Paul M W Tucker: Monetary policy, stability and structural change
Speech by Mr Paul M W Tucker, Executive Director and Member of the Monetary Policy Committee of
the Bank of England, at the Confederation of British Industry, Guildford, 1 March 2005.
* * *
MONETARY POLICY, STABILITY AND STRUCTURAL CHANGE1
Judging by the macroeconomic data, either there have been some fairly profound changes in our
economy or we have been blessed by extraordinary good luck over the past decade or so. GDP has
grown without interruption for 50 quarters. Unemployment has fallen from around 101⁄2 % in 1992 to
61⁄2 % in 1997, and just over 41⁄2 % on the latest reading. Inflation fell through the first half of the
1990s, and since 1997 has, on average, been close to the Government's target. All that is, of course,
well known.
But it may be less familiar that quarter-to-quarter changes in output growth and inflation have over
recent years exhibited a strikingly different pattern from those of previous decades. Both output
growth and inflation have been less variable (Chart 1; Table 1). Inflation also seems to have become
less persistent. By that, I mean that, whereas in the past rises or falls in inflation tended to be
protracted, more recent fluctuations in inflation have been short lived. Work undertaken by Bank of
England economists,2 summarised in Table 2, suggests that - at least statistically - this apparent
change occurred around the time of the UK's introduction of inflation targeting in 1992.
The policy debate - inside and outside the Bank - has recently refocused on the possibility of some
other changes in the way our economy functions. Less than 18 months ago, the Bank's interest rate
was just 3.5%, essentially because the MPC wanted to stimulate private sector domestic spending to
offset the effects on aggregate demand of weak net trade, given adverse developments in the world
economy. As global conditions recovered, and with a pick up in public sector spending, we were able
gradually to withdraw much of that stimulus during 2004 in a series of steps which were widely
anticipated and understood across the financial and real economy (Chart 2). With the slack in the
economy being absorbed, attention shifted to gauging the degree of demand pressures and their
implications for the inflation outlook. In particular, on the basis of some simple statistical relationships,
a question has been posed about whether there has been some change in the extent to which
demand pressures feed through into wages and prices. Most notably, as discussed in the Bank's
February Inflation Report, the steady falls in unemployment over recent years have not been
accompanied by a rising rate of earnings growth (Chart 3). These issues obtained some prominence
towards the end of last year when, despite apparently buoyant demand, inflation on the CPI measure
fell to 1.1%.
Lower variability in output growth and inflation, lower inflation persistence, apparently weaker pass
through of demand pressures - all told, this points to the importance of identifying and understanding
the complex combination of structural changes affecting our economy. Today, I plan to give a broad
overview of some of them, as they confront policymakers.
Our standard tools of economic analysis - in particular, statistical modelling - are not especially
well-suited to real-time detection or quantification of the underlying forces of change. They can,
though, alert us to puzzles when the data persistently deviate from past patterns. Business managers,
by contrast, are exposed to the reality of change day by day. Unable to shield yourselves from
change, businesses can indeed succeed by embracing it - shaping your environment as well as
responding to it. That underlines the value of the Bank's dialogue with business, facilitated and led by
our regional Agents across the UK. Colloquially, you enrich our grasp of what is 'going on out there'.
Economic analysis then helps us to match your various real-world stories to puzzles we see in the
data.
Inflation and firms' price-setting behaviour
In the medium-to-long run, the average rate of inflation is determined by the rate of nominal expansion
permitted by the monetary authority. But over shorter horizons, decisions taken by businesses - in
particular, about wages and prices - affect quarter-to-quarter fluctuations in inflation and, more
generally, how demand pressures feed through to inflation.
Economic policymakers draw on a number of ways of thinking about those influences on inflation
dynamics. There is no model that can, uniquely, capture the richness of the real world. But surprising
though it may be to some, one of the ways in which we think about firms' price-setting behaviour would
be familiar to anyone running a business. Namely, that firms charge a mark up, or profit margin, over
the marginal costs of their various inputs - labour, capital, raw and intermediate materials, etc - with
both the mark up and costs varying according to current and prospective demand conditions. This is
represented schematically, indeed crudely, in Diagram 1. The key feature is that when demand rises
and firms utilise their capacity more fully and add to their labour force, their costs and prices tend to
rise. That might involve old-fashioned 'cost-push' inflation, with firms raising prices to maintain
margins in the face of increased (marginal) costs. Or firms might initially be able temporarily to raise
margins, with labour and other costs later 'catching up'. In either case, firms and wage bargainers will
be influenced by what they think is going to happen to inflation in the future. Again simplifying, two
features are added to the diagram to bridge from firms' so-called 'output' - or wholesale - prices to the
retail prices which the Bank targets. First, as well as being an input to producing firms, some imports
are directly consumed by households. Second, distributors - including, most obviously, retailers - add
another mark up, reflecting their own costs and desired profit margins. Changes in the economy
affecting any of the links in this (stylised) chain will have a bearing on inflation dynamics. The
challenge is to separate out cyclical, or temporary, factors from the more structural influences that over
some periods alter firms' costs and margins. That is important for policymakers, as to form a view on
the medium-term outlook for inflation we need to distinguish between short-lived and persistent
influences.
Monetary regime change
The monetary framework is one such structural influence.
One of the most encouraging features of the post-1997 landscape has been that, as well as inflation
tracking the target fairly well, expectations of inflation have been well anchored to the target (Chart 4).
Uncertainty about future inflation has also fallen3 (Chart 5 ). It was different in the past. A
characteristic shared by the various monetary regimes tried out by UK governments during the 1970s
and 1980s was that no one could easily judge what rate of inflation the authorities were trying to
achieve - or, therefore, have much idea about the outlook for inflation. As feared by one distinguished
economist of an earlier generation, "every business venture [risks being] transformed into a
speculation on monetary policy".4 In those circumstances, it may well have seemed reasonable to
assume that recent inflation outturns were a good basis for guessing the near-term path of inflation.
And given the evidence, firms and households could also have been forgiven for acting on an
assumption that the authorities would be slow to respond to excess demand and so to upward
pressures on inflation.
By contrast, the current regime seems, so far at least, to enjoy high credibility. In consequence, when
setting prices, firms might well place more weight on policy delivering inflation in line with the target
than on recent inflation outturns. If so, that might be part of the explanation for the much lower
persistence in inflation I described earlier. In other words, when shocks to the economy cause
inflation to deviate from target, firms may nevertheless set prices on the basis that it will return to
target fairly quickly - which would, of course, itself help to bring inflation back to target. In a similar
vein, firms and households might now expect the Bank to tweak policy fairly promptly in response to
shifts in demand. In which case, the influence of such demand shocks on wage and price setting, and
so on inflation, would plausibly be somewhat weaker than in the past.
But sound monetary policy is not the only important change in the economic environment. That much
is apparent from even a brief examination of real-economy influences on firms' costs and prices. I
shall discuss just three: the labour market, financing markets, and competitive conditions in product
markets.
Labour market
For most businesses, their workforce accounts for the major part of their input costs (Chart 6). Firms
in general - and the economy in aggregate - have therefore been profoundly affected by the
transformation in the UK's labour market over the past quarter century. The key influences have been
well documented.5 In particular, industrial relations legislation altered the way in which unions
operate, and union membership has fallen (Chart 7). Unemployment and social security benefits have
been progressively reformed, increasing incentives to work. Use of part-time workers has increased
(Chart 8), in part due to the expansion of the services sector, and perhaps also more flexible ideas
about working patterns. The mechanisms via which employers and employees find each other - job
search - have improved, helped by investment in employment exchanges and perhaps recently by the
internet.
In combination, these developments provided the conditions for unemployment to fall over the past
decade without adding to inflationary pressure. During the transition, the supply capacity of the
economy accordingly increased by more than would otherwise have been achieved; and any given
increase in real aggregate demand would have put less pressure than otherwise on supply, and so
would have had a weaker effect on firms' costs and prices. That does not mean, however, that the
feed through of demand pressures into inflation will be permanently weaker. Instead, the apparently
flat relationship, illustrated in Chart 3, between unemployment and wage inflation is, at least in part,
most probably a symptom of the sustainable level of unemployment having gradually fallen. That is
effectively what the MPC has assumed in making judgments about the outlook for inflation. We can
be reasonably confident about the direction of change, but not about its size.
That can be illustrated by the current conjuncture. Over the past few years, there have been at least
two other influences at work. First, for some years we enjoyed an improvement in our 'terms of trade'.
That meant, simply put, that the aggregate price of the goods and services we produce and export
rose relative to the aggregate prices of our imports. This increased the purchasing power of
households' incomes (Chart 9), and so may have dampened wage pressures as the labour market
tightened. To the extent that this explanation should be given any weight, it would tend to be a
temporary factor, pointing to an upside risk to earnings growth looking ahead.
A second apparent feature of our environment works the other way round. Anecdotally, the role of
migrant labour has increased in various sectors - partly associated with the enlargement of the EU's
single labour market. If that continued, with new residents continuing to help to meet particular skill
shortages, the labour supply available to UK businesses would increase, implying that the economy
could potentially accommodate stronger aggregate demand than otherwise. However, the available
data do not really enable us to get beyond anecdote and speculation.
Financing
Another important input for firms is finance - for working capital and investment. Here too, there seem
to have been changes - in the range and terms of the sources of finance available to both firms and
households - that could potentially influence the extent of cyclical fluctuations in output and inflation.
One characterisation of the past would be that firms and households depended on bank loans for
external finance; and that banks loosened or tightened credit conditions sharply in the different phases
of a business cycle, reining back when the economy suffered a downturn and arrears and losses
mounted. For the UK, this is well documented for small-firm finance during the early-90s recession.6
Although the stability of output growth over the recent past happily deprives us of a proper test, there
are reasons to think that cyclical swings in the availability of finance may now be somewhat less
marked than in the past. In the first place, the greater stability brought by the new monetary regime
may make a difference. Compared with the past, there should be less risk of the monetary authority
delaying a response to incipient inflation until the point that it is forced to slam on the brakes,
effectively engineering recession to quell inflation expectations and in the process contributing to a
sharp spike in unemployment, loan defaults and bank losses.
A more stable macroeconomic environment may also, by reducing the risks for new entrants, be one
amongst a number of influences fostering competition. There is perhaps some circumstantial
evidence of that in, for example, the decline in margins on personal loans (Chart 10). That would tend
to reduce the credit constraints facing households. As does the increased availability of loan products
that enable homeowners to borrow against the free equity in their houses.
Broadly similar changes have been underway in business finance, where competition also comes from
outside the banking sector through firms' access to richer capital markets. The proportion of UK
nonfinancial firms' debt accounted for by bonds has risen from around 15% in 1990 to over 30% now
(Chart 11). Our largest firms have access to the international commercial paper, bond and
asset-backed markets; and to derivative markets for managing their financial risks. For smaller firms,
compared with a decade or so ago, there seems to have been an expansion in asset-based financing
options enabling them to utilise collateral more effectively.7
Taken together, a richer supply menu may leave firms and households somewhat less exposed to
being severely credit rationed in an economic downturn; and may enhance their ability to cope with
cyclical economic fluctuations. If that helped to dampen the effect of shocks, output growth and
inflation may vary a little less than otherwise, and monetary policy may need to respond less
aggressively than in the past to keep the economy on a stable path.
But, again, it can be difficult to disentangle cyclical from more durable changes. A topical example is
the risk premium priced into financial instruments. To pick just one indicator, corporate credit spreads
have been falling for a few years, to levels that last prevailed in the mid-90s (Chart 12). In degree, that
seems likely to reflect a relatively benign global macroeconomic environment together with
balance-sheet strengthening in the corporate sectors of a number of major industrialised countries. But,
conceivably, it also reflects better diversification of risk - facilitated, for example, by the rapid growth of
new instruments such as credit derivatives and by greater cross-border investment of savings. If so -
if risk premia were systemically lowered - that would tend to reduce firms' cost of capital and increase
households' financial wealth. Alternatively, the price of risk may just be temporarily low, possibly too
low.8 The upshot is that we cannot yet be confident about the durability and macroeconomic
implications of the changes seen in the financial environment.
Mark ups
It is a commonplace that competition has intensified.
This is associated with 'globalisation'. The facts are familiar. World trade has grown relative to world
output (Chart 13). A wide range of emerging-market economies, notably in Asia, have become
material participants in the world economy. Some UK businesses have relocated part of their
production, or outsourced to firms operating in markets with cheaper labour costs. Partly reflecting
these developments, although also increased specialisation, the share of imports in UK business
investment and in consumption has steadily risen (Chart 14).
These developments make markets more contestable. As does effective competition policy. An
example in recent years was the car market, where prices converged with those prevailing on
continental Europe.
The internet, or e-commerce, also brings greater contestability, by making it a lot easier for businesses
to check the prices of competing suppliers, and for consumers to compare prices across different
retailers (Table 3).
Over time, these forces would be expected to reduce firms' margins - at least in sectors that were not
previously especially competitive. So long as that process of adjustment was underway, inflation
would tend to be lower than would otherwise be implied by any given set of demand conditions. In
addition, if and when their margins became thinner, firms might become more aggressive in controlling
costs in the face of fluctuating demand, which might weaken the pass through of demand shocks into
inflation.
The new monetary framework might reinforce some of those effects. Over recent years, more than a
handful of business managers have commented that, when inflation was both high and highly variable,
it used to be easier to implement - or 'get away with' - price increases. In a low inflation environment,
it should be easier for business customers and consumers to distinguish relative price changes from
increases in the general price level. That too should foster greater flexibility and efficiency in our
economy; and is one of the contributions that low and stable inflation can potentially make to broader
economic welfare.
One striking example is the distribution sector. Anecdotally, competition in UK retailing has been
intense. This seems to manifest itself in the aggregate data in two phases. As documented recently
by my MPC colleague Steve Nickell,9 retailers' margins were compressed in the years around the turn
of the century. Since then, they seem to have crushed their costs through measures delivering rapid
productivity growth. In part, that appears to have been achieved by disintermediating wholesale
distributors, whose margins have continued to fall (Chart 15). At a macro level, the effect was, for a
period, to open up a gap between producer output price inflation and retail goods price inflation (Chart
16). In other words, for a while some structural changes in the distribution sector reduced the feed
through of demand pressures into retail price inflation. Looking ahead, one downside risk to the
MPC's central projection is that we cannot rule out that this process has further to go.
The current conjuncture and policy
Monetary regime change, labour market reform, financial innovation, the technological revolution,
globalisation - it is a heady combination, which unavoidably adds to the challenge of discriminating
between cyclical and structural influences when forming a view on the macroeconomic outlook. But it
is equally unavoidable that policymakers must try to do just that.
That brings me to the current conjuncture and so to policy.
My own take at present is as follows. In my judgment, there is, on balance, most likely a degree of
excess demand in the economy. Surveys suggest above-average capacity utilisation. And there is
some corroborative evidence in the rise in output price inflation relative to costs, and in anecdote of
some firms being able to pass on cost increases (Chart 17).
Given a tight labour market, how does that fit with earnings inflation having been relatively subdued?
One possibility is that as aggregate demand has picked up, firms have in the first place increased
output by making greater use of their existing workforce and capital. That would be consistent with
anecdotal evidence of firms having held on to labour during the earlier slowdown in aggregate
demand; and with the pick up in private sector productivity growth over the past year or so (Chart 18).
Looking ahead, it would also suggest a degree of upwards pressure on earnings growth.
As reflected in the Inflation Report published a couple of weeks ago, conditions of excess demand,
combined with the likelihood of stronger import prices, point to inflation gradually rising back towards
and through the 2% target over the next two years or so. There are many risks around that central
outlook but, taken together, compared with November I judge them to be slightly less to the downside
over the medium term. The recent rise in CPI inflation suggests, for example, that we were not stuck
materially below the inflation target. And, as I discussed earlier, the puzzle about the apparent weak
feed through from demand to inflation is reduced somewhat by the Committee's judgment that the
performance of the labour market improved over recent years. That leaves continuing demand
pressures likely to feed through to inflation, looking ahead. With monetary policy needing to be set on
a medium-term view, overall I concluded at the MPC's latest meeting that our interest rate should be
increased by 25 basis points - a small tweak to reflect the outlook.
But, as my remarks today have emphasised, there are considerable uncertainties. Two final thoughts
about them.
The first concerns the precision with which any monetary authority can achieve its objective. In the
bad old days, it should probably have been clear when the economy was experiencing unsustainable
excess demand. In today's world, when we discuss excess or deficient demand we are generally
addressing much smaller deviations from trend than in the past, as Chart 19 suggests. In
consequence, our debates about cyclical conditions lie well within the margin of error of any sensible
estimate of underlying trends - especially given uncertainty about the structural changes affecting the
economy. In a similar vein, we - and commentators - need to keep some perspective about
deviations from the inflation target. In November, the year-on-year measure of CPI inflation was 1.1%.
By January it was 1.6%.
Secondly, when inflationary problems loomed in the past, inflation expectations - amongst
businesses, households and in financial markets - increased, both signalling and bringing about the
incipient rise in inflation. Today, we appear to enjoy well-anchored inflation expectations, which will
affect price-setting behaviour in the ways I have touched on. Indeed, modern economic models of
various kinds - inside and outside the Bank - tend to assume policy credibility, anchoring
mediumterm expectations. If that were so, the medium-term outlook for inflation would be assured. In fact,
credibility is not something that can just be assumed. It has to be achieved, and continually
reachieved, by policymakers - through our actions, and reasoned explanations of them.
For that reason alone, policy inevitably remains a judgmental process - not one mechanically tied to a
particular model, but one that draws on a wide range of inputs, including the insights of our business
contacts. Learning is, accordingly, inherent in our mission. Over the next few years, if the economy
escapes being buffeted by shocks, we will learn quite a lot. In the meantime, notwithstanding the
uncertainties, we have to make judgments and explain them.
Chart 1: Absolute changes in quarterly inflation
Percentage points
6.0
RPI
5.0
Consumption deflator
4.0
3.0
2.0
1.0
0.0
1960 1965 1970 1975 1980 1985 1990 1995 2000
S ource: Bank of England and ONS
Table 1: Average absolute changes in quarterly inflation and GDP growth
Consumption Deflator GDP
RPI
growth
1960-1979 1.10 0.76 1.45
1960-1972 0.83 0.57
1.18
1973-1979 1.58 1.11
1.93
1980-1992 1.19 0.59 0.69
1993-2004 0.79 0.34 0.34
Table 2: RPI inflation persistence
1947-1972 0.56
1972-1992 0.91
1992-2004 -0.05
Per cent
6.5
6.0
5.5
Outturns Nov 03 IR
5.0
4.5
Feb 05 IR
4.0
3.5
3.0
2000 2001 2002 2003 2004 2005 2006
Source: Bank of England
Chart 3: Earnings growth and unemployment
Average earnings in Q4
(percentage change on a year earlier)
30.0
1971 - 79
25.0
1980 - 89
1980
20.0
1990 - 99
15.0
2000 - 2004
1990
10.0
1971
2000
5.0
0.0
-6.0 -4.0 -2.0 0.0 2.0 4.0 6.0
LFS unemployment rate in Q1 (per cent of workforce)
BIS Review 16/2005
Diagram 1: Inflation process
Labour
costs
Output
Demand
prices
pressures
Other
costs
Imports
Distribution
(directly
sector
consumed)
CPI
inflation
Chart 4: Inflation expectations
Per cent
8.0
6.0
Index-linked gilts
4.0
2.0
Consensus
0.0
1989 1992 1995 1998 2001 2004
Source: Consensus and Bank calculations. Inferred expectations are for five-year
inflation in five years' time
basis points
250
average prior to establishment of MPC
200
150
100
50
average since establishment of MPC
0
1993 1995 1997 1999 2001 2003 2005
Chart 6: UK labour share
percentage of GDP
80
75
70
65
60
1955 1961 1967 1973 1979 1985 1991 1997 2003
Source: ONS
BIS Review 16/2005
Chart 7: Percentage of workforce with trade union membership
Per cent
60
50
40
30
20
1970 1974 1978 1982 1986 1990 1994 1998 2002
Source: LFS and Nickell, S. and Quitini , G. (2002), 'The recent performance of the
UK labour market', Oxford Review of Economic Policy , Vol. 6(4), pp 26-35.
Chart 8: Proportion of part-time workers
Percentage of total employed
30
25
20
15
10
1985 1988 1991 1994 1997 2000 2003
Source: ONS and Bank calculations
Chart 9: Real household disposable income growth and terms of trade
Percentage change on a year earlier
1990 = 100
8.0 112
Real household income growth
6.0
108
4.0
2.0
104
0.0
100
-2.0
Terms of trade
-4.0
96
-6.0
-8.0 92
1990 1992 1994 1996 1998 2000 2002 2004
Chart 10: Margins on personal loans to households
Per cent
10.0
8.0
6.0
4.0
2.0
0.0
1993 1995 1997 1999 2001 2003
Source: Bank calculations. Spread of effective personal loan rate rates over
Bank of England repo rate
Chart 11: Composition of UK PNFC sector gross debt
Other debt
Per cent
Securities other than shares
Borrowing from non-UK resident MFIs 120
Borrowing from UK resident MFIs
100
80
60
40
20
0
1990 1992 1994 1996 1998 2000 2002 2004
Chart 12: Corporate credit spreads
Basis points Basis points
1000 300
High yield (lhs)
250
800
200
600
BBB (rhs)
150
400
AA (rhs)
100
200
50
AAA (rhs)
0 0
2000 2001 2002 2003 2004 2005
Source: M errill Lynch Option-adjusted corporate bond spreads
Chart 13: Share of world imports in world GDP
1995 = 1
1.5
1.2
0.9
0.6
0.3
0.0
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003
Source: UN (pre-1980); IMF WEO Summer 2004 database (post-1980)
Chart 14: Import shares in consumption and business investment
expenditures
Per cent
45
40
35
30
Business investment
25
20
15
Consumption
10
5
1970 1975 1980 1985 1990 1995 2000
Table 3: Value of sales over the internet by
UK non-financial sectors
£bn Households Business-to- Total
business
2002 6.4 12.7 19.0
2003 11.4 28.2 39.5
Source: ONS
Percentage of output at basic prices
25.0
Retail
20.0
Total distribution sector
15.0
Wholesale
10.0
5.0
0.0
1992 1994 1996 1998 2000 2002
Chart 16: Output price inflation and CPI goods price inflation
Percentage change on a
year earlier
4.0
3.0
Producer output prices
2.0
1.0
0.0
-1.0
CPI goods
-2.0
-3.0
1997 1998 1999 2000 2001 2002 2003 2004 2005
BIS Review 16/2005
Percentage change Percentage changes
on a year earlier on a year earlier
15.0 8.0
Input prices (lhs)
Unit wage costs (rhs)
6.0
10.0
4.0
5.0
2.0
0.0 0.0
-2.0
-5.0
-4.0
-10.0
Output prices (rhs)
-6.0
-15.0 -8.0
1996 1997 1998 1999 2000 2001 2002 2003 2004
Chart 18: Private sector productivity
Percentage changes on a year earlier
5.0
Per hour
4.0
Per head
3.0
2.0
1.0
Per job
0.0
1995 1997 1999 2001 2003
Source: LFS, workforce jobs data and Bank
BIS Review 16/2005
Chart 19: Private sector factor utilisation (based on production
functions)
Percentage deviation of output
Elasticity of Substitution = 0.5 from trend
Elasticity of Substitution = 1
8
6420-2
-4
-6
-8
1986 1990 1994 1998 2002
Source: Bank calculations. Based on an assumed production function which describes the
relationship between inputs - labour and capital - and output. T he measures show estimates of
the changes in output estimated to be due purely to changes in the utilisation of the inputs.