Mr. King looks at the UK economy and monetary policy Speech by Mr. Mervyn King, an Executive Director and Chief Economist of the Bank of England, at the Building So Association Annual Conference in Bournemouth on 27/5/98.
Next Monday - 1 June - sees the start of the statutory basis for Britain's new policy regime. An independent Bank of England will, through its Monetary Policy Committee (or set interest rates to achieve an inflation target of 2½%. For over 30 years economic policy in been bedevilled by inflation and the resulting instability of output and employment. Stabili prices and macroeconomic performance more generally - requires a credible commitment to a mon and fiscal framework embracing low inflation and sustainable public finances. That we now have.
But stability of the economy is not the same as stability of interest rates. interest rates must go up and down according to the state of the economy if the inflation ta met. In contrast, if monetary policy is successful in achieving the inflation target then, pre short-term interest rates will have moved over the economic cycle, long-term interest rate relatively stable. And, from the perspective of your borrowers, whether on fixed or flo mortgages, what matters is the predictability of the cost of a loan over the life of the mortga fluctuations, within reason, of monthly payments. Timely movements in short-term interest rate means by which both the average cost of a mortgage, and its variability, can be reduced to the necessary to attract loan finance. In so doing we should be able to avoid crisis - and inevi changes of interest rates of the kind that we have seen so often in the past. Indeed, since target was adopted in October 1992 there have been no changes of interest rates of that kind were decided at the regular monthly monetary meetings. Moreover, the switch last May to a timetable of meetings for the Monetary Policy Committee - with all interest rate decisions an 12 noon on the Thursday on which the MPC meeting concludes - was a major step forward in redu uncertainty in financial markets.
## Through the Looking Glass .....
So if interest rates must be flexible, in which direction are they likely to mo wish I could tell you. Inflation, as measured by RPIX, rose to 3.0% in April, compared with March. But that jump largely reflected the Budget changes to excise duties which took effect e year than last. That will drop out of the index in the third quarter of this year when RPIX likely to fall back towards its target level of 2½%.
However, this relatively optimistic short-term outlook reflects an extraordinaril inflation environment. The combination of a strong exchange rate (still about 25% above its August 1996), a 20% fall in dollar oil prices over the past year, and an average fall of 9 commodity prices, is holding down retail price inflation. Domestically generated inflation is higher than RPIX inflation. As the one-off effects of the rise in sterling wear off over the next year or so - as indeed they will unless sterling appreciates further - inflation will st the target unless domestically generated inflation declines.
In the long run, domestically generated inflation is likely to be close to t increase of unit labour costs. At present unit labour costs are rising at about 3½% a year. figures released earlier this month - which showed that average earnings in the economy grew and in the private sector by no less than 5.6% - were undoubtedly disappointing. It is too so how far they reflect the impact of higher bonuses this year than last. In any event, to hit target those rates of earnings growth will have to fall back.
These high levels of earnings growth are not the underlying cause of inflat pressure; they are a symptom of a tight labour market. Equally, the prospects for earnings gro critically on the future path of output and on inflation expectations. The MPC's central proj May Inflation Report is that the pace of output growth will slow. But a slowdown in economic g not, in itself, sufficient to hit the inflation target. The central issue for monetary policy
nominal demand will slow sufficiently quickly to prevent retail price inflation rising when th effects of a high exchange rate and lower commodity prices wear off.
The extent to which domestic demand growth slows down is crucial. At present, we relying on a sharp deterioration in the trade balance to keep output growth down to levels that to rising inflationary pressure. But in the longer-run domestic demand growth must fall from rate of 3½ - 4% to something closer to trend. During 1997 as a whole, consumption grew by 5% growth rate is already moderating. And the MPC's central projection is for a further slow domestic demand during this year. That is likely to be brought about by a combination of the monetary tightening that has been put in place over the past year or so. But there are real There is a risk that consumption may prove stubbornly buoyant. Real personal disposable increased by 4.2% last year, and the ratio of net financial wealth of households to their inc an all-time high of over 3. Those factors will support consumption. The latest retail sales fi some comfort with volume growth below that in the middle of last year when consumption stimulated by windfall gains, predominantly from the conversion of building societies. (Rarel many, been so grateful, to so few building societies.)
## Highs and lows in house prices
In the past, domestic demand has been sensitive to developments in the housing ma In the late 1980s house prices increased by 40% in two years, while consumption rose by ov Borrowing using housing as collateral - so called equity withdrawal - amounted to almost 50% increase in consumption over that period. The impact of rises in house prices on consumption cause and which is effect - remains hotly contested by economists. A rise in house prices lea to an increase in wealth but also to an increase in the cost of housing services. Or, to put if the price of your home goes up, you will not be able to spend more on other things if you w on living in your home. So it is not at all clear that changes in house prices will in fact ha impact on household spending.
Perhaps of greater importance is the role which house prices play in signalling c confidence about the future. In common with other assets, such as equities, house prices ca quickly to news about future economic prospects. And house prices and consumer confidence do s be closely correlated. So house prices may be a leading indicator of sentiment about the eco hence of consumption and domestic demand. But, just like equities, house prices also reflect real interest rates. Since long-term real interest rates have fallen from over 3½% to below past year, it is not surprising that house, and other asset, prices have risen.
Precisely because housing is an asset, its price is more volatile than most go services in the retail price index. As such, it is important to look at house price levels as rates of change. Although house prices have been rising quite rapidly over the past couple of returned to the peak reached in the late 1980s only at the end of last year, and exceeded it time in the first quarter of this year. That, of course, followed the sharp fall in house pri 1990s - house prices fell by over 10% between 1990 and the end of 1992.
For most families, apart from future earnings and pensions, their wealth is domin one asset and one liability. The asset is their home and the liability is the mortgage on difference between these two is sensitive to the state of the economy. In a low inflation w prices are likely to rise and fall whereas the mortgage liability is fixed in money terms. T has the potential to create large swings in household net worth which may well exacerbate fluct demand and output. The upside consequence was seen in the consumption boom of the 1980s, and opposite was evident in the bust of the early 1990s when falls in house prices meant that a 1½ million families had negative net equity resulting in higher precautionary saving an consumption.
The forward-looking information contained in house prices underlines the importanc MPC attaches to measuring them accurately. The recent divergence between the rates of house
inflation implied by the Halifax and the Nationwide indices is both puzzling and unfortunate. of house price inflation recorded by the two indices began to diverge at the beginning of 1997 recently published data suggest that house prices, as measured by the Nationwide index, rose in the year to April 1998, whereas, according to the Halifax index, they rose by only 5. household wealth in the year to April 1998 rose by £80 billion more according to the Nationw the Halifax index. Such differences matter in our assessment of the economy.
The Bank of England, together with representatives from the Halifax and Nationwide from the Department of Environment, Transport and the Regions (DETR), have spent a great deal o and effort trying to understand the cause of this divergence and to assess what is really h house prices.
The answer to the first question - what accounts for the divergence? - remains l mystery. The Bank's preferred explanation, reached I have to admit via a process of eliminatio plausible explanations rather than by the existence of incontrovertible evidence, is that th reflects the way in which house prices are 'mix adjusted' to take account of the different ch of the houses bought and sold in any one month. Changes in the relative composition of t portfolios of the Halifax and the Nationwide over the last year or so are likely to have ma effect.
To answer the second question - what is really happening to house prices? - the Ba developed an alternative measure of house price inflation using data from the Land Registry. T have the advantage that they cover nearly all housing transactions in England and Wales and so comprehensive than the data used by either the Halifax or the Nationwide. However, the Bank est far from ideal. The published Land Registry data are not 'mix adjusted'. And, although the Ban apply a simple mix adjustment to take account of the basic type of property brought and sol county in which the property is located, it is less sophisticated than that used by either Nationwide.
So I would not want to claim in any way that we at the Bank have found the true me of house price inflation. Rather, the Bank estimate was developed in the spirit of trying t guidance to the members of the MPC on the relative weights that they should attach to the co pictures painted by the Halifax and Nationwide indices. The house price index constructed Department of Environment, Transport and the Regions is also helpful in this respect. That ind advantage that it is constructed using a more complete method for adjusting for the mix o transacted than the Bank estimate, but it is based on only a small sample - approximately mortgage-backed transactions.
The Bank estimate suggests that house prices increased by 9.0% in the year to 199 compared with 6.9% measured by Halifax and 12.9% by Nationwide. The Bank estimate is broad consistent with the DETR index, which shows a 7.9% increase over the same period. But further required on this issue which is of importance to us all.
## 'Divided we stand, united we fall'
That brings me to the Monetary Policy Committee and the prospect for interest rate transparency of the new process means that the debate about monetary policy within the M explained clearly to the world at large. Hence the reasons why monetary policy is so finely ba I believe, now widely understood.
But it is not just the policy debate which is now more transparent. The voting r each individual member of the MPC is in the public domain. There is a good reason for this. D is an incentive for individuals to cast their vote for the policy most likely to hit the inflation target. I have little doubt that the prospect of having to defend one's voting re makes individual members of the MPC well aware of their responsibilities. There can be no
behind the coat-tails of the chairman, nor disowning a decision subsequently by claiming to ha against a position adopted by consensus. Transparency should improve both the quality of decis the accountability of Committee members.
But there is an additional point which is fundamental to the role of the Monetar Committee. Its purpose is to take technical decisions about the level of short-term interest the issue is one of technical judgment it is better to rely on the collective wisdom of nine p views of only one individual. I have noticed that the highest in the land often rely on team whereas you and I have only one. Of course, it is often tempting to take comfort from t confidence with which any one doctor proclaims his or her diagnosis. But the evidence suggest difficult cases reasonable experts can interpret the evidence in different ways. Rather than from one self-confident view, which I would find difficult to challenge, I would like to know balance of professional opinion lies. That is why in the case of essentially technical jud sensible to rely upon collective wisdom, and there are other areas in which we do precisely tha Lords, for example, reach their decisions by aggregating individual judgments, and the same is United States Supreme Court. The MPC is based on the same principle. For such a system to wor crucial that the individual members of the MPC give their best judgment and do not try to artificial consensus.
When policy is clearly off-track, as in the spring of last year, it is not diffi unanimous decisions, as the Committee did through 1997. But when policy is finely bala disagreements about the precise level of interest rate are not only likely but an indication broadly on-track. That is why the motto of the MPC should perhaps be 'divided we stand, uni fall'.
Some commentators have been unable to resist labelling members of the Committee either 'hawks' or 'doves'. There is a fundamental problem with this labelling. It makes no se new system to describe individuals as hawks or doves. Each member of the Committee has the inflation target. Unlike some other central banks, MPC members cannot entertain closet views a attractions or dangers of slightly higher or lower inflation. Their task - to which they personally accountable - is to hit the Government's inflation target. So members of the Commi on interest rates according to the economic data, which change from month to month, and the an those data. No one takes a position that higher interest rates are a good or a bad thing out o you drove past an infant school at 40mph, you might well be described as driving dangerously fa you drove at 40mph on a motorway, you might well be described as driving dangerously slowly. A must be judged in the light of the circumstances. In terms of monetary policy, that means positions which members of the MPC take on interest rates will change over time according to the economy evolves. But if interest rates themselves cannot be predicted, because they d changing economic data, what should be predictable is the way MPC members respond to those da predictable 'policy reaction function', to use the jargon, should, over time, diminish the in market commentators take in the meetings of the MPC and direct that interest to what is happeni economy.
So, as the voting record shows, it is seriously misleading to think of the MPC in fixed camps of 'hawks' and 'doves'. As circumstances change, it is easy to imagine that the shall be 'doves' and the 'doves' shall be 'hawks'. And, over a five year period, since each m the MPC is trying to hit the same inflation target, I predict that it will be impossible between 'doves' and 'hawks'. What will the commentators call us then? If Britain either has or to join Monetary Union, then the birds may have flown the nest. But if the MPC is still sett rates in Britain, then I hope that we shall be seen as a group that is tediously predictab raising interest rates, sometimes cutting them, but always moving in response to the economi order to hit the inflation target.