(Updates with pound in fifth paragraph, comment from Treasury Committee Chairman Andrew Tyrie in last paragraph.)
June 16 (Bloomberg) -- Bank of England Governor Mervyn King said officials should continue to hold interest rates at a record low because weak growth in wages and money signal the current bout of above-target inflation will prove temporary.
“Subdued rates of increase in average earnings, as well as remarkably -- some might say disturbingly -- low growth rates of broad money have provided strong signals that inflation will fall back in due course,” he said in a speech in London late yesterday. A rate increase “would have meant a weaker recovery, or even further falls in output” and “a risk of inflation falling well below the target in the medium term.”
King’s defense of keeping the benchmark interest rate at 0.5 percent comes as inflation accelerates further above the bank’s target. While borrowing costs will have to rise to more normal levels at some point, he said, the timing is “simply impossible” to know. The governor, who will chair the first meeting of the Financial Policy Committee today, also said banks must have much higher levels of capital to protect against potential losses.
Lenders are continuing to improve balance sheets and reduce leverage, King said. A return in interest margins from “unprecedentedly high levels” will affect the speed at which policy makers raise interest rates, he said.
The pound extended its decline against the dollar today after data showed U.K. retail sales fell more than economists forecast in May. The British currency was trading at $1.6140 as of 9:54 a.m. in London, down 0.3 percent on the day.
“The committee is watching extremely carefully for any signs of a pickup in domestically generated inflation and it will take action as soon as it is appropriate to do so,” King said. “When conditions in the banking sector return to something closer to normal, those spreads will contract and the rate at which that takes place will have an important influence on the speed at which bank rate will rise.”
Some measures of money supply have shrunk even after the bank completed a 200 billion-pound ($325 billion) bond-purchase program. The measure of M4 the central bank uses to assess the effectiveness of its asset purchases fell 2 percent in the three months through April on an annualized basis.
Data yesterday showed the pickup in inflation to 4.5 percent, which is more than twice the bank’s 2 percent goal, hasn’t fed through to salaries. Wage growth including bonuses weakened to 1.8 percent in the three months through April from 2.4 percent in the first quarter.
The challenge for the Monetary Policy Committee is weak growth and faster inflation at a time when the economy “is going through a major rebalancing of demand and output,” which will take “several years to complete,” King said.
“Uncertainty inevitably surrounds both the speed of the rebalancing and the impact of today’s consumer-price inflation on tomorrow’s domestically generated inflation,” he said. “So it is simply impossible to know now at what point monetary tightening will begin.”
A weaker pound was a “necessary precondition” for the economy to rebalance, according to King, who said policy makers have had to “look through” its effect on inflation. Sterling has dropped about 25 percent on a trade-weighted basis since the start of 2007.
“We could have raised bank rate significantly so that inflation today would be closer to the target,” King said. “But that would not have prevented the squeeze on living standards arising from higher oil and commodity prices and the measures necessary to reduce our twin deficits.”
King also raised concern that the European Commission may weaken capital and liquidity rules for banks agreed by global regulators under the Basel III accord. He said that putting in place adequate resolution procedures had to go hand in hand with ensuring that lenders are sufficiently protected against future crises by holding an adequate level of common equity.
“A crucial part of the new Basel III framework is the recognition that only common equity is a truly loss-absorbing layer of capital,” he said. “I am, therefore, concerned that the European Commission will propose a weakening of the Basel standards in that area.”
King will present the findings of the Financial Policy Committee’s meeting on June 24. He will comment on where the panel, created to oversee financial stability, sees risks increasing.
‘Doing and Learning’
“The FPC will be both doing and learning,” King said. “In the wake of such a severe crisis, it is unlikely that excessive credit growth will be the major problem over the next few years. Indeed, the present problem is the reverse.”
Lawmakers on Parliament’s Treasury Committee are examining accountability at the Bank of England and King responded to comments by former policy makers on the extent of the powers he will have as chairman of the FPC.
Willem Buiter and Kate Barker told the cross-party panel last month that responsibility for financial stability should lie more with Chancellor of the Exchequer George Osborne than the central bank.
The bank will show the same commitment to transparency for the FPC that it has for the MPC, King said, adding that “the bank must be fully accountable to Parliament and the public.”
“I know some of you are concerned about the powers of the governor,” he said. “But with decisions taken by committees and enhanced accountability, those powers are not what they were.”
Andrew Tyrie, chairman of the Treasury Committee, said today the scope of the FPC’s powers raises questions about oversight of its authority.
“If they do act, this will affect us all,” he told BBC Radio 4’s “Today” program. “How do we make sure they have the legitimacy to act?”
--With assistance from Scott Hamilton in London. Editors: Fergal O’Brien, Andrew Atkinson
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