Mervyn King: Stocktake of the UK economy
Speech by Mr Mervyn King, Governor of the Bank of England, at the East Midlands Development
Agency/Bank of England Dinner, Leicester, 14 October 2003.
* * *
The Bank of England is back in Leicester. Between 1844 and 1872 there was a branch of the Bank of
England in Leicester, located in Gallowtree Gate. Sadly it operated at a loss, in part because the
Agent lived in style driving about town in a carriage and pair with two men in livery, and the branch
was closed. Only six years ago did we re-establish our links with the City through the creation of a new
Agency in the East Midlands. The purpose of that Agency - staffed by four members of the Bank who
work in rather less style than their predecessors - is to listen to you and other businesses about what
is happening on the ground.
The reports of our Agents around the country are crucial to the Monetary Policy Committee. The
information we receive from you, and our other eight thousand business contacts around the country,
are key pieces in the large jigsaw puzzle of the UK economy that we assemble each month in order to
see the big picture.
Some of the statistical fog hanging over the British economy lifted a week or so ago with the
publication of a new picture of demand and output over a number of years. The official statisticians
have redrawn the profile of growth in different sectors of the economy. In particular, the data for
spending and output in the first half of this year now appear more consistent. But October is often a
month in which fog turns into storms. So it is worth asking whether the remaining statistical fog
enveloping the UK economy foreshadows stormy economic weather ahead. After a decade of
unparalleled stability of both growth and inflation, it is time to take stock.
For much of the 60 years since the end of the Second World War, Britain experienced a succession of
economic cycles - variously described as stop-go or boom-bust. On average these were larger than
the fluctuations experienced by other major industrial economies. Not only was our growth rate lower,
it was also more variable. But the past decade has seen a remarkable shift of fortunes. In the 10 years
from the second quarter of 1992, the average annual growth rate of GDP was 2.9%, above the
post-war average of 2.5%. Following the adoption of an inflation target in late 1992, inflation averaged
2.5%, the lowest for a generation, and never deviated more than one percentage point from that
average. Unemployment fell from almost 10% to around 3% on the claimant count, its lowest level for
almost three decades, and has now been virtually unchanged for twenty months, by far its longest
period of stability. The terms of trade moved in Britain's favour, raising our national standard of living.
And output has risen in every single quarter since the middle of 1992, something that is true of no
other G7 economy.
Why were the 1990s so successful? And can that success continue? Four features of our economy lie
behind this improved performance. First, the new monetary framework - based on an explicit target for
inflation, a high degree of transparency, and, since 1997, independence of the Bank of England -
made it clear to everyone that monetary policy was, and would continue to be, targeted on maintaining
low and stable inflation. Second, a substantial fiscal consolidation turned a deficit of 8% of GDP in
1993 into a sustainable position for the public finances based on a set of clear rules for government
debt. Third, a continuing programme of supply-side reforms, over a period of 20 years, made it
possible to reduce unemployment without generating higher inflation. Fourth, although the unexpected
twists and turns of the world economy did pose real challenges to monetary policy, especially in the
latter half of the decade, those shocks tended to average out over time rather than cumulate in either
an upward or downward spiral. In other words, the economic surprises alternated between good one
year and bad the next, rather than adding up to "one damn thing after another". In that sense, Lady
Luck smiled on us.
Of course, we were not alone in enjoying the 1990s. In the United States growth was so rapid that at
least two authors wrote books entitled "The Roaring Nineties" and another chose the title "The
Fabulous Decade". In contrast, continental Europe experienced slow growth and heart-searching over
structural reforms. As with much else, our economic performance lay somewhere between the excited
exuberance of the United States and the relative disappointment of continental Europe. So the UK
experienced a non-inflationary consistently expansionary - or "nice" - decade; a decade in which
growth was a little above trend, unemployment fell steadily, and, supported by the improved terms of
trade, real take-home pay rose without adding to employers' costs, thus allowing consumption to grow
at above trend rates without putting upward pressure on inflation.
Will the next ten years be as nice? That is unlikely. The terms of trade will probably not rise as much in
future as they have in recent years - about 10% since 1996 when sterling started to appreciate - not
least because sterling's effective exchange rate has fallen by around 7% since the turn of the year.
Moreover, there is no longer the margin of spare capacity that has provided a buffer for policy over
much of the past decade. So when shocks, as they will, hit our economy it is almost inevitable that
there will be somewhat greater volatility of both output and inflation than the remarkable stability to
which we have become used in recent years.
But the case for realism about what we should expect is not a case for pessimism; rather the opposite.
The macroeconomic framework in this country is sound and proven. And the real benefit from Britain's
new-found position of macroeconomic stability is that it provides an opportunity to improve our supply
performance - to boost productivity, education and enterprise in order to generate the resources
needed to raise living standards. Such improvements are, in the long run, both more important and
more glamorous than the rather dull and repetitive role of the Bank of England in trying to maintain
macroeconomic stability. The Bank of England is only the referee; you are the players.
Unlike countries such as the United States, which has witnessed a significant and seemingly durable
rise in productivity growth, in Britain the underlying rate of increase of output produced for each hour
worked has remained broadly stable. We can take some comfort from the latest revisions to the
National Accounts which show that productivity growth was not as depressed as previously thought,
but it still remains close to its long-run trend of around 2% a year, insufficient to close the productivity
gap between ourselves and our major competitors.
Of course the Bank of England has to look to improve the quality and professionalism of its own
activities. And, together with the Court of the Bank, the new executive team is exploring ways to
enhance the effectiveness of our operations. Improving our market intelligence, refocusing our
financial stability role, and making central services more professional, are examples of ways in which
the Bank aims, in all its activities, to pursue standards of excellence, as it has in monetary policy.
There is one additional area where change could prove beneficial. After the Monetary Policy
Committee decides on the level of interest rates, that decision must be implemented in the money
markets. The Bank will be carrying out a review of its money market operations with a view to
improving and simplifying them, and reducing overnight volatility in those markets. The Bank's Markets
Director, Paul Tucker, will be consulting the market shortly.
For the United Kingdom as a whole, pressing on with reforms to raise productivity is essential to future
prosperity. The strategy which the MPC has pursued in recent years - stimulating domestic demand to
compensate for weak external demand in the face of a strong exchange rate - carries the risk that
there could be a sharp correction to the level of consumer spending at some point in the future. That
risk is exacerbated by the continued strength of the housing market and associated borrowing that we
have seen in recent weeks. It is possible that such weakness of domestic demand might be offset by
an improvement in productivity, although as yet few signs of that are observable.
Three lessons from past monetary policy experience are relevant to the present position. First,
monetary policy can target only the aggregate price level. And inflation expectations are now firmly
anchored on the inflation target. But the risk of a correction to consumer spending derives from the
possibility of sharp movements in relative prices, particularly of assets. Expectations of the key relative
prices within the economy, such as asset prices and the exchange rate, are volatile and difficult to
measure, and changes in them are often desirable signals to producers and consumers alike. So it
would be a mistake to target those relative prices. But understanding how they affect the expectations
and spending decisions of the players in the economy is an essential part of monetary policy.
Second, it is easier to measure the money value of spending and output in the economy than to split it
into estimates of "real" output, on the one hand, and price indices, on the other. That is why the latest
data revisions have altered the picture of real growth over recent years, leaving estimated money
spending and output broadly unchanged. In such circumstances it is sensible to focus on money
spending. Indeed, the success of the new monetary framework can be seen in the stability not just of
retail price inflation but also of the growth rate of domestic demand in money terms. Over the past few
years the annualised growth rate of nominal domestic demand has remained in the range of 41⁄2% to
51⁄2%, a much greater degree of stability than experienced for many decades.
Third, it is extremely difficult to anticipate the future path of interest rates. That is because the
Monetary Policy Committee sets rates in response to news in the economy, and that news is
inherently difficult to forecast. Each month the Committee makes a careful assessment of the outlook
for inflation, and it is that which will guide our decisions on the appropriate level of interest rates. It is
over 3 1/2 years since interest rates were last raised - the longest such period since Bank Rate was
held constant at 2% through the 1940s. At some point reducing the present degree of monetary
stimulus will be necessary in order to keep inflation on track to meet the target. The timing of any such
decision will reflect our judgment of the outlook for inflation. Listening to our business contacts and
learning from our visits around the UK is an important input into that judgment.
To retain the unrivalled degree of stability that we achieved during the "nice" decade will be an even
more difficult challenge for the future. The present monetary and fiscal frameworks provide a
seaworthy policy vessel, but, as all sailors know, fog, especially statistical fog, can be dangerous. So
we must hope that Lady Luck will continue to smile on us.