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Get Four
|  | JULY 1, 2004
By Stanley Reed Inside the Bank of England The venerable central bank has led England to unprecedented prosperity. Now it's trying to contain a housing bubble. Will it succeed? John Bartlett pulls his blue sedan up beside a red brick building in a run-down industrial park outside of Birmingham, England. Inside, he gets a warm handshake from the finance director of a $35 million maker of specialty industrial fasteners. Bartlett, the Bank of England's man in the West Midlands, is making his annual call on one of his 600 to 700 contacts. Over tea in a modest meeting room, Bartlett goes through his checklist in these confidential interviews. How is the company doing? It is booming. What about labor costs? Not too bad, because competitors are laying so many people off. And investment plans? The company has just ponied up $1.8 million for new machinery and a laboratory. EYES AND EARS. After an hour, Bartlett is off again -- this time up the road to visit a car dealer in North Birmingham. The dealer reports tougher going: Manufacturers are pushing more and more cars on the dealers, and it's getting harder to meet sales goals each month. In June, sales "started dropping off just when your friends at the bank pushed up rates," the dealer jokes. Bartlett and 11 other regional agents around Britain are emblematic of the way Mervyn King and his predecessor Eddie George have energized the Bank of England. Being a regional rep used to be a dead-end job. But that was before the bank gained the authority to set interest rates in 1997. Formerly, that was the Chancellor of the Exchequer's job, and he listened more to the siren song of politics than sober economic observation in setting monetary policy. But no more. Now that the bank has sole authority over interest rates, the agents are among King's most important eyes and ears. Their findings are distilled into a report for the rate-setting Monetary Policy Committee each month -- and MPC members say the agents' on-the-ground reporting is a valuable supplement to reams and reams of numerical data. "AIM TO BE BORING." King and his colleagues at the BOE are paying particularly close attention to the soundings of Bartlett and others because the British economy is entering a risky phase. In the past seven years, the BOE has been one of the world's most successful central banks -- perhaps second in effectiveness only to the U.S. Federal Reserve. Since 1997, when the BOE finally became independent, it has managed rates so nimbly that Britain has not seen a single quarter of economic contraction. Growth in that period in Britain has averaged 2.6%, vs. 3% for the U.S. Inflation has been benign: 2.3%, the same as in the U.S. And Britain has avoided both the blowup of the 2000 bubble that hit the U.S. and the freeze-dried growth that has afflicted the Continent. While Britain's average annual growth has not increased all that much in the past decade, the economy has avoided the savage recessions that punctuated the early 1980s and 1990s. This admirable steadiness has won King, a self-assured academic with a wry sense of humor and a soft spot for soccer, a top reputation in the rarefied world of central banking. The BOE itself is considered by many a model of best practice -- more so even than Alan Greenspan's Fed, which many economists consider a one-man band. Predictable and effective -- that's what King likes about the bank he runs. "For much of the postwar period, British macroeconomic policy was too exciting for comfort," King says, ensconced in a cozy late 18th century-style sitting room in the bank's columned inner sanctum in London's financial district, the City. "We should aim to be boring." CHOPPIER WATERS. But all the field reports indicate that King's life could get uncomfortably exciting very soon. By his own admission, the era he dubbed "nice" -- for Non-Inflationary, Consistently Expansionary -- is lurching to an end. King thinks the economy is near the limit of what it can produce in both manufacturing and services -- a situation that normally pushes up prices. The British labor market is tightening, he notes, and the world interest-rate cycle has turned. Growth is still solid and consumer spending robust, but things are getting choppy.
The BOE has already been hiking rates, moving into a more hawkish position much faster than the U.S. Fed. Some critics, though, say the bank hasn't moved fast enough, and that, despite King's own blunt warnings, the only way out is a major tightening and possibly a recession. A big spike in rates -- every increase of 100 basis points slows GDP growth by half a percent -- would make most Britons feel poorer very fast. Three-quarters of all mortgages are adjustable on a monthly basis. SOUNDER FRAMEWORK. Such a scenario would evoke the end of the last big property boom in the early 1990s, when housing prices crashed. Britons had to wait out most of a decade to see property values come back. So a real estate bust and a hard landing would make the bank's admirers wonder if the BOE is as skilled as claimed -- or the beneficiary of a stretch of uncommonly good economic luck. King and his colleagues are working hard to avoid that outcome. He thinks the much sounder macroeconomic framework that Britain has put into place over the past 15 years gives the country a good chance of avoiding the vicious cycles of boom and bust that once plagued the economy. The reforms by Prime Minister Margaret Thatcher that privatized chunks of the economy and defanged big labor have made Britain the most flexible economy in Europe. But the struggle to balance the competing interests of growth and inflation in the months ahead will be the BOE's severest challenge since independence. And they will test the techniques King and others have fashioned for the bank, techniques that have buffed the bank's reputation. "The Bank of England is the state of the art in central banking at this moment," says Adam S. Posen, a former Fed official now with the Institute of International Economics think tank in Washington. "They've got a healthy discussion, that includes both inside and outside advisers."
Central bank watchers also applaud the bank's 2% inflation target set by the chancellor, which holds the MPC to account not only on the upside but on the downside. In this regime, producing no inflation is considered as big a problem as producing too much. Targeting is partly designed to prevent bankers from killing growth by being overly hawkish. The ECB has a 2% target -- but also gives heavy weight to money supply growth. A recent study by Charles Wyplosz, professor of economics at the Graduate Institute for International Studies in Geneva, and two colleagues, found that 21 central banks target inflation. The BOE itself borrowed the concept from the Reserve Bank of New Zealand. "But a small bank would never influence the world of central banking like the BOE has," Wyplosz says. Even some Fed policymakers, led by Governor Ben S. Bernanke, want the U.S. to adopt an inflation-targeting regime -- though Bernanke prefers to target a range, from 1% to 2%.
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