Be honest with you, it is enormously frustrating because I think the evidence that we've had subsequent to the conflict breaking out bears this out. I was expecting that we would be able to be here this afternoon at the inflation target, and I think the evidence bears out that we would have been. We're not. And I think the overshoot is pretty much entirely due to events in the Gulf. And I'm afraid it is most likely that there will be some more to come because the UK has naturally a delayed pass-through, and the energy price cap tends to cause some delay to the pass-through. So that's the world we're in. It is highly, of course, uncertain. Indeed, I would go further than that and say it's highly unpredictable as to where this is going to go. Three things are really important in terms of thinking through that situation. One is how long is this conflict going to go on for? Two, how much damage has been done to the energy supply infrastructure and how long will that damage take to replace even once the conflict comes to an end? And then the third one, which is the one that obviously we are most focused on in terms of what we can do with monetary policy, is what are the likely second-round effects from that? We may come back later, but we are in what I would call a trade-off position, which is we've got inflation going to be higher than we expected it to be, activity lower. Nearly all our simulations suggest slower growth rather than a recession, but again, I caveat that with the highly unpredictable and uncertain point. And we are having to make judgments about not only the scale and duration of the inflation but also this key question: what is the context of the economy in which it's hitting and the degree of softness we're seeing in the economy. So that's the short run. The long run, I think, is in some ways, if you're looking at the overall economic situation, even more important actually. And it's this, and the UK is not unusual in this respect. So I'm not telling a particularly UK-specific story, but it's highly relevant. We've had slower growth in the UK now really for the last 15 to 17 years. And if you talk about potential growth, the supply side really shows up in lower productivity growth rather than lower labor supply growth. It's really a productivity story. Now, that makes a very big difference. We've done some very naive calculations and said, imagine you had the same roughly 2.5% potential growth that we had pre that period. Imagine we had exactly the same shocks. So we had COVID, we had Ukraine, we had this one. Imagine we had exactly the same fiscal policy. Where would we be today relative to where we are today? And the answer is I think we would be in a very different debate about policy, particularly fiscal policy, but it affects monetary policy as well because obviously it's a speed limit for us. So this growth story is really very important. Now, it's not unique, the UK is in a similar situation to many countries in this respect, but I think it begs a lot of questions around two things which I think are important drivers of growth in the longer run. One is trade, the openness of the economy. The other is technology, because I think ultimately technology is the ultimate driver of growth in the long run. And it is quite possible that, and we've seen this before in British history, that we've been between periods of what we tend to call general-purpose technology in innovation. So the period I was talking about in the past was a sort of ICT internet period. The question is what's going to be the next one? Most likely it's AI and robotics, but this question about the rate of growth in the economy and the impact of that is critical.
Very interesting. Thank you. Well, there's lots there we come back to, but let me hand over to Lord Burns for the next question.
Good afternoon. You've just mentioned the issue about the second-round effects of an increase in oil prices. In the past, I would say that the second-round effects have generally been substantial and often underestimated. And that's been particularly the case when the economy has been running hot, had an expansion of demand and also monetary growth. And the key policy judgment that you set out in your May report is that you think the present conditions with weak demand and a weak labor market may possibly lead to the second-round effects being smaller than has been the case in the past. Although if stretched out, I think your report goes on to say they could even be that much higher. Some commentators I notice are worried that the consequences of this approach is likely that policy tightening will be too late again as has often been in the past, as one waits to see the evidence unfold and by the time the evidence unfolds it's a bit too late. Does this worry you at all?
Yeah. So you're right. I agree with you. You can't wait for the hard evidence of second-round effects to be with you because it will be too late at that point if they are larger. So it is going to have to be a judgment. It always has to be a judgment. I would say two things about the current situation. One is going into this, we were seeing softening in the labor market. We were seeing something of an output gap opening up. We thought softening in the labor market. We saw it in the behavior of vacancies. We saw it in private sector wage settlements converging back down to a point where it looks reasonably consistent with the inflation target. Latest numbers do, I use, I do make the point about private sector advisedly. That was very deliberate to say that because there is a gap and there is a widening gap if anything between the private sector and the public sector. But private sector settlements which we tend to look at more because they obviously feed directly through into pricing. So there is that body of evidence and certainly when we go around the country, when I go around the country, and this was in commentary on things that happened last year such as the national insurance change, firms saying that they were having to take more of it on their margins rather than on prices. Now, the second thing I would say on this is that a little bit depends on where you start and different members of the MPC will have different views on this, but in my view we have already tightened for the reason that we were expected to cut rates this year pre the conflict. And I think that was reasonable, I was thinking perhaps one or two cuts this year and the market was pricing one or two cuts and that's off the table as a result of the consequence of the inflation consequence of the outbreak of the conflict. And the most obvious illustration of this is mortgage rates. So the two and five-year mortgage rates are up pretty much 1%. So there has been a tightening of financial conditions. So I put those two things together to sort of in a sense I hope help with answering your question which is I fully agree with you. You can't wait for the second-round effect. I think there is evidence of softening but I do think we actually have a bit of time not least because we have in effect tightened policy.
The report also you set out where the risks lie of doing too little and too much. And people are very interested in this question about the degree of flexibility that's built into the current remit. And sort of broad question, I mean do you think the amount of flexibility that you have within the remit is just right for the kinds of circumstances that we face? You know, the extent to which you, the judgment about how rapidly one seeks to bring the inflation rate back down to target.
Well, I think it is important to have that flexibility. Now, it's quite interesting. I made some remarks on this in a speech in Reykjavik last Friday. There are sort of two, oversimplifying a bit, there are two forms of remit that exist in this world. One is what we tend to call the dual mandate. The sort of thing the Federal Reserve has where there's a price stability part to it and there's an employment part to it and they sit on the same level. They're not weighted explicitly. That's a matter of judgment. And we of course only have the former at the sort of the top level. But then as you rightly say we have this language about what we tend to call the trade-off language which is as you say the speed at which we can bring inflation back to target when we face the sort of situation we face today. I think it may be because I'm more used to it but I think our version has merit. I think it isn't of course completely prescriptive. It leaves judgment, but I think it creates more of a framework for the decision-making than the dual mandate structure, which I just do think leaves it very open what the weights are on those two things. So, I think it has the benefit of causing us to need to be much more in a sense considered and explicit in terms of saying how we're actually using that language and how we're using that part of the remit and this is clearly a moment to do so. So at the moment I would say if it is the case that the second-round effects are going to be muted then this part of the remit will be critical to the response.
And a final question. You worry that I was looking at the three forecasts that you make and it seemed to me the three circumstances set out, the end result of this is going to be that for almost the whole of the 2020s we've going to have had an inflation rate above 2%. I'm trying not to say this personally, I'm not, this is at all personal, but do you think that this in any way, and in fact for really quite a large part of the time we will have turned out we've been above 3%, does this throw any doubts on this set of arrangements that we have?
Well, I'll take that in two parts. I think what it does illustrate is that you had a period obviously from the very early days of this regime in the pre-financial crisis period which was a period of very good conditions, the nice period as Mervyn King called it. And it hasn't been like that recently. Indeed arguably since the financial crisis, but certainly recently we've had a whole series of shocks. Some of them global, one or two of them not. And they've been mostly negative supply shocks which have pushed inflation up which are the harder ones to deal with obviously in a monetary policy framework. Now first of all I think the general answer to your question is that any framework has to deal with the more difficult conditions. I mean if it can't, it's no good if it can deal with times when life's easy but it can't deal with the harder conditions. So that has to be true. I don't think it's an argument for saying if you just raise the inflation target to 3% everything would be okay. I don't think that's the answer to that question. I think that would be a too simple an answer, a simplistic answer to it. But I think it does come back to this question that it puts us in the position where we have to focus more on how we manage the path back to target and of course ultimately get there because we've got to give the public confidence that the target is for real.
Thank you. Baroness Wheatcraft.
Thank you. You talked about the fact you're already effectively tightening by not bringing down rates and mortgages have responded and property prices have to a certain extent. But other asset prices really have not come down very much at all. And I just wonder whether you were surprised, I don't suppose you were, by the remarks of the deputy governor last month when in April when she was really quite outspoken about concerns over asset prices.
Well, I wasn't surprised at all. Not at all. I mean let me, there are really two stories going on in the world economy at the moment. So we've talked about obviously the impact of the conflict in the Gulf, the effect on energy prices. So that is the first story. The second story is the, if you like, the AI tech story. Much bigger story in the US but it's having repercussions for the rest of us and our institutions are investing in these things. And this I think is the way to square what otherwise appears to be the paradox that we're seeing in financial markets because what we're seeing is that if you look across the major markets, take it in three parts, the impact of the Gulf and the energy shock is almost entirely focused on particularly debt markets and particularly government bond markets and yields. Exchange rates actually relatively little affected. Now that is not illogical if this is a global shock. And then the third one is sort of risk markets. So equity markets and credit spreads which if you spent your life only looking at those you would not realize there was any event going on in the Gulf. Now the way to square those two because otherwise you think this is very strange is you've got these two big developments going on. So Sarah's comments were really addressing the question of asset values in equity markets and credit spreads and saying what are the risks around those and should we, how worried should we be that they seem to be in a sense ignoring everything else that's going on around them. And there are risks there. I mean you may say there was a set of risks from the Gulf because this thing had become big enough to in a sense dominate the AI type story. I think the second thing is that there are, I mean I'm actually quite a believer in the AI story as an economics proposition. So I'm not saying this to sort of undermine AI. I think it is actually very important. But obviously the job of equity markets for instance is to value the future stream of earnings. So to value the future productivity gains from this thing and they could get it wrong in a number of ways. So they could get it wrong in, well think of three ways. One obviously they could just overvalue the whole thing. I mean we could still have a very positive benefit from AI but they could get it wrong in terms of the degree. Two, everybody is currently priced to be a winner in the sense of the, and you look back at history actually everybody usually isn't a winner actually. That's a fairly unusual state of affairs.
Are you predicting the equivalent of the dot-com crash?
Well, not, well I'm not, no, it's not quite that because in the dot-com bubble you had people with no earnings and no prospect of earnings. I'm making a slightly more modest point that if you look at something like the internet for instance, you look back at who the original sort of big pioneering names in the internet were, they're not necessarily the ones who are here today. So pricing everybody today to be a long-run winner isn't really consistent with history. The third one which I think is important is that again I'm drawing on history. These, going back to what I was saying earlier about technology, these what I call general-purpose technology innovations. So things like electricity, internet, tend to take longer to come through into the productivity and economic growth stories than people predict. So there's a famous comment by Bob Solow that you can see the computer everywhere except in the productivity series. There's a famous story that Edison from first doing a power station to US productivity was about 50 years, it was eight decades between James Watt inventing a steam engine and it coming through what we think was UK productivity and that's because it usually involves a lot of other innovations to sort of go with the initial thing. Now I think AI will be a lot quicker than, I mean the world's moving a lot faster than that as we're seeing with AI at the moment. But it could well be that the markets are too optimistic about that speed of.
Is it factoring in sufficiently the scale of the investment that companies like Anthropic or even?
Yeah. Yes. I mean it does require very substantial and that is taking place very substantial scale investment. So just to put that back into context to what Sarah said, there are substantial risks there. Yeah.
And final quick one. Is enough being done to regulate the alternative loan markets?
Well, first of all, the private credit alternative loan market of course is supporting a lot of the investment in the tech sector and that's a good thing by the way. It's a good thing. I also think there is quite a lively debate obviously as to whether we've got this because we've overregulated the banking system. My response to that is in good part the difference, we want these two things to coexist because the liabilities of banks are money, people's deposits and people want assured nominal value for their money, for our deposits but you also need an investment sector which doesn't have assured value which makes money but may occasionally lose money where risk is taken and we want these two things and we don't want them regulated in the same way in that sense. Now what however is the worry in the private asset world. Well I would say generically two things. One, do we fully understand the linkages between the two. So they're not living on separate islands. They are connected. And that's why we're doing in our second system-wide exploratory scenario to understand the interconnections. And the second thing is do the investors and particularly now it's going into retail investment understand what they've got. Because if they do then the odds of it being a sort of smooth transition and the bumps will be sort of smoothed over are much higher if they don't then it will be a, you know. I think the jury's out on that one frankly at the moment. I mean I'll give you an example just briefly from this country. So you may remember some years ago we had the so-called property funds. And that blew up, well it suddenly blew up after the Brexit referendum. And these things were weirdly structured in the sense that they were what's called daily dealing in an asset that not only you couldn't deal daily, you couldn't value it daily because it's commercial property. And the sort of the escape clause was to suspend the fund, suspend redemptions which we did. Now in the end it sort of passed off and I ended up concluding that I think probably most of the investors even though what was on the can looked weird, it was completely weird and nonsensical. I think they probably knew what they'd got. But you can't tell that in advance that well.
Thank you. Thank you very much. We're moving on to energy now with Lord Pettig.
Yes. Sorry to leave this fascinating subject Governor. Let's go back to energy. So if the energy, if all movement carries on, if the energy crisis or the energy costs were to rise more and if the government was tempted to put in a package not dissimilar or of some form of support package as we saw in Ukraine in the first round in 2022-23. In your mind what would be the most desirable way from a monetary standpoint for the government to structure that? And I should say the context against this is that in 22-23 the package cost about 2% of GDP, call it 50-55 billion. And secondly there's been a lot of admonitions or some form of statement from the IMF suggesting the government should resist any kind of support given the state of our, you know, the cost of capital already in the economy and the level at which the gilts are trading. So that's the overall.
Well look, it's not for us to sort of advocate fiscal policy. So let me be quite careful what I say. First of all I would say this is so far at least this is in nowhere near as big an energy shock as the 2022 one. And 2022 of course had two legs to it. I mean, the energy prices went up. You remember when the conflict broke out in February and then another big leg up in the summer of 2022. I think I would limit myself to in a sense, I'd put a little bit of a frame on what the IMF said was that I think they were really supporting the sort of the phrase temporary and targeted as a set of measures. So in other words, they were steering against a sort of a big all-embracing. If you're thinking about it, be careful about big all-embracing packages. Do something that's temporary and targeted. Targeted in the sense of the recipients obviously, temporary in the sense of the length of it. And I think in the context of overall fiscal policy and the overall fiscal position, I think that is sensible advice.
When you look at the, I was looking at the notes here and I hadn't realized that because of the energy cap the level at which actually prices are due to rise even if nothing happened, even if we had some form of resolution nonetheless they're going to be rising quite dramatically. Do you think that's in the price? Do you think that's in the market?
The July reset, yes, I think it is, yes. Because in a way you can work it out pretty exactly because the so-called observation window is over now. So I mean our staff always do it in advance and they get it pretty close actually and I know outsiders do as well. So once you've got through the observation window you can get it pretty accurately.
Thank you very much Lord Young. In the Mais lecture, the Chancellor promised a roadmap for future fiscal devolution and she went on to say that this would be a permanent transfer of power and resources from central government to local government. Are there any implications for monetary policy if you have a country with increased regional fiscal autonomy?
Well, so our convention is that we take the government's fiscal policy as announced and use that to form our views of the future impact on the economy and therefore form monetary policy and we use that in our forecasting. So I think if that were to come to pass then we would do the same thing but from the sort of the top-down perspective we'd obviously have to do some more adding up because it would be a more devolved structure but we would still do the same thing. I think we would add up the set of components of fiscal policy to get the overall position of fiscal policy. And we'd obviously then have to do the conditioning looking forwards on what the sort of stated policy was for each component of it. So make our life a bit more complicated but I don't think it's undoable. Then I think we'd look at it on a second level which is what I call sort of bottom-up if you like and say, and here our regional agents would have a particular role to play. Is the consequence of that devolution of fiscal policy going to have impacts on the pattern of activity across the economy which would be different to the one we're seeing at the moment and I think we would do that as well.
Do you see any problems if for example a regional authority tried to develop a countercyclical fiscal policy to deal with local unemployment? Would that pose any problems for monetary policy? Could you cope with that?
Yeah, sorry. I mean countercyclical fiscal policy. Well, if they developed a countercyclical policy to borrow and inflate to deal with local unemployment does that have any implications at all? It would, well I suppose national policy, two things. I mean first of all it would depend how substantial that would be. So it would depend on what sort of weight that would have in overall fiscal policy. Secondly, we would obviously again have to take it as what it is and then set monetary policy taking it into account. So I mean you, I'm sure you could construct sort of scenarios in which it could cause monetary policy to look different. I think that would be quite extreme as a sort of end of the distribution. I think most of the probable sets of what I would imagine regional fiscal policy to be wouldn't get into that territory but it's possible but say our framework is we can deal with, I mean whether we like it or not we could deal with it.
Thank you. Thank you very much Lord Raisin.
Thank you. We've had a number of witnesses over the months querying the quality of ONS statistics. Do you feel policy makers are flying blind or has there been progress on data quality issues?
So we're not flying blind. Well, no. So and I'll come on to, I do think there's been progress. I mean just go back the sort of obviously the core celebr, and it's on the record. I've said it. I said it in parliament a number of times. I mean it did cause us problems because it is very crucial to our work. Moreover it coincided with a point in time where one of the most important elements of that was the so-called inactivity element of people who are not in the labor force. And whereas many other aspects of the labor force survey, so unemployment particularly for instance we can use other means of coming at assessing it, inactivity we are very dependent on the labor force survey for it's a particular sort of feature of that so that was problematic and our staff worked very hard to develop alternatives which they did. I mean the ONS have been working on the LFS for some time. I think it's fair to say that the participation rate in the survey is now back to I think where it was pre-COVID. But there is still further work to do. They have put back the launch date for the transformed LFS. Certainly we do have our chief economist Hugh Pill sits on the committee that acts as an advisory body for them and I know I think Hugh's view was that was a sensible decision. Felt that they hadn't solved enough of the underlying issues to get to the point where you would be confident to launch it. So that work is still going on. It is a tough nut to crack. I think the ONS are doing the right things and we strongly encourage they keep going. I'll give you another example more recently which I think is a very positive story. There have been question marks around the seasonality of the GDP numbers and particularly first quarter, fourth quarter and it appears that there has been some shift in the pattern of activity. May be related to going to one fiscal event a year and there was an ONS blog publication a few weeks ago which I thought was excellent because it basically said look we've got it, we can observe it, here's what it is, it's real, this is what we're doing about it. You know we think we've captured about 80% of it, you need evidence, you can't obviously make it up so there's about 20% to go where we haven't got enough evidence yet and by the, obviously if you combine the first quarter and the fourth quarter together you can look through it and you're probably going to end up with a, you know if you average those two out you probably got a reasonable number. So I thought from a point of view of national statistics that's really very helpful and what you sort of look for really to say yeah look things happen in national statistics, I mean the world is messy and noisy as it were and I thought that was a very good example of the ONS dealing with it and we work very closely with them. So I think we're getting back to that place but we will continue to work very closely with them because it's very important.
A recent example of course has been the flash forecast for April of a 100,000 reduction in payroll numbers. Normally would have assumed to be flowing through into increased unemployment figures. But if the ears have got that wrong then policy makers should not assume that that would be the case.
We put very little weight on the flash numbers. And the ONS also, if I remember right, put a health warning on those numbers because they do and they've got it wrong the last two years. Well, they get revised a lot. So I mean you can have quite a sort of theoretical argument or even slightly sort of philosophical argument about really if those numbers are so unreliable, should you publish them? Yes. I mean, it's the same with monthly GDP. There was a great rash of we really do need to have monthly GDP. And I think people are now saying, well, you know, yeah, but it isn't that reliable. So what's the better argument? So, we actually put very little weight on the flash number because it does get revised a lot.
Thank you, chair. And thank you for being with us. Can I raise a couple of issues which are current but also continually controversial. The first of those is immigration. Now we've seen recently a fall, fairly dramatic fall on net immigration. What is your view on the impact of a fall of this magnitude whatever the political discussion is saying on the economy?
Well, first of all let me say I, as I hope you understand, I do not get involved in discussions about the pros and cons of immigration because that's not for the Bank of England. But I'll answer your question from an economic point of view because it's an important question. I mean it obviously is an important because it's an important part of the labor supply question. So it is relevant. What I would encourage is putting it into the sort of broader perspective of labor supply because there are several very big moving parts in this story of which this is one of them and it is an important one. The others I think are the fact that we've got an aging population on average and will continue to do. I mean this is set in the future because it's due to falling birth rate. The third one is the one that was obviously very much in the news last week which is the question of young people's participation in the labor force. The fourth one is one that actually probably was in the news some years ago but doesn't get much coverage now but actually has offset some of the negative numbers on participation which is that we've been going through this period of increasing female participation because of the equalization of the retirement ages. But you can only do that once obviously and that's coming to the conclusion. And the fifth one is obviously looking forwards which is what is going to be the effect of AI, artificial intelligence on employment. And I would say that because I do think it's important to sort of tell the economic side of the story around each of these including immigration actually. And it's important to put them all into context together to see the overall picture, which I don't think often gets done. You don't mind me saying so.
Thank you for tiptoeing through a minefield.
If I'm still alive, let me throw another couple of hand grenades then. Thank you. I mean, basically what you're saying is all very complicated, which I think we all understand. And there are, you identified five dimensions. Taking them in aggregate, does that mean that the labor market is still a source of serious uncertainty given the unpredictability of some of these things in terms of policy formulation? Or is it no more difficult than it's ever been?
Well, I think looking forwards it is an important issue because going back to what I said I think to the first question, chair's question, this lower growth story over the last 15 years actually hasn't so much been a story about labor supply and part of that story of course was that prior to this latest immigration number immigration was higher than it had been presumed it would be, let me put it that way. Going forwards and going back to this question about how we get growth and potential, the growth of the potential capacity of the economy, maintaining labor supply is obviously an important part of that story. And you have to set that against as I say the context of an aging population particularly. Now I'm not going to say therefore the answer must be, you know, immigration must be higher because that's not my territory frankly it would be wrong for me to go into that territory. But what I do think is that this whole debate needs to be set in the context of we need to maintain the labor supply in the economy. What is the way to do that? I mean what is the most effective and best way to do that? Taking all these things into account of which immigration is one of them.
Okay. And are there, you mentioned wrong assumptions about the level of immigration. Are there other lessons that we can learn from previous periods where that's been the case as well. I mean I recall 25 years ago it was predicted by our learned academics that the number of Polish immigrants if we opened up would be 18,000. I think that was about 850,000 short of that figure. There must be lessons from that.
Yes, I'm sure there are. And well I mean it is the case that certainly if you go back to a few years ago, only a small number of years ago certainly we had to revise our forecasts very substantially because in fact the immigration numbers turned out to be very different to the ones that were in the, we don't do our own immigration projection and we use largely the ones the ONS and the OBR come up with actually and so of course it turned out the actuals were very different to the forecasts.
Okay. And final question, chairman, if I might. You referred among the five factors that you outlined, I hate the acronym NEET, but we're left with it, the young people who are not in employment and so on. Would you like to say something on the long-term economic impact of that?
Well, I think it's, look again it's not our area but I think, but we have to take it into consideration. I think it is very substantial. And I think particularly when you set this into the context of sort of an aging population. I mean if you combine an aging population and lower levels of participation in the labor force by young people then you know you become more worried at that point. So I think.
And a, yeah, yes, well the aging population is reflecting a lower birth rate. I mean there's obviously an increase in longevity as well but it is principally reflecting a lower birth rate as you say rightly and if you combine those two things together I think that's a very very important issue and a very serious issue. Yeah.
Could I ask one quick follow-up? You said very interesting remarks at the beginning about the UK productivity problem in the last 15 years. And of course it's not as simple as just rectifying what the relative problems were in order to boost productivity in the future as you also said but what's the best account in your view of the major drivers of that disappointing productivity growth in the last 15 years?
I think it is principally probably a technology story. So I mean there are these, I think there are long cycles of technology in that sense because there are these things called general-purpose technologies and the whole point about a general-purpose technology is that it spawns innovation across the whole economy. So it's not limited in that sense. So the internet, ICT is a good example as I say the original case is the steam engine I think. But there are pauses in those periods. I mean we had one in the late 19th century as well actually. So there are pauses and I think it is quite possible that we have a pause because I have to say to people, people say to me yeah but the internet's everywhere surely and I, but it's here we're talking about the contribution to growth. So eventually you do sort of saturate the economy with an innovation and I think that probably did take place broadly with the internet for instance and ICT and the question then becomes what's the next one. So I think that is a part of the story. It's not anybody failed. It's the next big question is how quickly are we going to see a leg up in productivity from further innovation.
A little bit on this question. I was going to ask a follow-up question on this. Going back to inflation. So in a way all these indicators except potentially AI point to reduction in labor supply and ultimately a reduction in output. Is this fundamentally inflationary? Is it something that actually is going to, you know, beyond you talk about long-term, short-term? There's all moves in the short term but long term and we have a strike now. People want to only work four days a week rather than five. And you would say most people to some degree in the economy tend to maybe not work for.
Well if it restricts the supply capacity of the economy then yes it does have an effect and we have to take that into consideration in setting policy.
Thank you. Lord Newby, can we move on to reserves and two particular questions. The first is the fact that the bank pays interest on commercial banks' reserves with you which is a very considerable sum and some people think that it will be a good thing if you didn't. And because the banks could be required to have a certain level of reserves anyway. And the interest is money that in the nicest possible way they don't need in an economic sense.
That may or may not be, probably is questionable actually, but you can question it. And the second thing is, which we had a lot of debate about in the aftermath of the financial crisis, was what is the appropriate level of reserves.
Yes. And we went round the houses as to how you decided that we have decided something. Do you think in current circumstances that level should be revisited or do you think it's doing what it's supposed to do?
Yeah, thank you. That's very good questions actually. So let me have a go. I'll take them in turn. So paying interest on reserves. So it's not free money as it sometimes gets portrayed. Let me do a bit of the accounting if you don't mind to start with. So when banks hold reserves with us, which is what these are, those reserves are an asset on their balance sheet. They have to fund that asset. So they have to pay the cost of funds to raise those reserves. So you've got interest rate on either side of that. It's not that this is free money in that sense. And I'll come back to the question of what they earn in a moment. And when you look at our balance sheet, it's therefore a liability on our balance sheet which we then invest and we are moving over time to what we call a repo funded balance sheet which means there will be no interest rate risk. That's no interest rate risk on our balance sheet. I mean I know that's the second slightly different question but equally gets in the news. So again, the aim is that this is a sort of a balanced system and it's an equilibrium in that sense and if you disturb it by saying don't pay interest on reserves then you're going to disturb the system. Now let's come to that. On the question of do banks need the earnings? Well, I would argue actually they do because they have to earn their cost of capital at least, and this is reflected in their market valuations. So we went through a period of about 15 years post the financial crisis where they were not earning their cost of capital and their so-called price to book, in other words their market value versus their book value, the market value was below the book value. That is now not the case. That hasn't been the case the last year or two. But that is important. I mean banks do have to earn their cost of capital in that sense because that is the basis on which the shareholders are prepared to provide the funding. I do recognize by the way that one of the challenges I think in that is that it's easy for me to say in a slightly sort of clinical way earn the cost of capital because of the size of banks and the size of their capital that is a lot of money in terms of when you look at the pounds and pence earnings of banks to earn your cost of capital you do have to earn a lot of money I recognize that but that is the economics of it. So if you said don't pay interest on reserves and require them to maintain the current level of reserves, that would knock a big hole in their earnings and their earning of cost of capital because an important part of their earnings is what's called the net interest margin which is the balance between what they earn on their assets and what they pay on their deposits. And they would have to pass that, well they would have to do one of two things. They would either seek to shrink the level of reserves and that will bring us on to the second part of the question or they will pass it on to customers. So in other words mortgages will cost more and payments on deposits will be less. So let's come on to the second part of the question the level of reserves. We don't target a level of reserves. Some central banks do actually we don't. Our system at the moment is that we will meet the system's demand for reserves. Now the stock of reserves at the moment is actually higher than the sort of steady state demand because of the fact that we've done quantitative easing in the past and it's coming down. So it's currently I think about 640 billion pounds at peak it was about 980. So the next question is where's the equilibrium we don't know exactly and it won't be constant over time by the way it's below where we are today. But you know I wouldn't be surprised if we've got 100 or 200 to go to hit that equilibrium. Now the question then is is that too high? So it's what they think they need. And let me say two things on that. First of all, reserves are the highest quality form of liquidity in the system because it's cash at the Bank of England. You can use those immediately. So if your deposit has started to run then that's immediate. You don't have to do anything for that money to be available. You can pay out. So it's important. It also smooths the operation of the payment system. The broader point and this is to me very interesting. It goes partly back to Lord Brandis's question is that liquidity in the banking system also supports the rest of the whole of the financial system. So I made this point to Lord Brandis's question about the interlinkages between private credit and the banking system. The banking system is still the ultimate source of liquidity for all of this activity and it is also supporting a much bigger government bond market and the liquidity needs of that and the fact that we've got a transformed government bond market as have quite a few other countries with a much bigger leveraged hedge fund position in it. The liquidity for which ultimately is coming from the banking system and ultimately if you like from us through the reserve operation. So the fact that the demand for reserves is now higher than it would have been 20 years ago doesn't surprise me. I think there if you say well yeah but don't you really want it to be lower that's you get into some very deep questions about the whole financial system at that point and what financial system we want because those reserves are as I say the ultimate high quality liquidity in the system.
