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, 16 June 2010.
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My Lord Mayor, Mr Chancellor, My Lords, Ladies and Gentlemen,
May I join the Lord Mayor in welcoming you, Chancellor, to your first Mansion House Dinner?
You have set a rapid pace in your first month in office, not least in your announcements this
evening.
In previous years I have sometimes set this gathering a quiz question. Tonight I want to
reverse the process by providing the answer and asking you for the question. The answer is
23, and later I shall ask you - to what question is 23 the answer?
Over the past year, there has been no slackening in the pace of economic and political
upheaval. The financial crisis that began in 2007 is not yet over. Much of the recent market
volatility reflects concerns about the ability of governments to service their own debt and
provide assistance where necessary to weakened banking systems, especially in the euro
area. Such risks have the potential to derail recovery and we cannot ignore them.
At home we face the challenge of ensuring recovery while rebalancing the economy,
reducing the fiscal deficit, and reshaping the structure and regulation of our banking system.
In playing its part to meet this challenge, the Bank of England has two priorities. Our first
priority must be to maintain low and stable inflation. Of late there have been those who doubt
our ability or willingness to meet the inflation target. In May, CPI inflation was 3.4%, and for
much of the past three years has been above the 2% target. Over that period the rise in
prices in excess of that implied by the target was around 3%. That can be accounted for by
the direct impact on the price level of the fall in sterling's effective exchange rate, of about
25%, which is supporting the rebalancing of the UK economy.
Inflation has not only been higher than in the previous decade; it has also been more volatile.
Our ability to keep measured inflation close to the target has been hindered by movements in
world oil and commodity prices, as well as the temporary reduction in VAT. Oil prices, for
example, have gyrated between $40 and $150 a barrel.
Although such price changes clearly lead to higher or lower CPI inflation for a period, by
themselves they do not generate the continuous rise in prices to which monetary policy
should respond. A continuous rise in prices would ordinarily be associated with strong money
growth, wage inflation, rapid increases in money spending and an excess of demand over
the supply capacity of the economy. The UK economy exhibits none of these traits - annual
broad money growth is around 1%, growth in regular pay is close to 2% and money spending
growth is around 3%; all of which are significantly lower than the average growth rates
recorded before the crisis. And a range of indicators point to spare capacity in the economy
rather than excess demand. Perhaps most obviously, unemployment is around 8%, three
percentage points above the average levels before the crisis - a million fewer people in work.
The Monetary Policy Committee judges that it is likely, though not certain, that this spare
capacity will press down on inflation. That seems to be happening in both the United States
and the euro area where underlying inflation is falling.
No one should take this as a sign of complacency. The MPC is conscious that there are
always risks to the upside, and the apparent rise in inflation expectations is one that
concerns us. We have always explicitly recognised that there is a significant chance that
inflation may turn out to be above target. A forecast is not a single number; it is an
assessment of risks. In our May forecast, the MPC judged that, under prevailing market
interest rates, the odds were in favour of inflation remaining above target over the next year,
whereas, looking two to three years ahead, the odds were on inflation being below the target.
There are always risks to the outlook - on both sides - and to ignore them in either direction
would be foolish. What the MPC must do is continually update its assessment of those risks,
and set policy in order that, on balance, inflation remains on track to meet the target in the
medium term.
No one should doubt our determination to meet the target. The inflation target introduced in
1992, and the new regime for monetary policy decision-making introduced in 1997, have
shown beyond doubt that monetary policy in the United Kingdom is dedicated to maintaining
low and stable inflation. Indeed, for ten years, I was, to my frustration, regularly described as
a hawk. But I am neither hawk nor dove. Everyone on the Committee votes according to his
or her judgement of the outlook for the economy. I have not changed. The Committee has
not changed. Circumstances have changed. When confidence, output and trade around the
world collapsed in the autumn of 2008, the balance of threats to the inflation outlook shifted
rapidly to the downside. So the Bank of England and central banks in other industrialised
countries responded by reducing official interest rates nearly to zero and injecting money
directly into the economy.
There will come a time when our task will be to manage the exit from such an abnormal
degree of monetary stimulus. The MPC will not hesitate to begin to withdraw the current
degree of stimulus when we judge that is necessary. When it comes, that is most likely to be
through a rise in Bank Rate with asset sales being conducted later in an orderly programme
over a period of time, leaving Bank Rate as the active instrument.
But monetary policy must be set in the light of the fiscal tightening over the coming years, the
continuing fragility in financial markets and the state of the banking system. I know there are
those who worry that too rapid a fiscal consolidation will endanger recovery. But the steady
reduction in the very large structural deficit over a period of a parliament cannot credibly be
postponed indefinitely. If prospects for growth were to weaken, the outlook for inflation would
probably be lower and monetary policy could then respond. I do, therefore, Chancellor
welcome your commitment to put the UK's public finances on a sound footing. It is important
that, in the medium term, national debt as a proportion of GDP returns to a declining path.
At the same time, it is important, however, that we work with our partners overseas to reduce
the global imbalances and promote an adequate level of world growth. Countries with large
current account and budget deficits will need to pursue both fiscal consolidation and policies
to improve their competitiveness. And countries with current account surpluses, while
understandably wanting to avoid unsustainable fiscal paths of their own, have a responsibility
to expand domestic demand so that the imbalances can be reduced. Only if the two sets of
policies work in tandem will growth prove sustainable.
Our second priority is to accept the challenge of the new responsibilities that you, Chancellor,
have asked the Bank to take on in respect of micro prudential regulation and macro
prudential control of the balance sheets of the financial system as a whole. I welcome those
new responsibilities. Monetary stability and financial stability are two sides of the same coin.
During the crisis the former was threatened by the failure to secure the latter.
The experience of the financial crisis taught us two important lessons. The first is that,
whatever its theoretical attractions - and there certainly are some - putting prudential
regulation into the same organisation as the oversight of consumer protection and market
conduct didn't work in practice. The two types of regulation require different skills and a
different approach. Separating them - the so-called "twin peaks" model of financial
regulation - is the right direction of reform. That conclusion is not a reflection on the people
who work at FSA. They are an able group and have worked hard to improve prudential
regulation over the past three years. I look forward to working with them in the future. Nor
does it follow from this first lesson that prudential regulation should necessarily go to the
central bank.
But a second lesson is that when banks hit trouble the central bank needs to be fully involved
in resolving those problems. The Bank of England cannot effectively perform its role as
lender of last resort without first-hand knowledge of the health of the banks to which it might
provide support. In peacetime, regulation can be conducted outside the central bank. But in a
crisis, decisions must be made quickly and decisively and the central bank, working with
government which is always responsible for any use of public money, needs to be in charge.
That was one of our painful lessons.
In approaching our new responsibilities we shall build on the real improvements to its regime
of prudential regulation made over the past three years by FSA. But the Bank will bring its
own central banking culture. The focus of regulation needs to be on maintaining stability of
the banking system as a whole. We shall be looking not just at those aspects of a bank that
make it look unsafe in comparison with other institutions, but even more so at whether there
are common features that threaten the stability of the system, such as the dangerously high
leverage prior to 2007.
We shall aim to avoid an overly legalistic culture with its associated compliance-driven style
of regulation. That is an important reason for the separation of consumer protection and
market conduct from prudential regulation. We will need to exercise discretion when setting
capital and liquidity ratios for individual banks. And to do that properly will require changes to
the current legislation and rule book. We must reverse the seemingly inexorable trend
towards more regulation and more regulators. That did not work in the past and is not the
right response now.
I am absolutely delighted that Hector Sants has agreed to remain at FSA and then move to
the Bank to become the first chief executive of the new prudential regulator. In difficult
circumstances, Hector has engineered major improvements to FSA's prudential regulation.
Andrew Bailey will head the Bank's transition team and will be the first deputy chief executive
of the prudential authority. Together, Hector and Andrew form the perfect partnership to
make the transition work and create the new organisation.
In the new regime, regulation will reflect two different, though complementary, perspectives.
The first, as now, is a bottom-up perspective, focused on setting institution-specific capital
requirements. Those would be fixed requirements that banks could not breach. The second
is an overall perspective with a set of system-wide capital requirements that vary over the
economic cycle. Judgements on the level of these capital buffers will be part of the remit of
the new Financial Policy Committee. The prudential regulator, with its micro prudential
responsibilities, and the Financial Policy Committee, with its macro prudential
responsibilities, will need to work closely together, and that is one reason why it is sensible
that they are both in the central bank.
It is not difficult to see what role such a macro prudential regime might have played in the
run-up to the crisis. A progressive tightening of capital standards, for example, would have
helped rein in the near-tripling of UK bank balance sheets between 2002 and 2007. The
Bank's sermons on the storms ahead would have had more influence if at the same time a
collection plate was passed round the congregation so that money was available in the event
that the church roof had to be replaced.
But a macro prudential regime also has a key role to play in the downswing phase of the
cycle. Since 2008, credit conditions have tightened, jeopardising the recovery and, in turn,
threatening renewed losses for banks. By allowing banks to draw on their macro prudential
capital buffers, while credit conditions remain tight, the system is counter-cyclical. In other
words, a credible macro prudential regime could help forestall both excessive exuberance
and unnecessary caution. By altering the pressure on the financial brakes according to
circumstances, regulation, far from being an inflexible foe, would become a flexible friend.
This type of regulatory regime, and its objectives and tools, are largely untried and untested.
But that is not a reason for not trying and not testing. The Financial Policy Committee will be
a first. Over the next few years we will put in place a framework for financial stability to
parallel that for monetary stability. We need both. As we have seen, one without the other is
not enough. Just as the role of a central bank in monetary policy is to take the punch bowl
away just as the party gets going, its role in financial stability should be to turn down the
music when the dancing gets a little too wild.
Still, we should not put all our faith in regulation. It has limits. If the structure of banking
creates incentives to take excessive risk then regulators will be overwhelmed by the avarice
so vividly captured by Michael Lewis in his book The Big Short. Incentives must be right. One
misalignment of incentives today is the implicit guarantee to banks that are "too important to
fail", so that creditors have little incentive to monitor the behaviour of banks because they
believe they will be bailed out. This problem is too important to ignore. There is no one
simple solution. But we should not shy away from radical reform just because of the
opposition of vested interests. So I welcome the setting up of the Banking Commission, with
its talented commissioners and a wise and forensic chairman in Sir John Vickers.
Let me now return to the quiz question I posed earlier - to what question is 23 the answer?
Several plausible answers come to mind. First, 23 is the number of players in England's
World Cup squad in South Africa. Second, it is of course 23 years since England last won the
Ashes "down under". But neither of these are the right answer which is that 23 years is the
age difference between the Chancellor of the Exchequer and the Governor of the Bank of
England. In case there is any doubt, George is the younger. This age difference is highly
desirable because the appropriate incentives are to allocate the responsibility of determining
monetary policy to the older generation, which has a real interest in preserving the value of
money, and the responsibility for fiscal policy to the younger generation, on whom falls the
burden of excessive debt. If we are tempted to leave a large burden of debt for the next
generation to pay back, what better incentive mechanism than to have as Chancellor
someone who has a longer life expectancy than any previous Chancellor on record? Given
those incentives, Chancellor, I look forward to a harmonious coordination of monetary and
fiscal policy.
Lord Mayor, as we prepare to toast the Bankers and Merchants of the City of London, all of
us here tonight would like to pay tribute to your charitable work since you became Lord
Mayor. This year the Lord Mayor's charity "Pitch Perfect" is focussed on two educational
charities in which I have a special personal interest - the educational work of the London
Symphony Orchestra and Chance to shine, the campaign to regenerate cricket in state
schools which, in five years, has already brought the opportunity to play competitive matches
to more than one million children, over 40% of whom are girls. Your personal commitment
Nick to support these causes in times of great financial difficulty is a tribute to you and also to
the charitable instincts of the City of London. We thank you for that work, and I am sure that
everyone here tonight thanks both you and the Lady Mayoress for the splendid hospitality
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", Nick and Claire Anstee.