OREANDA-NEWS. July 17, 2015. This would, I think, be a mistake.  The specificity of the clauses animates the general principles.  It is because they are detailed and targeted at the concerns of the time that they are a genuine attempt to place a boundary on the authority of the King, rather than relying on vague platitudes.

Magna Carta was nowhere near the first attempt to encapsulate ideas of justice and good government, nor was it the last.  Indeed, it was a spectacularly unsuccessful attempt – and it was anyway concerned only with the interests of a very small segment of society.  But, largely because King John’s heirs were forced into a tight corner and therefore obliged to reissue the charter again and again after 1215 (in 1216, 1217, 1225, 1234, 1253, 1265, 1297 and 1300, to cite only the more famous reissues), it is Magna Carta that has become the icon of the principle that the exercise of authority requires permission from those subject to that authority – and that, once granted, this permission can just as easily be withdrawn.

At its most idealised, Magna Carta makes clear that power derives from the people and constrains the authority of the state. The state can in turn devolve power – to regions – and to independent bodies. But these bodies can never forget from where their power came or to whom they are responsible. Their authority is constrained to that necessary to pursue specific objectives and they are accountable to the people for their performance.

3. Monetary policy outlook

The Bank’s current Monetary Policy framework embodies these principles.

It wasn’t always the case. The Bank of England was brought into public ownership in 1946. 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.”  They were, instead, “assumed to carry over from [the Bank’s] earlier long history.”  In that regard, the Bank’s ‘constitution’ resembled that of the United Kingdom more broadly, comprising a rich history of law, principle and convention.

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.  In delegating authority to an independent body in this way, the Act ensured the Bank would operate under what Mervyn King described as ‘constrained’ rather than ‘unfettered’ discretion.  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.  By publishing its analysis, giving testimony, and delivering speeches, the Bank explains how it is exercising its powers to achieve its clearly defined policy Remits.

To illustrate these points, I will conclude with some reflections on monetary policy.  Our objective, given to us by Parliament, is to maintain price stability and, subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.  Our Remit builds in important accountability and transparency mechanisms.  One of which is the requirement for the Governor to write an open letter to the Chancellor if inflation moves away from its 2 per cent target by more than one percentage point.

Inflation developments

I am in the middle of a likely sequence of such open letters – I have another one due next month – on account of the record low inflation the UK is experiencing this year, currently at zero per cent.  Such letters must explain, among other things, why inflation has deviated from target and what policy actions the Monetary Policy Committee (MPC) is taking in response.

The ‘why’ is straightforward. The bulk of the shortfall of inflation below target can be explained by the sharp fall in the prices of commodities and other imported goods since last year.

Of these, 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 sum total of these effects has been to drag inflation below target by around 1 percentage points. This temporary period of below-target inflation has provided a welcome boost to real household income.

Inflation looking ahead

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 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.  It also reflects the lags in monetary policy, given that the peak impact on inflation of a given adjustment in interest rates is likely to materialise around 18-24 months after the change.

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.

First are the prospects that sustained momentum in economic activity will wring out any remaining slack.  This will require sustained growth above its past average of around 0.6 per cent per quarter. 

Even though the current recovery has been the slowest since the Great Depression, taking around 1? years longer to regain lost ground than it did following the recession of the 1930s, the signs are encouraging.  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.  Consumer confidence is around its highest level for over a decade. Businesses investment intentions are solid.  Momentum in the housing market is showing signs of returning.  Survey data point to continued momentum in real activity over the remainder of this year.

To be sure, 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.

 

Second, 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, which are a less reliable guide to firms’ future labour costs.

At a minimum, when taken together with survey indicators that continue to point to solid pay growth for new recruits, recent data give welcome reassurance that the risks associated with a deflationary mindset in the labour market have likely fallen significantly.

Further 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 pre-crisis average.

However, 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.  This may well mean firms’ unit labour costs have not picked up quite to the degree we had expected in our May Inflation Report. It’s too early to be definitive. Weighing past disappointments and recent indications of a pick-up, it is prudent to recognise that two-sided risks to productivity growth remain.

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 2 per cent each year on average, with wages and salaries growing at around 4? per cent and productivity at 2 per cent.  Inflation averaged 2 per cent, however, in part because import prices rose only by around ? per cent each year at the same time.

The possibility that history might repeat itself points to a third important consideration: the need to monitor developments in firms’ costs other than labour.  The sum of these is evident in so-called ‘core’ inflation, which are measures of prices that strip out the most volatile determinants of inflation, like energy prices, revealing more persistent trends.  In an open economy like the United Kingdom’s, those factors include import prices, which are affected by movements in the value of sterling, and which, on past experience, can take a considerable time to pass through to core inflation.[28]

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.

Policy strategy


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 this regard, one concern has been the constraint imposed on monetary policy by the effective lower bound on policy rates.

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, were 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.  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 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 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.

Taken together, these factors suggest that the ‘equilibrium’ real rate of interest – the rate needed to keep the economy operating at potential and inflation on target – which was sharply negative during the crisis, will continue to be lower than on average in the past.  It also seems likely that the equilibrium interest rate will move only slowly back up towards historically more ‘normal’ levels.  Everything else equal, that suggests a prospective tightening cycle that, once it starts, will be longer and shallower than those of the past.  In other words, we expect Bank Rate increases to be gradual, and limited to a level below past averages.

What does that actually mean?

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 4? per cent since around the Bank’s inception three centuries ago,[31] the same average as during the pre-crisis 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.

That said, the path is much more important than the precise timing of the first rate increase. And I am conscious of several important considerations which mean the actual path almost certainly will not be mechanical, linear or pre-determined.  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 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 post-crisis 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. That is in stark contrast to the US, where even over a two-year period, less than 10 per cent mortgages would be affected directly by a change in rates. We will learn more about the importance of these sensitivities as interest rates increase. Third, developments in the exchange rate have been important for UK inflation and activity, and in particular we have experienced persistent exchange rate pass-through to headline inflation.  This risk is particularly relevant at present when the monetary policy stance of our largest trading partner is diverging with ours. 

Most fundamentally, there are broader macroeconomic considerations, particularly the UK’s large external imbalances.  With the largest current account deficit in the advanced world, the right policy mix leans towards tighter fiscal, more accommodative monetary and tighter macroprudential policies.

Given these considerations, the MPC will have to feel its way as it goes, monitoring a wide range of indicators and adjusting the pace and degree of Bank Rate as it learns about the effects of higher interest rates on the economy. There is, in fact, a wide distribution of possible outcomes around any expected path for Bank Rate, reflecting the inevitability that the economy will be buffeted by shocks and that monetary policy will have to adjust accordingly. 

After all, as the story of Magna Carta shows, history rarely proceeds in a straight line… why should monetary policy?