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 at the Mansion House, London, 18 June
2008.
* * *
My Lord Mayor, Mr Chancellor, My Lords, Ministers, Aldermen, Mr Recorder, Sheriffs, Ladies
and Gentlemen:
Can it really be only a year since we last met in this magnificent room? With the financial
crisis continuing, I was tempted to deliver last year's speech again. But that would not allow
me to welcome the Chancellor to his first Mansion House Dinner as Chancellor. After the
past - difficult - year, could I say, Chancellor, how much we at the Bank have appreciated
the patience and good humour with which you have handled the "slings and arrows of
outrageous fortune".
Over that year, the west wind of a credit crunch emanating from the United States and the
east wind of higher energy and food prices resulting from the strength of Asian economies
have been stirring up the waters through which our economic ship must pass. These two
challenges of rising inflation and falling economic growth have led to a crop of doom-laden
predictions best captured by my less well-known addition to the well-known words of Robert
Frost:
Some say the world will end in fire,
Some say in ice.
But whichever it is
It won't be NICE.
That "non-inflationary consistently expansionary" decade, as I described it in 2003, has
drawn to a close. Yesterday we learnt that inflation in May rose to 3.3%. In line with our
remit, I sent an open letter to the Chancellor. As I said in my letter, inflation is set to increase
further over the next few months. Oil prices have doubled since the beginning of last year,
and, in real terms, are now as high as they were in the 1970s. And further sharp increases in
domestic gas and electricity prices are probably on their way.
So what should the Monetary Policy Committee do in the face of this rise in inflation?
The immediate cause of the current pickup in inflation is increases in food and energy prices
relative to other prices. They are caused by the pressure of demand on the supply of food
and energy in the world as a whole. Part of that pressure may well reflect expansionary
monetary policy in the world as a whole. But the rise in commodity prices cannot, by itself,
generate sustained inflation in the United Kingdom unless we allow it to. We will not. So
although inflation in the UK will rise in the short term, inflation will then fall back.
That means that the rate of increase of other prices and domestic costs, notably pay, must
remain low. The MPC does not take that for granted. Surveys - including our own - indicate
that expectations of inflation have risen, meaning that inflation is likely to have some
tendency to persist. That is why, as I explained in my letter to the Chancellor, we believe that
a slowdown in the economy this year, creating a margin of spare capacity, will be necessary
to dampen price and wage pressures and ensure that we fulfil our remit by returning inflation
to the target. And growth is now slowing quite sharply - broad money growth is falling,
business surveys point to particularly weak output growth in the second quarter and growth is
likely to remain subdued for the rest of the year.
Where Bank rate will ultimately need to move to bring inflation back to target is impossible to
judge now. Decisions on Bank Rate will be made one month at a time in the careful way that
the MPC has developed over more than ten years. But there should be no doubt that the
MPC is prepared to take whatever action is needed to return inflation to the 2% target and to
keep expectations of inflation in the medium term anchored to the target.
The fact that growth and inflation are heading in opposite directions has led some
commentators to question our monetary framework. Target growth not inflation is the cry. I
could not disagree more. This is precisely the situation in which the framework of inflation
targeting is so necessary. Without it, what should be a short-lived, albeit sharp, rise in
inflation, could become sustained. Without a clear guide to the objective of monetary policy,
and a credible commitment to meeting it, any rise in inflation might become a self-fulfilling
and generalised increase in prices and wages. And surely the lesson of the past fifty years is
that, when inflation becomes embedded, the cost of getting it back down again is a
prolonged period of sluggish output and high unemployment. Price stability - returning
inflation to the target - is a precondition for sustained growth, not an alternative.
We are in the most challenging period since the MPC was set up in 1997. But we have the
right framework in place to ensure that inflation returns to the target and growth recovers.
The stormy waters we are navigating now make for an uncomfortable passage compared
with the calm conditions of the nice decade. Our inflation performance then was surprising
not so much because inflation was low, but because it was so remarkably stable. Neither
inflation nor growth are likely to be as stable in the future. But even if inflation proves to be
more variable, it will not be systematically either higher or lower than the target.
The right framework is essential if we are to maintain low inflation and steady growth. But
there are two recent developments in our economy at present that no monetary policy,
whatever the framework, can prevent.
The first is the impact on living standards of rising food and energy prices. These prices have
risen relative to most other prices. Monetary policy should not, and in the end cannot,
prevent such changes in relative prices. They will show up either in higher consumer prices
or in a lower level of other prices and pay. Either way, the result is the same - a loss of real
purchasing power.
This year our real take-home pay will rise at a slower pace than national productivity. Rising
fuel, gas, electricity and food prices, mean that average real take-home pay will stagnate this
year. It will not be an easy time, and I know that some families will find it particularly difficult.
But it is only a temporary slowing in the growth of our real take-home pay and remember that
this is the opposite side of the coin to the falls in prices of manufactured goods from
countries such as China and India, which in the nice decade allowed our standard of living to
rise at a rate faster than productivity.
The squeeze on real take-home pay will arguably be an even more significant restraint on
consumer spending this year than the credit crunch. And it will affect the housing market too
- lower demand in the high street will go hand in hand with lower demand in the property
market. I have said in the past that there is no causal link between house prices and
consumer spending. That remains the case. How closely they move together depends on the
underlying forces that are driving them both. This year, the squeeze on real income growth is
likely to mean that both house prices and consumer spending weaken together.
The housing market leads me to the second recent development - the reassessment and
repricing of risk in the financial sector. It is clear that the housing market is being severely
affected by the reluctance of the banking system to expand its balance sheet further. Banks
are adjusting to the fact that many asset markets are unlikely to re-open in their old form and,
as they do so, the supply of mortgage finance is being restricted. Once the adjustment in the
financial sector is complete, banks will be able to resume lending. But the era of cheap
mortgage finance that underpinned the housing market in 2006 and the first half of 2007 is
over and, as a result, it is reasonable to expect the ratio of house prices to incomes to fall
back, though with real interest rates still low by the standards of the past fifty years, not to
previous averages.
These changes to our spending power and to the housing market are "real" shifts that,
although not easy to accept, we cannot side-step. Lord Mayor, we face the most difficult
economic challenge for two decades. But I am confident that we can meet it. Inflation will fall
back and growth will recover. But the cost of the necessary adjustment will depend on the
credibility of the framework for monetary stability. After all, the value of paper money rests on
only one thing - trust. Trust in the ability and determination of those setting interest rates to
maintain the value of money. Central to that is the independence of the Bank of England. An
independent central bank has, over time and around the world, proved to be a cornerstone of
the arrangements necessary to underpin trust in paper money.
So, Chancellor, I welcome your intention to introduce a proper process for making
appointments to positions on the Monetary Policy Committee.
I welcome too, Chancellor, the announcements you made tonight about the shape of a new
framework for financial stability to be embodied in a Banking Bill. I particularly welcome the
new responsibilities for the Bank of England and associated reforms to our governance. We
now have the chance to put in place a set of reforms that provide a coherent framework for
banking regulation. It is an opportunity we must not throw away. I can assure you all that the
Bank of England will devote time and resources to meeting the new responsibilities which the
Chancellor plans to give us.
Lord Mayor, shortly after assuming office, you were quoted as saying, "I think like a lawyer.
I'm very prudent, very risk-averse". What a pity you weren't running a bank a year or two
ago! But in a difficult year for the City you have provided leadership and thrown yourself into
the enormous workload of your office. Tonight all of us here would like to pay tribute to your
work since you became Lord Mayor, and to thank both the Lady Mayoress and yourself 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, David and Theresa Lewis".