National Champions of the 2013/14 Target Two Point Zero Interest Rate Challenge

National Champions of the 2013/14 Target Two Point Zero Interest Rate Challenge

We are the Oundle School Monetary Policy Committee.
This presentation will examine four areas – Costs and Prices, Demand and Output, Financial
Markets and finally International Outlook. As exemplified by the Fan Charts, Bank of
England projections for inflation have been relatively consistent with reality and our
own projections for inflation are shown on the blue Fan Chart. With disinflation in the
market, with the current level of inflation at 1.7% and the UK's growth forecast increased to 3.4%
for 2014, the UK economy is recovering. However, uncertainty still exists, much of
which comes from the influences of costs and prices, which my colleague will now explore.
The CPI headline rate is currently at 1.7%, a 4-year low, with the main downward contributors
being lower petrol prices. The sterling ERI has depreciated slightly since our last meeting,
however still remains over 10% higher than where it was 12 months ago. Finally, oil prices
have fallen by around $5.00 since our last meeting, which I shall discuss later. Input costs account from around half of CPI
goods prices, and these components have contributed around 0.7 percentage points to the headline
rate over the last 12 months.

While sterling fell during the financial crisis, the real
trade weighted effective exchange rate has appreciated by 10% since March 2013, helping
import prices to fall 0.7% in January. As the US economy strengthens, the pound may
lose some of its value against the dollar. However, a strong UK recovery should ensure
that sterling strength is maintained. This, combined with weak world export price inflation,
should ensure that the contribution to CPI from import prices fades over the medium term,
as represented by the shrinking balloon. Commodity prices have generally fallen over
the last 12 months, with The Economist commodity-price index down 5% year-on-year. Agricultural prices
should stay relatively stable; however, adverse weather conditions could provide an upward
pressure. Future markets show most prices declining
or remaining relatively stable over the next 12 months, while sterling's recent strength
should reinforce this.

Therefore, we believe commodity prices are likely to put a downward
pressure on the headline rate of inflation over the forecast period. Energy prices will be a major contributor
to CPI over the forecast period, directly through household bills and indirectly through
higher business costs. Last year energy tariff rises were smaller than expected, mainly due
to a reduction in green levies. However, energy tariffs are still 6% higher than where they
were a year ago, and we believe this upward trend is set to continue. Freezing the carbon
floor may help to limit some of the price increases, but as the UK's spare energy capacity
narrows, prices are likely to rise, threatening the 2% target. Brent oil has fallen around 4% since our last
meeting to $107.00 a barrel, and the IMF have placed a 50% probability of this falling below
£100.00 a barrel this year. Geopolitical concerns remain, with some civil unrest in
commodity rich regions. However, previous crises have only had a temporary effect on
commodity prices. Therefore – as supply from North America increases – we believe oil prices
are likely to have a slight downward trend, as shown by the graph, putting a downward
pressure on the headline rate of inflation.

Finally, annual factory gate inflation was
at 0.5% in February, whilst input prices fell 5.7% year on year. Both of these statistics
show little threat of inflationary pressure within a supply chain, especially as movements
in producer prices take about 12 months to affect shop prices. However, many fear that, as the economy recovers,
firms will push through large price increases to increase their margins. However, margins
have been protected in recent years by the weakness of bank lending, which has prevented
new firms from entering and contesting markets. Therefore, as credit constraints ease, we
believe competition between firms is likely to intensify, limiting increases in producer
prices, providing a downward pressure to inflation. In summary, the outlook for inflation from
the costs and prices sector remains subdued, whilst any increase in inflationary pressure
could be offset by tuition fees falling out of the CPI cycle in late 2015, which has added
around 0.3 percentage points to the headline rate over the last three years.

Now on to
Demand and Output. In the Demand and Output section of the economy,
the key factors that have changed since our previous meetings are unemployment – which
has fallen from 7.4 to 7.2% – and house price inflation, which has been steadily increasing
over this time. This increase in inflation has sparked fears from the OECD that the market
is overheating. However, significant regional disparities exist, with prices in London increasing
by 10.9% over this time, significantly dragging up the national average. However, overall, across the majority of the
UK, we believe the threat of a house price bubble is subdued as prices are still 25%
below their pre-crisis peak in real terms, while affordability and indebtedness measures
are far less stressed than they were during the financial crisis.

Looking forward, with the economic recovery
supported by the Help to Buy scheme, extended in the 2014 Budget to 2020, we believe this
demand will increase. And it's supported an increase in supply also, with private sector
house building up 20% last year. However, supply is still quite inelastic due to restrictions
on planning and construction, and so this increase in demand does pose upside pressures. The consumption that has supported the recovery
to date has merely been fuelled by the decrease in savings rate and the £12 billion worth
of PPI payouts. However, payouts are slowing and there is little scope for the household
savings rate to fall much further without unwinding all of the deleveraging that took
place during the financial crisis. And therefore real wages must begin to rise in order to
support the consumption and allow the recovery to continue. We expect this to happen in the second half
of 2014 as average earnings growth overtakes inflation. And there is some evidence that
this has already begun to happen, with private sector regular pay growth increasing by 2.2%
year on year.

There is also clear evidence of strong labour demand, with the annual rate
and growth of job vacancies at 19% in the three months to January, increasing real disposable
income, stimulating consumption and therefore an upside pressure in the medium term. Despite this, we believe there is little threat
of demand-pull inflation due to the amount of slack in the labour market. Although there
is falling unemployment, the level of under-employment has actually been increasing, with 8 million
people now working part time. And crucially the percentage of people working part-time,
because they were unable to find full time work, is increasing as you can see on the
graph. Supporting this, the most recent Bell-Blanchflower
index indicates that the level of under-employment may be as much as 2 percentage points above
the Labour Force Survey figure. Therefore, we believe the level of unemployment is understating
the amount of slack in the labour market, muting the impact of falling unemployment
on inflation. A key area to assess is productivity, which
has been falling over the past five years, and this is a stark departure from the trend
rate of growth historically, as you can see on the graph.

However, outlook per worker
has increased in the first three quarters of 2013. Many fear that the financial crisis
will have done permanent damage to the potential level of productivity in the economy; however,
we believe some decline is due to temporary factors such as a misallocation of resources
due to bank forbearance. However, increasing bank lending and investment suggests that
this constraint is loosening. The relatively modest rise in unemployment
suggests that fewer skills are likely to have been lost than in previous downturns.

so therefore, as the economy picks up, we believe productivity growth will increase
also. Coupled with the 2014 Budget, such as the doubling of investment allowance, this
allows real wages to grow without inflationary pressure. Business investment is up 8.5%, signalling
that the recovery is becoming more balanced. And investment intention surveys look promising,
with the UK's Economic Sentiment index at a 15 year high. Firms have plentiful cash
reserves to finance more investment, and private non-financial corporations currently have
£330 billion worth of cash deposited in UK banks. The lack of recent investment means
that we expect a strong recovery, stimulating aggregate demand in the short-term, causing
upside pressures, but more importantly increasing the productive potential of the economy in
the medium term – a downside pressure. The effect that the aforementioned increase
in demand will have on inflation depends on the amount of spare capacity in the economy,
which we had decided to evaluate using several different business surveys, such as the Institute
of Chartered Accountants in England and Wales Business Confidence monitor, which indicates
that over 50% of firms are operating at below full capacity.

Although this has been on a
downward trend, this is still above pre-crisis levels, and so it indicates that, although
the UK recovery is firmly entrenched, spare capacity still remains, allowing strong growth
without inflationary pressure – but actually poses the risk of inflation under-shooting
the target in the medium term. And this risk formed an important part of our considerations. In conclusion, increasing house prices, while
not posing the threat of a bubble, do still pose upside pressures, along with real wage

However, the level of under-employment and spare capacity in the economy, along with
increasing business investment, justifies a low Bank Rate, as only when the slack has
been used up will any price pressures appear. And altogether there seems to be low inflationary
pressure from the demand and output sections of the economy. Now on to Financial Markets. The problem over the past few years has been
that, despite QE, the broad money that is M4 growth continued to fall due to the reluctance
of banks to lend. However, broad money growth finally began to increase at the start of
2013 and this has continued in 2014, as shown in the chart. This was due to banks continuing
to repair their balance sheets over the last year, resulting in the health of the financial
sector improving significantly. One key indicator of the health of the financial
sector is the capital positions of major UK banks. UK banks' core Tier 1 capital levels
have increased by around £140 billion since the crisis, while the median leverage ratio
of UK banks has fallen from 50:1, as it was during the crisis, to a much healthier 24:1.
Both these factors signify that UK banks are in a significantly healthier financial state.
As such, we expect the lending to rise.

Supporting this, as shown in the chart, Deloitte's
most recent report on the cost and availability of credit reveals the cost of credit has fallen
dramatically since the peak of the financial crisis, while the availability of credit has
increased and is now at a post-financial crisis high. Hence business lending should pick up
in 2014, and is forecast to rise 2.5% this year. However at £417 billion, it is still
28% below the 2008 peak, and as the economy continues to recover, we expect lending to businesses,
and therefore – as mentioned by my colleague previously – business investment to rise.

This is especially clear when you consider
changes to the Bank's Funding for Lending scheme. These changes were implemented in
January 2014 and they resulted in the capital offset for household lending to be discontinued
and therefore corporate lending to be extended. This should refocus lending to small and medium
enterprises as opposed to the housing market, which the scheme did not initially do. Furthermore, banking regulators in Basel announced
in January 2014 a loosening of leverage ratio requirements for banks after pressure from
the banking sector had argued that the current conditions would stifle lending to consumers
and businesses. This loosening of conditions, while not severe
enough to affect the stability of the financial sector, will allow banks to report lower levels
of overall risk, thereby reducing pressure on banks' capital. Therefore, we expect business
lending and business investment to pose upward inflationary pressure. However, here is where the team had disagreement.
The other members of the team felt that business investment would be a downside risk in the
medium term due to productivity picking up, something which I disagreed with.

I believe
that any downside pressure as a result of productivity boosting the productive potential
of the economy would take more than a medium term of two to three years to materialise
due to the inertia developed by stagnant productivity. So the investment will mainly affect the demand
side of the economy instead, an upward pressure. As such, the team agreed to take both situations
into consideration and this is reflected in our conclusion later on. Now, looking at Equities and Corporate Bonds,
the FTSE All-Share Index has been continuing on its upward trend and has already surpassed
pre-crisis levels. Increases in interest rate expectations raise the rate at which investors
discount future returns. All else being equal, this should result in depressed equity prices.

However, as you can see, this has not happened.
What this suggests is that investors may have become more optimistic about the growth outlook,
thereby revising up their expectations for future earnings, dividend payments as well
as their expectations for interest rates. Hence if investors receive high interest payments
and the value of the investments rise, there will likely be a positive wealth effect as
well as a rise in disposable income for stockholders, resulting in increased consumption.

Furthermore, firms are more likely to tap
capital markets while the stock prices are high, and therefore business investment is
likely to be boosted further. Hence, as a result, both of these will likely result in
stronger upward demand-pull inflationary pressure. Summing it up, financial markets seems to
be finally close to fully recovering from the effects of the financial crisis. Banks
are healthy and lending again, businesses are finally gaining access to capital for
investment, and equities have been continuing on their upward trend and have surpassed pre-crisis
levels. Hence we find that financial markets will have upward inflationary pressures, especially
over the short and medium term. Now on to International Outlook. With 49% of trade being done with the EU,
and 16% of trade being done with the US, these are the key areas of international outlook
that we will be prioritising. In the eurozone the recovery is set to continue
after an encouraging set of Q4 2013 GDP figures now showing three quarters of consecutive
growth. Business growth accelerated in February with the composite purchasing managers' index
now at a two and a half year high, showing that the moderate recovery is set to continue
into 2014.

However, outlook for the area is mixed, with
significant national discrepancies between member states. Risks facing the periphery
have diminished recently, with unemployment in decline in recent months. However, despite
this, further adjustment is still required and will likely be hindered by the low rates
of inflation across the area as a whole. Over the medium term euro growth is set to continue,
providing a boost to UK exports and an upside pressure on inflation. The US grew at a slower rate than expected
last year, with annualised GDP revised down to 2.4%. However, we believe that much of
this can be attributed to the unusually cold weather last winter. Strong February growth
and nonfarm payrolls and factory outputs both show that the US economy has bounced back. We interviewed Paul Dales of Capital Economics,
who confirmed our analysis that a period of strong growth and increased consumer spending
lies ahead for the US.

Given this US recovery, there is plausible upside risk to be felt
by the UK economy if the recovery continues quickly. FED tapering has been a contributing factor
in recent emerging market volatility, partly causing a sharp reversal in capital inflows
and currency depreciation in these countries. Financial conditions have now improved, but
the risk of slowdown remains. Slowdowns in emerging markets will probably have limited
direct impact on the UK, but more widespread financial market disruption to indirect trade
linkages would have a more significant impact. Finally, we have analysed China as a potential
downside risk to the UK economy if the Chinese economy were to stall.

However, given our
limited trade with it, and various Chinese economic policy adjustments, any downside
effect would be felt through indirect transmission mechanisms. In summary, the outlook for global growth
has become more balance and improved. Upside pressures should be felt; however, downside
risks still remain. To conclude: we recognise the prevalence of
upside pressures on the UK economy. These include falling unemployment and increased
energy prices in the short run and the global recovery and the pick-up in house prices over
the medium term. However, on the downside, there exist low import prices, spare capacity,
the downward trend in commodities and the likely increase in investment aiding productivity.

Chief Economist

Yet the significance of these upside pressures
is mitigated by various factors. For despite falling unemployment, there is still significant
slack in the labour market. Despite increased energy prices, tariff rises have been smaller
than previous years. Despite global growth, there is still significant uncertainty in
the eurozone. And finally, despite the increase in housing prices, house prices are still
beneath their pre-crisis peak in real terms. Therefore, we have decided that, given the
magnitude of these downside pressures, they are a far more potent concern to be addressed,
and this justifies a low Bank Rate. We have also posited different scenarios for
the UK economy standing as risks to the 2% target. On the upside, there could be stronger
than expected US growth driven by consumers. With the UK's strong trade linkages, we would
be ideally placed to benefit, boosting growth and possibly leading to inflationary pressure
sooner than expected. Secondly, productivity may not pick up as
expected, the implication being that the recovery could quickly generate inflation, given that
in this scenario output would be close to its full potential.

On the downside, a strong euro, combined with
slow growth, could push the eurozone into deflation. This would see UK exports plummet,
causing the recovery to slow with the possibility of imported deflation. Finally, we may be underestimating the amount
of spare capacity, which could keep underlying inflation excessively subdued, in turn causing
CPI to fall even lower. These considerations fed into our Inflation
Forecast Fan Chart. Ultimately, therefore, our analysis exemplifies the little threat
of inflationary pressure over the forecast period. In light of this persuasive evidence,
the Oundle School Monetary Policy Committee has decided to maintain the Bank Rate at 0.5%
and maintain the stock of asset purchases at £375 billion. Finally, with regard to forward guidance:
we intend to maintain forward guidance in its current form, analysing key economic indicators
to assess spare capacity in the economy.

We also intend to begin releasing a graph, based
on members' expectations for the Bank Rate over the short, medium and long term. Each
anonymous dot represents the view of a member of the Committee on where they see the appropriate
level of the Bank Rate to be over coming years. The intention of this is to reduce uncertainty
over future rate rises, increase transparency and provide further guidance. This would also
help to reflect the polarity of views that exists within the Committee and counter the
perception that rates are likely to rise in the near term – adding credibility to our
forward guidance.

The simplicity of this graph would provide
an easy, simple to understand message to businesses and consumers. It is also important to point
out that, in reality, there would be nine dots to represent the nine members of the
Monetary Policy Committee. Thank you very much for listening. Thank you. You mentioned you'd done some special
analysis on China, and people often ask – what could go wrong with the Chinese economy in
terms of affecting the rest of the world? And what is there to suggest that actually
things will carry on as before, and how might that affect the rest of the world, including
the UK? So could you articulate a bit more the upside and downside risks from China for
the UK? I think the most important thing to note is
that this slowdown in China is a planned slowdown.

As part of their twelfth 5-year plan they
have said that they're going to lower their growth rate to 7%. And so what we're seeing
isn't a Lehman moment; this is a planned, controlled slowdown. And therefore we don't
see the effects of what people are calling a potential Chinese implosion to actually
be that great in reality, given that the Chinese Economic Policy Committee are doing so much
to control it. I think especially when you're talking about
what could possibly go wrong with China, we're seeing the first signs, what many people are
pointing to as being China's black swan moment, that is the corporate debt default that we've
seen two of in the last three weeks. And the issue here is that China's known it's had
a housing market problem for the past several years and this is the Chinese government's
response that normally they would bail out these banks, but in these special scenarios
they're leaving the banks to fail, because this is how they're going to weed out the
bad banks.

And this is something – it's not unexpected.
China has clearly made a stance on this and we found this out when we interviewed the
Minister Counsellor for Education at the Chinese Embassy in London, Mr. Zhang. We saw that
this is something that China are strict on, because they do not want to go into a Lewis
Turning Point with a lot of instability in the housing market. And China's biggest thing, though, with their
housing market is that it's not quite as leveraged as the housing market was in the US and Japan
when it went all wrong, even though the size of the housing market to GDP is roughly the
same. This is because China's interest rates have generally been rather low in previous
years, so the Chinese people have used housing as an investment, as a saving mechanism. And so, should corporate debt defaults happen,
most of China's debt is internally held, so the effects externally would not be as wide
as it was with Lehman Brothers, or that the biggest risk if China does implode and growth
does stall significantly, the biggest concern would be China would bring commodity prices
down with it and that would have severe deflationary effects.

And also the concern would be indirect trade
linkages. The EU as a whole has China as its largest trading partner, and the US as its
China's second largest trading partner. So in these cases, considering we have most of
our trade with the EU and the US, the indirect trade linkages there would severely affect
us. However, we understand that there is a possibility
of China stalling significantly, but we personally find that this possibility is very low, because
the Chinese government has a key track record of controlling their own government. For example,
in '08, when we first saw signs of Chinese growth stalling, China's government included
US$568 billion expansion to protect the government, and this shows that China has a key track
record, in protecting its government, as such, we find that Chinese growth, although it will
likely slow as it moves to a small tertiary-based economy, this is not a risk for the short
or medium term, and more something that we'd look at maybe ten years in the future. And just, on another, subject – the housing
market, I think you painted rather a benign picture.

But the FPC, as has been noted by
others today, put a statement out noting the sharp increase in high loan to value mortgages
and so on, and increase in those sort of products. Are you concerned about that aspect of the
economy? And how might how you feel about it relate to what the FPC discusses with you
or what the Bank corporately does about it? Well, what came out yesterday was that the
Bank of England feels that it's important to assess the amount of financial instability,
because it's come out that people are spending a higher proportion of their income on mortgages
than previously. And so therefore, even though prices are increasing, this actually supports
our argument for keeping interest rates low and stable, because so many people depend
on mortgages and mortgage payments, that if we increase rates quickly and by too much,
it will have great shockwave effects on to the financial market. And so, despite there
being increasing house price inflation, we do still believe that the best thing to do
is to keep rates low and increase them gradually. The Bank of England's own analysis has supported

They released a report I think last year where they modelled a prediction if interest
rates were to rise to 2%. And they found that the percentage of stressed mortgages that
there were, which they defined as people who spend more than 35% of their disposable income
on debt repayments or mortgage repayments, it would jump from the 8% it is currently
to a 16%, if interest rates were to rise by 2%. And this did inform an important part
of our policy prescription, because we want to wait until real wages can rise and people
can start to pay down some of their debts before we raise interest rates. And also, something the Financial Policy Committee
could do was the Help to Buy scheme, where we can't directly influence it, apart from
– Part 2 was a part that encouraged the enormous amounts of 95% loan to value mortgages that
have been given out, apart from the Part 1 that's being extended to 2020, it's only the
equity scheme, so that's only when the government takes a 20% equity part of – it only applies
to new built houses as well, which means that should stimulate housing supply as well as
demand – hopefully limiting a cap on price increases.

And following on from that, one other thing
that the Financial Policy Committee could do is they could use directions under the
SCR – Sectoral Capital Requirements – using this they would directly order banks to increase
the amount of capital that they hold in specific sectors that they find being risky. In this
case what we could do as the Financial Policy Committee is increase the amount of capital
banks must hold in the housing market, or more specifically higher value loans, which
we see as being more risky. So this is something that the Financial Policy
Committee we'll be asking to keep a strong eye over, and we will assess this as it comes
along in the future. You're asking the FPC to do that? Yes.

The Oundle FPC will do all that. I wanted to ask how you think your policy
decisions might evolve over the course of the next couple of years or so, in particular
the relationship between how the economy is developing and how you might change your policy
decision. When do you think the degree of spare capacity that you talked about that
currently exists will be used up? And when relative to that point at which capacity finally
reaches what you might term full capacity would you start to think about raising rates? So Charles Bean actually said recently that
spare capacity is being used up by businesses because they're reluctant to invest in new
capital expenditure because they don't know whether they'll get returns on this yet. And
so we do see spare capacity being used up eventually, and saying when this will happen
is obviously a very difficult forecast to posit. Further to Juliette's point, forecasting when
we're going to raise rates will depend on the size of the output gap as to how soon
we think the economy is going to create inflationary pressure. So the output gap can be compiled
using two things – the amount of spare capacity in firms and the amount of spare capacity
in the labour market.

Now Martin Weale last week came out with a
speech suggesting there was around 0.9 percentage points of spare capacity in the labour market.
However, we think this is slightly understating the amount of spare capacity, mainly because
in the forecast that he created, he modelled up to 2016 that the size of the population
would stay constant and the size of the workforce would stay constant as well. And we've realised
that, over the next two years the size of the workforce is likely to increase by 2.5
percentage points, mainly through increased immigration, growth in the population and
benefit reforms done by the government which are encouraging people to go back to work.
And therefore we think there's greater spare capacity in the labour market than maybe Martin
Weale was suggesting in his speech. And also, as we saw, the spare capacity from Freddie's
section, the spare capacity in firms is also 10 percentage points above where it was before
the financial crisis. And therefore we believe that the amount of spare capacity in the economy
is quite large, and therefore rate rises can be held off for a while. But does that mean, relative to where the
market currently expects the first rate rise to occur, which is some time roughly in the
first or early second quarter of next year, that you would expect it to be later or sooner? We had our forward guidance chart and I think
the different dots represented that most people expected a rate rise in 2015.

We're not entirely
sure when that would be in 2015. However, we think that in 2015 there will be a significant
– we think that over the 18 to 24 month time lag associated to a monetary policy there
will be small enough spare capacity to begin to create inflationary pressure over our forecast
horizon. However, of course this will be subject to revisions and any data that we get in meetings
before we raise the rates. Also it's important to note that it's
not just exactly the moment we increase interest rates, but that fact that we will increase
them gradually. And also we are aiming to reduce the amount of spare capacity through
our policy decision, and so they will impact on each other, and so if spare capacity does
not fall, we will not increase interest rates.

I'll move on, but Ian has an office next to
Martin, so he's going to take him back and tell him he's done his sums wrong, which will
be quite good – You had your own inflation forecast at the start.
I want to know what process you went through to get it – what sort of assumptions
did you make? And then how did you step off of that to get your individual dots? Did you
re-run whatever process it was or did you stick in pins relative to your central projection
– or what did you do? Okay, we're going to start just by explaining
the dot chart first. And both did inform each other, so we used our Fan Chart to then look
at the way we interpreted these various risks and pressures that fed into our creation of
the Fan Chart which I think Ollie's going to expand on.

And then we each independently,
and with the knowledge of each other's different sections, put where we thought – where we
would move the Bank Rate to from this period. And obviously the dot chart goes further than
the Fan Chart does. And as you get towards the long term, obviously these points would
be subject to movement depending what happened in the market. But I guess in that respect
it's better to focus on 2014 – 2016, and I know we each have our own reasons as to why
we did what we did in terms of placing the dots. So with the CPI Fan Chart that we made at
the beginning, the way we constructed that was taking the main pressures we thought from
each of our sections and then thinking of how much of an influence they were likely
to have in the short, medium or long term. And then to confirm this, we also interviewed
three different economists – Paul Dales from Capital Economics, Mark Gregory, Chief Economist
at Ernst & Young, and Rob Harbron from the Centre for Economics and Business Research.
And we showed them our Fan Chart and then we took their feedback and then sort of adjusted
it as to where we thought.

And up to actually yesterday, when we revised the Fan Chart again
due to new data coming out such as retail sales were up – so we thought that could provide
a bit more of an upward pressure. So it's been updated quite recently to represent
new data releases coming out. I'd like to ask at least one unfair question.
Like a number of other people, you noticed that M4 didn't grow very much after QE. Is
that because QE didn't do anything or is it because M4 would have plummeted without QE? Well we think the consideration here is that
the main reason we feel M4 didn't rise even despite QE by very much was because of the
reluctance of banks to lend due to their balance sheets being severely damaged from the financial

However, what we feel is that, without QE,
M4 growth would have plummeted even further, because that would have meant that banks would
have held back more capital from themselves. And I feel that this fact in itself, that the economy showing signs of
recovery and the fact that the banks are now saying they'll release the M4 as soon as their
balance sheets are into improve shows that the QE – it was actually successful in the
sense that it did help boost M4 growth in the economy, even though it had a slightly
larger than expected time lag. In the 10 years the MPC existed prior to 2007,
the average level of Bank Rate was 5%. In your chart here you say in the long term,
when presumably you think Bank Rate's going to be somewhere between 2 and 3, so why do
you think it's going to be so much lower than it averaged in the 10 years prior to 2007? So as a team, I think we do all agree that
the natural rate of the Bank Rate has fallen, and this 3% is what we see as potentially
the new natural level.

And obviously it's difficult to finally posit what that would
be, but I think generally 3% is a good estimate of what the natural rate would be, given the
structural changes that have occurred in the economy after the financial crisis. And following on from that, you mentioned
structural changes, and we specifically mean structural changes in financial markets. So
we see the risk appetite of most investors and banks has fallen significantly. We're
not going to be seeing leverage ratios of 50:1 and of that sort any more, because we've
seen what can happen. And as such we feel that the risk appetite has been severely decreased
and as such it will take less of a – the Bank Rate should be lower for it to stimulate the
same amount of growth. Further to that, the way you can think about
what the equilibrium rate of interest rate is is to take the 2% inflation forecast of
the MPC and then to add on the risk-free rate of return. So before the financial crisis that was about
3%. However like Malayandi has said – because of availability bars, because the financial
crisis has recently happened, many people – what they would use to associate a one in
a hundred chance of happening they may now associate a one in fifty chance of happening.
And this does mean that many people are now more willing to buy safer assets, and therefore
this has increased the price of safer assets, driving down the yield.

And therefore the
risk-free rate of return has declined significantly. And therefore that could have been driven
down to about 1% or possibly even 0.5%, which is why you see our longer-term dots at a much
lower rate than they were before the financial crisis. And adding on to this conclusively, we know
that financial markets have very short-term memory. So this long term we're referring
to here is the next five to seven years. We could see perhaps in 10 years we might see
an increase in the risk-free rate, but this is our prediction for the next five to seven
years. Okay, that's brilliant. Well done..

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