And that's one of the measures I think you're referring to alongside the reductions in bank rate as being under the broad umbrella monetary easing.
On one view the bank viewed their asset purchases and then monetary policy interventions in March 2020 as being designed above all else to step in and correct market dysfunction. From your understanding of the contemporaneous material, I'd like to ask you two questions. Firstly, does that motivation stand up to scrutiny? Was it actually the motivation at the time? And secondly, was it the correct motivation?
Well, I think it's understandable that, you know, I wouldn't have wanted to do it myself, but I think given the market dysfunction as it was perceived and given what other central banks were doing, I think it's understandable that the Bank of England decided, well, look, let's do it. Be on the safe side and let's do it. The trouble is it should have been unwound in the summer because the logic behind doing it for the reasons of market dysfunction would have implied unwinding it later in the summer. There was another reason given as I mentioned earlier in the minutes of the MPC which was a judgment that even leaving aside the market dysfunction argument, the impact of COVID was going to have a bigger effect on demand than on supply. I think that was a misjudgment and I certainly think that contributed to doing QE on a scale which did contribute to higher inflation further down the road. And I think it goes to the heart of what I said earlier on about trying to understand what is going on here. Forget economist jargon about demand shocks and supply shocks. What is actually happening on the ground? And of course, many of the data that came in would normally have been interpreted in terms of weak demand. You know, sales in shops down, theater ticket sales down. But the reason they were down was not because people had become pessimistic and didn't want to spend. It's because they were banned from going to theaters or shops or had decided for themselves that it wasn't safe to do so or the social distancing made it a pretty unpleasant experience. So the big impact of COVID was really on the supply side and it was the supply side measures that were taken by the government to cope with COVID-19 that generated that shock that made it impossible for people to spend. It wasn't that they were pessimistic and what it meant was that once those restrictions were going to be released then there was going to be pent-up demand which would spring back which is exactly what happened.
On one view the public health restrictions introduced affected the way that people could behave. So limiting supply in that way. On another view, one might say that with the prospect of an infectious disease that was deadly for many, many people may have voluntarily chosen to restrict their activity.
Does the argument that this was primarily a shock to supply, is it undermined by the notion of what people might voluntarily have done?
No, not at all. COVID itself was the shock and I think rather than thinking about supply and demand it must just be better what did people do and either because they were told that they couldn't do certain things or because they made their own decisions about what to do, that meant that this made it impossible for people, chose, you know, we were not going to contribute to production activity in the economy, we're not going to go to work. And this was not a reduction in spending that resulted from people's unwillingness to spend because they were pessimistic. It resulted from the nature of COVID itself. Once that had gone away, then there was no reason to suppose that their willingness to spend wouldn't just snap back again.
But judging the bank's actions in foresight rather than hindsight, was any of that knowable in March 2020?
I think it was. I mean I think a number of people commented about the fact that, you know, what the bank had done was to lead to a very significant increase in the broad money supply. They weren't alone in doing this. I mean the Federal Reserve were absolutely in the same boat. So I don't think this is something where I would put, you know, blame at the door of the Bank of England. I think in many ways it's blame at the door of the academic community which wanted to use traditional models to think about this. But the fact is the reason why spending fell, the reason why, you know, retailers couldn't sell, restaurants couldn't sell their meals was because of the nature of COVID not because there was some lack of general willingness to spend for which monetary policy expansion would be the appropriate response. You know, if you start off with a balance between demand and supply, supply goes down, the last thing you want to do is to boost demand. That's going to give you inflation.
COVID in many ways was almost a textbook example of too much money chasing too few goods. COVID reduced the number of goods. The bank could increase the amount of money. And so I think I understand from that that your view, and perhaps it's a widely accepted view, is that in undertaking monetary easing, particularly in the form of additional quantitative easing, there was a risk at some point that there would be significantly higher inflation than was desirable.
That was a view that a minority of economists had. I was in that minority. I think there was in the United States, which tends to have a disproportionate influence on economic debate, there was a group of people who became known as team transitory. Any rise in inflation through COVID affecting supply chains and so on would be transitory and that meant there was no need to raise interest rates. Inflation would go away of its own accord. I didn't accept that and there are very distinguished economists in the states who didn't accept it but nevertheless it was I would say a majority view in the academic profession and I think it's quite hard to blame central banks for not standing out from that, you know, they were influenced by it. But I think with the benefit of hindsight many people would now say well team transitory got it wrong. We had to raise interest rates from close to zero to around 5%. And even 5 years on, inflation is still above target. So the idea that it went away of its own accord simply wasn't true.
On the point of perhaps balancing risks in monetary policy decisions, particularly acute risks at a time of high uncertainty and high economic turmoil. Could I ask you to have a look at and then comment on the view of James Smith who has produced an expert report for the inquiry in this module. It's INQ 0000588133. It's paragraph 29 on page 11.
So, I see the paragraph in front of me.
Yes. I'm afraid this isn't the one I...
Uh, yes. This is the one that's on the page.
This paragraph for context for you comes after a graph that James Smith produced, a graph of VIX, which I think is a graph that maybe in crude terms demonstrates, as you can see on the screen there, market volatility. I don't necessarily want to go into the technical details of this graph, but I'd like to put to you the narrative of paragraph 29, please.
And it's this. As shown in figure four, which is the figure we've just looked at, measures of financial market volatility reached very extreme levels, even higher than during the financial crisis of 2008, indicating large falls in asset prices. But after the first few months of the pandemic, there was a significant easing in financial conditions. It is striking that during this period, the huge economic hit and the big swings in asset prices did not lead to the collapse of financial institutions or financial infrastructure. As discussed below, this was by no means assured before the crisis with the Bank of England repeatedly warning about the risks in the financial system and low levels of liquidity since the financial crisis. And the question I want to ask really is was the risk in not undertaking quantitative easing far too great to contemplate regardless of the risk of inflation?
No, I don't think that at all. I think that if one was concerned about low levels of liquidity, it would have been better to have introduced, as has happened before, a scheme to provide liquidity to those institutions that were at risk and then to withdraw that liquidity when conditions return more to normal. The problem with doing quantitative easing is that it did a lot more than that. It actually boosted aggregate money supply and that did create a bigger risk of inflation. So there were alternatives to dealing with it. But I think this paragraph demonstrates why I said it's so important to think about what is going on here. In the financial crisis 2008-9, it's true that the volatility in asset prices was less in some periods than it was in March 2020. But the risk to financial institutions, banks in particular, was much greater in 2008 than it was in 2020. By 2020, banks were better capitalized. They actually had quite a lot of liquidity in the form of these bank deposits with the Bank of England. They weren't facing the risks that we saw in 2008. So rather than thinking about these abstract concepts like sort of financial risks or demand or supply, I think it is very important and this is what central banks really have to do is to get to grips with what is actually happening in the economy. If there were concerns about a range of financial institutions in March 2020 then actually lending directly to them through a liquidity scheme would have directed support where it was needed. But as this paragraph says, after the first few months of the pandemic there was a significant easing in financial conditions. So the need for support was reduced at that point but the support itself was not withdrawn.
So we'll move to that in just one moment. I just want to end our discussion of March 2020 with trying to understand how high you pitch the criticism effectively of the actions taken not just by the bank but by central banks around the developed world. Is it fair to characterize your view as being somewhat critical of the actions of the bank in March 2020, but had those actions been unwound quickly thereafter there wouldn't be as much space between your argument and the argument of others?
Yeah. And I think if they had been unwound say in the summer then I would have no criticism. I think it's a fairly, you know, I think you can argue either way whether it was sensible to do QE March 2020, but if it had been withdrawn, it would have been withdrawn for the right reasons, and then I would have had no criticism.
And presumably there's always a range of reasonable interpretations, reasonable responses, and it's for the committee of the day to make those decisions.
Yeah. And I wasn't present. I don't know how concerned I would have been but I don't think I, you know, it's the with if I had been concerned about financial disruption I would have unwound it in the summer where I would have disagreed is the view, excuse me, that COVID was having a bigger effect on demand than on supply.
I'm going to ask you next about June 2020 and then about November 2020. In June 2020, the bank undertook a further extension of quantitative easing of 100 billion pounds. Of course, the bank rate at this stage was already at 0.1%. So, there was little to be done in that regard. Before I ask you to give your view of whether or not that was the appropriate action to take, could you help us with your understanding of why the bank undertook that extra quantitative easing at the time?
I think we'll have to ask them to explain why they decided to add to it. Then I suppose my concern about a lot of this is that whenever events changed and there seemed to be a problem, the bank felt it had to step in and do something. And all it could do really in general terms was yet more quantitative easing. And as I said, I think it is very important. I think many central banks since the financial crisis have fallen into the trap of accepting the description of being the only game in town. And I think what COVID revealed was they're not the only game in town. The government is another even more important game in town.
And this chimes, I think, with the recognition that monetary policy and fiscal policy need to be aware of each other.
Yes. Exactly. So when there are challenges that come up and you know it was a very difficult set of circumstances there's no question about it just takes enormous willpower to say I know there are problems I know that you feel something should be done actually monetary policy is not the right thing to do because it will threaten inflation down the road we have to find a different way of dealing with that requires a great deal of strength and there are enormous pressures on the governor in particular to say you know you've got to do something and I think it's important to be able to resist that.
And so in June 2020 we've tried to work out exactly how strong your view was in relation to March 2020. And you've explained that if it were unwound in the summer, you wouldn't have a particularly strong view. But I think your view does strengthen.
Yes, it does from the June onwards. Yes.
Because it was creating a risk to inflation.
The risk to inflation was present in March 2020, but I think the balance was perhaps finer in your mind then.
Well, I think that if you undo the boost to the money supply in March by withdrawing that increase in money supply in June, you're unlikely to have caused any long run impact on inflation.
What were the benefits of undertaking further quantitative easing in June 2020?
Well, I think it reflects the view as shown in the minutes that people on the committee felt that they were more worried about the downside risk to demand than they were. They interpreted events as saying this is a big fall in demand, bigger than supply. And I'm puzzled by that. And I think that it was always clear that once you remove the restrictions and once there was a vaccine and once COVID started to become less of a problem that we would return to where we had been and if people have been unable to spend for a period then actually there'd be pent up spending power which would then come out which would require monetary policy to respond to that. So I think going into a period where you felt we're gradually moving towards a period where COVID will be less of a problem. It was strange to keep interest rates at rock bottom and yet to do more quantitative easing.
I think your view is that with more broad money in the economy inflation is very likely. Is it your view that it's inevitable or not?
No, I don't think it's inevitable. And I don't think there's a mechanical link between a change in broad money and inflation. But when you see the amount of broad money in the economy rising by record rates and it was rising, you know, well into double digit rates by the end of 2020, peaking 15% in early 2021. You ought to be asking yourself the question, what is going on here? How can I afford to ignore that? Now there may be reasons and no doubt in the 1980s there were good reasons at various times to say these broad money figures are giving us a distorted picture of the underlying degree of inflationary pressure perhaps because of changes in financial structure or regulation that didn't seem any obvious explanation like that. But what the bank should have done at that point was certainly to have drawn attention to it and said, 'Well, we note that it's growing very rapidly, but for the following reasons, we've decided to ignore it.' That wasn't done. And I think this goes back to the question of how you calibrate the amount of quantitative easing. To my mind the easiest step in calibrating it is to say if we do quantitative easing of say 100 billion then this is equivalent to an x% increase in broad money supply can we justify that in terms of what's going on in the economy and maybe you can maybe you can't but it's a way of calibrating it. It was very difficult for people outside all central banks not just the Bank of England. And my critique here is not of the Bank of England as such. It's of all central banks in the industrialized world that they just ignored what was happening to broad money and didn't make any attempt to say, 'Well, we take note of it. We're not going to respond to it for the following reason.' I think you have to have an explanation as to why you're not going to respond to it when the increases are so large.
Thank you. My lady, I don't know if now would be an appropriate moment to have the mid-morning break.
Certainly, I suspect Lord King needs to have some glass of water or two. I hope your voice survives, Lord King. We know that you have other commitments, so the team will make sure you get away when you have to.
Thank you very much. I shall break now for until... I'll break for 15 minutes. So, come back at... 25 past. Yeah. Thank you.
Thank you.
Please, my lady, can you see us and can you hear us?
I can. Thank you, Mr. Hudson.
Lord King, before we get back to the questioning, just one matter of correction. I don't need it to be brought up, but you have alerted the inquiry to a typographical error in your witness statement. Your witness statement is INQ 0000656310 page 3 paragraph 5. You wrote this. Doctors and politicians share one problem in common. Patients and voters want to believe that their doctors and political leaders know what they're doing. And you meant doctors and political leaders.
Returning to substance of the questions then and November 2020 and the decision by the Bank of England to engage in a further 150 billion pounds of quantitative easing. We've effectively rated your view as not so strong on March, relatively strong on June. Is your view very strong that the November extension was the wrong thing to do?
I think the same as in June that I wouldn't have, I'm not persuaded by the arguments that were given for it. It's almost as if there was a view that there had to be some further monetary support of the economy if we were to come out of COVID and see economic growth again. And as I've explained, I think that the real issues which were real and serious were much more on the supply side which were government issues rather than on the side of the bank. And I understand the pressures that would have been brought to bear on the bank. You know, you must do something to help us. You must do something. But there are times when you know you have to say well there's no intellectual case for doing something on monetary policy we will support you in other areas and the bank did a lot of work in other areas different schemes to lend to businesses for short periods for longer periods to boost liquidity. All of these things were sensible, but it was the broad question of keeping interest rates very low for so long and doing quantitative easing, not unwinding the March, but doing more in June and November. These things I think reflected what I would describe as an unfortunate judgment that the impact on demand as such was much greater than the impact on supply. And I understand why that came about. I think it was a judgment. I mean, central banks speak to each other. Everyone would have been in the same position. What can we do to help? And it's very hard to stand out against that.
Just one point of clarification. When you referred to pressure there, I think it's plain to those of us in the hearing room, but you didn't mean any improper pressure or political interference.
No, certainly not improper pressure. No, I just think that and not from senior politicians. I think even from within the bank or from officials in the treasury, there would have been this view. We've just got to do everything we can. But there's no point doing everything we can if one of the things that you do has an adverse consequence of higher inflation, but doesn't actually help with any of the issues that you're facing. You do require very clear intellectual analysis of why you're doing what you're doing and I think that wasn't as clear as it should have been and I've explained why in terms of the failure to take into account the growth of broad money but why on earth there was in general a wish to boost aggregate demand to deal with this situation. If I can refer in my evidence I refer to a comment which Professor Summers made in the United States, the former Treasury Secretary, he had pointed out long before that the Biden fiscal injections were way over the top in terms of what was needed given any apparent disparity between aggregate demand and aggregate supply. The so-called output gap where aggregate demand falls below aggregate supply which would require a boost to demand. As he pointed out this isn't rocket science this is sort of very basic stuff but I think in the wish to be willing to do something politicians and others got swept up in the idea that whatever you can think of doing we just do and that's a mistake you've got to think very carefully about what it is you're doing and why.
This is a very engaging intellectual difference of view and a difference of judgments that may have been made at the time. The inquiry is interested in getting to the bottom of what it can realistically look at as lessons to be learned for the future. The concrete steps of how could this be done better in future circumstances. I will come on to discuss data at a later point but I think your main point is that this is a problem of assessment of the existing data rather than having simply more data.
Could you help us at all with concrete steps that could be taken to improve this situation in your view?
Well, I think one very concrete one is that when central banks engage in quantitative easing, they provide an explanation in terms of the calibration of it. Why 100 billion, not 200 billion? How do they think about it? And I think one of the problems that central banks have had ever since the financial crisis is the inability to think about quantitative easing in terms of its initial impact on the amount of broad money in the economy. One can certainly debate how in particular circumstances a given increase in the amount of money in the economy will affect the economy. That's a matter for assessment and debate. Plenty of room for different opinions, but it's a way of calibrating, you know, why would you want to increase broad money by 7% or 15%. Some numbers that will help to provide an explanation. Nothing was really provided and I think that is one thing I would suggest. More to the point generally I think there has been, and again many central banks would deny this but I do think in the House of Lords report recently on the Bank of England talked about this that there's a it's easy to fall into group think in central banks you speak to each other you recruit the same kinds of people from the same kinds of graduate schools. They have the same way of thinking about things and it's quite important on policy committees to have at least one or two people who think about it in a different way with a from a different background. And it's too easy in the world of economics for people to assume that a certain way of thinking about things makes sense. I've always been impressed that in jury trials in court, no one is allowed to say, 'Oh god, it's him again turning up.' You stick to a narrative about what's happened in this particular case. What's going on here? And central banks are not so good at saying what is going on here. They like to put it into compartments or this is a demand shock or this is a supply shock. That's how we respond to it. There needs to be much better focus on what's going on here. And to do that, you need people whose natural instinct is to say, you know, what actually happened? What's happening to this business or that business? One of the most useful people on the monetary policy committee in my time was a non-economist who was prepared to ask the kind of questions that no economist was willing to ask because they didn't want to be shown up as not knowing the answer to it. And having that diverse range of opinions I think is very important. It doesn't determine the outcome but you need to have something which is not just the output of the standard economic view.
Thank you, Lord King. There are two final topics if we have time. The first is to look at the inflation that came in 2021. And there is a table I'd like to draw your attention to which has been provided to the inquiry by the United Kingdom Statistics Authority or the ONS. The reference number is INQ000065760 and there is a table at page 106 which deals with CPI and PPI and I'll ask you to unpack these concepts briefly if we can but in essence what this table shows is a reference period of March 2021 to January 2022. The publication of the statistics comes roughly a month after the period they relate to. We have chosen this period because the first uptick that can be seen in inflation in this period at least in respect of the consumer prices index is around April 2021 and we've ended on February the 16th 2022 because we know in February 2022 Russia invaded Ukraine and causation if I can put it that way becomes a little muddier. Firstly the consumer prices index that's the measure of inflation to which the bank's price stability objective of 2% is tied isn't it?
