Mervyn King: Monetary policy developments
Speech by Mr Mervyn King, Governor of the Bank of England, to the CBI Dinner, Manchester,
20 January 2005.
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Now that the Christmas celebrations are over, and the decorations have been taken down, it is time for
a much-loved New Year tradition - speculating on how much we all spent over the Christmas period.
With over 200 coaches bringing shoppers from all round the country to the Trafford Centre over the
weekend before Christmas, New Trafford seems to be as popular and entertaining as Old Trafford.
Tonight, though, I want to look beyond the immediate prospect for consumer spending and ask
whether the level of saving in this country is adequate to provide for our future needs. But, first, a few
words on the immediate outlook.
Tomorrow the ONS will publish its first estimate of retail sales in December. Among the more lurid
headlines reporting sales over the holiday period was "Retail Festive Slump", followed shortly by
reports of "Record Levels of Sales". To interpret the experience of a few retailers - whether positive or
negative - as a national trend is highly misleading. Of course, exactly the same happens each year.
Last year newspapers reported "Confirmation of a Disastrous Christmas" and "Shoppers Played
Scrooge in December". A week later the ONS said that the volume of retail sales in December rose at
a rate more than double the increase expected by City economists, and the headlines became
"Spending Spree Signals Rate Rise".
The most important lesson from past experience is that, whatever the number turns out to be, it is
foolish to put much weight on any one month's figure, especially at Christmas. There are two reasons
for being particularly careful about the interpretation of data for retail sales in December. First, the
figure that will be published by the ONS tomorrow will be dwarfed by the seasonal adjustment that is
applied to the recorded data. That adjustment changes from year to year, often leading to revisions of
the figures for earlier years. Typically retail sales in December are around 20% higher than in
November. So even small errors in the estimate of the seasonal pattern of sales imply large errors in
the estimate of the seasonally adjusted figure. As a result the monthly data can be volatile and little
economic significance should be attached to the number for any one month. Second, retail sales are
only part of household spending, around 40% or so. It is quite possible, indeed likely, that spending on
services, such as leisure and holidays, behaves rather differently from sales of goods on the high
street. So retail sales are not always a good guide to movements of consumer spending as a whole.
For those reasons we should recognise that the true meaning of the Christmas story will not be
revealed until Easter - or possibly much later. The Monetary Policy Committee is more concerned to
discern the meaning of the path of consumer spending over a longer time horizon. For some years the
volume of consumer spending rose much faster than its post-war average. From 1997 to 2001 it rose
at an average annual rate of about 4%, and calendar year growth was last below 2% in 1995. We are
not so much a nation of shopkeepers as a nation that keeps shopping. Behind this growth was a
steady rise in real incomes, driven by increases in employment and falls in the prices of imported
goods. Those price falls followed the rise in sterling in the second half of the 1990s, and the increase
in cheap imports of manufactured goods, such as textiles, toys and electronic goods, from China and
other emerging market economies. Over the past three years, however, consumer spending has
decelerated and its growth has fallen to a more sustainable rate, close to its post-war average.
The slower pace of consumption growth was the result of real income growth returning to a normal
rate. It is striking, as the Monetary Policy Committee has said before, that for a number of years, and
despite the volatility of house price inflation, the saving ratio of households has been rather stable.
Some commentators are exercised by the possibility of a rise in household saving and hence a further
slowing of consumer spending. Their concern is that since consumption is the largest component of
total demand, the path of consumer spending is crucial to the outlook for output and inflation. Such
concerns about the short run are indeed analysed carefully each month by the Monetary Policy
Committee, and the results of that analysis feed into our monthly interest rate decisions. Visits like this
give me the chance to listen to you and learn from you and other businesses about what is happening
on the ground - not just in the retail sector but in manufacturing and services more broadly. And my
visit is the tip of an iceberg because we have a permanent Agency in the North West - staffed by
members of the Bank who live and work here.
But I want to step back from the immediate conjuncture and look further ahead. More relevant for our
future prosperity is the question not of whether we might save too much but whether we are saving too
little. The level of income that will sustain us in the future depends critically upon how much as a
nation we set aside today. In other words, what is happening to the national saving rate - the
proportion of the net national product that is not consumed by either the private or public sector?
Since the late 1960s the national saving rate has been declining fairly steadily, from over 10% to
around 5%. Although saving rates elsewhere in the G7 have also fallen, they were higher than in the
UK for most of the post-war period. Recently the gap between saving rates in the UK and the rest of
the G7 has narrowed considerably, not as a result of higher saving in the UK but lower saving
elsewhere. In large part this reflects changes in fiscal policy. There is ample empirical evidence that
higher government borrowing lowers national saving. And for twenty years or more the G7, while
lecturing each other and the rest of the world on the need for fiscal discipline, has continued to borrow
more and more. The ratio of net public debt to GDP in the G7 has more doubled since 1980 from
around 25% to around 60%. The UK is the only member of the G7 in which the ratio is lower than in
1980.
The UK has a clear framework for fiscal policy. Although rules and frameworks cannot guarantee that
governments will pursue sustainable fiscal policies, as the large deficits in the early 1990s illustrated,
they make deviations from medium-term sustainability more transparent. But in the rest of the G7 the
absence of a clear framework, as in Japan and the United States, or the lack of credibility in the stated
framework, as in the failure to enforce the Stability and Growth Pact in the euro area, has made it
easier to let the fiscal position slip. As a result, the G7 fiscal deficit is now close to its 25-year peak,
and the average national saving ratio has halved.
At home, the Government's fiscal rules constrain the path of fiscal deficits. They limit borrowing, over
the economic cycle, to the level of public investment and place an upper limit on the debt to GDP ratio
of 40%. In assessing the fiscal position it is important to look forward and not just backward at the
realised deficits over the past cycle. Of course, it is also important to recognise the many uncertainties
surrounding the future path of the public finances.
Central bankers probably talk too much about fiscal policy. Certainly, there are politicians, especially in
Europe, who believe central bankers confuse the deficits which dot the fiscal landscape with all
manner of economic evils, rather as Don Quixote confused the windmills which dotted the landscape
of La Mancha with the terrible giants sent by some evil force. So I do not want to overstate the case
and tilt at windmills, especially in the light of the fact that this month sees the 400th anniversary of the
publication of Cervantes' great novel. But it will clearly be important that the prudent approach to fiscal
policy that has served the UK so well in recent years is continued - over the next cycle and beyond. In
that way our national saving rate can be maintained or even raised.
The market response to inadequate saving is higher real interest rates. Since the UK is a part of an
open international capital market, long-term real interest rates in this country reflect the balance
between investment and saving, including the stance of fiscal policy, not just at home but throughout
the world economy. Surprisingly, in the light of the fall in G7 saving, UK long-term real interest rates -
as measured by the forward rates implied by the yields on index-linked gilts - are near their lowest
levels for twenty years. US and euro-denominated rates are also low relative to past experience.
There may be other factors that have offset the effect of fiscal policy on real interest rates, such as
demographic developments and higher saving and more open capital markets outside the G7. But
there remains a risk, as discussed in the Bank's recent Financial Stability Review, of an unwinding of
low long-term real interest rates as the stimulus from highly accommodative monetary policies across
the G7 economies is gradually withdrawn.
What do these arguments mean for monetary policy today? They imply, I believe, three main
challenges for central banks. First, the factors that affect the level of real interest rates in capital
markets around the world also determine whether a given official interest rate is an expansionary or
restraining influence on demand. When driving a car we normally know whether our foot is on the
accelerator or the brake. That is less obvious in the case of monetary policy - hence the debate among
economists about the level of the so-called neutral interest rate. Uncertainty about the extent to which
monetary policy is applying the accelerator or the brake justifies central bankers' continued interest in
the monetary and credit aggregates which contain information about the pace of nominal activity and
hence future inflation.
Second, over the next few years the transition to a higher national saving rate is likely to imply a switch
of resources from consumption in the private and public sectors to investment and net exports. It will
not be easy to achieve that while keeping inflation on track to meet the target and maintaining steady
growth in output. It is very likely that, when the ONS publish next week their first estimate of economic
growth in the final quarter of last year, it will show that the UK economy has now had 50 consecutive
quarters of positive economic growth. No other G7 economy avoided falls in output over that period.
But we should recognise, as I hope the English cricket team does tomorrow, that reaching a
halfcentury is no time for complacency but for renewed concentration.
Third, the ability to buy goods from abroad at ever lower prices has kept down inflation at home and
sustained faster growth in real incomes and consumption - just as Richard Cobden and John Bright,
and the other founders of the Manchester School, argued more than 150 years ago. And it is not just
consumers who are paying less for these items. Retailers are too. But the inflation rate of goods and
services produced in the UK has been rising modestly for two years or so. That has been offset in
large part by a fall in import prices. Although we can influence the former we have little control over the
latter. There would be risks to output and inflation in the medium term if we were to allow inflation of
domestically produced output to rise above target unless we were confident that falls in import prices
would indeed continue for some years.
The lesson that we should not place excessive weight on one month's figures is as true of inflation as
it is of retail sales. In December CPI inflation was 1.6%. Three months ago it was 1.1%. Six months
ago it was 1.6%. Yet the broad outlook for the economy - a central view of continuing steady growth
with low inflation - changed rather little during the period. The MPC cannot fine tune short-run
movements in output and inflation.
When the MPC published its Inflation Report in November, some commentators said that inflation was
seemingly stuck at around 1%, and that if growth were to continue at around trend then it was difficult
to see why the Committee's central view was that inflation would pick up to the 2% target looking
ahead around two years or so. Since then inflation has risen by half a percentage point in only three
months. Stating the point in that way shows how silly it is to place so much weight on small changes in
inflation and small deviations of inflation from target.
The appropriate response by central banks is to examine all the economic data, and to focus on the
outlook for inflation in the medium term. That is exactly what the MPC will continue to do. And by
keeping inflation on track to meet the 2% target, the MPC will be making its contribution to future
prosperity, both in the Trafford Centre and the country as a whole.