Report to the Treasury Select Committee
from Mervyn King, Governor of the Bank of England
The past year has been a painful one for the
UK economy. Mirroring developments in other advanced economies,
nominal spending, which normally grows at a rate close to 5%,
has fallen sharply. It is now around 10 percentage points below
its long-run trend. That is a measure of the monetary squeeze
that the economy has experienced in the wake of the financial
crisis last autumn. As a result, output has contracted sharplyby
almost 6%opening up a margin of spare capacity in the economy.
And that is now being reflected in the labour market: unemployment
has increased steeply, to its highest level since 1995.
Partly in response to the sharp fall in spending,
and the emerging margin of spare capacity, inflation has fallen
from its peak of 5.2% to 1.5% in October. Notwithstanding a temporary
pick-up in inflation over the next few months, spare capacity
will continue to pull down on the outlook for inflation for some
time to come. As a result, over the past year, the risks to the
outlook for inflation in the medium term relative to the target
have shifted markedly to the downside.
In response to these developments, I voted,
like the rest of the MPC, for sharp cuts in Bank Rate towards
the end of last year and in the early part of this year. Bank
Rate was cut from 5% to 0.5% in five monthsthe lowest level
of official interest rates in the Bank's 315 year history. In
March, when Bank Rate reached 0.5%, the Committee also chose to
embark on an unprecedented programme of asset purchases to inject
extra money directly into the economy to provide more stimulus.
Financial market participants will use this money to diversify
into other assets that have a higher return than holding cash.
In turn that will push up the prices of these other assets, and
so boost spending and the outlook for inflation. Initially, the
MPC voted unanimously for a £75 billion programme of purchases,
which in May was extended to £125 billion, again unanimously.
In August, owing to continuing weakness in the outlook for inflation,
I voted in a minority to extend the programme to £200 billion
pounds. At the time, a majority of the MPC voted for it to be
extended to only £175 billion. But in November, a majority
of the MPC voted to extend the programme of asset purchases to
In the short run, inflation is likely to rise
sharply, reflecting temporary factors such as an increase in petrol
price inflation and the reversal of last year's cut in VAT. But
in the medium term, the margin of spare capacity, if it persists,
will continue to drag down on the outlook for inflation.
Several factors will boost demand in the economy
looking ahead, and hence help to eliminate that margin of spare
capacity. Most notably there is the very significant monetary
policy stimulus. In addition, the depreciation of sterlingnow
around 25% lower than its peak in mid-2007will encourage
demand to switch towards UK-produced goods and services both at
home and abroad. And in the short run, a turnaround in the stock
cycle will also help to boost output.
But set against these factors, there are also
powerful forces that will act to restrain spending in the economy
as a whole. First, banks are continuing to lower their leverage
from extraordinary high levels. While this continues, the supply
of credit to companies and households will be impeded. Second,
households and companies are also likely to be cautious in their
spending behaviour in the face of uncertain future incomes and
profits. Third, there is a clear need for a credible plan to stabilise
the public finances in the years ahead. And finally, the level
of demand around the world, and hence demand for UK exports, is
markedly lower than in the summer of 2008.
Given all of these factors, at the November
MPC meeting, I judged that, without further monetary policy stimulus,
the risks to the outlook for inflation relative to the target
would be to the downside. It was for that reason that I voted
at the November meeting to increase our programme of asset purchases
to £200 billion. And I stand ready to take whatever actions
are necessary in the future to ensure that the outlook for inflation
remains in line with the 2% target.
Over the past year, I have given four on-the-record
speeches about the economy and monetary policy. I have answered
questions at four Inflation Report press conferences and made
six parliamentary appearances before the Treasury and Economic
Affairs Committees. Those appearances were all shown on television.
I have also appeared on television on a number of other occasionsfor
example, I gave interviews when the asset purchase programme began
in March. On average, I have made a televised appearance about
once every three weeks.
In addition, I have made eight visits to areas
outside Londonto Scotland, Northern Ireland, the North-East,
North-West, East Midlands, South-West, South-East and Central
Southern regions (including the Isle of Wight). The visits involved
numerous company visits and meetings with business people, and
have given me a valuable opportunity both to hear the views of
those in the business community first-hand and to explain the
decisions of the MPC. Those visits also gave me a good opportunity
to explain our monetary policy actions via interviews or articles
in the local press. In addition, I have given over 20 talks where
I have had a further opportunity to explain monetary policy.
Over the past year, I have also attended 14
sets of meetings abroad. Typically these are meetings of various
different international bodiesthe G7, G20, IMF and BISor
at other central banks.
18 November 2009