Magna Carta and the Bank of Eng­land

The Pak Banker - - COMPANIES/BOSS -

The Bank's cur­rent Mon­e­tary Pol­icy frame­work em­bod­ies these prin­ci­ples. As for­mer Gover­nor Ed­die Ge­orge re­marked, for the half cen­tury that fol­lowed "the Bank op­er­ated un­der leg­is­la­tion which, re­mark­ably, did not at­tempt to de­fine our ob­jec­tives or func­tions.

All changed with the pass­ing of the Bank of Eng­land Act in 1998, which made spe­cific "pro­vi­sion about the con­sti­tu­tion, reg­u­la­tion, fi­nan­cial ar­range­ments and func­tions of the Bank."

The Act brought great clar­ity to the Bank's re­spon­si­bil­i­ties and granted in­de­pen­dence to the Bank for the op­er­a­tion of mon­e­tary pol­icy. The Bank would be ac­count­able to Par­lia­ment for op­er­at­ing the in­stru­ments of mon­e­tary pol­icy to achieve the ob­jec­tives of mon­e­tary pol­icy, which would be de­ter­mined by the Gov­ern­ment.

The op­er­a­tional in­de­pen­dence of the Bank of Eng­land is an ex­am­ple of power flow­ing from the peo­ple via Par­lia­ment within care­fully cir­cum­scribed lim­its. In­de­pen­dence in turn de­mands ac­count­abil­ity in or­der that the Bank com­mands the le­git­i­macy it needs to ful­fil its mis­sion.

The sin­gle most im­por­tant fac­tor has been the steep drop in energy prices glob­ally.

The rise in the value of ster­ling has also played an im­por­tant role in low­er­ing non-energy im­port prices, which have fallen over the past twelve months. The MPC's in­ten­tion is to re­turn in­fla­tion to tar­get in a sus­tain­able man­ner within two years. That means set­ting Bank Rate to elim­i­nate the re­main­ing slack in the econ­omy, bring­ing about the sus­tained in­crease in costs nec­es­sary to achieve over­all in­fla­tion of 2%.

I ex­pect that this will in­volve rais­ing Bank Rate over the next three years from its cur­rent all- time low of ½ per cent. The need for Bank Rate to rise re­flects the mo­men­tum in the econ­omy and a grad­ual firm­ing of un­der­ly­ing in­fla­tion­ary pres­sures, a firm­ing that will be­come more ap­par­ent as the ef­fects of past com­mod­ity price falls drop out of the an­nual in­fla­tion rate around the end of the year.

As the econ­omy evolves, dif­fer­ent fac­tors will be­come wor­thy of par­tic­u­lar at­ten­tion in in­form­ing the tim­ing, pace and de­gree of likely Bank Rate in­creases. At the cur­rent junc­ture, three stand out.

Look­ing through the blip in the first quar­ter, the econ­omy has now been grow­ing above trend for a year and un­em­ploy­ment has fallen sharply over the past two.

The in­ter­na­tional risks to the growth out­look re­main. The sit­u­a­tion in Greece is fluid, and the on-go­ing slow­down in China could prove more sig­nif­i­cant. But on bal­ance we can ex­pect the global econ­omy to pro­ceed at a solid, not spec­tac­u­lar, pace.

Do­mes­tic costs need to con­tinue to firm. Af­ter a pe­riod of par­tic­u­larly weak wage growth, which re­flected a marked ex­pan­sion in labour sup­ply that is now largely ab­sorbed, wage growth is pick­ing up. The re­cent growth in wages has been stronger than we had ex­pected in May, though most of the up­side news was in bonuses.

Pos­i­tive wage de­vel­op­ments should be sup­ported by a con­tin­ued tight­en­ing in the labour mar­ket. Job-to-job flows re­main around post-cri­sis highs and the ra­tio of va­can­cies to un­em­ploy­ment is now back to its pre­cri­sis av­er­age.

What mat­ters for in­fla­tion is not wage growth in iso­la­tion but wage growth rel­a­tive to pro­duc­tiv­ity. Put sim­ply, firms are less likely to raise their prices if higher wages re­flect more out­put per hour worked. Along with faster wage growth, there have been signs of faster pro­duc­tiv­ity growth since the turn of the year. What is clear is that to re­turn in­fla­tion to tar­get, growth in labour costs must pick up fur­ther from their cur­rent rate of less than one per cent. The ex­tent needed de­pends on what is hap­pen­ing to other costs. In the decade prior to the cri­sis, labour costs grew by around 2½ per cent each year on av­er­age, with wages and salaries grow­ing at around 4¾ per cent and pro­duc­tiv­ity at 2¼

per cent. In­fla­tion av­er­aged 2 per cent, how­ever, in part be­cause im­port prices rose only by around ¼ per cent each year at the same time.

Over the past few years, core in­fla­tion has been par­tic­u­larly sub­dued, and it re­mains less than one per cent. We need to see in­creases in core in­fla­tion to have a rea­son­able ex­pec­ta­tion that, in the ab­sence of fur­ther shocks, over­all CPI in­fla­tion will re­turn to 2 per cent within the MPC's stated ob­jec­tive of two years.

De­liv­er­ing the growth in ac­tiv­ity, the rise in do­mes­tic costs and the firm­ing in core in­fla­tion mea­sures nec­es­sary to re­turn in­fla­tion to tar­get re­quires mon­e­tary pol­icy to be set ap­pro­pri­ately both now and prospec­tively.

In my view, with the heal­ing of the fi­nan­cial sec­tor and the less­en­ing of some of the head­winds fac­ing the econ­omy, that con­cern has be­come less press­ing with the pas­sage of time.

As I made clear in my first open let­ter in Fe­bru­ary, was down­side risks to in­fla­tion to ma­te­ri­alise the MPC could de­cide ei­ther to ex­pand the As­set Pur­chase Fa­cil­ity or to cut Bank Rate fur­ther to­wards zero from its cur­rent level of ½ per cent. In the cur­rent cir­cum­stances there is no need to wait to raise rates be­cause of a risk man­age­ment ap­proach and run the risk of in­fla­tion over­shoot­ing tar­get.

At the same time, the tim­ing and pace of prospec­tive in­ter­est rate in­creases need to be put into per­spec­tive. Head­winds to growth and in­fla­tion re­main. Growth in the parts of the global econ­omy that mat­ter most to the UK is run­ning ¾ per­cent­age points be­low its his­toric av­er­age. Ster­ling has ap­pre­ci­ated around 18 per cent over the past two years and around 7 per cent since the turn of the year. This will ex­ert a drag on in­fla­tion both through low­er­ing im­port costs and by low­er­ing world de­mand for UK goods. UK fis­cal pol­icy is about to tighten sig­nif­i­cantly. The av­er­age an­nual re­duc­tion in the cycli­cally-ad­justed bud­get deficit is pro­jected by the OBR to in­crease from around ½ per cent of GDP over the past two years to around 1 per cent of GDP over the next two - and the IMF ex­pects the UK to un­dergo the largest fis­cal ad­just­ment of any ma­jor ad­vanced econ­omy over the next five years.

The Bank of Eng­land is around half a mil­len­nium younger than Magna Carta. To put the lim­ited and grad­ual ex­pec­ta­tion in his­tor­i­cal con­text, short term in­ter­est rates have av­er­aged around 4½ per cent since around the Bank's in­cep­tion three cen­turies ago, the same av­er­age as dur­ing the pre­cri­sis pe­riod when in­fla­tion was at tar­get. The av­er­age pace of tight­en­ing since the adop­tion of in­fla­tion tar­get­ing in 1992 was around 50 ba­sis points per quar­ter.

It would not seem un­rea­son­able to me to ex­pect that once nor­mal­i­sa­tion be­gins, in­ter­est rate in­creases would pro­ceed slowly and rise to a level in the medium term that is per­haps about half as high as his­tor­i­cal av­er­ages. In my view, the de­ci­sion as to when to start such a process of ad­just­ment will likely come into sharper re­lief around the turn of this year.

First and fore­most, shocks to the econ­omy could easily ad­just the tim­ing and mag­ni­tude of in­ter­est rate in­creases. Sec­ond, the largest cu­mu­la­tive tight­en­ing in the UK since in­fla­tion tar­get­ing was adopted was 1 ½ per­cent­age points, com­pared to an av­er­age cy­cle of 3 per­cent­age points for the US Fed­eral Re­serve over the same pe­riod. This likely re­flects in part the greater sen­si­tiv­ity of UK house­hold bal­ances sheets in the medium term to float­ing in­ter­est rates, some­thing that could be par­tic­u­larly rel­e­vant in our still heav­ily in­debted postcri­sis econ­omy. Over a half of UK mort­gagors would pay higher rates in a year's time, and close to three-quar­ters of mort­gagors in two years' time, were in­ter­est rates to evolve ac­cord­ing to cur­rent mar­ket rate ex­pec­ta­tions.

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