Mervyn King: Monetary policy developments
Speech by Mr Mervyn King, Governor of the Bank of England, at the Lord Mayor's Banquet for
Bankers and Merchants of the City of London, London, 21 June 2006.
* * *
My Lord Mayor, Mr Chancellor, My Lords, Aldermen, Mr Recorder, Sheriffs, Ladies and Gentlemen:
Chancellor, I know how much store you put on education. So, in the modern spirit of audience
participation, let's see how our City audience matches up to the standards of the past. One hundred
years ago, candidates for employment in the Bank of England were required to take an examination.
The arithmetic paper contained 16 questions to be completed in three hours. I'm going to give you just
two questions and you will have either 15 minutes or the length of my speech, whichever is the shorter
and I am in no doubt as to your preference on that, to find the answers.
Qu.1: Simplify the expression;
2 1 1 1
×
4 1 of 1
9 2 3 13
÷-
1 5 5 7
+ -
1
3 6 8 12
Qu.2: A person invested £2,205 in a 3% Stock at 90. He afterwards sold out at 93 1/2, and invested
the proceeds in a 4 1/2 percent Stock at 98. What change was thereby made in his income?
Answers can be sent to the Financial Services Authority. No compensation is available if you are
incorrectly advised by your neighbour or any other person from the financial sector.
Twenty years ago, the City was anxiously awaiting its revolution - Big Bang. If ever there was an
example of structural change in response to global competition, Big Bang was it. None of the leading
broking and jobbing firms of the time now survives. Yet the City, and the people who work here, are
more successful today than at any time in its history. Few in 1986 could have imagined how much the
City would change and how far its domain would extend - from Canary Wharf to the West End, no
longer a single Square Mile but a banker's dozen.
A key ingredient of the City's success has been, as the Lord Mayor remarked, a stable set of rules
within which to play up and play the game. Simple, clear rules of the game are essential for a market
economy to function. But excessive regulation makes life difficult for us all. In March of this year I
received a letter from a certain government department which read as follows:
"Dear Mr. King; I am writing to inform you about how the changes to Crown immunity ... in relation to
planning legislation, will affect flying national flags ... . Flags are defined as advertisements under the
Town and Country Planning (Control of Advertisements) Regulations 1992. Under these regulations
you are allowed to fly the national flag of any country ... from a single vertical flagpole without
requiring the prior express consent of the local planning authority. The European Union flag is not
classified as a national Flag under the current regulations. ... the Office of the Deputy Prime Minister is
proposing to change the Regulations". Until then, however, consent is required. The letter continued: "I
have been advised that consent usually takes six to eight weeks to obtain and costs £75. You need to
send the completed advertisement consent form plus fee with a covering letter explaining when and
where you wish to fly the flag providing details of the size of the flag and photos of the flagpole in
relation to the building."
Chancellor, you can be sure that the Bank of England will abide by the rules - although we may not fly
many flags, both literally and metaphorically. The Bank now has a very clear focus on maintaining
monetary and financial stability - the former defined by the inflation target and the latter by the revised
Memorandum of Understanding between Bank, FSA and Treasury published in March.
The great strength of the 1997 reforms to the monetary policy process is that they establish clear rules
of the game for making decisions on interest rates. The Monetary Policy Committee sets interest rates
each month to meet the inflation target. But how do we implement those decisions in the market? Our
objective is to ensure that the policy rate set at the monthly meetings of the MPC is the rate in the
money markets until the following meeting. For many years, the Bank operated several times a day in
the money markets, but that hyperactive approach did not succeed in stabilising the overnight interest
rate which remained more volatile than in most other advanced countries. It was important to move to
a simpler system in order to reduce that volatility, and the new system of money market operations,
which was introduced last month, has done precisely that. The Bank now deals in the markets only
once a week. Almost all banks and building societies now have access to the Bank. And they no
longer have to balance their books with us at the close of business every day, but instead must
achieve a target balance with us on average over the month running between MPC meetings. For the
first time in its history, the Bank pays interest on reserve balances held by the commercial banks with
us. The rate paid by the Bank on those reserve balances is the rate set by the MPC - Bank Rate is
back.
Great credit is due to the teams led by Andrew Bailey and Paul Tucker who together managed the
introduction of the new system, proving that, as Cameron Cobbold remarked in 1958, "the Bank is a
bank, not a study group".
The 1997 reforms also changed the rules of the game for communication between the Bank and
financial markets, and I would like to say a word about what they are. Markets need to form a view on
the probabilities of different paths of future interest rates in order to price a wide range of financial
instruments. So they are interested in what central banks say. In recent months both the Federal
Reserve and the European Central Bank have found it far from straightforward to convey the likely
trajectory of future interest rates. And the Fed announced three weeks ago that Chairman Bernanke
had established a subcommittee of the FOMC to examine a number of "communication issues". There
is now a lively debate about how, and to what extent, central banks should try to communicate their
intentions with respect to future official interest rates to financial markets and the wider public.
At the Bank of England, our approach is to keep it as simple as possible. We don't say where interest
rates will go next for the simple reason that we don't know. And it would be quite misleading to pretend
otherwise. The MPC reaches a new judgment each month, made afresh in the light of all the new
information about the prospects for inflation. We don't decide in advance. So trying to give direct hints
on the path of interest rates over the next few months risks deceiving financial markets into believing
there are definite plans for the next few months when no such plans exist.
But in order to form judgements about the likely path of interest rates over somewhat longer time
horizons, markets do require some information from the central bank. To be precise, two key pieces of
information - our objective, and our analysis of the economy.
Our objective is the 2% inflation target given to us by the Chancellor and plain for all to see. And our
analysis of the economy is published in the minutes of our monthly meetings, in more detail in our
Inflation
quarterly Report, and in speeches by members of the MPC.
Knowledge of our objective and our analysis is all that markets need from us to form judgements about
the future path of interest rates. Changes in our analysis, and the range of views within the Committee,
may well affect the conclusions that financial markets draw about the likely path of interest rates.
Markets appear to have been rather successful in drawing conclusions because our decisions on
interest rates have not, by and large, surprised them. But there is a big difference between setting out
our analysis of the UK economy and dropping hints about decisions we have yet to make.
So all those listening to the speeches of MPC members - including this one - for a hint as to the
decisions we shall take in the coming months will be disappointed repeatedly. We make up our minds
one month at a time. Those, however, who read our Minutes, Inflation Reports and speeches to
understand our thinking will mine a richer seam. Knowing our thinking, they will be in a better position
to evaluate the implications of developments in the economy for the future path of interest rates.
There is one other arena where clearer rules of the game would be of great value - the Commercial
Court. After 13 years, we have at last drawn a line under the BCCI case, the most expensive fishing
expedition in history. It ended as a comprehensive victory for the Bank, both on the substance of the
case and on costs. The trial set new records - the longest opening speech in English legal history, an
even longer reply, and almost certainly the most expensive commercial litigation ever.
It is for others to comment on the behaviour of those who brought a case that even they described as
a blood sport. I can presume only that they were allowed to play within the rules of the game. In which
case, it is the rules of the game that should be questioned.
A legal framework for enforcing contracts and resolving disputes is not just an arcane process which
allows professionals to earn vast fees, but an integral part of the infrastructure of a successful market
economy. It matters that there are simple, clear and timely ways of resolving disputes. What the BCCI
case revealed was a legal system incapable of guaranteeing that. How can a case described by the
trial judge himself as built "not even on sand but on air" take thirteen years and over £100 million in
costs to come to a conclusion?
The Bingham Report was produced in only a year and contains all that is worth saying about the
supervision of BCCI. It was not comfortable reading for the Bank, but the Bank accepted and acted on
its findings. The subsequent legal proceedings over thirteen years have benefited only one group at
the expense, in the end, largely of the creditors.
As Mr Justice Lightman argued in his 2003 Edward Bramley Memorial Lecture, the adversarial system
imposes huge costs on litigants and defendants alike. As he put it, "to the great majority of the public
the perception (if not the reality) is that the legal system is a profitable monopoly of the lawyers". BCCI
showed that perception was indeed reality.
A system that is powerless to prevent a case so hopelessly misconceived continuing for thirteen years
requires examination. I very much hope that the Government will look carefully at this case, learn the
lessons, and take steps to ensure that such an outcome can never occur again.
Finally, who managed to obtain the correct answers to the two questions I gave you at the beginning?
Chancellor, you can see that mental arithmetic in the City is not what it was. In fact the answer to the
first question is 3/100 or 3%, and to the second question is £31 13s. 9d. - before tax.
Lord Mayor, over the past year you have brought the global economy to Mansion House, you have
opened its doors to many who would not otherwise have thought of entering, especially from the Asian
community, and you have gone out of your way to meet young people from our financial firms. You
have raised money for disabled children and you have promoted Cornwall - next Tuesday is "Cornwall
Day in the City" with, I hope, free pasties for everyone.
And tonight all of us here would like to pay tribute to your work since you became Lord Mayor, and to
thank both the Lady Mayoress and you for the splendid hospitality - Cornish produce in fact - which
you have extended to us all this evening.
So I invite you all to rise and join me in the traditional toast of good health and prosperity to "The Lord
Mayor and the Lady Mayoress", David and Tessa Brewer.