The most important bits from Mervyn King’s speech to the CBI on Tuesday night (emphasis ours)
For a decade inflation and Bank Rate were remarkably stable. But in only four months, the MPC has cut Bank Rate by 3½ percentage points to its lowest ever level of 1½%. Does this mean we have changed our target? No. We have taken those actions precisely because the sudden downturn in the world and UK economies created a significant risk that inflation would fall below the 2% target. Despite those big cuts, there remains a risk that inflation will fall below 2%.
The disruption to the banking system has impaired the effectiveness of our conventional interest rate instrument. And with Bank Rate already at its lowest level in the Bank’s history, it is sensible for the MPC to prepare for the possibility — and I stress that we are not there yet — that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures. They would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies. That should encourage the banking system to expand the supply of broad money by lending to the private sector and also help companies to raise finance from capital markets.
The conventional approach to such unconventional measures is to buy assets, such as government securities or gilts, which are traded in liquid markets to boost the supply of money. Provided the additional reserves are not simply hoarded by banks, as happened to some extent in Japan earlier in this decade, such asset purchases can increase the supply of broad money and credit and the liquidity of private sector portfolios, raising spending. The effectiveness of this approach is likely to be enhanced by the clear commitment by the MPC to take the measures necessary to meet the inflation target in the medium term.
In addition to these conventional unconventional measures there are also unconventional unconventional measures. When credit markets are dysfunctional, as some are at present, targeted purchases by the Bank of England of assets may improve liquidity in markets for those credit instruments. The objective of such purchases would be not only to boost the supply of broad money but also to increase liquidity and trading activity in the markets for those assets. A reduction in the illiquidity premium for a particular credit instrument might help to stimulate issuance by corporate borrowers and the resumption of capital market flows, thus reducing reliance on bank lending. It could also raise the values of assets that are currently under-priced because of high illiquidity premia, helping to strengthen the balance sheets of banks and other financial institutions.
Yesterday the Government authorised the Bank of England to conduct such operations, financed by the issue of Treasury Bills, in order to improve the flow of credit to companies. But at some point the Monetary Policy Committee might wish to adopt these unconventional measures as an instrument of monetary policy.
In conducting such operations, it is important to choose the markets in which to intervene extremely carefully. There is a fine dividing line between helping to oil the wheels in markets which are temporarily impaired, and artificially supporting markets in which there is no underlying demand. That is why, as Federal Reserve Chairman Bernanke said in London last week, central banks will look to intervene only in markets that “normally play major roles” in the functioning of the financial system.
Therefore, the Bank will need to be satisfied that there is a genuine private demand for an asset in normal conditions before it would be eligible for the asset purchase facility. We are aiming to complement and stimulate private demand, not substitute for it.
The Bank is actively considering in which markets targeted purchases might stimulate new issuance. One example is the corporate bond market. Spreads on high quality corporate bonds have more than doubled since early September to an average of over 5 percentage points. Despite innovation in financial markets this is the highest spread 9 since the mid-1970s. The Bank estimates that a significant element of this spread represents an illiquidity premium which could be reduced somewhat by increasing activity and liquidity in the market. Commercial paper is another case where purchases might help, although that market is considerably smaller in the United Kingdom than in the United States. In each case the Bank will keep the market fully informed, and more details will be published at the end of the month. It will be a matter of weeks not days before a programme of purchases can begin, but it will be weeks not months.
There is another reason to tread carefully. Such asset purchases involve taking more credit risk onto the public sector balance sheet. That is why the Bank will consider purchasing only high quality assets.
Despite the existence of a range of unconventional instruments, monetary policy is likely to be more effective when the banking system is working normally. So the first priority for policy is to fix the banking system so that it can resume its normal lending function. The contraction of lending to ordinary viable businesses — your businesses — is threatening to drive the economy further into recession. The package of measures announced yesterday by the Chancellor are not designed to protect the banks as such. They are designed to protect the economy from the banks. In particular, the Asset Protection Scheme aims to remove a degree of uncertainty about the future losses banks will make. It also has the effect of reducing the amount of capital banks need to hold against their risky assets. Both effects will serve to strengthen and underpin banks’ balance sheets and so support their lending to the real economy. To be clear, the scheme does not mean that the taxpayer will bear the full brunt of past lending mistakes by banks. Rather, there is sharing of losses between shareholders and the government — or coinsurance — with the government providing, at a price, insurance against only extreme outcomes for the banks. That can be to the advantage of all of us if banks help to underwrite the economy through the agreed lending targets and government underwrites the balance sheet of the banks. The insurance policy will be most cost-effective for taxpayers if all the major lenders sign up to lending targets.
Nevertheless, the problems in the financial sector mean that 2009 will be a difficult year for all of us. A pronounced contraction in spending and output is underway. As expected, output in the UK economy fell in the third quarter of 2008, but the downward momentum intensified in the fourth quarter. Manufacturing output is falling, and the key service sector surveys have reached record low levels in recent months. Total output in the fourth quarter is expected to have fallen sharply. In the first half of this year, the rate of contraction is likely to continue to be marked, and our trading partners are experiencing similar problems.
But the very significant policy actions taken in recent months will eventually stimulate a recovery in demand, output and employment. Bank Rate has fallen from 5% to 1½%. And, as I have explained, the Monetary Policy Committee has a range of options to stimulate the economy further if required. Fiscal policy has been eased. The banking system is receiving massive support to cope with the need to restructure its balance sheet. That will take time, but time is a great healer, even of banks. Since the summer, the exchange rate has fallen by almost 20%; and oil prices have fallen by around two thirds, both of which will boost demand. No one can know at what point the impact of all this stimulus will have a visible effect on activity; the lags in economic policy are notoriously long and unpredictable. But well-designed policies implemented within a consistent policy framework will eventually work.
Related Links:
Mervyn King speech to the CBI, January 20 2009 - Bank of England
King plans corporate bond spree – FT.com