Magna Carta and the Bank of England
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.