David Clementi: The Bank of England's roles in monetary and financial stability
Speech by Mr David Clementi, Deputy Governor of the Bank of England, at the Association of Private
Client Investment Managers and Stockbrokers (APCIMS) Annual Conference, London,
19 October 2001.
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Introduction
Thank you for the kind invitation to address your conference today. APCIMS performs an important
function, representing and informing the views of a wide range of private client investment managers,
brokers and banks. Its voice is increasingly heard in a number of public debates. At one time, back in
1984, I worked very closely with a number of private client firms as we sought to sell shares to the
retail market in British Telecom, the first of the large privatisation issues. It's good to see that a number
of the firms involved then are represented here today.
When Angela Knight asked me to speak, she said she wanted something which would allow us all, in
the midst of our day-to-day preoccupations, to lift our eyes to the horizon. That reminded me of Harold
Wilson's description of John F Kennedy: "he had his eyes on the horizon, but his feet on the ground."
"Keep your eyes on the horizon and your feet on the ground" certainly ought to be written into every
modern central banker's contract of employment. Looking to the future, assessing risks to our
economic and financial systems, and - where necessary - acting on these assessments is absolutely
core to what we do. So I am very grateful for the opportunity to expand on our role here today.
I want to cover three main themes. First, I want to explain the Bank's approach to the exercise of
monetary policy, and then, second, give you some assessment of the current state of the British
economy. And, third, I want to discuss the Bank's other key role - that of maintaining financial stability
in the system as a whole. That role is, I think, less well understood than our monetary policy
responsibilities. But financial stability is every bit as crucial to our national welfare. So I'd like to spend
a few minutes setting out our objectives, and picking up on one or two themes of current concern.
Maintaining monetary stability
I turn first, though, to the Bank's better known role, that of maintaining monetary stability. Our target for
monetary policy is extremely clear. We aim for 21⁄2% inflation in retail prices (excluding mortgage
payments) at all times. That target is set by the Chancellor. And it is symmetric: that is to say, we
worry as much about being below the target as we do about being above it. That makes sense
because the problems of severe deflation are just as great as the problems of severe inflation.
Since May 1997, when the current arrangements were put in place, RPIX inflation has averaged 2.3%.
If inflation is more than one percentage point either side of the target, we are required to write to the
Chancellor explaining the reasons for the miss and the steps we are taking to bring inflation back to
target. There was a flurry of excitement earlier this year when inflation reached 1.8%, and many
commentators thought that we might soon have to polish up our letter writing skills. But so far we have
not had to put pen to paper. Of course, a number of factors have contributed to the stability in inflation.
Monetary policy takes time to affect inflation, so inflation in the early part of this period reflects
decisions taken before the MPC was formed. And in the short term at least prices can reflect factors
other than monetary policy. But, judged against previous policy regimes in this country, inflation
targeting has been successful. Of course, you might expect me to say that. But the growing credibility
of the arrangements is also reflected in measures of expected inflation in coming years, most of which
remain close to the 21⁄2% target.
People often ask if this relative success at targeting inflation has come at a cost in terms of lost output
or employment. It is increasingly accepted, I think, that there is no such trade-off in the long run. And,
looking at the recent UK data, it is hard to see any trade-off even in the short run. Output has now
risen for 36 consecutive quarters, the longest continuous expansion since post-war records began.
And unemployment is close to its lowest level for a quarter of a century. In my opinion, that has not
happened by chance, but is the result of a range of policies. Achieving low and stable inflation is the
best contribution that monetary policy can make to the wider economic goals of sustainable growth
and employment. Having an inflation target certainly does not mean that we take no interest in real
activity. We have discretion over how rapidly we try to bring inflation back to target when and if it
diverges from 21⁄2%. And we regularly publish our best guess about the likely future path of growth up
to a two year horizon. But the aim of policy is clear - we do what is necessary to keep inflation on
target.
So far, I have spoken as if monetary policy is carried out by faceless bureaucrats hidden deep within
the vaults of Threadneedle Street. Of course, as any of you who read the Diary columns regularly will
know, nothing could be further from the truth! There are nine of us on the Bank's Monetary Policy
Committee, and we meet once a month to make our interest rate decision. This is a rigorous process,
and rightly so.
The first stage occurs on the Friday before the policy meeting, with a briefing by Bank staff on all of the
data that have been released over the previous month. The following Wednesday afternoon, the MPC
meets by itself to have a detailed discussion of all of the key issues raised by the data, plus any
tactical considerations. Then, on Thursday morning, each member indicates the factors he or she
considers relevant, and gives his or her vote. The decision is announced to the public at 12 noon, with
the minutes of the meeting following two weeks later.
The regularity and the rigour of this process are absolutely key to the continued success of the UK
regime. We do not respond in an unreflective way to individual pieces of data. We do not choose the
timing of meetings to suit the headlines or some special interest group. And we seek to avoid rush
judgements. Wherever possible, we try to take decisions in the round, on the basis of as broad a data
set as possible, and after detailed discussion of the alternative economic interpretations. Of course,
the Bank of England Act provides for flexibility where it is needed. Highly unusual events - such as the
terrible terrorist attacks - may demand a special meeting, such as the one we held on 18 September,
outside the normal timetable. But it is this regular, comprehensive, systematic analysis which is the
backbone of the process.
Of course, agreement on process need not imply agreement on substance. Members of the MPC do
not always agree precisely on the appropriate stance of policy, as those of you who read our minutes
will know. Indeed, an industry has grown up geared to guessing MPC members' personal habits,
psychoanalysing our personalities and classifying us into different species of the aviary. But it is
important to recognise, I think, that disagreements are evidence of the strength of the system, not its
weakness. Economic analysis involves a great deal of peering into the future, so it is not surprising
that there should be differences of view. And the opportunity to explore and explain these differences
in a rational and open way is an important part of getting to a better answer.
The outlook for the economy
Let me turn now to an assessment of the economy. The recent debate has, of course, been
dominated by discussion of the implications of the terrorist attack on the United States, and the
political and military response. The loss of life was grievous. Few of us will forget the sights we saw on
our TV sets that day. And for those most closely involved the feelings must still be of the utmost
intensity. Standing back, from an economic perspective I would say that the most serious impact has
been on sentiment, particularly in the United States. Consumer confidence there has fallen quite
sharply. Equity prices dipped in the immediate aftermath of the attack, the sterling price of oil has
fallen by some 18% since the start of September, and credit spreads have risen. Of course, equities
have since rallied strongly, with the FTSE100 for example now back above its pre-September 11th
levels. But substantial uncertainties remain. At the very least, firms and households are likely to delay
major expenditure decisions until things become clearer. And this may act as a drag on the recovery in
activity. The rise in the cost of security and insurance will also probably have a more long-lasting effect
on activity.
Discussion of the attacks has somewhat obscured the fact that the world economy seemed to be
slowing more rapidly than expected even before 11 September. Overall activity in the US had been
weak, despite continued strength in some sectors, notably retail. And the euro area grew by just 0.1%
in the second quarter, as net trade slowed sharply. The monetary policy reaction has of course been
rapid. In the United States, in particular, interest rates have already been reduced by four percentage
points since the start of the year. And fiscal policy has been expanded. These actions should clearly
stimulate demand. But, as is always the case, the size and timing of these effects is extremely hard to
judge.
So far this year, the UK economy has fared rather better than its main trading partners. GDP growth
has slowed from the peaks it reached during 2000. But the economy still grew by 0.6% in the first
quarter of this year, and 0.4% in the second. Much of that strength, of course, reflects domestic
demand growth, and particularly household consumption, which rose a further 1.3% in Q2. In many
ways, this should not be a surprise. Average earnings have been growing at around 4.5% per year,
house prices have been rising by between 10-15%, and total consumer borrowing is the highest in real
terms since 1988. But, even given these factors, consumption growth has been strikingly strong.
There are, of course, downside risks to the outlook for consumption in the UK. Consumer confidence
fell in September, even before the terrorist attacks. Despite the recent rally, equity prices are still much
lower than their peaks eighteen months or so ago, and that will have reduced consumers' financial
wealth. And there may be the first sign of easing in the labour market which, if it persists, will reduce
disposable incomes. Despite this, however, there is little sign yet of any sharp reduction in consumer
spending. Retail sales volumes grew by 5.9% in the year to September. That picture of continued
strength is corroborated by the CBI Distributive Trades Survey measure for September (gathered
largely after the 11 September attack), which was the highest since October 1996. And the higher
frequency British Retail Consortium survey suggested that sales volumes by the end of September
had returned to pre-attack levels.
I focus on the continuing strength of consumption because it - together with its partial correlate on the
output side, the retail service sector - is absolutely key to understanding why UK interest rates have
fallen less far than in other countries. But, of course, elsewhere in the economy, things have been
looking less bright for some time. In particular, the manufacturing sector has been struggling under the
effects of sterling's ongoing strength and the weakening in the world economy which I have already
discussed. Manufacturing output today is little higher than it was in March 1998, and employment in
the sector has fallen considerably over that period. The difficulties faced by the traded sector are
reflected in the UK's relatively weak net trade position, which has reduced GDP growth in 14 of the
last 17 quarters. Surprisingly, but encouragingly, manufacturing output rose by 1.4% in August - the
largest monthly rise for two years. Whether this pickup will persist is, of course, unclear at the moment.
In assessing whether some of these short-term movements are likely to last, the MPC is particularly
reliant on intelligence from firms. Like others, we pay close attention to the major industrial surveys.
But we are also able to call on our network of regional Agents, who talk each month to a wide variety
of companies, including, I know, some of you. It is clear from the Agents' reports that the confidence of
many of those they speak to has been hit in the aftermath of the terrorist attacks. Labour hiring and
discretionary spending decisions may be deferred for a while, whilst the situation becomes clearer.
And investment could be reduced if businesses look for a higher return to cover any increased risk.
What does all of this mean for inflation? So-called 'upstream' prices - including raw material costs and
factory gate prices - remain very subdued. Some business costs, such as insurance, will rise, but that
should be at least partially offset by the sharp fall in oil prices. RPIX inflation rose briefly above target
in August, but fell back to 2.3% in September. We are just starting to put our next formal inflation
forecast together, and you will be able to see the results of that exercise in the November Inflation
Report.
At this point, I know you would wish a crisp conclusion and some indication of where I think rates
should move in the future. Some of you may even think you have detected clues in what I have said as
to where I think rates should go. If you have, though, that would be an over-interpretation. There are, I
think, clear downside risks. The world economy may slow further if adverse confidence effects persist.
Spending which is currently delayed may be cancelled. And the labour market may begin turning more
decisively in the UK. But for the moment these risks need to be weighed against the continued
strength of domestic demand. Of course, if we are to meet our inflation target, a strong domestic
economy will be needed to offset the weakening influence of overseas markets. We have cut interest
rates by 150 basis points since the start of the year in part to achieve this, and the full effect of these
reductions have still to come through. All this will make for an interesting November round where, as I
indicated earlier, we will look carefully at all the data, making our decision firmly in the light of the
inflation target we have been set.
Maintaining financial stability
Having discussed monetary policy, I now want to turn to the other key role of the Bank of England
- that of maintaining stability in the overall financial system. This does not, of course, mean that we
supervise individual banks, building societies and investment firms. Since 1997, that role has been
carried out by the FSA. The Bank, by contrast, is responsible for providing analysis of potential threats
to the system as whole. We are responsible for financial system infrastructure, in particular payments
systems. And, in exceptional circumstances, we would be responsible for undertaking official support
operations to prevent difficulties in one institution affecting other parts of the financial system.
Of course, we cannot do these jobs in isolation. Co-ordinating our system wide perspective with the
FSA's daily supervisory responsibilities and the Treasury's legislative role is essential to the smooth
functioning of the arrangements. A Memorandum of Understanding, signed by the Bank, the FSA and
the Treasury in October 1997, sets out our respective responsibilities, both in 'normal' times, and in a
crisis. And we work hard to foster these relationships, helped by the fact that I am a member of the
FSA Board and Howard Davies is a non-executive director of the Bank. The three institutions also get
together at least monthly, in what we refer to as the 'tripartite Standing Committee', to exchange
information and discuss current threats to financial stability. As you might expect, we have met more
frequently in recent weeks.
If the events of 11 September have had an important effect on monetary policy, they had huge
potential implication for financial stability as well. In the immediate aftermath, a key priority was to
make sure that markets had adequate liquidity to continue and settle their business. In addition to its
extensive operations in the US market, the US Federal Reserve entered into swap arrangements with
the ECB, the Bank of England and other central banks to ensure a continued supply of dollar liquidity
in other key markets. And the main payment systems extended their opening hours in the US,
enabling the huge daily volume of dollar payments to be made. I must say that I was particularly
impressed by the speed with which most of the big firms affected in New York were able to switch their
operations to their contingency sites. Some of those sites were in New Jersey, but others put
increased volumes through their London offices. There are of course a number of lessons which firms
based in the UK and elsewhere will want to take from the disaster. But, overall, I salute the US firms
and the US authorities for their actions, achieved at a time which for many involved was one of acute
personal anxiety.
More generally, we - like other central banks - carry out macro-prudential surveillance. The main
vehicle for reporting externally on the Bank's work in this area is the Financial Stability Review (FSR),
which is published twice a year. The purpose of the FSR is to survey potential risks to financial
stability, to analyse ways of responding to these risks, and to encourage an informed debate. This type
of forward-looking analysis is absolutely key to avoiding the systemic risks of the future. I hope that
many of you have had the opportunity in the past to read it.
Achieving financial stability in the UK not only helps maintain prosperity, it also makes it an attractive
place to do business. Earlier this month, the Bank for International Settlements released the results of
its 2001 survey of global turnover in foreign exchange and over-the-counter (OTC) derivatives
markets. And, yet again, the UK has done extremely well. Firms operating in the UK took over 31% of
the foreign exchange market, and over 36% of OTC business - roughly twice the size of the next
largest country, the US. Turnover in the global foreign exchange market has shrunk somewhat in
recent years, reflecting in part the introduction of the euro. But there have also been important
improvements in market efficiency, with for example the increased use of electronic broking. That is
reflected in the sharp rise in underlying customer business with firms like yours, which is a welcome
development.
Conclusion
Ladies and gentlemen, let me conclude at this point. It is clear that the events of 11 September, and
their aftermath, have given rise to considerable uncertainties. There is plenty, particularly overseas, for
central bankers to concern themselves with. When I spoke at a conference last week, one newspaper
commented that I always looked worried. Well, of course, central bankers are paid to worry. But when
reviewing the economic situation we need to achieve a sense of balance. The data do not all point in a
single direction. Certainly in the run-up to the November MPC meeting we will need to take a careful
look, as I indicated earlier, at all the data. Our feet will be on the ground, but our eyes will scan the
horizon! Thank you very much.