Mr George elucidates the new monetary policy arrangement in the United Kingdom and in
the euro-zone
Speech by the Governor of the Bank of England, Mr E A J George, at The Chartered Institute of
Bankers in Glasgow on 18/1/99.
Mr President, Secretary of State, Lord Provost, my Lords, Ladies and Gentlemen.
It would be a masterly understatement to describe the past two years, since the last CIB Scotland
Dinner, as eventful.
Here in Scotland, following the referendum and last year's legislation, you are now actively
preparing for the elections to the Scottish Parliament in May.
In my own neck of the woods, we have seen responsibility for the implementation of monetary
policy devolved upon the Bank's new Monetary Policy Committee.
And elsewhere in Europe, 11 countries have merged their separate currencies into the single
euro, thereby passing responsibility for monetary policy from national authorities to the new
European Central Bank.
These are truly historic events.
I have no wish to become embroiled in the matters of Scottish politics this evening - I'm more
than happy to leave that to the Secretary of State. I simply wish you all well, and look forward to
developing a constructive dialogue with the new Parliament as we have with the Scottish
banking and business communities. But let me say a few words about the new monetary policy
arrangements here in the United Kingdom and in the euro-zone.
The real significance of those arrangements - in both cases - is that in introducing them the
respective governments confirmed their common commitment to achieving and maintaining
effective price stability in their respective currency areas. That role for monetary policy is not
simply an end in itself, in some abstract, doctrinaire way. On the contrary it recognises that
consistently and reliably low inflation, into the medium and longer term, is a necessary means to
the end of sustainable growth of output and employment, which are, of course, the truly good
things of economic life that we are all seeking to achieve.
Our own new legislation defines the MPC's objective as to maintain price stability and, subject
to that, to support the Government's economic policy, including its objectives for growth and
employment. The Maastricht Treaty defines the primary objective of the European Central Bank
as to maintain price stability, and without prejudice to that objective to support the general
economic policies of the European Union.
There are significant differences between the two statutory frameworks. In our case, for example,
the precise definition of the stability objective is determined by the Government; and there are
much more rigorous requirements for transparency of the MPC process and public accountability
for MPC decisions. I am convinced that our arrangements are wholly appropriate to our
particular circumstances. But the essence of what we and the ECB Governing Council are
mandated to do is very much the same.
It involves in effect aiming to keep overall, aggregate demand in the economy (as a whole) more
or less continuously in line with the underlying overall capacity of the economy (as a whole) to
meet that demand. Effective price stability is essentially a measure of our success in achieving
economic stability in that much broader sense.
It is a limited role. Neither we nor the ECB can do very much directly to affect the underlying
supply side of the economy which depends upon its structural characteristics, and above all, in
today's world, on the efficiency and flexibility of goods, capital and labour markets. Monetary
policy cannot substitute for supply-side reform, but by maintaining price stability we can,
indirectly, help markets to function more effectively.
Nor can either the MPC or the ECB do much directly to influence the pressures on particular
firms or particular sectors or regions of the economy; we and they can only influence the
monetary situation in the economy of our respective currency areas, as a whole. We have
essentially one instrument: the short-term interest rate. But, again, if we are successful in
achieving overall stability, that will also contribute over time to a more rather than less
favourable operating environment for the different component parts of the economy. But that is
the most that either we in the MPC or the Governing Council of the ECB can hope to do.
The fact that we both have essentially the same objective - and are subject to the same
limitations - does not, of course, mean that we can adopt the same policy stance - the same level
of short-term interest rates, as some commentators have recently, and oversimplistically,
suggested. We start from different positions, and our respective economies are subject to many
different, as well as many of the same, influences. That was an important economic reason why
the Government decided, rightly in my view, not to participate in the first wave of monetary
union - despite the attraction, in the right circumstances, of nominal exchange rate certainty
across the European continent. It was, I know, a matter of regret to many of our European
partners; but there was also a sense of relief, because many of them recognised that our different
economic situation would have complicated European monetary management had we joined
from the outset, as it would have complicated monetary management in this country.
In our case, the UK economy has grown at an average annual rate of around 3% now for the past
six and a half years (to the third quarter of last year). That is well above any plausible estimate of
the underlying rate of growth of capacity in the economy as a whole - which is typically
estimated at some 2-21⁄2%. So what we were in fact doing over this period was steadily
reabsorbing the economic slack created by the recession of the early 1990s. In the labour market
this was reflected in a rise in employment of some 1.65 million to an all-time high on the latest
figures (for the three months to last November) of 26.6 million. It was reflected, too, in a fall in
the rate of unemployment from a peak of 10.6% (on LFS figures) to the current rate of 6.1%,
which is the lowest rate for almost 20 years. As far as the regional impact is concerned, I would
note that over this period unemployment in Scotland - though still higher than in the UK as a
whole - has also declined - to 7.6% on the latest LFS data, compared with a peak of 10.8%; and
on a claimant count basis it, too, is currently lower than for 22 years.
These developments in the labour market produced only a fairly gradual pick up in pay
settlements and earnings growth compared with past periods of labour market tightening -
though we have, of course, been unsighted on what has happened to earnings growth more
recently. And underlying retail price inflation - on the Government's inflation target measure
(RPIX) - averaged some 23⁄4% a year through the expansion, and is currently exactly on target at
21⁄2%.
By the time of your last dinner it was already becoming clear that overall output growth needed
to moderate if we were not to run into overall capacity constraints and a pick-up in inflation. The
exaggeratedly strong exchange rate against the core European currencies - reflecting inter alia
market misperceptions about the prospective strength, or rather weakness, of the euro - was itself
moderating external demand, especially for manufacturing output, while at the same time
exerting a restraining price effect on domestic inflation. But domestic demand growth -
including demand for services - continued to accelerate through 1997, and that was the
background to the tightening of monetary policy in 1997. We could not avoid that tightening,
despite the uncomfortable sectoral imbalance within the economy. To have done so would, as I
have said elsewhere, have put the whole of the economy - including the internationally exposed
sectors we would have been trying to shelter - at risk of accelerating inflation, so it would not
have helped even those sectors in anything other than the short term.
Meanwhile, in the euro-zone things were very different. Demand and output growth in the major
continental economies remained generally fairly sluggish for much of the period, only really
starting to pick up towards the end - helped by relatively weak exchange rates. Unemployment,
which is much the most urgent and important issue confronting Europe, actually increased; and,
despite some improvement over the past year or so, it remains at or close to double digit rates in
all the largest euro-zone countries. Inflation against this background remained low, tending lower
- as did interest rates. The position is complicated in the euro-zone by a reviving political debate
about just how much of the unemployment reflects supply-side weaknesses requiring structural
reforms, and how much it reflects inadequate overall demand. The outcome of that debate will be
crucial to the future evolution of the euro-zone. But in the immediate situation there was no
reason to suppose that continued growth of demand and output was inconsistent with effective
price stability in the zone as a whole.
So much for our different starting points. But over the past year, the world - and I mean the
world - has changed quite dramatically for both of us in that we have both been affected by the
international economic slowdown.
This started, in fact, with the financial disturbances in Asia in the latter half of 1997, but even as
late as the beginning of last summer it seemed as if it might have only limited impact on the
overall world economy. The IMF, for example, was still then projecting 3-33⁄4% world growth in
1998 and 1999 respectively - which was certainly a setback compared with their forecast of over
4% just six months before - but it was hardly catastrophic.
Since last summer it has become increasingly clear that things are likely to be significantly worse
than that. The financial collapse in Russia, deepening recession in Japan, the long battle - then
sudden defeat last week - in Brazil's attempt to hold its exchange rate, and fluctuating fears of
possible knock-on effects on the major countries' financial markets all contributed to an
increased sense of financial fragility, which has not been easy to contain. We can, I believe, still
avert a more general international financial upheaval (and the financial markets' response to the
latest developments in Brazil, as well as the beginnings of a recovery in capital flows to some
countries in Asia, are reasonably encouraging in this respect). But, we are nevertheless bound to
see a pronounced slowdown of world economic activity. The IMF has cut its latest (December)
forecast for world growth to less than 21⁄4% in 1998/1999. And the risks almost certainly remain
on the downside. That's still not global slump or recession. But large parts of the world economy
are in fact in recession and the prospect for the world as a whole turns very much on what
happens in the major industrial countries.
In essence, what we are seeing is a sharp cutback in capital flows to much of the emerging world
and to some of the transition economies, enforcing on those countries a corresponding cutback in
domestic demand and creating the need for an urgent improvement in their current accounts. The
counterpart is a sharp decline in net external demand in the industrial countries, which, if it is not
offset by action to stimulate domestic demand in those countries, could lead to weakening global
activity and price deflation.
In fact to varying degrees - reflecting differing assessments of how far their particular currency
area is expected to be affected by the slowdown in external demand, and different starting points
in their assessment of trends in domestic demand, and of how close they were initially to full
capacity, in their respective overall economies - both the UK and the euro-zone, as well as the
US, have acted fairly aggressively to reduce interest rates since the autumn; and Japan has moved
to more active fiscal stimulus. And if the global economic prospect, and net external demand in
the industrial countries, were to deteriorate further, then it would be right to contemplate further
moves in the same direction - consistently with our aim of effective price stability. What we are
trying to do, as I said earlier, is to keep aggregate demand in line with the supply capacity of our
economies. We have no interest in the creation of unnecessary spare capacity in our economies
as a whole or in a fall in the underlying general price level.
But what this will inevitably mean is a worsening of the balance of payments on current accounts
of the industrial countries, individually and collectively, reflecting the imbalance between
external and domestic demand growth in our economies. That imbalance clearly will need to be
reversed at some point as the flow of international capital is restored to a more sustainable level.
The pressures can in the meantime be mitigated by official international financing, but private
flows may take a while to settle down. For the time being, though, the directly and indirectly
internationally exposed sectors, not just of the UK economy but throughout the industrial world,
will continue to operate in a highly competitive environment.
All in all this is an uncertain and difficult prospect. It will be an exceptionally challenging period
for both international and domestic monetary policy management in both the UK and the
eurozone as well as in the rest of the industrial world. And it will, I know, be a challenging period for
many of you - even though the excessive strength of the exchange rate has now started to ease.
But our economy as a whole starts from a position of relative strength compared with the past,
and our own financial underpinnings, including both corporate and personal sector balance
sheets, are relatively robust. We are currently seeing an overall slowdown - as we needed to do.
That slowdown could go further. But I would frankly be surprised if it developed into a steep or
protracted recession - that certainly is not the most probable outcome; it is not a necessary
outcome; and it is one which the MPC will certainly seek to avoid - always consistently with
achieving our inflation target.
Mr President, I can promise you that the next two years will be eventful. The only other certainty
is that we will be confronted by the millennium. But I would hope that by the time we meet at
this Dinner again the situation will be both clearer and calmer.
In the meantime, I thank you once again for your excellent hospitality and I ask you all to rise
and to join me in a toast to the health and prosperity of the CIB in Scotland.
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