Mr. King examines the impact of the recent turbulence in international financi markets on the UK economy Speech by Mr. Mervyn King, a Deputy Governor of the Bank of England, to the National Council of Building Material Producers in London on 21/10/98.
Few industries have suffered more from volatility of the British economy than and the past few months have been more volatile than most. 'The times they are a-changing' be an appropriate theme tune for all of us. What has changed the economic climate over the to three months? Here at home the most obvious sign has been a sudden decline in busine consumer confidence. The fall in the CBI's measure of business optimism over the last two is the largest seen since the early 1980s. The level of consumer confidence appears more r it too has also fallen since the middle of this year.
What has changed the economic climate over the past two to three months? Here home the most obvious sign has been a sudden decline in business and consumer confidence fall in the CBI's measure of business optimism over the past two quarters is the larges early 1980s. The level of consumer confidence appears more robust, but it too has fallen middle of this year.
Away from home, the major development has been increased fragility in t international economy. Following the default on its debt by the Russian government, the im of capital controls by Malaysia, and the near collapse of the hedge fund Long Term Management, financial markets world-wide have exhibited extraordinary volatility, driven b of risk, a flight to quality and liquidity, and the beginning of a significant reduction financial institutions. What does this turbulence mean for the British economy?
Before answering that question, I want to say a few words about the Monetary P Committee. Just under two weeks ago, the Monetary Policy Committee, for the first time in history, cut interest rates. When I accepted your invitation to speak today, I did not would be able to explain to you the reasons behind our latest decision. For, until today, of our meetings were published with a lag of some five to six weeks. But, as the Bank an earlier this month, the minutes will now be published only two weeks after the monthly m And the minutes from our meeting on 7-8 October were published at 9.30 a.m. this morning increase in transparency should help commentators and financial markets alike to assess th of the MPC and to predict its future decisions. As I have said on other occasions, the aim is to pursue economic stability, not to spring surprises on an unsuspecting world. Surpri good for newspapers, but not for most other businesses.
So what were the issues facing the MPC two weeks ago? Remember that the aim o the MPC is to hit an inflation target of 22. Sometimes inflation will be above the target below. But over a run of years the outturn should be as close to 22 as possible. It is c remit that deviations of inflation from the target are regarded symmetrically. Inflation ca as well as too high. For over thirty years, central banks have not, until recently, opportunities to show that they understand this. I can assure you that the MPC does circumstances change, as they have over the past few months, then so will our policy.
The recent turbulence in international financial markets brings a new set of p and risks, over and above those that resulted from the Asian crisis which started in the se last year. It is important to distinguish between the crisis of the so-called 'tiger' econ which, although clearly impacting on world trade, was indeed largely restricted to Asia
more recent financial contagion which has afflicted almost all emerging markets and affe financial system of the industrialised world.
There are three aspects of the world economy which are relevant to our own pos First, private capital flows to emerging markets have in many cases come to an abrupt halt. have consequences for trade balances and activity in both emerging markets and indust countries. Second, falls in equity prices around the world have reduced household wealth. the sudden increase in risk aversion in financial markets is changing the balance sheets institutions and some fear that this may lead to a credit crunch.
The reduction in capital flows to emerging markets started over a year ago concerns about the foreign currency exposures of a number of countries led to withdrawals and a liquidity crisis in Asia. That liquidity problem was compounded by macroeconomic structural problems which varied from country to country. But the net effect was that capit emerging markets in Asia fell from over $110 bn in 1996 to only about $10 bn in 1997 retrenchment has continued during 1998. Why does this matter? In the absence of other sou finance, a reduction in net capital inflows has to be matched by a corresponding improveme current accounts of the emerging market economies. To achieve such a rapid turn-round current account required significant depreciations of their currencies and deep recess counterpart to the improvement in the current account of the countries affected is a l deficit, or smaller trade surplus, in the rest of the world. The UK is not immune to th trade balances, and the impact of the Asian crisis on our exports has, of course, been comp the rise in sterling since 1996.
If the Asian crisis affected most a relatively young, and only temporarily w tiger, the recent turbulence was heralded by the growl of a much older, more grizzly, announcement by the Russian government on 17 August of its intention to restructure payme its domestic bonds led to a fundamental reappraisal of international investors' willingn risk. The reappraisal caused the average cost of capital to emerging market economies - mea interest rates on their bonds - to rise to levels not seen since the immediate aftermath o crisis in 1995. This increase in cost is likely to lead to a further reduction in net c emerging markets and so magnify the adverse trade effect faced by the industrialised world.
Second, the greater aversion to risk has led to falls in equity prices thro industrialised world. The FT/S&P world stock market price index has fallen by nearly 12% s peak three months ago. In the UK, the FTSE All-Share fell by nearly 20% over the same perio fall in equity prices is likely to lead to both lower consumption growth, as consumers ad fall in net wealth, and lower investment growth, as firms react to the higher cost of capit
Third, the heightened aversion of financial institutions to risk has led to 'credit crunch'. A credit crunch occurs when lending institutions try to reduce their expo and, in so doing, the size of their balance sheets. In recent weeks, the desire of these reduce the scale of their leveraging and move to less risky portfolios has led to a redu amount of capital available to support liquid financial markets. As a result, asset price have been volatile. So far the consequences of turbulence in financial markets have bee restricted to securities markets, especially in the United States. These markets are som important in the provision of corporate finance in the UK, although if the reduction i market issuance were to persist this could affect the ability of the personal and corpora obtain finance from both banks and the capital market. As yet lending by UK banks has no
affected to any significant extent. The monetary statistics published yesterday show that credit grew by 0.7% in September, leaving the 12-month growth unchanged at 8.7%.
The MPC will watch carefully for any signs of a credit crunch developing. The monitors indicators of credit conditions in the financial markets on a daily basis. And t asked the Bank's regional Agents to conduct a survey of borrowing conditions faced by bus around the country in time for the MPC meeting in November.
The international situation is, of course, only one of the factors that influe rates. In the August Inflation Report, the MPC made clear that it expected - indeed wan growth of domestic demand to continue to slow throughout this year and into next. A slowd necessary because, as the restraining effects on retail prices from the rise in sterling s domestically generated inflation must fall if the inflation target is to be met.
The latest data from the Office for National Statistics show that domestic and output have been growing broadly in line with the desired path. But survey data markedly weaker picture for output and orders, both over recent months and, more impor looking ahead. The lags with which changes in monetary policy affect the economy mean th MPC can not wait to find out whether the surveys provide an accurate prediction before policy. Each month the MPC balances the information contained in official statistics, anecdote and the impressions of conditions in industry relayed to us by our network of agents.
An issue of considerable importance is the state of the labour market. The Inflation Report argued that the outlook for inflation depended critically upon the labour in particular, on the behaviour of earnings. At the time of that Report the latest figur growth was 5.4%. Given historical levels of productivity growth of around 2%, this level o growth was, on the face of it, incompatible in the long run with the inflation target of 2 an extended discussion during the summer, both within the MPC and among commentators in press and the City, about the extent to which those levels of earnings growth had been di the impact of bonuses during the Spring of this year and so might be expected to fall in without the need for an easing of pressures in the labour market.
Since August, the estimates of this key economic statistic have been revise once, but twice. The good news - somewhat ironic given the amount of attention it attract this year - is that as a result of these revisions the 'great bonus debate' of the summer non-issue. Bonuses, we are now told, if anything subtracted from, not added to, the g earnings in March and April of this year. The bad news, however, is that if before the r was difficult to know how to interpret the impact of bonuses on earnings growth, it is, fair to say, now extremely difficult to know how to interpret any aspect of the earnings da
Statistics, official or otherwise, are neither right nor wrong. They are estim are often revised as new information becomes available. But what is striking about th revisions is that the changes do not result from any new information about earnings, but s a change in the procedures used to weight together the earnings in different firms and in may be that this change has made it more difficult to make comparisons of earnings over t hence to measure underlying earnings growth.
Whatever the explanation, there has certainly been a change in the estimated of earnings growth over the past two years. The revised data suggest that instead of ris
throughout last year, as the economy grew at above-trend rates and the labour market tight rate of growth of earnings actually fell. From a peak of 5.3% in February last year, earn is now estimated to have slowed consistently until March of this year, when it reached 3.9%. This deceleration in earnings growth coincided with a period in which, according Labour Force Survey, the labour market tightened considerably: employment rose by 360 unemployment fell by 320,000 and the unemployment rate fell from 7.8% to 6.5%. Over the period wage settlements accelerated. And the revised data imply that since March of this y pace of economic growth has slowed, earnings growth has accelerated, from 3.9% in March to in June.
It is not easy, therefore, to reconcile the revised earnings data with other i on the labour market. And these data really matter for the MPC's assessment of the UK eco can promise you that the Bank, the Treasury and the Office for National Statistics will, as urgency, be working together to try to understand what is happening to earnings.
Decisions on interest rates must take into account not only those factors whic highlighted this morning - the international economy, the possibility of a credit c uncertainty about the trend in earnings growth - but also a wide range of other informati to the outlook for inflation, including the behaviour of the monetary aggregates, whic growing quite rapidly, and the fall in sterling's effective exchange rate. Over the next more important data will become available, including the first estimate of GDP growth in quarter, a CBI Industrial Trends Survey and the monthly report from our regional Agents. next meeting on 4 and 5 November, the MPC will take into account all of this informati occasions like today are part of the process by which we obtain more information and e views with those most directly affected by our decisions.