Mr George talks about monetary policy in the United Kingdom: The Economic Prospect  (Central Bank Articles and Speeches, 18 Feb 99)
Central bank: boe | Type: speech | Date: 1999-02-18

## Mr George talks about monetary policy in the United Kingdom: The Economic ProspectText of the Chancellor's Lecture delivered by the Governor of the Bank of England, M George, at Hertfordshire University on 18/02/99.As you would expect of a central banker I will talk about monetary policy - under th 'The

Economic

Prospect'.

I

will

begin

by

explaining

what

it

is

that

we

are

tryi through monetary policy; then I'll describe how we've been doing, where we are now where we might be headed.

## What we are trying to doSo let me begin with what it is that we are trying to do.In one sense that's very easy to explain these days.

The previous Conservative Gov had already in 1992 defined the objective of monetary policy in terms of a target ra price

inflation.

The

new

Labour

Government,

immediately

on

assuming

office,

simi defined the objective in terms of an inflation target, but went an important step soon as Gordon Brown became Chancellor of the Exchequer, in May 1997, he announced t he would no longer exercise his powers to set short-term interest rates, which is t monetary policy, but instead he would set the inflation target, and delegate the ach that target to a new Monetary Policy Committee to be established in the Bank of EnglaThis position was subsequently formalised in the new Bank of England Act which came effect in June of last year.

That Act now defines the Bank's objective as 'the main price stability, and, subject to that, to support the Government's economic policy, i objectives for growth and employment'.Under the Act the Chancellor tells the Bank what precisely we are to understand b stability' and he has done this by setting a target of 2½% for a particular measu price inflation (RPIX - which is the RPI excluding mortgage interest payments); and the Act provides for the Chancellor to set the target each year, the expectation is practice set for the medium to longer term.

That is the political decision.

The task that target - the technical implementation of monetary policy - is then delegated, tr and accountably, to the MPC.

The Government no longer has the power - as it had und 1946 Bank of England Act - to issue directions to the Bank in the field of monetar except, in the terms of the new Act, 'in extreme economic circumstances'.So

the

objective

of

monetary

policy

these

days,

in

this

immediate

sense,

could

h clearer; and that objective is accepted across a broad part of the political spectrumBut it is important to understand that this objective - of permanent effective price not simply an end in itself.Now a lot of people think that, because our objective is defined in terms of an infl controlling inflation is all that we at the Bank of England actually care about. described as a lot of 'inflation nutters', or even as 'pointy-headed industrial hoo don't care at all about real economic activity or jobs - and I don't think these necessarily intended as terms of endearment!

That view I have to tell you is profo fundamentally wrong.The implication, of those who take that view, is that they think there is a trade-off inflation and the rate of economic growth; they think that if only we would let up a controlling

inflation

then

we

could

all

enjoy

higher

activity

and

lower

unemployment rising living standards, which are, of course, the really good things of economic life. very least, they say, if you were a bit less manic in your pursuit of low inflation, w avoid some of the worst damage that is currently being inflicted upon agriculture, upon parts of manufacturing, and even some service sectors.And that might even be true for a time.

The trouble is that, in anything other than th term, it would be likely to mean more rather than less economic damage, and lower rath than higher growth and employment.Often in the past in this country we behaved as if we thought that promoting higher gr and employment - which I repeat is, of course, what we all want to see - was largely a ma of pumping up demand.

We paid too little attention to the structural, supply-side, const All too often we tried to buy faster growth and higher employment at the expense of just more inflation.

But that was like trying to squeeze a quart out of a pint pot.

And you a the result: inflation accelerated, often accompanied by a worsening balance of payments, it could only be brought back under control - as eventually it had to be brought back control - by pushing up interest rates dramatically and forcing the economy into reces We get uptight these days when interest rates rise by ¼%: it was only 14 years ago tha were driven to increase interest rates by 4% in the space of 17 days.

I don't need to you - or perhaps I do - of the really miserable social as well as economic consequences right across the economy people lost their jobs, their businesses and their homes.

But more insidiously, repeated experience of boom and bust produced a pervasive short-termis in

business

behaviour,

which

infected

both

industry

and

finance,

and

both

employers

a employees, however much we all like to blame everyone else.

The reality during this per was that everyone was tempted to grab as much as they could while the going was good because they knew it would not last.But we have learned from that experience.

We've learned that in anything other than the s term there really is no trade-off between growth and inflation.

What we are trying to do through

monetary

policy

is

to

keep

overall

demand

in

the

economy

growing

continuously broadly in line with the supply-side capacity of the economy - as a whole - to meet demand.

Both the previous Government and the present one set a low inflation target as immediate objective of monetary policy, not as an end in itself, but in effect as a barom our success in keeping demand in line with supply.

So the real aim of monetary policy t days is to achieve stability across the economy as a whole in this much wider sense.Now, there is not a lot, frankly, that we can do, directly through monetary policy, to af supply side - the underlying rate of growth that can be sustained without causing inflat rise.

That

depends

ultimately

on

the

ingenuity,

the

productivity,

and

the

flexibility, economy, though it can, of course, be influenced by the whole raft of Government polici ranging

from

education

and

health,

through

taxation

and

social

security,

to

the

bal between regulation in all its forms, including regulation of the labour market, and prod efficiency.

Like the setting of the objective of monetary policy, these are, of course rightly, matters for elected politicians.Monetary policy operates on the demand side.

And the best help that we can give is to k overall demand consistently in line with supply-side capacity - symmetrically not lettingabove capacity but not letting it fall below capacity either - as reflected in achie inflation target.

That way we can moderate rather than aggravate the unavoidable downs of the business cycle, enabling steadier growth, high levels of employment an living standards to be sustained into the medium and longer term.

And if we can do t we will contribute indirectly to the supply side by creating an environment which en more rational, longer-term, decision-making throughout the economy.So that, Chancellor, is what we are trying to do.

The debate about monetary poli about

the

ends,

it

is

about

the

means.

We

are

every

bit

as

concerned

with

gro employment

as

we

are

about

price

stability

-

as

anyone

in

their

right

mind

m Permanently

low

inflation

is

a

necessary

means

of

achieving

growth

and

employ sustained into the medium and long term.

I don't think that any of us at the Bank o or on the MPC would get half the satisfaction that we do in fact get from our invol monetary policy, if we thought that controlling inflation was simply an end in itself

## How we've been doingSo much, then, for what we are trying to do.

How, then, are we doing?

Well - whatev read

in

the

newspapers

-

the

answer

is

that

since

we

adopted

an

inflation

targ immediate policy objective, we've actually been doing pretty well.Inflation over the past six years or so has in fact averaged about 2¾% a year on measure and it has recently been almost spot on its 2½% target.But equally important, total output in this country has grown consistently for alm years - 27 consecutive quarters - up to the final quarter of last year, at an averag of around 3%, and that is well above our long-term rate of growth of underlying ca some

2-2½%.

We

were,

in

fact,

over

this

period

steadily

reabsorbing

the

economic created by the earlier recession.Employment has risen on the most recent figures published yesterday, by some 1.8 mn 1992, to an all-time high of 27.3 mn.

And the unemployment rate is at a near 20-year just for the UK as a whole, but in nearly every region in the Kingdom.Encouragingly these developments in the labour market produced only a rather gradua up in earnings growth compared with past periods of labour market tightening, which important

factor

helping

to

contain

inflation.

And

our

balance

of

payments

rema surplus on the latest available data - for Q3 last year.Short-term interest rates - which are currently at 5½% - actually peaked last year at much of my 37 years at the Bank I'd have given my eye-teeth for them to trough at Long-term interest rates, which have recently been at around 4½%, are lower than been

since

the

late

1950's.

That's

certainly

good

for

the

economy

as

a

whole, recognise that it does not necessarily feel good to people living on interest on t even though those savings keep their real value far better than during the earlier pe inflation.The public sector's balance sheet is in excellent shape compared with most of the r world - and the Government's borrowing requirement position is strong and sustainablthe same is true of the balance sheets of the banking system, and of both the household corporate sectors.And on top of all that, England beat the Springboks at rugby - even if our cricketers did so well down under!Yet all that one reads about - all that anyone wants to talk about apparently - is the baSo let me not disappoint you this evening, and now come on to the bad news.Where are we now?By around the beginning of 1997 it was becoming clear that we were once again in danger having too much of a good thing.

Overall output growth needed to moderate if we were not run up against overall capacity constraints - particularly in the labour market.

In fac growth actually picked up during the course of 1997, from a rate of close to 3% to around partly under the impact of the windfall effect of building society demutualisation on con spending.

Aggregate

demand

growth,

in

other

words,

needed

to

slow

if

we

were

to

avoid overheating,

and

that

essentially

was

the

background

to

the

tightening

of

monetary

po during 1997 and the first half of 1998.But there was a major complication.

In the autumn of 1996 sterling's exchange rate agai the

core

European

currencies

started

to

strengthen,

and

by

early

1997

it

had

alr appreciated by some 17% against the deutschemark.

Although sterling appreciated rather l against the dollar - which also strengthened against the core European currencies over period - sterling's effective exchange rate index (ERI) still rose by some 13.5%.

Sterlin up further against the deutschemark right up until the spring of last year.It was never entirely clear just why sterling - and the dollar - strengthened in this perhaps more appropriately why the core European currencies weakened, when they did.It appeared to have little to do with relative monetary conditions between the Anglo-S countries and the Continent.

It may have had more to do with market perceptions - or mar misperceptions - about the future prospects for the euro.

Financial markets appeared at time

to

take

the

view

that

European

Monetary

Union

was

being

driven

increasingly

by political

determination

-

even

if

that

meant

softening

the

interpretation

of

the

eco convergence criteria written into the Maastricht Treaty.

They concluded that this impl broad rather than a narrow initial euro membership; and that that, in turn, implied a rather than a strong euro.But

whatever

the

reason

-

and

whether

it

was

valid

or

not

-

the

effect

of

sterl appreciation was to introduce a pronounced imbalance into the UK economy.

It dampened net external demand, and had a restraining influence on cost and price inflation, at a time domestic demand growth remained unsustainably strong, and when we were approaching full capacity.We

understood

very

well

that,

after

a

relatively

favourable

exchange

rate

environme following

our

exit

from

the

ERM,

the

abrupt

appreciation

meant

that

the

internationa exposed sectors of the economy, including large parts of manufacturing industry, were n suddenly confronted with much harsher trading conditions.

That, as I say, had a dampenieffect on the UK economy and on inflation.

But we couldn't just rely on that to economy for us.

Clearly at some point the exchange rate would stop appreciating, external dampening effect would have worked its way through.

In the meantime, we need slow the rate of growth of domestic demand sufficiently to avoid overheating in the as a whole.

The strong exchange rate gave us somewhat more time than we would other have had to bring about this domestic slowdown - it meant that monetary policy did n to be tightened as aggressively as would have been necessary otherwise.

But we co avoid

tightening

policy

altogether,

even

though

we

realised

that

this

would

be increase the pressures on the internationally-exposed sectors, because in anything the short term that would have put the whole economy - including the internationally sectors we were trying to shelter - at risk of accelerating inflation.

I would rem right up until the summer of last year we were seeing signs of increasing pressur labour market, even in the manufacturing sector - reflected in increasing skills sh recruitment difficulties, in the employment/unemployment data, and in gradually in pay settlements.

The uncomfortable reality, as I've said very often before, is tha policy can only target the economy as a whole - it can't seek to protect individua sectors, or regions, however much we might wish it otherwise.

That - as I've discov not exactly a popular idea, but there's no question that that is the reality of it.Over the past year the world - and I mean the world - has changed very substantially.The exchange rate has, in fact, tended gradually to soften since last spring when t to

go

ahead

with

the

euro

was

finally

confirmed;

but

increasingly

since

the

aut internationally-exposed sectors of the economy have been dealt a further massive b result of global economic turbulence.This started, in fact, with the financial disturbances in Asia in the latter half of as late as the beginning of last summer it seemed as if it might have only limited im overall world economy.

The IMF, for example, was then still projecting 3-3¾% world g in 1998 and 1999 respectively, which was certainly a setback compared with their for over 4% just six months before, but it was hardly catastrophic.Since last summer it has become increasingly clear that things are likely to be s worse than that.

The financial collapse in Russia, deepening recession in Japan, the - then sudden defeat - in Brazil to hold its exchange rate, and fluctuating fears knock-on effects on the major countries' financial markets, all contributed to an sense of financial fragility, which has not been easy to contain, though I am now ho we will be able to stop the financial rot.But even if we can - and the financial markets' response to the latest developments as

well

as

the

beginnings

of

a

recovery

in

capital

flows

to

some

countries

in reasonably encouraging in this respect - we are now having to cope with the economi effects of these earlier financial disturbances.

The IMF has cut its most recent f world growth to close to 2%.

And the risks almost certainly remain on the downside. still

not

global

slump

or

recession.

But

large

parts

of

the

world

economy

are recession and the prospect for the world as a whole turns very much on what happens major industrial countries.In essence, what we have seen is a brutally sharp cutback in capital flows to mu emerging world and to some of the transition economies, creating a corresponding nurgent improvement in their current accounts.

This has caused massive currency depreciati and forced the emerging countries to make equally sharp cutbacks in domestic demand.

Th counterpart is a sharp decline in net external demand in the industrial countries, whic were not to be offset by action to stimulate domestic demand in those countries, could i lead to weakening global activity and price deflation.In fact to varying degrees, reflecting differing assessments of how far our particular c areas are expected to be affected by the world slowdown and different starting points, re both to our assessment of trends in domestic demand, and of how close we were initially full capacity, both the UK and the Euro-zone, as well as the US, have acted fairly aggres to reduce interest rates since the autumn; and Japan has moved to more active fiscal sti And if the global economic prospect, and net external demand in the industrial countries, to

deteriorate

further,

then

it

would

be

right

to

contemplate

further

moves

in

the direction - consistently with our aim of effective price stability.

What we all aim to d said earlier - is to keep aggregate demand in line with the supply capacity of our econo We

have

no

interest

in

the

creation

of

unnecessary

spare

capacity

in

our

economies

a whole, nor in a fall in the underlying general price level.But that will still inevitably mean a sharp deterioration in the balance of payments industrial countries, collectively and probably individually, reflecting the imbalance b external and domestic demand growth in the industrial economies.

And that in turn is bo to mean substantial pressure on the internationally-exposed sectors of the economy, not j this country but throughout the industrial world, and we are already seeing ample evidenc that.In the case of this country these adverse international influences really began to affec as overall demand was already weakening in response to the earlier monetary, and incident fiscal, tightening.

The result was a very sharp decline in industrial - especially manufa -

confidence,

and

widespread,

and

often

exaggerated,

fears

of

recession,

which

in

t appeared to undermine consumer confidence.

The slowdown - or soft landing - we had been consciously seeking to engineer threatened quite rapidly to become a much sharper declin or harder landing - than we had either expected or needed.

And that, of course, is why promptly changed our monetary policy stance as we did, cutting interest rates by 2% to 5 in the space of five months.In doing so, we have demonstrated that the inflation target is - as we have frequently sa - symmetrical, so that we would be at least as determined and aggressive in cutting rates thought we were likely to undershoot the inflation target as we had been earlier in raisi to avoid an overshoot of the inflation target.So, where do we go from here?I would strongly advise you to regard anyone who claims to know with any great certain where we go from here with the gravest possible suspicion.

Forecasting the economy is ve definitely

an

art

rather

than

a

science

-

though

some

artists

craft

their

work

rathe carefully than others.But, for what it is worth, the Monetary Policy Committee's view - described in considera detail

in

our

recent

quarterly

Inflation

Report,

which

I

can

make

available

to

you remarkably modest fee if you care to get in touch with me afterwards - is that while wenot see much growth in the first half of this year - certainly in the internation sectors of the economy - overall output growth will pick up on the back of stronger demand as we move towards the Millennium to around trend or above from the second ha next year.

We can't of course altogether rule out an actual downturn in total outp next few months, though the odds are against that for the economy as a whole.

And reasonably

confident

that

the

slowdown

will

be

relatively

mild

and

short-lived

compared with equivalent periods in the past, for example at the beginning of the 1 1990's.

The good news is that we expect inflation to remain close to the Government target over the next two years, which should allow the relatively steady growth we in the overall economy since 1992 to resume on a sustainable basis.Within this overall picture, we are still confronted with the difficult problem o between external and domestic demand and the sectoral and regional stresses that thi At some point, as global economic activity begins to recover, we will again need restrain the growth of domestic demand, but that is a problem for the future.Given the present international economic environment, and given the present advance of our own economic cycle, if the outturn over the next couple of years is anythin this - that is about the best we can realistically hope for.