King gives warning on wages as Darling strengthens Bank

Bank of England Governor Mervyn King last night warned that people would have to bear a squeeze on real take-home pay this year, and lambasted those who claimed the Monetary Policy Committee should focus on growth rather than inflation.

He was speaking as it emerged that Sir John Gieve, the deputy governor at the Bank of England with responsibility for financial stability, would step down in spring 2009, two years earlier than scheduled. Gieve was given a rough ride by the Treasury Select Committee last year over the Northern Rock crisis.

King, addressing the Lord Mayor's Banquet for Bankers and Merchants of the City of London at the Mansion House, signalled the MPC might be forced to raise benchmark UK interest rates from 5% if restraint was not shown by people in wage demands and by price-setters.

He said: "There should be no doubt that the MPC is prepared to take whatever action is needed to return inflation to the 2% target and to keep expectations of inflation in the medium term anchored to the target."

However, King last night indicated absolutely no shift at this stage to such a tightening bias, declaring: "Where Bank Rate will ultimately need to move to bring inflation back to target is impossible to judge now."

He said UK economic growth was "now slowing quite sharply" and highlighted the negative impact which stagnation of real take-home pay this year would have on the housing market and high street.

Official data on Tuesday showed annual UK consumer prices index inflation jumped from 3% in April to a 15-year high of 3.3% in May - leading King to predict it will rise above 4% later this year.

The Bank of England Governor's speech did nothing to change the impression he gave in his letter to Chancellor Alistair Darling this week, explaining the jump in inflation to more than one percentage point above target, that he would prefer to avoid raising rates if possible.

King paid tribute to the "patience and good humour" shown amid the global credit crisis by Darling, who told the Mansion House audience about radical plans to give the Bank of England legal responsibility for financial stability, to strengthen the role of the Financial Services Authority and to advertise openly for the next Governor of the Bank.

Reflecting on last year's collapse of Northern Rock and the global credit crisis, Darling said that effective powers were necessary for the FSA to tackle market abuse and ensure investor confidence.

Darling said the Government would be bringing forward new legislation to provide the FSA with additional powers and outlined how he now intends to give the Bank of England formal legal responsibility for financial stability in addition to its existing power on monetary policy. A new Financial Stability Committee, including members drawn from outside the Bank, will sit alongside the rate-setting MPC.

Darling said the plans would bring valuable, external expertise, with City experience, to bear on the Bank's decision-making.

He also announced plans for a more transparent procedure for senior appointments, which will see the posts of the governor, deputy governors and external members of the MPC advertised.

Darling said he would announce today the name of a new deputy governor to replace Rachel Lomax - widely expected to be the Bank's chief economist Charles Bean. Lomax's remit is monetary policy.

Chiming with King on the need to avoid inflationary wage settlements, Darling renewed calls for pay restraint in the public and private sectors to head off the danger of an inflationary spiral. Darling acknowledged that "times are tough", but insisted the UK will avoid recession, telling his audience: "Our economy will continue to grow."

He added: "Continued restraint on pay is required from both the public and private sector. We must recognise the need to reward efforts of people who work hard. But to return now to inflationary pay settlements would undermine rather than raise people's living standards with a damaging circle of wage increases eroded by steadily rising prices. We must never return to those days."

King, rounding on criticisms of the MPC's single inflation-targeting mandate as the UK economy slows sharply, told the Mansion House dinner last night: "The fact that growth and inflation are heading in opposite directions has led some commentators to question our monetary framework. Target growth, not inflation is the cry. I could not disagree more. This is precisely the situation in which the framework of inflation targeting is so necessary. Without it, what should be a short-lived, albeit sharp, rise in inflation, could become sustained."

He added: "Without a clear guide to the objective of monetary policy, and a credible commitment to meeting it, any rise in inflation might become a self-fulfilling and generalised increase in prices and wages. And surely the lesson of the past 50 years is that, when inflation becomes embedded, the cost of getting it back down again is a prolonged period of sluggish output and high unemployment.

"Price stability - returning inflation to the target - is a precondition for sustained growth, not an alternative."

King laid the blame for the current spike in inflation squarely on "increases in energy and food prices relative to other prices".

He added: "But the rise in commodity prices cannot, by itself, generate sustained inflation in the United Kingdom unless we allow it to. We will not. So, although inflation in the UK will rise in the short term, inflation will then fall back. That means that the rate of increase of other prices and domestic costs, notably pay, must remain low."

King said: "Rising fuel, gas, electricity and food prices, mean that average real take-home pay will stagnate this year. It will not be an easy time, and I know that some families will find it particularly difficult...The squeeze on real take-home pay will arguably be an even more significant restraint on consumer spending this year than the credit crunch...It is clear that the housing market is being severely affected by the reluctance of the banking system to expand its balance sheet further."

The MPC has cut base rates by a quarter-point three times this cycle. Hopes of a further near-term cut have been all but killed off by a raft of warning signs on inflation in recent weeks.