Andrew Bailey.

Q1 The Chair: Welcome to this meeting of the Economic Affairs Committee. I am delighted to welcome the Governor of the Bank of England, Andrew Bailey. Thank you very much for coming this afternoon, Mr Bailey. Before I kick off, I should declare an interest as an adviser to Banco Santander.

I will start with the first question. We are going to try to keep our questions to the point. I hope you will forgive me, Governor, in asking you to do the same with your answers.

Let us start by looking back, before we look forward. Looking back over the last few years, we are ending an era of cheap money and ultra-low interest rates. Do you think the Bank properly understood the impact of QE, given its scale and duration?

Andrew Bailey: I think at the time we were very clear on why we were doing it. If you go back to March 2020, there was the major dislocation of financial markets and the major turndown in the economy because of the onset of Covid. I think we had approximate financial stability reason for doing it on the day or week in question but, in our view, almost instantaneously, the monetary policy argument came into play as well.

If you were to ask me what we have learnt about QE, I would say there are two things. By the way, we published quite a large staff paper earlier this year, partly in response to our own work on QE and partly in response to your report, which was very useful. First, so far—not that by saying this, I am saying that we are about to use it again—it has not been used as extensively in history. The evidence we have is that its effects are probably more state contingent than we first thought they would be. The Bank of England holds that view probably rather more than other central banks, but that may just be our own experience. By that, I mean that it works most effectively in a crisis or a period of extreme stress. That is not to say that it does not have effects at other times, but its effects are more pronounced at that time.

Secondly—I thought this point was very well put by Ben Bernanke in the book on monetary policy that he published earlier this year—to my mind, QE has the effect of lowering longer-term rates, which eases financial conditions for households and businesses. Certainly, looking back to 2020, and even 2021, bearing in mind the situation we had with Covid, that was very much the argument behind it. It stabilised and eased financial conditions, and we were looking for that sustaining effect.

Q2 The Chair: Last July, our committee published our report and questioned the latest round—at that point—warning that it could be inflationary. Since then, Huw Pill, talking about the rounds of QE that were undertaken in 2020, has said, “Whether they would be chosen now is an open question”. Do you think his framing of that is right—that it should be an open question?

Andrew Bailey: The point that Huw and I would probably differ on is that he would speak with hindsight, as he did on that question. I am not prepared to engage in hindsight answers, because the fact is that we make policy based on what we know at the time. I will leave it to historians to judge with hindsight. Saying that monetary policy would have been somewhat different had we known everything we know today is not a terribly radical statement to make at any point in time.

The Chair: Thinking about where we are now, and given its scale and duration, do you think QE has begun to blur the distinction between monetary and fiscal policy?

Andrew Bailey: Not at all. During Covid, both monetary and fiscal policy were acting consistently—that is the word I always use. They were both acting countercyclically in the face of a very big shock to the economy. I do not think it blurred policy in that sense. Now we are doing quantitative tightening; we are selling the stock of assets. To be very clear, there is no discussion between us and the Government about what we should and should not do in terms of the pace and timing of that.

Q3 Lord King of Lothbury: It is very nice to see you, Andrew. You said that in 2020 in particular, you felt that the weakening of the economy was one of the major motivations for QE. If that weakening was a reflection of the supply side, rather than demand, surely you want to tighten policy at that point, not ease it.

Andrew Bailey: There was a very important difference at that point in time. I would agree with you as a normal matter, but in 2020-21, much of the tightening of the supply side was a matter of temporary government policy. Parts of the economy were closed and the furlough scheme was in place, which had an end date. We had to look forward to what would happen once that temporary closing of the economy came to an end, as it did, and what would be the state of the supply side at that point. Here I would emphasise—you are right to point to this—that when I look back on this period, there are things that we clearly could not see; I would challenge anybody to say that they could see that Russia was going to invade Ukraine at that point.

There were two other big judgments. One was around the transient nature of the global supply-chain shock, which we can come back to if you wish, and the other was around the supply side—not that the Government had in a sense enacted measures to restrict it, but what would happen when those measures were lifted. Particularly in the labour market, which I know you are looking at in your inquiry, it has turned out to be much more constrained on the supply side than we thought it would be. Sadly, I am afraid the UK is following a very different pattern to other countries in that respect.

Q4 Lord Livingston of Parkhead: Thank you, Governor, and nice to see you again. Last time you were here, we talked a bit about the impact of a rise in interest rates. Can you share with us what discussions you have had with the Treasury, both during the time of QE and since we have had very substantial interest rate rises, about that impact, particularly regarding the losses arising from QE?

Andrew Bailey: Let me put it into a bit of perspective. Going back to Lord King’s time, the agreement to pay over the cash proceeds was made just over 10 years ago, in November 2012. Since then, £123 billion of cashflow has been paid by the Bank to the Treasury, exactly in line with what was agreed. It has been clear ever since that there would most likely be a reversal of that cashflow at the point when QE came to be unwound. The reason is that QE was enacted in a period of falling interest rates and was going to be reversed in a period of rising interest rates, so the funding cost, the cashflow, would go into reverse.

There has never been any question—it has always been unambiguous in the correspondence, communication and what has been said publicly, and it has been reported on a lot of times—that this would happen. That is exactly what is happening now. It has just started to go into reverse; the first cash payment has come the other way. However, I must be clear that QE was never meant to be a revenue raiser for the Government. That was never the intention. Lord King is much better placed than I am to talk about the original debate, but there was a question as to whether it would be better for the cashflow to be retained or not, and it was settled 10 years ago. The consequences have always been spelled out.

Q5 Lord Livingston of Parkhead: Not surprisingly, there is a renewed call to look at the interest paid on reserves, as we talked about last time you were here. You were very clear then. Have your views changed? Also, you were quite clear that this is a fiscal decision, with which I think we have some sympathy—but when we saw the then Chancellor, now Prime Minister, he said that it was a monetary decision. Can you give us any clarity?

Andrew Bailey: I will have a go. I would draw three points out on this. First, an important objective of monetary policy is to transmit the MPC’s decisions on bank rate into the economy. By far the simplest way to start that process is to pin down the very immediate point of the yield curve at the chosen policy rate. The simplest way to do that is to pay the policy rate on reserve accounts at the Bank of England that the banks hold with us. That is unambiguous; it is not volatile, and does not require any trading to happen. That is what remunerating the reserves is.

Secondly, to reiterate the point I made before, because of that there is no monetary policy reason to vary it. Any decision to do so would be a fiscal policy decision.

Thirdly, it is very important to clarify something. Sometimes when I listen to this debate, I get a sense that this is free money for the banking system, and the more we put the official rates up, the more free money there is. That is not the case. The way to think about it is that any benefit the banks get from it is the difference between the official rate and their cost of funding, because they have to fund the reserves—the reserves are an asset on their balance sheet, so they have to fund those positions. The benefit is that difference. Their cost of funding will rise as we put up Bank Rate.

I cannot be precise about whether there is a benefit, what it is or whether it will change over time. It probably will change over time, for the simple reason that, when rates fell to very nearly zero during and after the financial crisis, the relationship between bank funding costs and the official rate probably changed somewhat—the funding costs did not fall as far as the official rate, so we may see some reversal of that. But broadly, it is not free money in that sense.

Q6 Lord Livingston of Parkhead: Finally on this subject, you are absolutely right; we all expected that rates would go up, and we talked about that last time, but none of us could have anticipated by quite how much they would go up and in how short a time. When we raised the point that one should prepare for the impact of rates in any way, your colleague Ben Broadbent commented that it would not be a problem because the rates would go up only when the economy was strong. I think “countercyclical” was the word he used. Almost all of us here are aged and remember the 1970s, so we commented about stagflation. On reflection, were we perhaps a little relaxed about the whole issue?

Andrew Bailey: I cannot remember how long ago that comment was.

Lord Livingston of Parkhead: Last time you were here, in 2021.

The Chair: It was in May 2021.

Andrew Bailey: Quite a lot has happened since then. Unfortunately, we are now in a situation which some people call a “trade-off”: in other words, higher inflation and weaker growth. By far the biggest single cause is the consequences, particularly for energy markets, of Russia’s invasion of Ukraine. But you are right that that comment is dated. It is a reasonable comment for a more normal cycle of monetary policy, but we are not in that position now.

The Chair: To clarify, on the point about whose decision it is, is it still your view that it is the Chancellor’s decision unless it is a fiscal decision?

Andrew Bailey: We have not had any conversations about this, to be very clear. We would obviously have to enact it; my point about whether it is a fiscal decision is that there is no monetary reason for us to vary the remuneration of reserve accounts. If the Government wished to do that, we would have to talk about it, which is not something we have discussed or contemplated.

The Chair: I think Huw Pill said last week that he is “not a fan of the proposal”. Does that summarise your view as well?

Andrew Bailey: Yes, but, to be very clear, there is no proposal in any official sense. I would agree with Huw on that.

Q7 Viscount Chandos: Governor, you have said that we have moved on to a phase of quantitative tightening. It is early days, but could you say how you feel it has gone to date and give an indication—not necessarily numerical—of what scale of QT you could see being appropriate over the next few years?

Andrew Bailey: I will happily give an indication. It is a very good question. I will say how much we have done and then come to the scale point. To be clear, there are two ways in which we are doing this. One is the natural run-off of the portfolio, whose principal proceeds we do not reinvest—interest is different, as we talked about on Lord Livingston’s question. We started that in spring and then more recently, in the last month or so, we started actively selling the portfolio. The reason we have to do that and the Federal Reserve, for instance, does not is that it has a very short-duration QE portfolio, whereas ours is balanced to reflect the issuance of UK government debt, so we have a lot more longer-duration debt in our book.

We have reduced the gilt portfolio altogether by about £41 billion or £42 billion. The largest part of that is run-off, but we have now sold, I think, about £4.5 billion of gilts in auction.

There is a second part to what we are doing. We had a £20 billion corporate bond portfolio as part of the overall QE, and we are selling that as well. Again, I think about £4.5 billion of that has now been sold. We are auctioning several times a week on both books.

We may well come on to our recent intervention later, but I do not have any results on that, I am afraid, because it is going on as we speak. It is the first date when we can sell those bonds as well, if people approach us.

Altogether, the total is £45 billion to £46 billion. That has reduced the QE portfolio to about £830 billion of gilts and about £15 billion of corporate bonds. Then there is the additional £19 billion from the recent intervention.

I will take the second part of your question in two quick parts. First, we have stated an intention to reduce it by £80 billion in the first year. There is no reason to think that we are not on track for that. A really interesting question is how far we will reduce this portfolio, which is £850 billion altogether, before we reach the equilibrium level of reserves—the equilibrium level that the banking system needs to meet its financial stability and liquidity needs.

We do not know the answer. I can give you two bookends: one is what we had, which is almost what we have today; and the other is what we had before the financial crisis, which was very small. The answer is certainly between those two numbers, but it is uncertain, because we have never been in this position. The equilibrium level will be higher than it was before the financial crisis, because the effect of liquidity regulation and liquidity provision for the banking system demands a larger stock of reserves. I want to be clear: we are not going to sell the whole lot, or at least, if we do, it will have to be replaced by something else.

I do not expect this to happen for quite a while, but we already have in place forms of market operations that we can do if we sense that we are hitting that equilibrium level and getting pressure in the short-term money market as a result. We will have to be ready for that. The Federal Reserve had experience of that a couple of years ago.

Viscount Chandos: The beauty of run-off is that it does not involve any capital loss.

Andrew Bailey: That is not the case, because there would be a funding cost. The funding cost of the portfolio would be negative in that case. This is because of the rising interest rate point I made. I have seen that written and I am afraid it is not true. The loss can come in one of two ways, or a combination—as you say, one is the sale. If we do not sell it, it would come from the cost of funding the portfolio for longer.

Viscount Chandos: I understand that, but the longer the maturity of the bond sold, crystallising the mark-to-market value, the more that is a net present value, as it were, of those future funding losses. The NIESR advocated a very substantial one-off transaction in June of this year. Were that to be the Bank’s conclusion on what should be done, that would crystallise a substantial loss because of where the mark-to-market value is.

Andrew Bailey: That is true. The point I was making was that it would bring forwards a cost. I have seen a number of newspaper articles recently that have said that if the Bank of England just retained the portfolio for its natural life, there would be no loss, but that is not the case. You are right that if we did a single, very big sale, it would bring it forwards. However, we have obviously had a period of severe illiquidity in the gilt market; indeed, it is not back to normal at the moment. Doing that would be very inadvisable, frankly.

Q8 Viscount Chandos: If there were a moment when it was advisable and involved that bringing forward of losses, are you confident that the Treasury and the Government would be comfortable with that and that the terms of the indemnity—as you know, we are a bit frustrated not to have been able to see it—would ensure that you could do it on your judgment and decision?

Andrew Bailey: I am sorry about the indemnity. It is not the Bank of England’s decision whether to publish it; it is strictly a Treasury decision. I am confident that there are no wrinkles in the indemnity in that sense.

We would have to take a number of decisions. One would be about market conditions, from the point of view of what is a sensible way of selling the gilts but also from the point of view of the broader financial stability considerations of the gilt market. Those would be our considerations.

We have set the number of £80 billion for the first year, but we have not said anything about the period thereafter. I was very clear on this, because, frankly, we want to observe what happens in the first year before deciding the pace thereafter. We could always vary it from year to year anyway.

Viscount Chandos: Can you model clearly how much of any target comes from run-off and therefore what market sales are required to meet that target?

Andrew Bailey: Yes. We know the run-off, because it is the maturity schedule of the bonds we hold. Run-off is not at all even, because the maturity schedule is not consistent; it fluctuates.

Viscount Chandos: Bringing forward the loss by a sale changes where the duration risk lies. The NIESR analysis was about the shifting of duration risk. Its advocacy of substantial QT is to bring it back. Would that be a consideration of the Bank, or the Treasury?

Andrew Bailey: It is for us to consider those things, because it is our balance sheet. As I said, we would have to look at what we judge to be the optimal flow of sales from the point of view of the portfolio and the market.

Viscount Chandos: It is your balance sheet.

Andrew Bailey: Yes, it is.

Viscount Chandos: Legally, yes, but the effect of the indemnity blurs the issue.

Andrew Bailey: I understand that point, but I would say that successive Chancellors have not sought to intervene in those decisions.

Q9 Lord Rooker: To take you back to the 44 days of the Truss Government—this is not hindsight—it was not normal. The day before the Chancellor got into his seat, he sacked the Permanent Secretary. There were clearly briefings from the Government against the Bank and yourself. The Treasury did not give the Bank the briefings that would normally happen before major financial statements, whether Budgets or not. With all these warnings and negatives, which were not normal, why was there not better co-ordination between the Bank and the Treasury before the mini-Budget at the end of the week, to prevent the need for the short-notice, large-scale intervention by the Bank? We have not seen a satisfactory explanation of the processes between the Bank and the Treasury in this respect.

Andrew Bailey: First, I am probably stating the obvious, but this was an extraordinary time. I have no doubt in my mind that Treasury officials told the Bank of England and me everything they knew. There is no question of anything being hidden between Treasury officials and the Bank of England, as far as I know. However, let me say two things—

The Chair: Sorry, I need to jump in on that. You are saying that Treasury officials told Bank of England officials everything they knew, so there was someone else in the Treasury, not Treasury officials.

Andrew Bailey: Can I come on to that? I would say two things. First—and, I have to say, we have seen this in some of the commentary from the former Prime Minister and the former Chancellor—the lack of clarity between them as to what would actually be in this statement illustrates the problem: it was not known. It was not clear what would be in the statement.

The second thing, which is very important from our point of view and is a point I made in a statement on the Monday immediately afterwards, is that not involving the Office for Budget Responsibility in the process took away a good deal of the substance we rely on to go with a Budget, from the point of view of forecasting and understanding the impact of the measures that are being taken. That just was not there; there was nothing.

You are very right to ask the question, but to be very clear: this was a most extraordinary process, in that sense.

Lord Rooker: You have been very careful in your use of words about Treasury officials. Somebody knew what the Chancellor was going to do. Are you saying that you had no advanced warning of the £46 billion of unfunded tax cuts—that no one in the Bank had that warning?

Andrew Bailey: I knew what had been said, particularly by the Prime Minister during the leadership campaign, where signals had been given about what the intent of the policy would be, but we did not know what would be in the statement. We had some ideas, some of which were probably better ideas than others, but I am afraid that, for parts of it, we had no idea what would be in it.

The Chair: To be clear, which ideas did you know about? What did you actually know?

Andrew Bailey: Some bits had been pre-announced or at least trailed around.

The Chair: Forgive me for saying so, but the word that springs to mind is “slapdash”, with bits of ideas coming out.

Andrew Bailey: Well—

The Chair: Just let me finish. I am not necessarily saying that it was your fault; what I am trying to get at is what the Treasury was telling you. Was there a formal communication in any shape or form detailing items announced in that mini-Budget?

Andrew Bailey: There was no formal communication of the sort we normally have. It was a quite extraordinary process in that sense. To reiterate, although it is by no means the only part of it, the absence of the OBR part of that underlined that lack of structured communication and presentation. It was just not there.

Lord Rooker: From my experience, it is quite unusual for a big statement like that to be made so late in a week. It would normally be on Tuesday or Wednesday; this was a Thursday, if I remember right.

Andrew Bailey: It was a Friday.

Lord Rooker: So at the very end of the week, which is very unusual. It was known on the Monday that it would take place and that the OBR had been sidelined. You were obviously aware second-hand of the criticism from the Government of the OBR, the Bank and everything else. Did you make any formal request to the Chancellor or the Treasury to get on the record, for your own audit trail, that the Bank needed some advance information?

Andrew Bailey: It is not for me to speak for the former Government, but it was not a normal week because Monday was the Queen’s funeral. I think Parliament went into recess at the end of that Friday, as I remember, so there was a desire to get a lot of things into that week. I am not an expert but Budgets certainly do not normally appear on Fridays, in normal circumstances. It was obviously a quite different week, in that sense.

I can only reiterate what I have said. As is well known, because the then Chancellor said it quite often, he and I talked quite often, but it was not at all clear to me what would be in the statement.

Lord Fox: Without overlabouring this, on the point Lord Rooker made, did you make representations formally either to the Treasury or to the Chancellor that you needed to have detailed advanced knowledge as to what would be presented that Friday?

Andrew Bailey: I did not say to the Chancellor, “You have to tell me what will be in this fiscal statement”, because, frankly, I would never say that to a Chancellor. Then again, I do not need to say that in normal circumstances. We have channels of communication.

Lord Fox: But clearly not in this case.

Andrew Bailey: No, it was not happening in this case. I reiterate the point about context; it was an abnormal week, in that sense. But no, we would normally not be in that situation. It was a very abnormal situation.

Baroness Noakes: To clarify, it was not a Budget.

Andrew Bailey: No, it was a fiscal event.

Baroness Noakes: It was a fiscal event. It was never intended to be a full-scale Budget because it was clearly signalled in advance that the financial strategy would come at a later stage. Was there a reasonable expectation that you would get the kind of information that you would get on a Budget?

Andrew Bailey: No.

Baroness Noakes: So we are talking about a situation where there was no natural expectation that you would get that normal level of information?

Andrew Bailey: You are making a very fair point. I do not want to be judgmental about this, because the reason why it was termed a fiscal event rather than a Budget is because if it was a Budget the OBR would have to be involved, because of the legislation that governs the operation of the OBR, so it was not termed a Budget. There might have been other reasons why it was not, but for that reason alone it was not a Budget.

The Chair: I know you do not like hindsight, but if you had known, what would have been different? Jon Cunliffe has said, “While fiscal policy is not our responsibility, it affects the economy. We need to factor it in”. How would it have been factored into your decision-making and your actions if you had known this was coming?

Andrew Bailey: The MPC met the day before, so we announced our monetary policy decision on the Thursday, with the fiscal event on the Friday. It was not a monetary policy round with a forecast and a monetary policy report, but we would have been able to factor it in more if we had known. By the way, that is why we made it very clear in what we said on the day before that we would have to factor it in in the following round, which was at the beginning of November.

Q10 Lord King of Lothbury: The MPC met on the Thursday, the day before the mini-Budget. The very clear convention would have been that a Treasury official was present at that meeting and would have briefed the MPC not on individual tax measures but on the overall scale of changes in the balance between taxes and spending. Was there a Treasury official at that meeting?

Andrew Bailey: There was.

Lord King of Lothbury: Did that official brief the MPC on the broad scale of the measures?

Andrew Bailey: Let me take that in two parts. It is fair to say—and this is why I said what I said at the beginning—that I do not think that Treasury officials were clear on what was going to be in it at that point. This is supported by commentary from the then Chancellor and the then Prime Minister.

Lord King of Lothbury: Even the day before, Treasury officials did not know what was going to be in it?

Andrew Bailey: No, I do not think it was settled at that time.

The Chair: So there was no overall sense of what would be done?

Andrew Bailey: That is my second point. It is very hard to draw a strong message on the overall extent without having OBR involvement in something that sizeable.

Lord King of Lothbury: This practice of a senior Treasury official briefing the MPC predates the OBR. There was a tradition in which Treasury officials would give clear guidance to the MPC as to the likely overall economic impact, even though they were not free to describe individual tax measures or to go into enormous detail. With a change of that magnitude, it certainly would have been normal for a Treasury official to tell the MPC, “Hey, something quite big is going to be announced tomorrow. I can’t tell you a precise number, but it’s going to be big”. It would have been very unusual for the Treasury official to come back the next month and say, “I’m very sorry, I forgot to tell you last month”.

Andrew Bailey: I must be clear: the Treasury official told us what they understood to be the situation.

Lord King of Lothbury: What size of giveaway did they give?

Andrew Bailey: Going back to your point about the OBR, in the pre-OBR days its functions were performed within the Treasury. The Treasury does not have that function anymore, so it cannot do that itself. This was one of the great frustrations: that what I would call the economic analysis that went with it was not there.

Lord King of Lothbury: But there were ready reckoners, which even the Treasury now has, which would have enabled them to say, “This is a very small tax giveaway”, or, “It’s a very big one”. Did they say it was a very big one?

Andrew Bailey: I remember that at the time there was speculation that this would be quite a substantial package. There was no great secret about that. Our position in the MPC was that we did not know how substantial it would be. We were quite careful in the language we used in describing the outcome of our meeting to be clear that we knew this was coming and would have to be factored in in the following meeting.

Lord King of Lothbury: What was the biggest surprise to you? Was it the actual announcements in the mini-Budget or the market response to them?

Andrew Bailey: That is a good question in terms of relative judgments. It is interesting; I asked a number of senior people in the market what had surprised them, given what they knew about it before it happened. The answer had two parts. The first thing, which they knew but obviously had not factored in, was the absence of the OBR—not only that, but the positive “We don’t want the OBR involved” message that came across. Many people gave me the “flying blind” analogy. The second, interestingly, was the abolition of the top rate of personal taxation, which, by the way, we had no idea was going to happen.

Lord King of Lothbury: I do not think you would normally have been told that in advance, as it was a specific measure.

Andrew Bailey: In a sense, that is the kernel of this discussion. All they had was a set of specific measures; they did not have the economic impacts. I fully take your point, as that is how it normally happens. We do not necessarily need to know the detailed measures, but we need to know their economic impact—but that was not there, because there was no OBR.

The top rate of tax was interesting because, in economic terms, it was not the biggest thing in that package—it is a low marginal propensity to consume for that group. People told me that they were substantially surprised that it was done at that point in time, in that context and situation. People in the markets said that those two things had quite a big impact on their reactions to it and judgment on the direction of UK economic policy and fiscal policy-making at that time, which was very negative.

Q11 Lord Skidelsky: To return the discussion to the gilt markets programme, what were the roles of the Financial Policy Committee and Monetary Policy Committee in that decision?

Andrew Bailey: Do you mean quantitative tightening or the action we took in the crisis we have just had?

Lord Skidelsky: The gilts intervention.

Andrew Bailey: I am happy to go through that. To put it into context, in our judgment we were facing a situation where there was a severe risk to financial stability—in other words, a problem particularly at the long-maturity end of the gilt market that could have spread. That was a financial stability risk. The Bank executive analysed the risk and prepared and designed the measures we could take. I know there may be questions around the choice of measures, which I would be happy to answer. The Bank executive then went to the Financial Policy Committee to ask whether it agreed with our assessment of the financial stability risk, which it did, and therefore whether we should take these measures to intervene, which it did.

The process was therefore not a monetary policy process and there was no policy meeting of the Monetary Policy Committee. There was a meeting of the Monetary Policy Committee, but it did not reach a policy decision. The reason there was such a meeting was that the Monetary Policy Committee had to reach a view on whether its ability to execute monetary policy would be adversely affected by taking this action. It was not asking the Monetary Policy Committee to do something; it was asking it to determine whether this would impede its ability to set monetary policy.

The decision of the Monetary Policy Committee, quite rightly in my view, was no. The reason for that was that the primary tool of monetary policy is setting the interest rate. There was nothing in the financial stability decision to conduct that operation to purchase gilts that impeded the Monetary Policy Committee’s ability to use the tool of Bank Rate. At its next meeting, the Monetary Policy Committee was able to take into account the consequences of that intervention for monetary conditions and take a decision to set Bank Rate appropriately and accordingly. That is how it was done.

Q12 Lord Skidelsky: More generally, you have OBR forecasts and Bank of England forecasts. Are they based on the same model and do they come to the same sort of conclusion? You mentioned the lack of economic analysis underlying the mini-Budget. Can you say a bit about the models?

Andrew Bailey: First, we do not have one model but a suite of them, to borrow Lord King’s phrase from many years ago. Whatever model or models the OBR uses, we do not have the same ones, so they are different bases. More substantially, if you look at what the OBR has recently published in its view of the economy and our recent publication of the November Monetary Policy Report, they are different.

I observe four differences. One is that we and the OBR take a different view on the future evolution of the labour supply. We have a weaker view of the labour supply; its view is rather more what I would call endogenously cyclical—in other words, as the economy recovers, labour supply will appear and recover. Secondly, it has a stronger view of productivity growth than we do. Thirdly, its cyclical recovery is stronger; I think it always closes the output gap at the end of its forecasts, whereas we do not. Finally, its view of the saving rate is different. It has a stronger view of activity in the economy going forward, because it thinks that more of the savings built up during the Covid period will be run down than we do.

The Chair: Lord Livingston wants to come in on the OBR, but before that I will bring in Lord King.

Q13 Lord King of Lothbury: To go back to that week of the gilt markets intervention, you said there was a meeting of the Monetary Policy Committee. It has had a small number of emergency meetings in the past, but it has always produced minutes.

Andrew Bailey: It was not a formal decision-making monetary policy meeting. No decision was taken on monetary policy.

Lord King of Lothbury: But the role of the Monetary Policy Committee is to make decisions on not just Bank Rate, as you suggested, but QE. All previous decisions on QE were taken by the MPC. It was asked to approve the decision whereby QE would in essence be carried out; that would not be described as a monetary policy decision but a financial stability decision. Nevertheless, you would still expect that, even if the MPC members judged that it was appropriate that it be carried out for financial stability reasons and did not impede their ability to conduct monetary policy, there would be a minute to that effect.

Andrew Bailey: There is a minute of the meeting to that effect, which says that, in the view of the Monetary Policy Committee, it will not impede the ability of the Monetary Policy Committee to set monetary policy. But that does not involve it setting monetary policy on that day.

Lord King of Lothbury: Has that minute been published?

Andrew Bailey: No, because it was not a formal meeting of the Monetary Policy Committee in the sense of the legislation.

But I really must push back: it is not QE. I am sorry, I really do not agree with that. Yes it is purchasing gilts, but it is done for a financial stability reason. It is temporary and targeted, which is why they are for sale today onwards. I have been clear that it was an absolutely key point for me, and frankly for other members the Monetary Policy Committee, that we must do everything we can to distinguish this from QE.

The final point I would make is that we have two objectives: monetary stability and financial stability. We have to be able to intervene where needed in both. Of course we are now in a phase where, if we have to intervene for financial stability reasons, unlike March 2020 it is going in the opposite direction to monetary policy. We recognise that, but I have to be clear: should we need to intervene for financial stability reasons, and on this occasion we felt that we did, we have to be able to do it.

Lord King of Lothbury: I do not want to challenge what you did or your motives for doing it, but earlier today you said that back in 2020 you did QE partly for financial stability reasons and partly for reasons to support the economy. Whatever the merits of that, the Monetary Policy Committee met and published minutes—

Andrew Bailey: It took the decision.

Lord King of Lothbury: Yes, it took decisions. It is therefore a bit odd suddenly to describe buying gilts for a different motive, because that is not what happened in 2020. Would it not have been simpler to have a short formal meeting of the Monetary Policy Committee and publish the minute to reveal to the world that the MPC had been involved and was content for this to occur? The failure to do that somehow muddies the water a little.

Andrew Bailey: My concern goes the other way, as to your point about it being QE. If the MPC was seen to be involved in this it would strengthen the argument that it was QE. I was very clear that it was not QE; it was a financial policy intervention.

If you do not mind me reflecting slightly more broadly, I am very conscious as Governor that the FPC, which does not get as much attention as the MPC—in one sense that is a good thing, because we do not want financial stability going wrong too often—does not have the same profile as the MPC. I sometimes wish that the MPC had less profile and that the FPC had more, but we will go into that. When we intervened for financial stability reasons, and only for those reasons—that is the distinction from 2020—it was very important the FPC was very clearly seen to be taking that action and taking the decision, and that it was explained in financial stability terms. Therefore, the decision on monetary policy—which, if you do not mind my saying, was the language you used in the exchange of letters with George Osborne in 2012, quite rightly, over the question of any monetary policy implications from the cashflows on QE that we were talking about—is the right way to handle it.

Q14 Baroness Noakes: To stay in the same period of time, the gilt purchase operation was due to stress in the bond markets, which was in turn due to the impact of the LDI strategies that had been pursued by a number of pension funds. What lessons have you learned from that LDI episode?

Andrew Bailey: I will start with the specific and broaden out, if you do not mind. My assessment of what happened in the LDI world at that point was that it was the interaction of two things. One was the scale of the movement in long gilt prices. To put that in perspective, the movement over the critical four days was two times larger than any previous movement over that period of time. If you go back before March 2020 it was three times larger, so it was a very big movement of the long end of the gilt market.

I am not sure whether that on its own was enough to cause the problem we had; it is an interesting question. What then happened was that there was a structural problem in the LDI fund world. There are two sorts of LDI fund—actually three, but the other one is not part of this. The so-called segregated funds, which are the big pension funds, have their own LDI fund. Then there is pooled funds: smaller pension funds pool together into an LDI fund.

The structural problem was that, when the movement in long gilt prices happened, the LDI funds faced very big margin calls on the repo and derivative contracts that they had. They could not meet these calls on their own from their own resources. There is a process for dealing with that which, in smaller ways, they deal with quite often, which is called rebalancing, where they call down liquidity from the main pension fund, because the LDI funds are sub-funds of the main funds.

The scale of the need for this rebalancing was bigger than anything they had had to deal with before, which in a sense exposed the structural problem. As I will come on to, it is much more difficult in the pooled funds than the segregated funds because they had to get the trustees of the parent funds to agree to transfer the liquidity. In the time available, which was short, and on the scale needed, the very clear message we were getting was that the trustees were not set up to do that—in a sense, I suppose we do not want them to take decisions too quickly normally. It was more difficult for the pooled funds, because there was essentially a collective action problem: many pension funds had to take the decision to transfer liquidity to the pooled LDI fund. It was clear that that process was not going to happen. Had it not, or had we not found a way around it, they would have gone into a form of technical default. That is when financial stability triggered.

What have I learned from this? The scale of movement of gilt yields was extraordinary. There was a question as to where, in any stress test, we set the boundary, if you like. I am happy to come back to that if you want. What was also uncovered, which had not been focused on, was the structural problem of how you effect the mechanism for rebalancing in a period of stress. That is a very clear issue for the LDI world.

Baroness Noakes: Going back to 2018, when the Financial Policy Committee identified that there was an issue around LDI funding of pension funds, are you saying that the structural problem was not unearthed at that time?

Andrew Bailey: The focus then was more on the segregated funds, because they are bigger. That is a key message in there.

Baroness Noakes: That exercise did not unearth the underlying fragilities?

Andrew Bailey: It is interesting. I have discussed with colleagues and posed the hypothetical—which I do not like—that if the world consisted only of segregated funds, would we have had to intervene? It is arguable; it is a very fine balance. We might not have had to. It would have been a difficult world, but we might not have had to intervene.

Baroness Noakes: When you came to action, several regulators were involved—you, the FCA and the Pensions Regulator. Do you have any reflections on the regulatory landscape and whether it works well together?

Andrew Bailey: It is not just that set of regulators, if I may add one more thing. I think I am right in saying, because the chief executive of the FCA told me this, that none of the LDI funds is domiciled in the UK. I think that they are domiciled in Ireland and Luxembourg, so regulators outside the UK are part of this picture as well. We have to bear that in mind.

On your point, there are two areas of complexity. One is domestic pension regulation, which is a complex landscape. I have seen it while wearing different hats in my career. Some parts of it are more adjusted to what I call financial regulation, in the sort of eventual sense, than others. But there is another part of it, which is the fact that a lot of these funds are almost entirely—in this case entirely—overseas.

Baroness Noakes: Was that recognised as a regulatory risk back in 2018?

Andrew Bailey: I do not think it was put out as a regulatory risk.

Baroness Noakes: So we have had an imperfect understanding of the regulatory risks being faced from a financial stability perspective.

Andrew Bailey: Looking back, one of the interesting and quite relevant things about this is that I have heard quite often that LDI strategies became complicated to the point where pension trustees did not follow or understand them and they were outsourced to advisers, which is also an issue in terms of risk management.

Q15 Baroness Noakes: With the benefit of having been through that, do you think any changes are needed to the powers of regulators or the ways in which they operate in the UK going forward?

Andrew Bailey: We need to look at the complexity of that landscape. We also need to look at whether all the relevant parts of it are set up to do what I might call financial regulation. I do not say this in a critical sense—it would be easy to misinterpret it—but the Pensions Regulator is not an independent regulator in the sense that the FCA and the PRA are.

Baroness Noakes: Is anybody doing any work on this?

Andrew Bailey: We are certainly doing work on lessons learned. It is probably for the Government to speak on what they will do.

Baroness Noakes: You mentioned stress testing. The stress tests that were done in various ways in 2018 and subsequently, both by the FPC and via the Pensions Regulator, were of 100 basis points. That started in a period of ultra-low interest rates. Did it never cross anybody’s mind that, when interest rates started to move up, and were forecast to do so, 100 basis points might look a little light, if nothing else?

Andrew Bailey: I will come back on this. As I said earlier, a stress test will look at how much a rate can move in a short space of time, whether that is a threat to financial stability and, in this case in particular, whether the rebalancing process would correct for that in time. I do not think it is just a question of saying, “Surely you thought rates could move by more than that”. As I said, the moves at this time were unprecedented in terms of that time period. For me, the issue is more the structural barrier to dealing with it.

Baroness Noakes: But surely an understanding of the kind of stresses and results produced by stresses is an important element of that. For example, I understand that no reverse stress testing was undertaken to see what kind of strain would cause serious problems.

Andrew Bailey: That is true. My point is that now we have had this experience, so we are holding them to a higher level of resilience, which is appropriate. There is a question in any stress-testing or examination world as to where the level of resilience and the tail of the distribution of outcomes is set. We have exactly the same issue with the Bank’s stress test—how far into the tail do you put the stress test?

An issue that we have to think hard about is that in the world of bank stress tests we pick a point on the tail of the distribution beyond which a formal resolution regime kicks in. Here there is no formal resolution regime, as we found; the Bank of England has to step in with this operation. You cannot have infinite resilience in any financial system. You cannot have it anyway, but at some point the cost of having it would become huge. What is the optimal point for relying on an alternative approach, which is an intervention by the authorities?

Q16 Baroness Noakes: To conclude this set of questions, do you think that the Financial Policy Committee performed well in the LDI crisis?

Andrew Bailey: The Financial Policy Committee identified the issue in 2018, as part of identifying non-bank finance generally, around which there is a much bigger issue that we may want to come back to. In the crisis itself, the FPC did its job, and the intervention was effective.

Baroness Noakes: Having identified it in 2018, do you think what it did in 2022 was enough?

Andrew Bailey: I take the point. The FPC has a set of priorities—we did a lot of other practical things in the intervening period. We can look back now and say, “It would have been good if the system had put more attention on LDI pension funds”. Obviously, we will do that, but a world of hindsight judgment comes in there.

The Chair: Paul Tucker was quite forthright with us last week in saying that you neglected it. I take it you disagree with what he said.

Andrew Bailey: I would say to Paul that it is a hindsight judgment, having had a movement in gilt rates that is outside the historical experience. Secondly, as he will remember from his time on the committee, we have to make judgments on relative priorities. We have to deal with a very big landscape, and we made those judgments.

Q17 Lord King of Lothbury: In defence of the FPC, in 2020 it suggested a solution to the problem it had identified in 2018, which is the one you have reverted to at the end of all this—a liquidity facility that can be made available either to the pension funds or the banks, which can then lend to the pension funds. Would it not have been possible, with this proposal from the FPC in 2020, to prepare a liquidity facility in time to use it, which would have been preferable to direct intervention, as it is what you went back to when you ended the intervention?

Andrew Bailey: I will tell you what happened in this case. We spent a couple of nights trying to work out how to do this based on the tools we had. My preference, as you say, would have been to intervene with a form of repay facility from the Bank of England to the pension funds, rather than us having to buy gilts. That would have been a better way to do it.

Two problems defeated us, which reflect the two different ways we could have done it. We could have done it with the LDI funds themselves or the main pension funds. The LDI funds did not own the assets at the time. Whatever assets they had had to be transferred from the main funds; they did not have the assets to lend against at that point. That was not an option that we could put into effect.

On the main pension funds, I come back to the pooled funds issue. The pooled funds were far more of a problem than the segregated funds, as I said earlier. There are some 175 pooled funds and—we do not know the exact number—around 1,800 pension funds participating in them. First, frankly, there is a problem of numbers. We are not set up, and I do not think it is feasible to be set up, to deal with that sort of operation. Even if we could do that, we ran into the problem I mentioned earlier that they needed the decision-making and processes in place to effect it in very short order. They would then have had the liquidity and would have had to transfer it to the LDI funds. Frankly, given the time we had and the fact that there was a severe problem in the market—in my judgment, when we launched the gilt purchase operation, we were probably within an hour of having a severe problem—it was just not feasible.

Lord King of Lothbury: Given that the FPC, to its credit, suggested such a facility in 2020, preparation might have made it possible.

Andrew Bailey: I am not sure that it would have worked in that situation. I do not think we could have solved the collective action problems involved in that. I can assure you that we spent a lot of time trying to do it—it was not something we passed over lightly.

Lord King of Lothbury: Given that the funds had to meet cash margin calls, if they did not have the decision-making capacity to respond quickly, there is clearly some failure in the regulation of pension funds.

Andrew Bailey: I think this goes to Baroness Noakes’s question.

Q18 Lord King of Lothbury: Finally, on this question of creating a liquidity facility for a non-bank institution, clearly a very big one, what is your current view on which entities or kinds of entities ought to qualify for access to central bank liquidity—against appropriate collateral, of course?

Andrew Bailey: There are parts of the non-bank system that have liquidity mismatches, if you like. Parts of the asset management world have those, as do parts of the money market fund world, although I should caution that I am not sure some of them have the assets that we would naturally want, because they are often investing in bank assets. Those would be two obvious ones. We have also talked about pension funds.

The background to this is that, frankly, we are having to devote a lot more time to the non-bank world now, relative to the past. That is a function of the regulation of the banking system post financial crisis and the way the world has evolved. Earlier this year, in the wake of Russia’s invasion of Ukraine, our concern was around some parts of commodity financing. We have put in place a guarantee facility for energy financing precisely for that reason.

Q19 The Chair: Briefly, before I turn to Baroness Kramer, I want to ask you about the very hard-hitting piece that the former president of the Federal Reserve Bank of Minneapolis wrote, titled “Markets Didn’t Oust Truss. The Bank of England Did”. His contention is that “it refused to extend its support beyond October 14, even though its purchases of long-term government bonds were fully indemnified by the Treasury.” He continued—this is the key point—“It’s hard to see how that decision aligned with the bank’s financial-stability mandate and easy to see how it contributed to the government’s demise.” What would you say to that?

Andrew Bailey: I answered that question the other day, but I will answer it again. There are three reasons why that article is, frankly, constructed on a false premise.

Let us start with the point about financial stability. There was, in my view, a serious moral hazard problem involved in this operation. Unless we were able to draw it to a close credibly and promptly, we would have been stuck buying gilts for a lot longer. There was no good reason for us to go there; in fact, it would have been a very bad thing. Of course, there are parts of the market that would love to have the Bank of England permanently offering to buy gilts. It was imperative that we made it clear that there was a deadline and stuck to it. There was a lot of risk.

I was criticised heavily for the comment I made in Washington at the time, being told that it was not credible. That brings me to the second point. By the time I made the comment on the Tuesday—we finished the operation on the Friday—and particularly after we had changed the terms that morning to say that we would purchase index-linked gilts, which we did not wish to do, but realised we had to, to finally solve the problem, my view, based on the continuous contact we were having with the LDI management funds, was that the problem would be dealt with by the Friday, and indeed it was.

Those are the first two reasons. We have covered the third quite extensively in the questions you have asked me. I have been very clear that it is not a QE operation, but it was running directly counter to the direction of monetary policy. We could not leave it out there for longer than we absolutely had to, because it would have increased the risk of people thinking that we were turning monetary policy round and doing QE.

I am afraid that there are three very big flaws in that article. We did not bring the Government down. We did a limited operation for financial stability purposes. We did exactly the right thing and ended it promptly. I am sorry; you can see that I am passionate about this, but the article is quite wrong.

Q20 Baroness Kramer: Could I just build on the questions started by Baroness Noakes? You started to suggest that you have rather a lot to say on what you call the non-bank banking or finance world, which I call shadow banking. Could you talk us through, from your perspective and that of the FPC, the kind of systemic risks that are appearing in that world and what actions need to be taken to address them?

Andrew Bailey: It is a huge landscape. One of the challenges for us domestically, but also globally, particularly for the global Financial Stability Board, with which I am heavily involved, is how we have appropriate surveillance of this world. One point I draw out from the questions that Baroness Noakes quite rightly asked me is that there was a structural problem embedded there. How do you survey a world that big and get down to that level of structural problem? That is a challenge we have to meet.

Money market funds are one area. The Financial Stability Board has already come out with its recommendations on that. I start with money market funds for good reason. Covid was the second time we had problems with money market funds. We also had problems with them during the financial crisis, so it was unfinished business, as far as I am concerned.

I return to the point I made earlier: very few of the sterling money market funds are domiciled in the UK. I am sure that the FCA will introduce rules, but we have to be realistic about their effect, particularly until the EU introduces rules, which it is not doing at the moment.

Baroness Kramer: Could you tell us a little about how you are trying to tackle that issue?

Andrew Bailey: It is happening particularly through the global Financial Stability Board and peer pressure, frankly—saying that you have to put these into effect. In the US, the SEC has come out with recommendations, but it now has to put them into effect.

I mentioned commodity markets because that was an issue earlier this year. It is a somewhat opaque area of the financial system, in my view, but it is important. Open-ended funds are obviously a very big part of the landscape. Some parts are more illiquid than others. We have had experiences in this country, for instance with property funds; I have to deal with them on occasions, so that is another example.

If you want me briefly to broaden it out across this landscape, we also face risks that go across the banking and non-banking worlds. Again, going back to the question I was asked about prioritisation, one of the big things we are doing this year is a cyber stress-test. This is a very big risk, and it is only getting bigger. I am afraid the whole Russia/Ukraine thing has brought this back to the top of the list, so we are currently doing a very big test scenario on how cyber-risk would actually play out and how the industry is resilient against it. I hope that helps.

Baroness Kramer: It helps to worry me more. Is there anything I can press you for to get a sense of the response that is needed? Are you resourced to do it? Do we need changes in the regulatory landscape? Are there steps we should be taking to bring that arena into some measure of reasonable resilience? Is it too early to say? Is somebody going through this in detail? If you could help us more with this, I would be grateful.

Andrew Bailey: Regulators are going through it in detail and the FPC is very much involved. I will draw on another thing that has been in the news recently. This has come more to the fore because of the growth in the non-bank world relative to the bank world and the regulation of the bank world. We have to have a very clear sense of the risks to public policy objectives and financial stability that go with this world. You have probably read about the recent disagreements on Solvency II—

Baroness Kramer: I was going to touch on that, yes.

Andrew Bailey: That comes up everywhere I go. At the heart of that is a quite reasonable public policy debate about the right balance between financial stability, protecting policyholders and securing investment in illiquid assets in this country to encourage growth. There are different views on that. Ensuring that that public policy debate is had properly is critical.

Baroness Kramer: What forum is necessary for that public policy debate? Here I think it is going to be merely in the context of the Financial Services and Markets Bill, which is a pretty narrow-based debate.

Andrew Bailey: I hope you do not mind me saying this: I think Parliament can help us a lot here by enabling us to bring that public policy debate to the fore.

Q21 Baroness Kramer: That is welcome. Could you expand a little on the issue of Solvency II? Obviously, you know the content of the Bill that is coming to us. Given that, are you concerned to any degree about the increased scope for risk within, in this case, the pension and insurance industries by investing in illiquid assets? I keep hearing about upscaling and infrastructure. I have done infrastructure finance; I know how high risk that is. Have you exercised you mind around this, or has the FPC? Do we have a formal statement on it?

Andrew Bailey: The PRA particularly has spent a great deal of time on this. As you rightly say, the issue is having the right scope for allowing these types of assets into the asset pool for annuities which, because of the commitment, obviously have to deliver predictable cash flows. We very much take the view that EU Solvency II needs reforming—the EU takes that view too—and there is scope to increase the range of assets that produce predictable cash flows. That will and should encourage investment. There have been differences of view over how far that goes, particularly between us and the industry. The comment you have just made in a sense bears out the issue.

The Government are the decision-makers on this at the moment; the rule-making power has not passed to the Bank of England yet. The rules on their own were not where we thought they should be, but the Government have also said that they will introduce more powers for us, for instance in the area of stress-testing and publishing the stress-tests of individual firms, and also attestations by senior management. We will put that package into effect as soon as the pieces are done in Parliament. Ensuring that that public policy debate happens and that we strike the right balance is critical.

Baroness Kramer: When Sir Paul Tucker spoke to this committee, he prayed in aid the ghosts of Eddie George and George Blunden to try to encourage us not to give the PRA a competitiveness objective, even as a secondary objective. Do you have a comment on that?

Andrew Bailey: I understand where Paul is coming from on that and have a lot of sympathy with him on it. I will be very clear on my view, which I have shared with successive Governments. A secondary competitiveness objective has to be framed in terms of supporting long-term growth in the economy. It also has to be clear that it is consistent with international standards. We cannot have a situation where the UK is trying to go against international regulatory standards.

The UK is a world-leading international finance centre. The legal and regulatory systems are part of the competitiveness of a financial centre. People want to do business in places that have robust legal systems and sensible regulation. They do not want to go to places that do not have those features—at least, good businesses do not.

The Chair: So you support the secondary objective, with those caveats.

Andrew Bailey: If it is framed well, we can make it work.

Baroness Kramer: I heard that as a fairly strong caveat.

The Chair: Let us see what everyone else has to say.

Q22 Lord King of Lothbury: Can I bring you back to monetary policy, the more boring element of your remit?

Andrew Bailey: There are no boring elements of monetary policy.

Lord King of Lothbury: It is a difficult position at present, with inflation at 11%, a very tight labour market and, as you pointed out earlier, big surprises in how the participation rate in the labour force has fallen, contrary to what is happening in most other countries. It is also very hard to predict headline inflation. A reversal of the price increases on energy and food since the beginning of the year might bring inflation down to close to zero a year from now, although it would then bounce back the following year—

Andrew Bailey: Not all the way back, I hope.

Lord King of Lothbury: No, but part of the way back. Nothing is inevitable, but given where we start, is it not a central view that a recession is part and parcel of the process needed to get inflation back to not lower than where it is now but 2%, on a sustainable basis?

Andrew Bailey: The scale of the external shocks hitting the economy and the effect they are having are coming through in a very big shock to UK real income. That appears as inflation, then as a shock to real income and activity. Unfortunately, before we in the monetary policy world get involved, that on its own is pushing the economy into negative activity and making recession more likely. I use the comparison that the scale of the energy price shock this year, which will be capped by what the Government is doing over the winter, is larger than that of any single year in the 1970s. That is quite a sobering comparison.

That on its own is the backdrop to the risk of recession. You rightly characterise and describe what might be the central case path for inflation. I would also say—this is critical for monetary policy-setting purposes—that within that picture of inflation coming down rapidly, and in terms of the Monetary Policy Report issued at the beginning of the month, we have the largest upside risk to inflation, in year 2 certainly, than at any time in the history of the MPC. We see a substantial risk to the picture that you rightly describe, and it is on the upside.

I think this is consistent with when you did it. We do not build that from the bottom up; it is a top-down view with stories, if you like, attached to it. For me, the biggest story is the labour market and the risk of second-round effects in that market from the shock to labour supply that we are seeing, as you rightly said. That explains part of the picture of monetary policy.

Lord King of Lothbury: We have 6.5% private sector wage inflation now. With those upside risks, a 3% Bank rate does not seem likely to be enough to bring inflation back down to 2%.

Andrew Bailey: As I think Huw Pill said when he was here the other day, and as the MPC said in its statement, our expectation is that there will be more to do.

Lord King of Lothbury: When you think about how much to do and look ahead, given that the central view is of quite a prolonged recession, for understandable reasons, would it not be better to get to the peak of it sooner rather than spreading it out?

Andrew Bailey: That goes back to the point I made about the fact that we are dealing with a risk at the moment. There is a central view of how it might unwind quite rapidly. There is a risk, so we are having to watch carefully the evolution of that risk. The big external shocks are moving as well.

There are three big external shocks going on at the moment—the labour market is domestic, obviously. There is the energy price shock, which is coming out of Russia and Ukraine. The size and force of that has been reasonably stable for a while, but it is just very big. The second, the earliest of the external shocks, is the post-Covid global supply chain shock. We are now seeing clear evidence that that is unwinding. The third is food. Unfortunately, as the global supply chain shock has unwound, the food price shock has come the other way. It is a hard to allocate that precisely to external and domestic causes, but quite a bit of it is external, and unfortunately Ukraine is another part of that story.

Q23 The Chair: There is a very interesting article in the Times today arguing that the wage price spiral is a mistaken narrative, and making the case for that. How much should one look at the wage price spiral as a factor as we look ahead?

Andrew Bailey: The word “spiral” obviously creates slightly dangerous connotations about where it is going. Lord King gave the numbers earlier, and 6.5% is well above where you would expect pay settlements to be in any normal situation, but it is not well above where you would expect it to be in the current situation. That is not to say that I like the situation—I do not like it at all—but it is not currently much out of line with where we thought it would be.

What is happening in the labour market is quite interesting. I go around the country a lot with our regional agents and, for the last year, I have been meeting firms that wanted to talk to me about the problems of recruiting labour. Those problems are still there to some degree, but the message I got was that this is changing. I was out two weeks ago making two visits, and firms are now beginning to see that pressure begin to ease. We are seeing it, first of all, in the so-called vacancies to unemployment ratio, which seems to have stabilised, at least, at a high level. We are beginning to see some signs of that. Going back Lord King’s question about how much more we are going to do and how quickly, we will obviously be watching that very carefully.

Q24 Lord Fox: To come back to the answer you gave to Lord King—you talked about a series of shocks, including energy price shocks and others—clearly homeowners are about to face a mortgage repayment shock. You pointed to the upside risk to inflation in year 2. This is clearly an upside risk to those homeowners of yet further increases in the mortgage rate, particularly in areas where, as there is a higher price, that will become a higher burden. The IFS pointed to the middle part of wage earners being hit particularly by this.

What is the prospect, in your view, for mortgages as we go through? For how many years ahead do we think that they will be facing the sort of shocks that they will be facing?

Andrew Bailey: Let me divide that question into two parts. For those mortgage holders who are on variable-rate mortgages—I am very sensitive to this because I understand the difficulties—rate rises will get fed through pretty much immediately. For people on fixed-rate mortgages there are two factors, the first of which is the pace at which they reset. About 50% of UK mortgages, both on variable and fixed rates, will reset by the end of next year. New fixed-rate mortgages are priced off the interest rate curve; essentially, they price off the swap curve.

On Lord King’s point, the market is expecting us to raise interest rates. In fact, I think that, as of today, their idea of the peak of our rate cycle is probably about 4.75%—although I am not endorsing that. We pushed backed against the market in the last MPC round, which is an unusual thing for us to do, but it was done to take out what I would call the last elements of the UK risk premium that had got in as a result of the problems we had in September and October.

The peak of our rate cycle was at 6.2%, right at the peak of the disorder. It was still at about 5.2% when we undertook the Monetary Policy Report. Frankly, we thought that was on the high side.

This is relevant to your question because how much fixed-rated mortgages will go up depends not just on what we do but on what we do relative to what the curve estimates it will be. I think that there are now signs—and I was hoping that this would happen—that, after this dislocation in the market over September and October, mortgages are now more available—but there are some signs that the price of new fixed-rate mortgages are coming down somewhat as that risk premium comes out of the pricing.

Lord Fox: Do you think that the high street lenders of mortgages will be in a position to be able to support this higher issue, as well as repossessions if they happen?

Andrew Bailey: None of this is easy. I know that this is very difficult for many households and many people in this country. There are important ways in which the system is more robust now, from the point of view of lenders. That should encourage lenders, who are now under requirement to provide more support to borrowers on repossessions than they were in the past.

Frankly, we are seeing fewer loan impairments so far. Total debt service ratios are coming back to where they were before interest rates fell, but they are not back at what I would call particularly difficult levels. The scale of people with high interest servicing costs is not as high as it was, as, since 2015, the FPC has capped the proportion of new mortgages that can have high levels of loan to income ratios.

The third factor, which is more to the benefit of the lenders, is that compared with past periods of stress in the housing market and of heavy losses, loan-to-value ratios are lower.

Lord Fox: The upshot is that people coming off fixed-rate mortgages will have to face quite a shock for quite a while.

Andrew Bailey: That is true, yes.

Q25 Lord Fox: I will now ask the question that I was supposed to ask about time lag. You are dealing with monetary policy and that has a lagged effect on inflation, so are you not just playing catch up, to some extent? Although we will not dwell on hindsight, if you had been able to move earlier, would you not have been, in a sense, chasing the horse out of the stable?

Andrew Bailey: Yes, in principle—but, in practice, that would have involved us, given the lags, raising interest rates substantially in the middle of the Covid impact. You must then ask: what would have been the impact of doing that, given the situation we were in at the time?

If you do not mind me saying so, I sometimes read quite a bit of this commentary and feel that it sort of pretends that Covid never happened.

Lord Fox: I think we can all agree it happened. Finally, you talked about international pressure. How much are your decisions limited by the decisions of other central banks, or at least modified and moved around by the international context?

Andrew Bailey: Not at all really, in that sense. I am in very close contact with the other central banks, as is normal. I read people asking, for instance, “Why doesn’t the Bank of England do the same thing as the Federal Reserve?” We are facing some elements that are part of a common shock and, frankly, some elements of a very different shock. The US has much more of a demand shock than either the UK or the Euro area.

An example of that is the level of GDP in this country, which is still not above the level it was pre-Covid. That is not the case in the US, where it is about 4% higher. It is not the case in the Euro area either. We have a much more constrained labour market, as we were discussing earlier. There are differences, so when each of us sets monetary policy, our decisions reflect them.

One way in which we are experiencing common ground, as we were saying earlier, is that global shocks at the moment are a much bigger part of the landscape than they often are.

Q26 Lord Layard: I want to come back to the previous question. You mentioned the fall in real income, which is due to the change in the terms of trade. I do not think that 99% of the population of the country has any idea that this is the central problem we face. I wonder why the Bank is not making this clearer to people. People do not understand why they cannot be paid enough to compensate for inflation. It is a quite natural thing for people to wonder. I would have thought that the Bank would have brought this message out.

Is there some hesitation in going for this as a very clear central message?

Andrew Bailey: No, not at all. I will probably be a bit provocative in a moment. We have been saying, for quite a bit more than a year now, that there is a very big real income shock hitting this country. Exactly as you say, it will have an effect on national real income and on individuals’ real income. It is transmitted through the terms of trade, as you said, and monetary policy cannot hide it. We cannot make it go away; we have to deal with the consequences of it.

Our narrative, certainly for a year now, has been focused on that. The provocative thing I will say is this: there is awful lot of commentary that says, “No, it was QE that did it”, but I am afraid that we just do not buy that narrative. I am happy to debate QE at length and what it did or did not do, but the biggest shocks that are hitting us are, as you rightly said, the external shocks—the external real income shock. The biggest one by far now is the Russia-Ukraine shock.

The Chair: Can I briefly, Governor, pick you up on one point? Sir Dave Ramsden gave a speech last week, in which he appeared to question what the Chancellor was saying. When he unveiled the Autumn Statement, the Chancellor said that the Government’s £55 billion of consolidation would allow interest rates to be significantly lower. Sir Dave Ramsden pointed out that the vast majority of the measures do not come into effect until April 2025. So it will have very little effect on the MPC’s three-year forecast horizon, relative to what was assumed in the November Monetary Policy Report. Is the Chancellor correct in saying that the measures he has introduced will ensure that interest rates will be significantly lower?

Andrew Bailey: I do not think that there is any question that the physical consolidation is quite substantially backloaded, and the Chancellor has been quite clear on that. There is one important reason for that. If you do not mind, I will go back to the previous Government for a moment. We talked about the growth package, but the biggest fiscal loosening in that package was the energy package. The Chancellor has brought that back substantially by limiting its duration, but that was the biggest fiscal action at that time.

It is backloaded, but I would say—and I do not think Dave Ramsden would disagree with me on this—that what the actions of the current Chancellor have substantially contributed to is the removal of what I call the UK risk premium out of the interest rate curve, which has now pretty much gone away, but which was a substantial issue.

Q27 Lord Monks: Following a bit from Lord Layard’s question, what is the breakdown between the “made in Britain” inflation component and headline inflation? In a previous answer, you mentioned the energy shocks and the “made in Russia and Ukraine” factors. How do you see the breakdown between the domestic and the international?

Andrew Bailey: I am trying not to be overly precise here. If we look at the excess of inflation over the target, our assessment would be that about 40% of it is caused by energy; a little over 20% is the traded goods shock I mentioned earlier; and another 20% is from food. That sums up to just over 80%.

With food, however, you then have to decide, as I mentioned earlier, which part of it is traded and which part of it is domestic—and the answer is that we do not know. If you just consider the import weight of food, which is one way to do it, you end up with a number which is in the low 70s. That sounds overly precise, but I think it gives you a sense of the scale of these external shocks. It has come off a lit bit; I made a comment earlier this year that it was probably 80%, which was true then when the traded goods shook was quite a bit bigger than it is now. Certainly, however, a percentage in the low 70s would be appropriate.

Lord Monks: So there is a very substantial international component?

Andrew Bailey: Yes.

Lord Monks: This brings me to my old job in the TUC: how do you explain to the domestic population that it is not their fault—it is not down to them, because wages have been flat for quite a good few years—but they have to bear the main burden of getting out of recession?

Andrew Bailey: It is very difficult, and this comes back to Lord Layard’s question on how you get that message across. This terms trade shock, as the Lord Layard rightly described, is something we cannot hide, and we cannot make it go away. Obviously, there is a bargaining process for wages, the wage share and the profit share. I know that I was very unpopular earlier this year for making a comment about this. I tried to couch it in terms not of wage increases but of large and excessive wage increases. Although what I am going to say will be stepping beyond my brief somewhat, I will do so because I have previously said it to the Treasury Select Committee: this is particularly important in the context of those who are low paid. As we go around the country, our agents and I observe that wage settlements this year have been structured somewhat differently to give more protection to the low paid, and that is sensible.

It is very difficult. To go back to Lord King’s question, the risk is coming from this constraint in labour supply and the risk that both wage bargaining and price setting by firms create these second-hand effects. We have to raise interest rates further than we otherwise would to counteract that. It is a very difficult message to convey.

Q28 Lord Monks: As a final question, are there any particular sectors that worry you for pressing above-inflation or for inflation-equalling rises?

Andrew Bailey: I would not want to pick out particular sectors of the economy as there are quite big differences between them. I would note that differences are not actually abnormal between private sector and public sector pay increases.

Lord Monks: What about the finance sector?

Andrew Bailey: I do not think that this is particularly about the finance sector. There is a large part of the finance sector that is not earning high wages: people who work in bank branches, and so on, do not earn high wages. So in the aggregate macro sense, I do not think that this is really about bankers’ bonuses, for instance.

Q29 Lord Griffiths of Fforestfach: It is a great pleasure to see you here. We are at the end of asking questions on inflation. There is one part of the picture you present that I do not understand, which is borrowing. At present, clearly, there are supply-side factors which are leading to inflation—we all agree on that. But if we look at the evidence, in the first 18 months from March onwards during the pandemic, we created a huge fiscal imbalance, with public expenditure going up tremendously, so that demand was going up much more greatly than supply.

We also let the money supply rip, so you had demand inflation coming from both monetary and fiscal policy. You said earlier that you were very close to other central bank governors. It seems to me that the main central bank governors—yourself and those of the Federal Reserve, the European Central Bank and so on—all stated that inflation was something temporary, but, obviously, it proved not to be. Somehow, there is reluctance among the central bankers to pay much attention to the increase in excess demand through monetary and fiscal policy and to shift much more in terms of supply.

Although I can see that, at present, you make a very good case for that, I still cannot understand what happened for the first 18 months.

Andrew Bailey: There are several parts to answer. I would qualify the idea that demand in the UK recovered strongly relative to supply. Yes, there was an initial bounce back in the summer of 2020, but it is worth bearing in mind just how far the economy had dropped in the spring of 2020. At that point, when recovery took place, that recovery ran out of impetus and left the economy with—I am trying to remember this—something like 5, 6 or 7 percentage points of GDP below where it had been before that fall started. Since then, as I said earlier, the UK economy has not recovered strongly. Activity in the UK economy on GDP is below where it was pre-Covid.

Supply came up in the question that Lord King asked. It is true that supply was restricted but, following the point I made earlier about that, that was a product, as we saw it then, of deliberate decisions by the Government and public interest to restrict the productive capacity of the economy in the interests of controlling Covid.

Certainly, from late 2020 into early 2021, we knew, for instance, that the furlough scheme was going to come to an end, and we were having to look at what we thought the supply side of the economy would look like post the end of the furlough scheme. By the way, unemployment was rising at that point as well. That has been the surprise to us. We were well at the lower end of people’s unemployment forecasts of what would happen after the furlough scheme ended, but of course we were all wrong—I have to admit that. The labour supply has been much more restricted than we thought it would be.

I will finish on this point about transience that you rightly raised, because it is a very important point. When I look back to a year or more ago, the reason we were making that point—and, as you say, so were all the other central banks—was because, at that moment, we were facing only one external supply shock, which was the traded goods shock post Covid. This was a combination of the switch in demand from services to goods which we thought would reverse itself—it actually has in this country, but not so much yet in the US—and the Chinese question, which appears to be back now, around the impact of the zero-Covid policy on supply from China.

The point about transience was this: if we were facing a single supply shock of that nature, there would be reasons to believe that it would be transient and it would run its course. The following question was: would the time taken to run its course be shorter or longer than the monetary transmission cycle, and therefore should we respond to it or wait for the second-round effects?

I say that because the big problem we now have is that we do not have a single shock: we have since been hit by an even bigger shock, the Russia-Ukraine situation, with no gap between those shocks. The problem we have is that the reasonably well-established economics argument about a single supply shock and how you deal with it has been, in a sense, invalidated by this sequence of shocks, which now run over a much longer period. In terms of thinking about inflation expectations, you have to draw the same conclusions: that this is a much more prolonged period of shocks, and therefore we have to intervene in a different way.

When I talk to my fellow governors about this, there is a reasonably shared view on this. Frankly, this has changed in ways that we did not expect, and we have had to respond to that.

Lord Griffiths of Fforestfach: I do not want to go on about this, but I well remember in, August 2020, looking at what was happening to commodity markets, to the prices of gold, silver, precious metals and so on, and looking at what was happening in a secondary market with, for example, the price of Michael Johnson’s shoes, and to objets d’art, wine and similar things—and, for all of those things, it was going up. If you look at successive inflations in the British economy—during, say, the first four years—the beginning of an inflation is always led by a rise in asset prices. You still seem to be saying that demand was, if not inconsequential, very limited.

Andrew Bailey: The point I was making is that the UK economy, which is very different from the US economy, has not had a strong recovery over this period—I wish that it had. Coming back to the point about the level of GDP, it is lower than it was at the end of 2019.

There is a distinction because the US is quite different in that respect. It had a much stronger demand recovery, principally because it received very big fiscal policy injections from both the Trump Administration and the Biden Administration.

Lord Griffiths of Fforestfach: Thank you. May I ask just one last question?

The Chair: Go on then. Christmas is coming early for you, Inspector Columbo.

Andrew Bailey: You can forgive him anything.

Q30 Lord Griffiths of Fforestfach: You said earlier, Governor, that the Bank uses a suite of models. Econometrics and building econometric models are not my fields. On Dynamic Stochastic General Equilibrium models, DSGE models, I have read some research by people who were once colleagues of mine at the LSE. They make one observation about these models: that they work very well if there is a degree of uncertainty in the world, but, when you have major shocks, such as the financial crisis of 2008 or a pandemic, and the structure changes, they are not very good at capturing them.

In the Bank, when you come to make an estimate of inflation, you clearly have the outputs of the models. You have said yourself that you pay quite a lot of attention to the views of agents, which is exactly what is happening on the ground. Presumably, you also look at what other forecasters say. In an MPC meeting, when you come to a conclusion and say, “This is going to be our forecast for inflation”, how do you bring those different views together?

Andrew Bailey: First, we have models in the plural, but we override the models with our own judgments. As you said, they are based on how we interpret the data, including the evidence the agents are getting and the evidence that we as members of the Committee get when we go around the country with the agents.

At the moment, there are three areas where we are overriding what the models tell us. One is labour force participation—it is weaker. I said earlier that the OBR tends to adopt a more endogenous approach, which is what the models would give you, and are saying that the labour force will respond. None of this is a criticism of OBR, but I am afraid that we are just not seeing that evidence.

The second, and probably more important, area is that we have overridden and put more inflation persistence into the view of the future than the model would give us.

The third area is that, on the basis of the evidence we have seen this year, and agents are particularly important in this, we have assumed a faster and larger pass-through of energy prices into consumer price inflation than the model would tell us.

The Chair: Very good, thank you. I will invite Lord Stern and Lord Layard to ask their questions and then close the debate.

Q31 Lord Livingston of Parkhead: I would like to ask a question. I am not asking about the differences between the OBR and the Bank of England models. Do you think that there is problem in that you are basing interest rates off a substantially different view of the economy from the Government running fiscal policy? If each of you had the other’s model, you would be getting very different outcomes, so is there anything we can do about the fact that we are effectively running monetary and fiscal policy off two entirely different models?

Andrew Bailey: There are differences and some of these have always been there.

Lord Livingston of Parkhead: They are particularly large at the moment.

Andrew Bailey: I am not sure about that. This is probably a function of the sheer scale of the shocks. The economy is just much more volatile at the moment, so I am not particularly surprised that our views are probably a bit further apart.

We talk to the OBR at lot and our economists are in regular contact—not that that influences the policy-making process. I gave you a list of what I thought were the issues, and we will certainly talk to the OBR economists about them, because we will learn from them and, hopefully, they will learn a bit from us too.

The Chair: I am sorry, but we will have to close after these two questions.

Q32 Lord Stern of Brentford: Thank you, Governor, for coming and for your very direct answers. I declare that I advise on the climate with NatWest and Citibank. If it is any consolation, 25 years ago I asked the Treasury modellers why their models came back to equilibrium so quickly. Their answer was that they had come to my lectures in Oxford at the time on general equilibrium theory, which I did not think was adequate. That story demonstrates the existence of a very long-standing difference, and it matters for the reasons we have already described.

I will turn to the real economy, investment and growth. There are a lot of areas where the primary responsibility lies with the Treasury and the Government, including growth, climate, income distribution and so on. At the same time, however, primary responsibility does not mean sole responsibility, and you have already, in your answers, particularly to Baroness Kramer’s questions, recognised growth as a very important part of the set of issues you should be paying attention to.

Could you help us understand what you can and should do to encourage investment and growth, including in the allocation of investment, which has not always been in the most productive areas?

Andrew Bailey: That is a very good question, because one of the big things that we have not talked about but could is the decline in the trend rate of growth. The labour force story is a big part of that, of course. We did Solvency II, so I will not go back over that.

The other thing I would highlight is that since the early days of Covid we have been very involved, with the Treasury and the FCA, in something called productive finance work—this goes back to some of Baroness Noakes’s questions on LDI, and is in the defined contribution world, by the way—which, with the industry, is helping to design long-term asset funds that can support safe and secure investment in long-term illiquid assets. It is a very big question, and we have a part to play in that, I recognise.

Lord Stern of Brentford: Would it help if the Government’s strategy on growth was—how do I put it—even clearer?

Andrew Bailey: I am not going to get into the question of how clear or otherwise the Government’s strategy is. How we deal with the decline in the trend of growth is a critical question, and it makes monetary policy more difficult.

Lord Stern of Brentford: Thank you. There is a lot to discuss, but I really ought to pass on to other colleagues.

Q33 Lord Layard: I have two quick questions on the labour supply and how you forecast it. You have already talked about the participation rate of the existing population and that you are rather conservative about whether that will bounce back. Is that because you think of it mainly in terms of the increase in sickness, or because you think there is some change in leisure preference resulting from Covid?

The second question is immigration. As I understand it, in the last 12 months a huge, unprecedented number of visas—1 million—have been given altogether. One leading expert, a nameless colleague of mine, tells me that he thinks that net immigration in the last year has been half a million. That puts a very different colouring on the labour supply situation, does it not?

Andrew Bailey: It does. I am not going to comment on immigration per se, as I hope you will understand. There is a lot of uncertainty around the immigration data and has been since Covid happened. Again, and this comes from our agents and my experience when I go round the country, there is a lot of talk from businesses about the difficulty in recruiting labour and how the change in labour flows and migration flows has affected them. I do pick that up.

On your first question, funnily enough, I was talking to Bank economists about this yesterday. We are seeing, interestingly, what our economists call dual detachment, by which I mean that there has been a flow of labour from employment into inactivity, particularly among the 50 to 64 age group, and a second wave, which is people becoming more detached—in other words, expressing less interest in getting a job.

The second part of that goes to your point. The flow into long-term sickness, which is certainly very evident in the Labour Force Survey, is, our economists say, not people leaving employment and going straight into long-term sickness, but subsequently—the second leg of the duality, as it were—becoming long-term sick or declaring long-term sickness. That seems to be happening.

The other thing I would say about the labour market, which again our economists talked to me about yesterday, is that in the last few months the efficiency of the matching process of job search seems to have declined. They were speculating as to whether, with unemployment at a very low level, you might expect that to happen, but it certainly seems that the employment-matching process has declined in efficiency. Our agents again say that that is consistent with the anecdotes that they get.

Lord Layard: Increased turnover is behind a lot of that.

Andrew Bailey: Employers are also finding it harder to match skills.

The Chair: What are your thoughts on that rise in inactivity not being reversed, because, as you said, there has been a dramatic rise in the number of people who are not looking for work and are not wanting work?

Andrew Bailey: As I said earlier, we have adjusted our view and our forecast view to assume that that is a more permanent feature. We are not assuming that it will come back.

The Chair: Thank you very much. I think that is that. I am sorry, but my colleagues have to speak in a debate—it is not something you just said. Thank you very much indeed, Governor. You have answered all our questions very comprehensively, and I am very grateful to you, as I am sure all my colleagues are.

Andrew Bailey: Thank you.