Mark Carney: Speech at the Mansion House Bankers and Merchants
Dinner
Speech by Mr Mark Carney, Governor of the Bank of England and Chairman of the Financial
Stability Board, at the Lord Mayor's Banquet for Bankers and Merchants of the City of London
at the Mansion House, London, 12 June 2014.
* * *
Introduction
My Lord Mayor, Ladies and Gentlemen.
A year ago when my predecessor Lord King delivered his final Mansion House speech, he
noted "clear signs that a recovery in the UK, albeit modest, [was] underway."
That recovery was due in no small part to measures he and his colleagues had initiated
including extraordinary monetary stimulus, recapitalisation of the banking system and
innovative support for lending.
The task a year ago was to secure that recovery in the face of continued domestic frailties and
ongoing international weaknesses. At home, unemployment and underemployment remained
elevated, productivity growth was anaemic, and debt levels were high. Abroad, the European
crisis had moved only from its acute to its chronic phase and financial markets were
demonstrating their fragility during the "taper tantrum".
With this backdrop and with real wages around 10% below their pre-crisis levels, it was not
surprising that consumer confidence, though improved, remained low. Business confidence
was similarly shaken by past shocks and current scepticism about the ongoing strength of
demand.
The Bank responded to these challenges.
Forward guidance gave households and businesses confidence that Bank Rate would not be
raised at least until jobs, incomes and spending were growing at sustainable rates. Guidance
encouraged businesses to hire and spend, and helped keep expected interest rates low, even
as the economy recovered strongly.
In parallel, we encouraged banks to continue repairing their balance sheets. Changes to the
Bank's liquidity policy further supported lending. The core of the financial system is now on a
sound footing and making an increasingly important contribution to the recovery.
We are now faced with the challenge of turning that recovery, which has steadily gained
momentum and breadth over the past year, into a durable expansion.
To do so, we need balance.
Its absence can have serious consequences. One has only to look back to 1931 when Britain's
economic prospects were strained by high unemployment, a large budget deficit and a
deteriorating balance of payments. In the ensuing crisis sterling was forced off the gold
standard and the government of the day resigned.
And the Governor? With the uncanny foresight of a central banker, Montagu Norman had
already left the scene "to get a bit of rest [in Quebec]", he said, "for I have had a very hard time
of it lately and I have not been so well as I would like to be."1
However tempting, I will lean on Canada not for restoration but for a nautical analogy to
describe how we can address the challenges we now face. Rather than appeal to the stately
Duchess of York on which my predecessor sailed, I will look to the trusty canoe - a craft that
can navigate the most rapid and treacherous waters...provided its paddlers work in sync.
Those economic currents are flowing swiftly, with the economy expanding at an annualised rate
of 4% and jobs growing at a record pace.2 But there are rapids ahead, with old imbalances
persisting and new ones emerging. The economy is still over-levered. The housing market is
showing the potential to overheat. And the current account deficit is now at a record level.
Navigating these hazards requires close coordination between all those in the boat; that is,
between fiscal, monetary and prudential authorities. Tonight I want to explain the Bank's
contribution to delivering a durable expansion characterised by balance in the macroeconomy,
the housing market, and the financial sector.
Before doing so, I would like to join the Chancellor in paying tribute to two individuals.
The first is Sir David Lees, who as Chairman of Court has overseen the transformation of the
governance and responsibilities of the Bank. David, I am extremely grateful for your support
during my first year as Governor.
I'm also enormously grateful for the wise counsel of Charlie Bean during the past year. Always
working, Charlie is tonight discharging his duties as President of the Royal Economic Society.
Throughout his career, at the Treasury, in academia and at the Bank, Charlie has been a
leading thinker and practitioner in the pursuit of macroeconomic balance. Internationally he has
inspired countless policymakers, myself included. On behalf of all colleagues past and present,
I would like to echo the Chancellor by thanking Charlie for his exceptional period of public
service and the enormous contribution he has made to the economic well-being of this country.
Macroeconomic balance
The UK economy is currently unbalanced internally and externally.
Internally, there is wasteful spare capacity - an output gap - concentrated in the labour market.
The Monetary Policy Committee (MPC) currently estimates this gap to be around 1-11⁄2% of
GDP, though we caution against false precision as there are wide confidence bands around
this central view.
The MPC's current guidance makes clear that we will set monetary policy to meet the inflation
target while using up that spare capacity. This has implications for the timing, pace and degree
of Bank Rate increases.
There's already great speculation about the exact timing of the first rate hike and this decision
is becoming more balanced.
It could happen sooner than markets currently expect.
But to be clear, the MPC has no pre-set course. The ultimate decision will be data-driven. At
this point it is safest to conclude, as the MPC has, that there remains scope for spare capacity
to be used up before policy is tightened and that a host of labour market, capacity utilisation
and pricing indicators should be watched closely to determine how that slack is evolving.
Growth has been much stronger and unemployment has fallen much faster than either we or
anyone else expected at last year's Mansion House dinner. So far this has been largely
matched by indicators which suggest that there is more supply capacity in the labour market
than we had previously thought.
As a result of these two welcome developments, despite rapid jobs growth, pay pressures and
unit labour cost growth have remained subdued.3
The MPC expects the rate at which slack is being eroded to slow during the second half of this
year as output growth eases and productivity growth recovers. But thus far there are few signs
of a deceleration in output growth. And a challenge in deciding when to begin normalising
policy is that actual output can be observed but potential supply cannot. That is why the MPC is
monitoring a broad range of indicators including coincident ones such as the behaviour of
wages and prices.
Of course navigating the upcoming bend in the river isn't the end of the journey.
The MPC has rightly stressed that the timing of the first Bank Rate increase is less important
than the path thereafter - that is, the degree and pace of increases after they start. In
particular, we expect that eventual increases in Bank Rate will be gradual and limited. That is
because the economy will face the ongoing challenges of public and private balance sheet
repair, a 10% appreciation of sterling over the past year or so, and muted growth in our main
export markets. In addition, in the medium term, higher capital, liquidity and other prudential
requirements can be expected to lead to higher spreads between borrowing rates and risk-free
rates than before the crisis.
Moreover, a highly indebted private sector is particularly sensitive to interest rates.4
Caution over the path of rate increases once they begin is also needed because we start at a
point from which interest rates cannot easily be reduced. The effects of an excessive or an
excessively rapid tightening of monetary policy could prove damaging and difficult to undo.
Perhaps for these reasons, financial markets expect Bank Rate to rise to only 21⁄4% over the
next three years and, on that basis, the MPC expects the economy to move towards internal
balance - almost closing the output gap - in the same period.
Just achieving internal balance will not be enough to guarantee a durable expansion. It matters
how we do so. Excessive reliance on consumption or non-tradable sectors, such as housing, all
financed by borrowing abroad at an overvalued exchange rate would prove only temporarily
satisfying.
The UK's current account deficit is at a record level. The perennial trade deficit has been
reinforced by the fact that the UK is growing much faster than its main trading partners. More
recently the sharp fall in the returns we earn on our investments abroad has led to a negative
3% swing in our net investment income.
This is not an immediate cause for alarm. As the world and particularly Europe recovers,
demand for our products and returns on our investments should increase. More
competitiveness gains from the past depreciation may yet be realised, and in any event, unlike
for much of Montagu Norman's time, our exchange rate will remain flexible.
Nonetheless, sustained borrowing from abroad to consume at home is hardly a recipe for a
balanced and sustainable expansion. Borrowing to invest, improve productivity,
competitiveness and incomes is.
Amidst much commentary about an unbalanced recovery, it should not be forgotten that
business investment has accounted for more than a quarter of GDP growth over the past six
months. The MPC's forecasts rely on continued rapid growth of business investment over the
next few years, leading to a revival in productivity and real wages, which in turn will allow
consumption to grow without an unsustainable decline in household savings.
Creating the right conditions for investment is thus essential. In a world of corporate caution this
will likely require interest rates consistent with our guidance.
The Bank is well aware that such a monetary stance could encourage other risks to develop.
For instance, there is evidence of growing vulnerabilities in financial markets. Across asset
classes, implied volatilities are well below their long-term averages. Spreads in high yield and
peripheral bond markets have collapsed. And covenant-light loans are the new normal. While
the banking system is much more robust to spikes in volatility, end investors may not have fully
absorbed the extent to which financial reforms will distribute shocks across the financial
system.
This may be a case of still waters running deep - often the most dangerous time on the river.
That is why an essential counterpart to our monetary stance is macroprudential vigilance and
activism. Nowhere is the need for that more acute than in the housing market.
Balance in housing
Across the country, house prices have risen by around 10% over the past year, approaching
their early 2007 levels. Price inflation has broadened and accelerated across regions.
Expectations that prices will continue to rise are now most marked outside London.
There have been some signs of a slowdown in activity, with mortgage approvals falling back to
their mid-2013 levels. The Bank is watching closely to determine the extent to which this
reflects an underlying slowing of housing demand. However, some of this likely stems from
lenders adjusting to the Financial Conduct Authority's (FCA) tough new Mortgage Market
Review underwriting requirements. More worryingly, surveys suggest some slowing could
reflect would-be sellers holding back properties from the market in anticipation of higher future
prices - an early sign of extrapolative price expectations.
The underlying dynamic of the housing market reflects a chronic shortage of housing supply,
which the Bank of England can't tackle directly.5 Since we are not able to build a single house, I
welcome the Chancellor's announcement tonight of measures to increase housing supply.
To be clear, the Bank does not target asset price inflation in general or house prices in
particular.
It is indebtedness that concerns us.
This is partly because over-extended borrowers could threaten the resilience of the core of the
financial system since credit to households represents the lion's share of UK banks' domestic
lending.
It is also because rapid growth in or high levels of mortgage debt can affect the stability of the
economy as a whole.
An economic expansion is more precarious if there are a large proportion of heavily indebted
households. History shows that the British people do everything they can to pay their
mortgages. That means cutting back deeply on other expenditures when the unexpected
happens, potentially slowing the economy sharply. That's why recessions that follow rapid
credit growth tend to be deeper and longer lasting.
It is for these reasons that the Bank of England's Financial Policy Committee (FPC) is
mandated to address systemic risks arising from unsustainable levels of debt, leverage or
credit growth.
In this regard, the UK starts from a vulnerable position with household debt at 140% of
disposable income.6 There are some signs that underwriting standards are becoming more lax,
with the proportion of new mortgages at high loan-to-income ratios now at an all-time high.7 The
increase in house prices in the past year means we can expect the proportion of high
loan-toincome mortgages to grow further in the coming year even if the housing market begins to
slow. This is concerning because a durable expansion requires mortgages to be serviceable
over their lifetime not just when interest rates are at record lows.
The vulnerabilities associated with debt build up over longer periods than the ups and downs
with which monetary policy is usually concerned. In that sense, the credit and business cycles
are distinct. Using monetary policy now to target indebtedness would risk undershooting the
inflation target and damaging growth. For all of these reasons, monetary policy is the last line of
defence against financial instability.
Raising interest rates today would be the wrong response to this potential vulnerability
tomorrow.
Fortunately, we are not up the proverbial creek without a paddle. We have many of them which
we can use to steer towards two objectives.
The first is to ensure that the banking system is resilient. To that end, the Bank is conducting a
stress test to assess how well major banks and building societies can withstand a sharp
housing market correction during a prolonged and painful recession. The results and any
consequences that flow from them will be announced later this year.
The second objective is to reduce the risk of excessive indebtedness itself by taking out
insurance. Given recent experience, few can now believe that the right policy is to wait to mop
up the consequences of debt-driven busts after they crystallise. That is even more obvious
when Bank Rate is at its effective lower bound.
In other words, when you hear the thunder of the falls, it is wise to get off the river.
Measures to take out insurance can be graduated and proportionate if action is taken
sufficiently early. We can limit risks tomorrow by acting against a loosening in underwriting
standards in new mortgage lending today.
The value of acting early is reinforced by uncertainty around the precise impact of
macroprudential tools. While these have proven effective in other countries, they are still
relatively novel here.8 By acting, assessing, and if necessary re-calibrating, we are more likely
to strike the right balance to support durable growth over the medium term.
That's why authorities have already moved. Last autumn we took our foot off the accelerator by
removing capital relief for banks on new mortgages and, with the Treasury, by re-focussing the
Funding for Lending Scheme away from mortgages towards business lending. Those steps
were followed by the implementation in April of the Mortgage Market Review to reinforce banks'
underwriting standards and the stress test to underpin their capital discipline.
The FPC has a wide range of other tools if further action is justified. We can direct lenders to
raise capital held against mortgages or against all credit. Thanks to the FCA, we are now able
to recommend a tougher interest rate stress to which new borrowers are subjected when banks
assess affordability. We can also make prudential recommendations about the share of high
loan to income, loan to value and long tenor mortgages in banks' and building societies' new
lending.
In this regard, I applaud the Chancellor's intention to grant the FPC additional directive powers
in relation to these aspects of mortgage portfolio composition.
I also welcome the Chancellor's commitment to adjust the Help to Buy Mortgage Guarantee
Scheme to comply in full with any FPC actions.
When we meet later this month, the FPC will weigh carefully recent and prospective changes in
activity, prices and credit as well as the merits of graduated and proportionate actions to
mitigate the potential vulnerabilities arising from what is the greatest risk to the domestic
economy.
Balance in financial markets
The housing market is not the only market at risk of losing balance.
Confidence in some core financial markets has been buffeted by revelations of manipulation of
interest rate, FX and commodity benchmarks. There have been too many such episodes to
think each is an aberration.
We are working to restore balance through reforms based on the firm belief that the City's
strength is founded on markets. To restore the primacy of true markets, authorities are already
seeking to:
- End too big to fail. I thank many of you who are engaged with the Bank and the
Treasury to help make this the year we complete the job.
- Align risk and reward by developing a new remuneration code. This is not about the
societal question of the level of pay, but about the prudential question of its structure.
To properly align risk and reward, the Prudential Regulation Authority will be
prescribing deferral of variable remuneration, the ability to reduce deferred bonuses
when subsequent performance reveals them to be undeserved, and the ability to claw
back bonuses after payment.
But as the Chancellor stressed tonight, we must do more.
Recent events have shown the necessity of measures to ensure the fairness and effectiveness
of core markets.
That is why I welcome wholeheartedly the Fair and Effective Markets Review announced
tonight by the Chancellor, and to be led by the Bank's new Deputy Governor, Minouche Shafik.
Through that Review, we will build true markets:
- Markets that are open and transparent;
- Markets where access extends beyond a privileged few;
- Markets where all who wish to trade have common information and commonly
accessible prices; and
- Markets where the informational integrity of key benchmarks is beyond question.
Some of this will require changes to the way markets work, including changes to how
benchmarks are calculated and the implementation of reforms currently underway to create
greater pre- and post-trade transparency of standardised derivatives.
Some can be delivered, as the Chancellor announced, by bringing more activities within the
scope of regulation.
And some may require new codes of conduct. Specific codes for professionals in markets will
complement broader efforts to raise standards in banking by the new Banking Standards
Review Council. For those in markets we need a simple approach that recognises a
fundamental principle of the City: namely that true markets are the source of dynamism,
prosperity and progress.
Seeking to manipulate, game or profit from unfair access transgresses that principle. It
weakens the effectiveness of markets for all. It holds back prosperity. It should thus have clear
consequences, including professional ostracism.
We must work together to ensure that everyone on every trading floor understands that dealing
in a market means serving the needs of clients, investors and customers fairly and effectively. I
am delighted that one of the City's most experienced professionals and proven leaders,
Elizabeth Corley, has agreed to chair a panel of market practitioners that will inform the
Review.
Now, recognising the centrality of markets doesn't mean the Bank has a naïve faith that all
markets always function smoothly. The City's markets are not those of a textbook. We all know
that real markets can seize up in crises of confidence, threatening financial stability and the
wider economy.
Just as there will be times when central banks must backstop the banking system, there are
also times when they should backstop core markets in a way that supports their contribution to
the real economy but doesn't encourage excessive risk taking.
That need was behind the recent transformation of the Bank of England's sterling market
framework for banks, and it is why I can announce that, in the coming year, the Bank will widen
access to our facilities to include the largest broker-dealers regulated in the UK and to those
central counterparties authorised to operate in UK markets. We will also look into whether we
should further develop our capacity to lend in currencies other than sterling.
Conclusion
As tonight's announcements demonstrate, promoting a durable and balanced expansion will
sometimes require coordination between the Bank, the Treasury, other public authorities and
the private sector.
The Bank will also have to act on its own by using all of its tools in as complementary a fashion
as possible. The FPC is considering using macroprudential tools to insure against potential
vulnerabilities associated with the housing market. Doing so could reduce the need for
monetary policy to be diverted to address a sector-specific risk.
However, macroprudential policy is not a substitute for monetary policy. If it is used for
insurance it won't necessarily affect the path of interest rate increases. The need for internal
balance - to use up wasteful spare capacity while achieving the inflation target - will likely
require gradual and limited interest rate increases as the expansion progresses. The start of
that journey is coming nearer.
Unlike a canoe trip, the quest for economic balance never ends. With economies and markets
always moving between equilibria, it is the journey that matters. By working together we can
make that journey as pleasant and as prosperous as possible.
The need to work together extends beyond policymakers to all in the City. So I am delighted to
take up co-presidency of Heart of the City with you, Lord Mayor. This umbrella group for City
charities, co-founded by Eddie George fourteen years ago, is a great example of how
cooperation and social responsibility can be at the heart of business, building the social capital
necessary for vibrant and inclusive capitalism.
Fiona, you are to be commended for the energy and enthusiasm you have brought to your role
- as well as the excellent hospitality you have provided tonight. So let me invite everyone here
to rise and join me in a toast of good health and prosperity to "The Lord Mayor and the Lord
Mayor's Consort", Fiona and Nicholas Woolf.
References
Del'Ariccia, G, Igan, D, Laeven, L, and Tong, H (2012), "Policies for macrofinancial stability:
how to deal with credit booms", IMF Staff Discussion Note 12/06, June.
IMF (2014), World Economic Outlook, April.
Lim, C, Columba, F, Costa, A, Kongsamut, P, Otani, A, Saiyid, M, Wezel, T and Wu, X
(2011), "Macroprudential policy: what instruments and how to use them?" IMF Working Paper
No. 11/238, October.