That means that the rate of increase of other prices and domestic costs,
notably pay, must remain low. The MPC does not take that for granted.
Surveys – including our own – indicate that expectations of
inflation have risen, meaning that inflation is likely to have some tendency
to persist. That is why, as I explained in my letter to the Chancellor, we believe
that a slowdown in the economy this year, creating a margin of spare
capacity, will be necessary to dampen price and wage pressures and ensure
that we fulfil our remit by returning inflation to the target. And growth is
now slowing quite sharply – broad money growth is falling, business
surveys point to particularly weak output growth in the second quarter and
growth is likely to remain subdued for the rest of the year.
Where Bank rate will ultimately need to move to bring inflation back to target
is impossible to judge now. Decisions on Bank Rate will be made one month at
a time in the careful way that the MPC has developed over more than ten
years. But there should be no doubt that the MPC is prepared to take
whatever action is needed to return inflation to the 2% target and to keep
expectations of inflation in the medium term anchored to the target.
The fact that growth and inflation are heading in opposite directions has led
some commentators to question our monetary framework. Target growth not
inflation is the cry. I could not disagree more. This is precisely the
situation in which the framework of inflation targeting is so necessary.
Without it, what should be a short-lived, albeit sharp, rise in inflation,
could become sustained. Without a clear guide to the objective of monetary
policy, and a credible commitment to meeting it, any rise in inflation might become
a self-fulfilling and generalised increase in prices and wages. And surely
the lesson of the past fifty years is that, when inflation becomes embedded,
the cost of getting it back down again is a prolonged period of sluggish
output and high unemployment.
Price stability – returning inflation to the target – is a precondition for
sustained growth, not an alternative. We are in the most challenging period
since the MPC was set up in 1997. But we have the right framework in place
to ensure that inflation returns to the target and growth recovers. The
stormy waters we are navigating now make for an uncomfortable passage compared
with the calm conditions of the nice decade. Our inflation performance then was
surprising not so much because inflation was low, but because it was so
remarkably stable. Neither inflation nor growth are likely to be as stable
in the future. But even if inflation proves to be more variable, it will not
be systematically either higher or lower than the target.
The right framework is essential if we are to maintain low inflation and
steady growth. But there are two recent developments in our economy at
present that no monetary policy, whatever the framework, can prevent. The
first is the impact on living standards of rising food and energy prices.
These prices have risen relative to most other prices. Monetary policy
should not, and in the end cannot, prevent such changes in relative prices.
They will show up either in higher consumer prices or in a lower level of
other prices and pay. Either way, the result is the same – a loss of real
purchasing power.
This year our real take-home pay will rise at a slower pace than national
productivity. Rising fuel, gas, electricity and food prices, mean that
average real take-home pay will stagnate this year. It will not be an easy
time, and I know that some families will find it
particularly difficult. But it is only a temporary slowing in the growth of
our real takehome pay and remember that this is the opposite side of the
coin to the falls in prices of manufactured goods from countries such as
China and India, which in the nice decade allowed our standard of living to
rise at a rate faster than productivity.
The squeeze on real take-home pay will arguably be an even more significant
restraint on consumer spending this year than the credit crunch. And it will
affect the housing market too – lower demand in the high street will go hand
in hand with lower demand in the property market. I have said in the past
that there is no causal link between house prices and consumer spending.
That remains the case. How closely they move together depends on the
underlying forces that are driving them both. This year, the squeeze on real
income growth is likely to mean that both house prices and consumer spending weaken
together.
The housing market leads me to the second recent development – the
reassessment and re-pricing of risk in the financial sector. It is clear
that the housing market is being severely affected by the reluctance of the
banking system to expand its balance sheet further. Banks are adjusting to
the fact that many asset markets are unlikely to re-open in their old form
and, as they do so, the supply of mortgage finance is being restricted.
Once the adjustment in the financial sector is complete, banks will be able to
resume lending. But the era of cheap mortgage finance that underpinned the
housing market in 2006 and the first half of 2007 is over and, as a result,
it is reasonable to expect the ratio of house prices to incomes to fall
back, though with real interest rates still low by the standards of the past
fifty years, not to previous averages.
These changes to our spending power and to the housing market are ‘real’
shifts that, although not easy to accept, we cannot side-step. Lord Mayor,
we face the most difficult economic challenge for two decades. But I am
confident that we can meet it. Inflation will fall back and growth will
recover. But the cost of the necessary adjustment will depend on the
credibility of the framework for monetary stability. After all, the value of paper
money rests on only one thing – trust. Trust in the ability and
determination of those setting interest rates to maintain the value of
money. Central to that is the independence of the Bank of England. An
independent central bank has, over time and around the world, proved to be a
cornerstone of the arrangements necessary to underpin trust in paper money.
So, Chancellor, I welcome your intention to introduce a proper process for
making appointments to positions on the Monetary Policy Committee. I welcome
too, Chancellor, the announcements you made tonight about the shape of a new
framework for financial stability to be embodied in a Banking Bill. I
particularly welcome the new responsibilities for the Bank of England and
associated reforms to our governance. We now have the chance to put in place
a set of reforms that provide a coherent framework for banking regulation.
It is an opportunity we must not throw away.
I can assure you all that the Bank of England will devote time and resources
to meeting the new responsibilities which the Chancellor plans to give us. Lord
Mayor, shortly after assuming office, you were quoted as saying, “I think
like a lawyer. I’m very prudent, very risk-averse”. What a pity you weren’t
running a bank a year or two ago! But in a difficult year for the City you
have provided leadership and thrown yourself into the enormous workload of
your office. Tonight all of us here would like to pay tribute to your work
since you became Lord Mayor, and to thank both the Lady Mayoress and
yourself for the splendid hospitality which you have extended to us all this
evening.
So I invite you all to rise and join me in the traditional toast of good
health and prosperity to "The Lord Mayor and the Lady Mayoress, David and
Theresa Lewis".
