Mr. George discusses the framework of monetary policy in the UK and
Europe Text of the Sixteenth Mais Lecture delivered by the Governor of the Bank of England,
Mr. E.A.J. George, at the City University Business School in London on 24/6/97.
I was delighted to have been invited to deliver the Sixteenth Mais Lecture - until
some two or three months ago when you asked me to suggest a title! I confess that, at that stage,
I had not really thought about what I should talk about - so I offered you the portmanteau title of
"Monetary policy in Britain and Europe", hoping, like Mr Micawber, that something would turn
up - either here or on the Continent - to give some topicality to what I might say. Well happily,
Vice Chancellor, it has. On 6 May, just four days after taking office, the Chancellor of the
Exchequer announced some radical changes to the monetary policy framework in this country
including changes to the role and constitution of the Bank of England. I should like to discuss
some of those changes this evening against the background of the monetary policy framework
being developed in Europe, in preparation for the introduction of the euro, including the role of
the future European System of Central Banks (ESCB). But I should like to discuss them in the
context of the approach to economic management more generally in Europe and this country and
perhaps I might start with that.
Overall economic management
Sweeping generalisations are of course always dangerous. But from my particular
vantage point at least, there has, over the past decade or more, been a clear change of emphasis
across Europe but much more widely internationally - away from short-term, macro- economic,
demand management as the means of promoting the agreed end-objectives of economic policy,
of growth of output and employment, and of rising living standards, and towards the need for
macro-economic stability in the medium and longer term. Where before the implicit assumption
appeared to be that the supply side of the economy would respond relatively flexibly to
increasing demand, there is now the perception that over-ambitious short-term demand
management, which attempts to push capacity to its limits or even beyond, can generate
instability and uncertainty, damaging capacity growth in the longer term by distorting economic
decision-making in relation to investment, for example, or in relation to resource allocation.
The result is a broad consensus - across countries but also across a wide part of
the political spectrum within countries - on the need for macro-economic policy to be directed
towards stability and sustainability in the medium and longer term. This consensus is reflected in
the Maastricht Treaty - through the famous convergence criteria. It is reflected, too, in the
arrangements for the conduct of macro-economic policy now being put in place for the
introduction of the single European currency - including the monetary preparations for the
European Central Bank (ECB), and the agreement on the fiscal Stability and Growth Pact
recently confirmed by the European Council in Amsterdam.
But alongside this collective commitment to macro-economic stability, there is a
growing recognition that stability, on its own, is not enough. While it may be a necessary
condition for achieving sustainable growth of output and employment, and rising living
standards - the truly good things in life - and while stability may indeed be the most that
macro-economic policy can contribute in the longer term to those agreed end-objectives, it is not
in itself a sufficient condition for achieving them. So attention everywhere is now focusing
increasingly on the structural characteristics of our economies which essentially determine their
underlying, supply-side, rate of capacity growth.
The issue is starkly illustrated by the fact that despite very substantial progress
towards macro-economic stability within the European Union as a whole in recent years
including real progress towards effective price stability (with measured inflation now below 2%)
and strenuous efforts everywhere to cut back public sector deficits as required by the Maastricht
convergence criteria - output has stagnated, growing at an average annual rate of only 1% or so
over the past five or six years, and unemployment has risen inexorably, to around 11% across
the Union as a whole. And while it is true that activity may now be beginning to recover, the
pick-up is very largely driven by external demand - with the domestic economy still
depressingly weak.
Against this background, the need for greater supply-side flexibility within
Europe is increasingly widely acknowledged. And there are elements of a common approach to
bringing it about. These were reflected, for example, in the Resolution on Growth and
Employment adopted at the European Summit in Amsterdam a week ago, which talks of the
need to improve European competitiveness - with special attention to be given "to labour and
product market efficiency, technological innovation and the potential for small and
medium-sized enterprises to create jobs". It talks, too, of improving "training and education
systems, including life-long learning, work incentives in the tax and benefit systems and
reducing non-wage labour costs, in order to increase employability". But these policy
approaches are not well-defined across Europe, and it is probably at this stage stretching a point
to speak of even a "broad" consensus on specific approaches in this area. Even where particular
needs for change have been identified nationally, recent experience in some countries suggests
that there can be formidable resistance to bringing it about.
The new Government in this country is clearly joined in the European consensus
on the need for macro-economic stability; and it too emphasises the importance of supply-side
flexibility, indeed its thinking on supply-side issues clearly influenced the Amsterdam
Resolution which I have just mentioned. To quote a recent article by the Chancellor:
"The Labour Government is committed to monetary stability so that businesses
and families can plan for the future; to fiscal stability; and (on the supply side) to
higher levels of investment in both people and business; to a modernisation of our
welfare state, and, not least, to free trade and a constructive engagement in
Europe."
This country's approach overall to economic management is, therefore, wholly
consistent with that of our European partners; and we start from a somewhat more comfortable
position, in which our own recent progress towards greater macro-economic stability has in fact
been accompanied by somewhat stronger growth of activity - averaging over 21⁄2% over the past
five years - and by a sustained fall in unemployment to around 71⁄4% on a comparable ILO basis.
Monetary management
Within this overall economic policy context, there is a particular commitment,
throughout the European Union, to monetary stability; and I should like now to consider some of
the very recent changes to our own monetary policy framework against that background.
(i) Objective
I begin with the objective of monetary policy which, both here and on the
Continent, is allocated specific responsibility for achieving and maintaining price stability.
The Maastricht Treaty states that "The primary objective of the ESCB shall be to
maintain price stability. Without prejudice to the objective of price stability, the ESCB shall
support the general economic policies of the Community...."
In his statement to the House of Commons on May 20th, the Chancellor said:
"The Bank (of England)'s monetary policy objective will be to deliver price stability, and,
without prejudice to this objective, to support the Government's economic policy, including its
objectives for growth and employment."
At this level, our respective missions are effectively identical. But it is important
to understand that price stability is not simply an end in itself, but a means to the end of
sustainable growth. What in fact we are, in principle, trying to do in maintaining price stability
is to keep the growth of monetary demand more or less continuously broadly in line with the
underlying capacity growth in the economy - in effect using price stability as an indicator of
stability in the economy as a whole. And although we cannot hope to achieve that in practice
with any great precision, we can reasonably aspire to help to moderate the economic cycle rather
than aggravate it, as so often in the past.
The Maastricht Treaty makes no provision for any further definition of the ECB's
primary objective. It is left for the ECB's Governing Council to determine how to interpret
"price stability" in any particular circumstance. Indeed, the ECB will need to decide whether it
has a specific target for inflation at all, or whether, operationally, it adopts an intermediate
monetary target, or elements of both.
In the case of the United Kingdom it is the Chancellor who determines the precise
inflation target, which he has subsequently set at 21⁄2% for the Retail Price Index excluding
mortgage interest payments; and the Chancellor reserves the right, in extreme economic
circumstances, to override the Bank of England's operational independence in seeking to
achieve the Government's target.
In practice, in either case, the degree of latitude that these arrangements
apparently provide is likely to be limited by the need to maintain the credibility of the
commitment to price stability, with financial markets and with the public at large. But in the
United Kingdom at least, where public support for monetary stability is more recently
established than it is, for example, in Germany, the elected Government's public and explicit
commitment to low inflation may provide reassurance, and help to secure greater acceptance of
the policy.
In any event the Bank's remit under the new arrangements is unmistakably clear.
We are charged with delivering the Government's inflation target. Operationally, that means that
we are to aim consistently to achieve 21⁄2% on RPIX as a mid-point, so that, with a balanced
distribution of risks, there should be an even chance of outturns - at the end of our two-year
forecasting horizon - either above or below 21⁄2%. The measure of our success will be how close
we in fact come to 21⁄2%, not on any particular date, but on average over time.
(ii) Transparency and accountability
The clear separation of responsibility for setting the inflation target (the political
decision) from responsibility for achieving it (the technical decision) also helps to ensure that the
Government and the Bank are separately accountable for their respective roles in the monetary
policy process. And in this area of accountability, too, there are considerable differences
between the arrangements that will apply to the ECB and to ourselves.
In the case of the ECB, the Treaty requires that it "shall address an annual report
on the activities of the ESCB, and on the monetary policy of both the previous and current year,
to the European Parliament, the Council and the Commission, and also to the European Council.
The President of the ECB shall present this report to the Council and to the European
Parliament, which may hold a general debate on that basis." In addition, the ECB President and
the members of its Executive Board may be invited, or volunteer, to appear before the competent
Committees of the European Parliament.
In the case of the Bank of England:
(i) The minutes of the Monetary Policy Committee's (MPC) meetings to
determine interest rates will be published, identifying how each member voted,
with an explanation of why the individuals who voted against were opposed to
the majority decision.
(ii) The MPC's performance will be reviewed regularly by a reformed Court of
Directors, and the Bank's Annual Report will be debated in the House of
Commons.
(iii) The Bank will continue to publish its quarterly Inflation Report, reviewing
both the outturn and the prospect for inflation in relation to the target; and the
Treasury Select Committee will take evidence from the MPC on the Inflation
Report.
(iv) And, as Chairman of the MPC, the Governor is required to write an open
letter to the Chancellor if inflation strays by more than 1 percentage point either
side of the 21⁄2% target. The letter would refer as appropriate to the Inflation
Report, and explain why inflation was adrift, how long the divergence was
expected to last, and the action taken to bring it back on course.
Taken as a whole, these arrangements provide for greater transparency of, and
greater accountability for, the technical monetary process than anywhere else in the world.
Now I do not suppose, quite honestly, that anyone would particularly enjoy this
degree of public scrutiny. But it will certainly help to concentrate the minds of the MPC
members, and it is, I believe, a necessary feature of our new arrangements.
The technical implementation of monetary policy - even with a very clearly
defined objective - is not at all easy at the best of times. We have in practice a single
instrument - the short-term interest rate - the precise effects of which on the economy are by no
means perfectly understood, including by ourselves. We do know that it can take up to a couple
of years or more to have its full effects. So we have to rely substantially on uncertain forecasts
that are subject to unforeseeable shocks. Policy judgements in these circumstances are
necessarily an art rather than an exact science, no matter how much we apply science to
informing those judgements. And the judgements themselves need to be constantly reviewed and
frequently revised as relevant new information becomes available.
Transparency in these circumstances can only encourage a better informed public
debate and a more sophisticated public understanding of the issues. That in turn can only help to
strengthen confidence in the process - unless of course we make a frightful hash of it! I shall be
surprised - and somewhat disappointed - if the ECB Governing Council does not go to
considerable lengths to explain its policies to the public at large, for similar reasons, even if it is
not actually required to do so by statute.
(iii) The decision-making framework
Reflecting its multinational character, the policy-making body of the ECB, the
Governing Council, will comprise the Governors of the participating country central banks plus
the six members of the Executive Board. Our own MPC will comprise four "outside" members
directly appointed by the Chancellor, together with five Bank executives - the Governor, two
Deputy Governors, and two Executive Directors. The common characteristic is that in each case
the decision-makers will be professional experts rather than representatives of particular
interests. Any doubts that this would in fact be the case in relation to the outside appointments to
the MPC were certainly immediately dispelled when the names were announced: together with
our inside appointees, they are, as a team, as well qualified professionally for the task we have
been set as I can imagine anywhere in the world - and we certainly need all the help we can get.
The processes of the Committee are inevitably still evolving. It will, as you would
expect, be supported by the whole, considerable, range of the Bank's monetary, economic,
statistical and market expertise, supplemented by intelligence from the Bank's network of
regional agencies, with further front-line input both from the non-executive members of Court
and from our wide range of industrial, commercial and financial contacts.
The Committee will be closely involved in the preparation of the quarterly
Inflation Report, contributing to both the analysis and the forecasts. And, of course, it will meet
regularly on pre-announced dates each month - the dates determined by the monthly cycle of
statistical information - to take its decisions on monetary policy. These monthly meetings are
spread over three days: a whole-day meeting to receive briefings from the Bank staff on the
latest developments; an afternoon meeting to identify and discuss the important underlying
issues, and any tactical considerations there may be; and a final morning meeting to decide upon
any necessary policy action. The Committee will need also to provide for emergency meetings in
the event of a crisis, but if we are successful in our task of achieving permanent, long-term,
stability I would hope that that will prove to be a very rare occurrence.
(iv) Implementation of policy
Compared with the complexity of the decision-making process in relation to
interest rates, implementation of those decisions is relatively straightforward.
In the case of the ECB, the short-term interest rate will basically be contained
within a corridor, bounded, at the top, by an overnight lending facility to the commercial banks,
and, at the bottom, by an overnight deposit facility in which the banks can place surplus funds.
Within the corridor the market interest rate will be steered by means of open market repurchase
operations. The ECB may also require commercial banks to hold with the system minimum cash
reserves; and it will offer a limited amount of longer-term credit to commercial banks at market
rates; neither of these features appear to us to be necessary for monetary policy purposes, but
they represent an element of continuity from the arrangements which currently apply in some
prospective member countries.
In our own case the arrangements are even simpler. The decision on interest rates
will be announced at noon following the final, morning, meeting of the MPC, and the chosen
interest rate will be applied in our daily money market operations - mostly these days through
repurchase operations in gilt-edged securities. Limited facilities for late lending to the remaining
discount houses and the settlement banks are available to ensure the smooth functioning of the
payments system at the end of the day.
Looking at the monetary policy arrangements, planned for Europe and as they
now are in this country, as a whole, it is clear that while there are significant differences of detail
- such that our own arrangements would certainly require considerable further modification to
make them compatible with membership of the ESCB - the essential similarities are much
greater than the differences. Crucially, the primary monetary policy objective of price stability is
the same, and the responsibility for achieving that objective is in each case entrusted to a broadly
based group of technical experts not subject to political influence. That does not of course
guarantee that we will, here or in Europe, succeed in achieving permanently greater stability but,
perhaps presumptuously, I do think it gives us every chance of doing so.
Concluding remarks
Mr Chairman, what I have tried to do this evening is to draw attention to what I
see as a very striking coincidence of basic approach to economic - and in particular monetary
management within Europe but also between Continental Europe and this country. We are
clearly, it seems to me, on parallel tracks as far as our commitment to macro-economic, both
fiscal and monetary, stability is concerned, though we may be travelling at different speeds when
it comes to supply-side flexibility.
That coincidence of basic approach is a prerequisite for sustainable economic
convergence within Europe - without it I do not see how monetary union could be on the
agenda. But the question that is often then put to me is, if in fact we are on parallel tracks - in
terms of our basic approach - why then do we not get on the same train and commit ourselves to
joining monetary union. So let me conclude with just a few remarks on that subject.
The potential attraction of travelling together with our European partners is very
clear. There would, other things equal, be real economic advantages in exchange rate certainty
across the single market area, which can only be realised through the single currency. The same
certainty cannot be achieved by the countries of Europe independently pursuing
macro-economic discipline, although that should over time help to minimise the degree of
intra-European exchange rate volatility.
But there are real risks.
We are not all starting from the same station. Domestic demand in this country,
for example, is currently growing at a rate which we cannot sustain for very long without the
emergence of inflationary pressures. In the major countries of Continental Europe, on the other
hand, domestic demand remains, as I say, relatively subdued. The possibility of such cyclical
divergences will not simply disappear on January 1st 1999 and they would seriously complicate
the operation of a single monetary policy. So too would a variety of possible internal or external
shocks which affected euro member countries in different ways or to different degrees.
But more fundamentally - and I can't keep up the railway analogy - I am frankly
nervous at the prospect of introducing the euro at a time of very high and very different rates of
unemployment across Europe. It is not that I think unemployment can be addressed directly by
more expansionary macro-economic polices - that ought to be clear from my earlier remarks. I
share the view that unemployment needs to be addressed fundamentally through supply-side
policies - though it may be that the problem is currently being aggravated in the short term by
the heroic attempts being made to meet the fiscal criteria according to the Maastricht timetable
in a context of cyclical weakness. The problem is that we cannot be confident how individual
countries may respond to this situation. My concern is that the persistence of these wholly
unacceptable levels of unemployment across Europe, and the very real difficulty of
implementing appropriate supply-side reforms, could begin to undermine public support for
macro-economic stability in some countries - even though significant relaxation on this front
would provide at best only short-term relief. In that case, economic convergence, if it were
achieved, could prove difficult to sustain. There are perhaps some suggestions that this may be
beginning to happen; and it may be for this reason that the foreign exchange markets are
implying that they expect relative euro weakness - to our own considerable embarrassment as a
result of the corresponding strength of sterling's exchange rate. I have no doubt that, if the euro
goes ahead, the ECB would in fact seek determinedly to exercise its statutory responsibility for
maintaining price stability within the euro area. But its job would be enormously more difficult
if this came to be seen, at least in some countries, within the euro area - however mistakenly - as
an obstacle to the end-objectives of economic policy, including particularly increasing
employment.
My conclusion, Mr Chairman, from all this is that whether or not the euro
proceeds on the present timetable, and whether or not the UK is a part of that, the really
important thing for European prosperity is that the present broad policy consensus holds
together. But if we are to be able to hold on to macro-economic stability - as we must - then we
have to find answers to the urgent problem of European unemployment. That involves
addressing the problems of supply-side flexibility as an immediate priority. And that, Vice
Chancellor, is the message that the new Government has recently carried to Europe.