Mervyn King: Monetary policy developments
Speech by Mr Mervyn King, Governor of the Bank of England, at the Great Hall, Winchester,
10 October 2006.
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My Lord-Lieutenant, Ladies and Gentlemen
Thirty years ago, inflation reached 27% - the highest that any G-7 country has experienced in the past
fifty years. A few months later, Southampton won the FA Cup for the first, and only, time. You will be
pleased to know that I see no causal relationship. Later in 1976, Jim Callaghan, as Prime Minister,
delivered a famous speech to the Labour Party Conference in which he said "We used to think that
you could spend your way out of recession ... I tell you in all candour that option no longer exists, and
in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose
of inflation into the economy, followed by a higher level of unemployment as the next step". One of the
economists who developed that insight - an American, Professor Edmund Phelps - was yesterday
awarded the Nobel Prize. Low and stable inflation - 2.5% at present - is now the cornerstone of our
economic policy.
In that 1976 Cup Final every one of the players came from the British Isles. Today, it is hard to find
British players among the top Premiership teams - globalisation is everywhere. We are all
eyewitnesses to the tremendous economic impact of the integration of hundreds of millions of people
in China, India, and the former Soviet Union into the world trading system.
Globalisation has magnified world supplies of manufactured goods and capital as well as the labour
force. Prices of all three have changed, and we have not been immune to those changes. Between
1995 and 2005 the prices of consumer goods imported into Britain fell by around one-third relative to
the average price of other goods and services. But the greater supply of manufactured goods from
newly-industrialised countries has come at the cost of a greater demand by those same countries for
energy and raw materials of all kinds. The prices of oil, steel, copper, lead and nickel have all more
than doubled.
And in a buoyant British labour market it is not just foreign-born footballers who have been in demand.
Over the past two years, around half a million migrant workers (or possibly considerably more, we
simply do not know) have arrived from the new member countries of the European Union and
elsewhere in the world. It is unlikely that migration on that scale has had no effect on wages, or,
indeed, on rents and house prices.
Some of you may be tempted to think that because the growth of the Chinese economy has affected
key prices in our own economy, inflation in Britain is now largely determined overseas. Low inflation in
industrialised countries, it is argued, is made in China. As with the Arthurian legends, epitomised by
King Arthur's Round Table above us, that too is a myth. Despite large changes in relative prices, the
average change in prices - inflation - has been remarkably stable. Indeed, it is striking that in a
decade in which prices moved so much, overall inflation was more stable than in any decade for a
hundred years. It was a decade that in my first speech as Governor, I described as NICE - a
non-inflationary consistent expansion.1
How can inflation be stable when individual prices move around so much? The explanation is that
inflation is the result, in the old adage, of too much money chasing too few goods. Inflation arises
when the total amount of money spending (or nominal demand) in the economy is greater than the
value today of the available goods and services. When the Bank of England changes Bank Rate to
keep consumer price inflation close to the target of 2%, we influence - albeit imprecisely and with a
time lag - the amount of money spent in the economy and so the inflation rate.
In short, inflation is made at home.
Nevertheless, we cannot and do not control the price of every item in your shopping basket. That
distinction between changes in individual prices and changes in the average level of prices is
fundamental to an understanding of recent movements in inflation and the response to them of the
Monetary Policy Committee.
Let's take a closer look at the NICE decade. Two factors were particularly important in delivering
stability. First, companies and employees responded flexibly to sharp movements - both up and down
- in input costs. That new-found flexibility, unlike in the 1970s, meant that firms absorbed cost
pressures partly in profit margins, partly through efficiency improvements, and partly by resisting
increases in the prices of other inputs. With a clear commitment by the Bank to meet the inflation
target, raising prices (so losing market share) was a less attractive strategy for meeting the challenge
of higher input costs than searching for ways of reducing other costs. And employees recognised that
the consequences of higher world prices, such as for energy, on living standards could not be avoided
by higher money wages. So wages rose more slowly when employers faced higher National Insurance
contributions and energy prices than when the costs of imported inputs were falling.
Second, monetary policy supported a broadly steady path for total money spending - during the
decade 1995-2004, the growth rate of nominal domestic demand fell within a narrow range of between
51⁄4% and 61⁄4% in all but one year - so that the new flexibility meant that price rises in some parts of
the economy were balanced by price falls elsewhere, leaving inflation overall close to the target. When
the prices of some goods fell, such as imports in the late 1990s, people had more disposable income
to spend on other goods and services. That pushed up demand in those sectors and encouraged
companies to raise prices. Conversely, when some prices rose, as with energy prices over the past
two years, the resulting squeeze on income available to spend on other goods and services helped to
bear down on inflation in those sectors. With steady growth of money spending, a change in relative
prices can be consistent with stable inflation overall.
Monetary policy - a credible commitment to the inflation target and a broadly stable growth of total
money spending - was then, and is always, the key to low and stable inflation. That point was made
forcefully in a speech in February by the late David Walton, whose untimely death in June was a great
loss to the Monetary Policy Committee.
Over the past couple of years our economic performance has not been quite as "nice" as in the NICE
decade, but it was "not so bad".2 In 2005, output growth slowed to 1.9% and inflation rose to 2.5%.
Back in 1976, to describe this as "not so bad" would have been the understatement of the year. It
followed a period of rather strong nominal domestic demand growth which, by placing pressure on the
supply capacity of the economy, accounted for some of the subsequent pickup in inflation. At the same
time, sharp rises in the prices of oil and other commodities reduced the income households had
available to spend on more discretionary items and put downward pressure on those prices. Not
surprisingly, that loss of spending power was one of the contributory factors to the standstill in
consumer spending in the second quarter of last year. But since then consumer spending and output
growth in the economy have picked up, and in the first half of this year were growing at around their
long-run average rates.
After a prolonged period during which consumer price inflation was below its 2% target, inflation has
been above target for nine out of the past thirteen months. So what are the challenges facing the
Monetary Policy Committee as it tries to bring inflation back to the 2% target?
Since their peak in early August, oil prices have fallen by around a quarter. In due course, that will
ease the pressure on petrol prices and fuel bills, including gas and electricity. The direct impact was
seen in the producer price data published yesterday, and will be seen in CPI inflation over the coming
months - making it less likely that I will have to write an explanatory letter to the Chancellor than was
the case two months ago - although the anticipated fall in inflation for September may not persist for
long.
Over the past year, profit margins, especially in manufacturing, have been squeezed and outside the
oil sector the share of profits in GDP has fallen. The recent fall in oil prices will ease the pressure on
firms' input costs allowing them to restore profit margins without an increase in output prices.
Nevertheless, according to surveys, businesses are more likely to raise prices than during the NICE
decade. And in their own survey, the Bank's Agents found that half of those (largely manufacturing)
firms which had experienced some erosion of margins were now intending to raise prices.
A change in oil prices does not in itself tell us where overall inflation is headed in the medium term. For
that, we need to look at the balance between money spending and potential supply.
The growth of total money spending in the economy has picked up in recent quarters - nominal
domestic demand rose by 6% in the year to Q2. And the growth rate of broad money and credit in the
economy is now higher than at any point since 1990.
There is, however, great uncertainty about potential supply. The possibility of continuing migration
from the new member countries of the European Union and elsewhere is likely to increase the
potential labour force available to UK employers. And it appears that more people of pensionable age
are choosing to continue to work. The difficult judgment facing the Monetary Policy Committee is to
what extent that increase in labour supply, and hence potential output, will allow a faster expansion of
total money demand without upward pressure on inflation.
Given the uncertainties about the supply potential of the economy, we will need to keep our eye on the
ball and monitor closely the evolution of wage and cost pressures. But it is no easier for the Monetary
Policy Committee to read those than for most English batsmen to read Shane Warne's deliveries, and
it is just as difficult for someone who, in terms of MPC meetings is 114 not out as it is for those still
playing themselves in. The new factor is that, although wage pressures have so far been subdued, it is
still not clear that earnings have been sufficiently restrained to accommodate the past rises in energy
prices and the fall over the past year in the prices of our exports relative to our imports without a
squeeze on profits. Ultimately, both developments must result in lower real incomes.
At this point, let me save the economic commentators a degree of anguish. Nothing in this speech is
meant as a hint about our decision in November, which will be based on an assessment of the outlook
for inflation two years or so ahead. That decision will be taken only in November, and much can
change between now and then. Rather, I have tried to explain the challenges facing the MPC when it
decides on interest rates.
Although we can control our own inflation rate in the medium term, temporary fluctuations in output
and inflation will occur. We saw that in 2005. Moreover, we cannot insulate ourselves from the real
economic consequences of the extraordinary changes taking place thousands of miles away from our
own island. They will affect what we produce, what we buy and, most important, our standard of living.
But to say that we are exposed to changes in the rest of the world is a far cry from saying that
monetary policy is impotent to control inflation.
It is highly appropriate that I have been talking this evening about the recent decisions of the Monetary
Policy Committee in the shadow of King Arthur's Round Table. For the Round Table symbolised the
equality of the knights. To quote one authority, "there is no head of the table at a round table, and so
no one person is at a privileged position." Equally, the Monetary Policy Committee comprises nine
members, each with one vote, and the decision is determined by a majority of those votes rather than
by consensus. No individual has a monopoly of wisdom and the pursuit of a consensus may hinder the
discovery of the truth. Of course, I would not claim that the Bank of England is the long-lost site of
Camelot, nor that meetings of the MPC are characterised by jousting and feasting. But I hope you can
see that in its deliberations, the MPC has adopted the spirit, if not the literal shape, of the Round
Table.