Inside The Bank Of England

The venerable central bank has led Britain 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. 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.

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. Perhaps most menacing, real estate prices in Britain are soaring -- 15% at the latest annualized rate -- and a serious property bubble seems to be forming. "Anyone who is making the assumption that house prices always go up because they have gone up the last five years," King warned a parliamentary committee on June 24, "that's not a very sensible way to think of the risks involved."

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.

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."

That model has done so well in recent years that the 310-year-old Bank of England -- where porters in pink tails and top hats still open doors -- is now the hot topic among central banks. The BOE's nine-member Monetary Policy Committee is much more nimble and accountable than the 18-member governing council of the European Central Bank. Fans also note the inclusion of four outside executives on the committee. They currently include Richard Lambert, a well-known journalist, and Kate Barker, a former Ford Motor Co. economist. "Our committee is certainly not a rubber stamp," says Barker.

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%.

Britain's central bank has catered to the needs of investors as well. It publishes the minutes of the MPC's monthly debate 13 days after it meets, which gets the bank's thinking to the markets before the committee meets again. "They've helped us to understand what they are doing and why they are moving and what they want the response to be," says David Hillier, an economist at London-based bank Barclays Capital. In contrast, the Fed doesn't publish its minutes until six weeks after it meets -- and no one ever knows how the ECB board voted. "The Bank of England has set the standards for central banking, and the world is moving in their direction," says Wyplosz.

Well, maybe not everyone. Greenspan has resisted inflation targeting. Supporters of his approach note that while the BOE has avoided the lows of the U.S. economy, it has never achieved those thrilling highs that have created so much wealth in the U.S. -- and that have usually been followed by fairly shallow recessions. Likewise, the bank has never had to act as a de facto custodian of the global financial system as the Fed has, turning on a dime to cut rates in critical moments like the 1987 crash and September 11. And the BOE has never had to deal with as many unpredictable developments. King himself admits that there is little New Economy effect in Britain -- and no surge in productivity whose effects are so difficult to measure. Greenspan has ably dealt with all these phenomena.

A Political Animal

But there's no denying King's stature among financial policymakers. The Birmingham native has been a key player in modernizing Britain's once-amateurish economic policymaking since he became chief economist at the bank in 1991. And he is enough of a political animal to have successfully shepherded ideas such as inflation-targeting through the dog-eat-dog world of British politics. "Mervyn King developed the framework under which the bank gave advice" to the chancellor, says Alan Budd, who was chief economic adviser to the British Treasury until 1997. "When the bank was given independence, it had a system in place." King still keeps his lines open to Chancellor of the Exchequer Gordon Brown through monthly working breakfasts -- though both men say rates are never discussed.

The son of schoolteachers, King, a tax specialist, has his light side and passionate enthusiasms -- some highbrow and others not. He organizes a book discussion group at the time of the award of Britain's prestigious Booker Prize, and he is a fervent fan of classical music, serving on the Advisory Council of the London Symphony Orchestra. He is also a fanatic follower of his hometown's Aston Villa soccer club and sometimes entertains friends with a tongue-in-cheek lecture on the relationship between Aston Villa's fortunes and the performance of the British economy. "He is good fun, very unpompous," says Derek Scott, Tony Blair's economic adviser from 1994-2003.

Fun and games aside, at the BOE King is considered a demanding and principled boss. For instance, being the top candidate to succeed Eddie George as governor didn't prevent him from being the only MPC member to stick his neck out and vote for rate hikes two months in a row in June and July, 2002.

Like other central banks, King and the BOE are now contemplating new rate rises. The MPC forecast in May that inflation, now under 1.5%, would exceed its 2% target over the next two years if interest rates weren't hiked. The economy is likely to clock growth above 3% this year, but Britain's non-inflationary growth rate is considered to be closer to 2.75%. Sensitive to the threat of overheating, the BOE has jacked up interest rates four times, to 4.5%, starting last November. Most analysts think the bank will hold off raising rates in July but then hike them again in August, with rates going up to 5% by yearend. The MPC seems to have put aside hopes of productivity gains that would permit Britain more leeway in keeping rates low. "My own view is that there is less evidence of a New Economy in the productivity numbers than most people expected three or four years ago," says Barker, who has been an outside committee member since 2001.

Another source of potential upward pressure on rates is Brown, who, by some accounts, has undergone a conversion from penny-pinching Iron Chancellor to money-gushing Big Spender. King has made his worry about that known. In a mid-June speech in Brown's presence, King gently prodded the Chancellor to deliver on his assurances that the public finances would "swing back to what is known in the trade as a sustainable fiscal position."

Shedding Its Skin

King is far from pessimistic about the outlook -- merely, he says, realistic. He and his committee members certainly have a greater margin of error to work with than they did 10 or 15 years ago. Accurately or not, the old ad hoc rate-setting system gets much of the blame for the policymaking failures that hobbled Britain's economy for decades. For starters, the old system, which came of age in the post World War II years, fell short on transparency and professionalism. Back then investors could be forgiven for suspecting that whim and political expediency lay behind rate decisions. And they were often right. The Prime Minister occasionally became involved, and there was much less policy discussion than today.

In contrast, in the seven years since Prime Minister Tony Blair and Chancellor Brown made the bank independent, Britain has definitively shed its reputation for economic mismanagement. Unemployment, now just 4.8%, continues to fall, and prosperity extends far from London. Thanks to the growth of service businesses, once-gritty Rust Belt northern cities such as Leeds and Manchester are booming. "Overall, the bank has been very effective," says Danny Gabay, a former Bank of England economist who now serves as director of Fathom Financial Consulting in London. "It has achieved something that previously eluded Britain: a sense of stability."

That stability and the robust economic growth it has fostered have been an enormous boon to Blair and Brown. Pro-business conservative chancellors in the past, such as Nigel Lawson and Norman Lamont, both unsuccessfully urged their bosses, Margaret Thatcher and John Major, to give the bank its independence from politicians. But it was the Labour Party that finally took the gamble just days after its May, 1997, landslide victory at the polls. Now voters, who used to consider Labour hopeless at economic management, say they trust the party more than the Tories on economic matters. After all, ill-advised monetary policy robbed Thatcher of many of the benefits that might have been expected during her tenure as Prime Minister. Rate cuts by Chancellor Lawson in 1987 and 1988, for instance, overstimulated the economy, stoking inflation and contributing to the long recession of the early 1990s.

Voters give most of the credit for the decision to make the bank independent to Brown, strengthening his hand in any potential contest for Labour Party leadership. In another twist, the bank's effectiveness convinces many Britons that they have no need to adopt the euro and enter the realm of the ECB. Why swap the BOE for the ECB? many Britons ask.

Despite its role-model status, bank officials admit it hasn't been independent long enough to have a proven track record. Some critics say the central bank went too far in the slowdown of 2001-2002 in trying to offset a sharp drop in exports and investment by stoking consumer demand. In particular, they criticize two rate cuts in 2003 before the bank began its march upward. "The BOE is now reaping the whirlwinds of a policy error," says Gabay, who thinks that rates could go as high as 6%.

But other observers are less pessimistic. Ben Broadbent, an economist at Goldman, Sachs & Co. (GS ) in London, says that while house prices may be rising fast, the rest of the British economy is not in the midst of an out-of-control boom as it was before the last recession in the early 1990s. Instead, spending has been in line with income growth. One issue is that the economy relied on consumption to avoid recessions in 2001 and 2002 when investment and exports plummeted. The bank, he says, now hopes to achieve more balance. "Even if the housing market does weaken" the massive 20% or so that Goldman is forecasting, Broadbent doubts "that will have catastrophic effects," because business investment and exports are picking up. The British have not had an economic catastrophe for some time. It's up to the BOE -- old in years, but young in its independence -- to make sure one doesn't happen now.

By Stanley Reed in London with Richard Miller in Washington and David Fairlamb in Frankfurt

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