Mervyn King: Monetary policy developments
Speech by Mr Mervyn King, Governor of the Bank of England, to the South Wales Chamber
of Commerce, Cardiff, 23 October 2012.
* * *
Of the many memorable moments in an eventful summer, recall that balmy night in late July
when attention was diverted from the economy by the Opening Ceremony of the Olympic
Games. The sound of Welsh children singing Cwm Rhondda on that beautiful beach in
Rhossili filled the Olympic stadium. Inside the stadium, we saw not manna descending from
heaven, but thousands of athletes and volunteers rising to their challenge.
If the Olympics aimed to inspire a generation, the challenge for economic policymakers is to
give that same generation the opportunities to make the best possible use of their talents in a
vibrant economy. After a period of lopsided expansion, with growing trade deficits and debt
levels, and a collapse of their banking systems, advanced economies across the world are
facing a huge adjustment. Such is the scale of the global adjustment required that the
generation we hope to inspire may live under its shadow for a long time to come.
During the course of this year, the challenge has grown as the economic sky has darkened.
The storm clouds coming from the Euro area have not yet lifted, and in other parts of the sky
new clouds have drifted over. China, India and Brazil, the three largest emerging market
economies, are all slowing. According to the latest IMF projections output will fall this year in
no fewer than 10 European economies. And the IMF recently lowered its forecast for growth
in the advanced economies next year.
Ours may be a sceptred isle, with its own currency and control of monetary policy, but we
cannot insulate ourselves from these events. So this precious stone set in the silver sea
seems more like a storm-tossed vessel. Despite the probable rise in output in the third
quarter, the big picture is that GDP is barely higher than two years ago, and remains some
15% below where steady growth since 2007 would have taken us. Total exports have risen
sharply in the wake of sterling's depreciation, but manufactured exports to Europe are falling.
Recovery and rebalancing of our economy remain the main challenges for economic policy.
Here in Wales, despite impressive improvements to the infrastructure - not least the
remarkable regeneration of Cardiff Bay and the magnificent monument to Welsh culture in
this Millennium Centre - your economy too is suffering with total production well below its
peak in 2007.
In combating the downturn, monetary policy has played its part. Bank Rate has been cut to
its lowest level ever and the Bank has purchased £375 billion of assets in order to inject
money into the economy. Although this unprecedented degree of monetary loosening has
prevented a depression, it has caused pain to those dependent on interest income. And we
have not been able to avoid a sharp rise in youth unemployment.
In the long run, we will need to rebalance our economy away from domestic spending and
towards exports, to reduce our trade deficit, to repay our debts, and to raise the rate of
national saving and investment. So you are probably puzzled by the fact that we seem to be
doing exactly the opposite of that today. Almost four years ago now, I called this the "paradox
of policy" - policy measures that are desirable in the short term appear diametrically opposite
to those needed in the long term. Although we cannot avoid the long-term adjustment to our
economy, we can try to slow the pace of the adjustment in order to limit the immediate
damage to output and employment. Loose monetary policy today will eventually give way to
a tighter stance of policy as the economy recovers. In confronting the paradox of policy, the
Bank has had to show some of the same fleetness of foot and ability to feint as my
Cambridge contemporary, Gerald Davies. So let me try to explain this evening what
monetary policy can do and what it can't.
In doing this I am not going to pretend that I shall be entertaining. But these are serious times
and you deserve a serious explanation of what we at the Bank can do and what we can't, or
shouldn't.
Let me start with what monetary policy can do. When banks extend loans to their customers,
they create money by crediting their customers' accounts. The usual role of a central bank is
to limit this rate of money creation, so that an excessive expansion of money spending does
not lead to inflation. But a damaged banking system means that today banks aren't creating
enough money. We have to do it for them. And as private sector balance sheets contract,
public sector (government and central bank) balance sheets have to take the strain. The way
in which the Bank of England expands the money supply is to purchase government gilts
from the non-bank private sector and credit the bank accounts of people from whom the gilts
are purchased. Please note that we are not giving money away.
What is the effect of these purchases? They push up the price of gilts thus lowering yields.
As the sellers of gilts use the proceeds to buy other assets, the price of those assets also
tends to rise. Increases in asset prices boost wealth, and at the same time reduce the cost of
borrowing for companies and households, which helps to stimulate spending and hence
output. The size of these effects is of course uncertain. But there can be no doubt that our
economy would have followed an even more painful path over the past few years in the
absence of asset purchases.
Some question the scope for further purchases, or their likely effectiveness. I do not have
any concerns on the first point. The quantity of gilts in private hands is higher now than when
we began our asset purchases, and the government continues to issue new gilts at a rapid
rate. As far as the effectiveness of gilt purchases is concerned, it is of course true that as gilt
yields have declined the room for further falls is reduced. But it is not the sole objective of
asset purchases to push down on government bond yields. Raising the price and reducing
the risk premium on a much wider class of assets is equally important.
Although monetary policy can play a crucial role in supporting the economy in these difficult
times, there are limits to its ability to stimulate private sector spending. Those limits are
inherent in any form of monetary easing, not only asset purchases. Two limits are important.
First, monetary policy supports demand and output by encouraging households and
businesses to switch demand from tomorrow to today. But when tomorrow becomes today,
an even larger stimulus is required to bring forward more spending from the future. Since the
paradox of policy has been evident for almost four years, tomorrow has become not just
today but yesterday. When the factors leading to a downturn are long - lasting, only
continual injections of stimulus will suffice to sustain the level of real activity. Obviously, this
cannot continue indefinitely. Policy can only smooth, not prevent, the ultimate adjustment. At
some point the paradox of policy must be resolved.
Second, the scale of the underlying adjustment is large, and monetary policy cannot put off
for long the necessary change in the pattern of demand and output. A downward correction
of expectations about future incomes and wealth has rendered unprofitable some of the
investments made before the crisis. A good example is the investment made in shopping
centres which is now either proving less valuable than anticipated, or making redundant
some of the other pre-existing stock of retail space. Almost 1,000 high street chain stores
closed in the first half of the year. Lower asset values have left debt levels looking too high.
Households, businesses and, especially, banks are all deleveraging.
Nowhere is the overhang of debt more obvious than in the banking sector where
deleveraging is holding back the flow of new lending. During the crisis central banks have
provided liquidity to banks on a truly extraordinary scale, so much so that there were no
takers for additional liquidity in our latest auction. It is still useful to keep that auction facility
as an insurance policy. But banks are now overflowing with liquid assets. Their problem
remains insufficient capital. Just as in 2008, there is a deep reluctance to admit the extent of
the undercapitalisation of the banking system in many parts of the industrialised world. The
verdict of the market is clear - without central bank support banks still find it expensive to
borrow.
So the Bank of England, together with the Government, has set up the Funding for Lending
Scheme (FLS) which provides banks with access to finance for up to four years at below
prevailing market rates for term funding. Crucially, the more banks lend to UK households
and businesses, the more they can borrow from the Scheme and the cheaper is that funding.
That provides a powerful financial incentive for banks to supply more credit.
More than 20 banking groups, including the five largest lenders to the UK real economy and
covering nearly 80% of all such lending, have so far signed up. Since the Scheme was
announced bank funding costs have fallen by around 100 basis points (see Chart 1). Not all
of this is attributable to the FLS - the announcement by the ECB of Outright Monetary
Transactions has also played an important role. But it is noteworthy that UK bank funding
costs have fallen by more since June than have European bank funding costs (see Chart 2).
The effect of the FLS will be seen in the lending data only after some months because of the
time it takes for banks to change their lending strategies and for data to be collected and
published.
The FLS can be only a temporary scheme. The window of opportunity which it provides must
be used to restore the capital position of the UK banking system. I am not sure that
advanced economies in general will find it easy to get out of their current predicament
without creditors acknowledging further likely losses, a significant writing down of asset
values and recapitalisation of their financial systems. Only then will it be possible to return to
a more normal provision of the vital banking services so crucial to an economic recovery. In
the 1930s, faced with problems of sovereign and other debt similar to those of today, the
pretence that debts could be repaid was maintained for far too long. We must not repeat that
mistake.
Over the past three years, the Bank of England has bought £375 billion of government bonds
- gilts - from the private sector to create a lot of new money. Many - perhaps some of you -
are understandably concerned about the use of such an unusual and unfamiliar policy. Some
people talk about the dangers of money creation. I want to explain why it is important to
distinguish between "good" and "bad" money creation. In essence, the argument is very
simple. "Good" money creation is where an independent central bank creates enough money
in the economy to achieve price stability. "Bad" money creation is where the government
chooses the amount of money that is created in order to finance its expenditure. Insufficient
money creation can lead to a contraction of the money supply and a depression. We saw
that in the United States during the Great Depression and we see it today in Greece.
Excessive money creation leads to accelerating inflation and ultimately the collapse of the
currency.
The role of the Bank of England is to create the right amount of money, neither too much, nor
too little, to support sustainable growth at the target rate of inflation. We are not doing it at
the behest of the Government to help finance its spending. It is the independence of the
Bank that allows us to create money without raising doubts about our motives. But just as it
is crucial that governments do not control the printing of money, so too the unelected central
bank must not determine the levels of taxes and public spending. Fiscal policy is a matter for
elected governments.
There has been some talk about the possibility that money created by the Bank could be
used directly to finance additional government spending, or even that money could be given
away. Abstracting from the colourful metaphor of "helicopter money", such operations would
combine monetary and fiscal policies.
There is no need to combine them because, as now, once the Bank has decided how much
money should be created to meet the inflation target, the case for the Government to
increase spending or cut taxes to counter a downturn stands or falls on its own merits. What
determines the interest rate at which the government can borrow, however, is the path for the
amount of government debt held by the private sector, rather than the total amount of gilts in
issue. That is true when the Bank purchases gilts and will be true later when the Bank comes
to sell the gilts.
Not only is combining monetary and fiscal policies unnecessary, it is also dangerous. Either
the government controls the process - which is "bad" money creation - or the Bank controls
it and enters the forbidden territory of fiscal policy. It is peculiar, to say the least, that some of
the same people who believe that the Governor of the Bank is too powerful also believe that
he should stand on the steps of Threadneedle Street distributing £50 notes - a policy which
you will appreciate is rather hard to reverse. For the same reason, the Bank could not
countenance any suggestion that we cancel our holdings of gilts. The Bank must have the
ability to reverse its policy - to sell gilts and withdraw money from the economy - when that
becomes necessary. Otherwise, we run the risk of losing control over monetary conditions.
Giving money either to the government or to households directly, or indeed cancelling our
holding of gilts, means that the Bank of England has no assets to sell when the time comes
to tighten monetary policy. And when Bank Rate eventually starts to return to a more normal
level, as one day it will, the Bank would then have no income, in the form of coupon
payments on gilts, to cover the payments of interest on reserves at the Bank of England that
we had created. The Bank would become insolvent unless it created even more money to
finance those interest payments, and that would lead ultimately to uncontrolled inflation. That
is a road down which the Bank will not go, and does not need to go. I suspect that the
advocates of "helicopter money" and related ideas are really talking about a relaxation of
fiscal policy. It would be better to be open about that.
Enough of what the Bank of England should not be doing. So what should we be doing?
Since the Monetary Policy Committee last published an assessment of the economic outlook,
other central banks have been active. The European Central Bank announced its plans for
Outright Monetary Transactions, the Bank of Japan expanded the scale of its asset
purchases, and the Federal Reserve committed to continue with its asset purchases until the
outlook for the labour market improves substantially. Our current programme of asset
purchases will be complete by next month. What happens after that will depend upon the
outlook, beginning with an appraisal of where we are today.
Judging the present state of the UK economy is far from easy. On the one hand, over the
past two years total output, or GDP, has been much weaker than expected. In fact, output
has been broadly flat over that period. And the zig-zag pattern of quarterly growth rates of
GDP that we have seen this year is likely to continue, as we may see on Thursday when
figures for the third quarter are released.
On the other hand, there are other more encouraging signs. First, the labour market gives a
very different picture to that conveyed by the output data. In the private sector, more new
jobs have been created than over any other two-year period since the mid-1990s. And in the
past year, unemployment has been falling, and falling faster in Wales than in the United
Kingdom as a whole. Second, inflation has now fallen back to 2.2%, close to our 2% target.
Although recent increases in domestic energy and food prices are likely to leave it a little
above target well into next year, the fall in inflation means that the squeeze on real
takehome pay, which accounted for much of the weakness in consumer spending over the past
two years, has eased somewhat. And retail sales figures are consistent with a pickup in
consumer spending.
The disparity between weak output growth and a buoyant labour market is not easy to
explain. It is not the product of a switch from full-time to part-time jobs because total hours
worked have risen at the same rate as employment. Productivity per head is 4% below its
level of five years ago. No-one really understands why. Perhaps the output data are
understating the true picture. Perhaps the black cloud of uncertainty moving towards us from
the euro area means that businesses are choosing to meet demand by expanding
employment, which can if necessary be adjusted downwards relatively easily, rather than
investing in new capital equipment which cannot. Perhaps flexible wages have encouraged
employers to hold on to labour. Or perhaps forbearance by banks has allowed inefficient
firms that might otherwise have had to contract to continue with more labour than can be
employed in the long run.
One thing we can see clearly is that the recovery and rebalancing of the UK economy are
proceeding at a slow and uncertain pace. At this stage, it is difficult to know whether some of
the recent more positive signs will persist. The Monetary Policy Committee will think long and
hard before it decides whether or not to make further asset purchases. But should those
signs fade, the MPC does stand ready to inject more money into the economy.
Printing money is not, however, simply manna from heaven. There are no shortcuts to the
necessary adjustment in our economy. The problems in the world economy mean that we
shall have to be patient. Over the past twenty years, during regular visits to Wales, I have
seen several waves of restructuring of the Welsh economy. And the rebalancing of the UK,
towards manufacturing, offers opportunities for Wales.
As for the MPC, you can be sure we shall be looking for as much guidance as we can find,
divine or otherwise. What better inspiration than the memory of those children on Rhossili
beach singing Cwm Rhondda.
Chart 1: Major banks' indicative senior unsecured bond spreads(a)
(basis points)
Mansion Draghi
House speech
US
speech
OMT QE3
500
Europe
UK 450
400
350
300
250
200
150
100
50
0
Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12
(a) Each line is an unweighted average of the spread between euro-denominated senior
unsecured bonds and equivalent maturity swap rates for a selected bond issued by each of
a selection of major banks in the region. The selected bonds have residual maturities of
between two and six years.
Source: Bloomberg and Bank of England calculations.
Chart 2: Major banks' indicative senior unsecured bond spreads since announcement
of FLS(a)
(index, equal to 100 on 14/06/2012)
Mansion House
Draghi
OMT QE3
speech speech
125
100
75
US
Europe
50
UK
25
0
Jun-12 Jul-12 Aug-12 Sep-12 Oct-12
(a) See footnote to chart 1.
Source: Bloomberg and Bank of England calculations.