This content is from: Corner Office

GOOD AS GOLD

Timing, for central bankers, is everything. It's an art as much as a science, and one that few central bankers master consistently.

Timing, for central bankers, is everything. Knowing exactly when to apply the brakes to nip inflation in the bud, or when to ease open the throttle enough to spur the economy, can spell the difference between prosperity and recession. It's an art as much as a science, and one that few central bankers master consistently.

Count Sir Eddie George among those exalted few. He became governor of the Bank of England a decade ago, just as it was gaining new influence over monetary policy. His sage counsel and discreet but effective lobbying helped persuade the government of Prime Minister Tony Blair to give the bank control over interest rates in 1997.

Since then he and his colleagues have succeeded beyond the government's wildest dreams, keeping inflation close to its 2.5 percent target while helping the U.K. enjoy steady growth and its lowest unemployment rate in 25 years. Now, as economic conditions take a turn for the worse, he is, with exquisite timing, leaving, having reached retirement age.

In June he hands over the reins to his deputy, Mervyn King, just as the fabled Old Lady of Threadneedle Street confronts its biggest challenges in years. To begin with, the bank must contend with a gaping budget deficit as the Labour government ramps up public spending on education and health care, a trend that could put upward pressure on interest rates and inflation. Meantime, the U.K.'s economic growth masks an unprecedented tension between a beleaguered manufacturing sector and a boom in consumer demand and services that complicates the bank's delicate balancing act. Cutting rates to help pressed manufacturers might only fuel consumer spending. As housing prices gallop ahead at a rate of 25 percent a year, some economists fear that today's boom could turn into tomorrow's bust, prompting calls by some analysts for the bank to prick the "bubble" before it explodes.

"The U.K.'s recent economic performance largely reflects extra monetary and fiscal easing without a matching supply-side gain," asserts Michael Saunders, European economist for Schroder Salomon Smith Barney. "The price, in terms of further increases in inflation and the deficit, will become more evident in the coming year."

How well King will meet these challenges is an open question. Sir Eddie is a pragmatic man who has exerted a steadying influence over the bank's Monetary Policy Committee, encouraging vigorous debate while maintaining the group's cohesion. King, by contrast, is a brilliant economist with a more contentious nature. An anti-inflation hawk, he has clashed with the committee majority on several occasions, notably last June, when he found himself on the losing end of a 7-to-1 vote in arguing for a rate hike. Taking such a losing stand as governor could undermine his authority on the committee and, worse, in the financial markets.

On top of these economic challenges, the bank faces its toughest political test yet as the U.K. nears a decision on the euro. The latest signals seem to point against early entry, including a recent hint of delay by Minister for Wales Peter Hain, a key voice on European issues in Blair's cabinet and one of the government's biggest euro champions. Prime Minister Blair is keen to see Britain join the currency during his premiership, but for Chancellor of the Exchequer Gordon Brown, the bank's success increasingly seems like a good reason for keeping the U.K. out of the euro. Speaking in Parliament in November, Brown noted that Britain's unemployment was lower than that of Germany, Japan and the U.S. for the first time in the postwar era. "I believe that we are better placed because our monetary regime was designed not only for times of high growth but for times of global difficulty as well," he said.

The government is due to make its recommendation by June, and politicians and the public will look to the central bank for an objective assessment of the economic arguments for joining the euro or staying out. King previously has highlighted the risks to the U.K. of joining the euro, and the announcement of his appointment in November was widely regarded as evidence of the anti-euro leanings of Chancellor Brown. But King is also a loyal civil servant in the best British tradition, and he is determined to avoid taking sides in the debate, even though joining the euro would effectively shut down his bank.

"The Bank of England would do a really successful and professional job to make the outcome of a referendum work," King told Institutional Investor in an interview shortly before his appointment. "If we wanted to take part in the public debate, we should find a different job."

How well are the bank's policymakers likely to perform their job? Judging by their record over the past five and a half years, it would be foolish to bet against them. The bank has succeeded not by luck but by design, one that is increasingly seen as the gold standard of modern central banking and is influencing policy at the European Central Bank and the U.S. Federal Reserve Board.

The Bank of England is the very model of a modern central bank. It combines a well-crafted institutional framework with a top-notch team of economists, led by Sir Eddie and King, who carry out policy. The bank has a single, clear target -- keeping inflation low to foster a good environment for growth. Crucially, the target is symmetrical, meaning it's as bad for inflation to undershoot the 2.5 percent goal as it is to overshoot it. This effectively builds a growth criterion into policy that should help guard against deflation, no small reassurance these days. Unlike the U.S. and Germany, the U.K. has avoided recession, finishing 2002 with its longest economic expansion since World War II intact.

"We've now had over 40 successive quarters of positive growth," Sir Eddie says in an interview. "I mean, you can't ask for anything more really. That's all been pretty thrilling."

The bank also operates with a degree of openness that would make bankers at the ECB blush. The nine-member Monetary Policy Committee comprises the bank's top five officials and four prominent outside economists, a varied group that encourages debate. The bank publishes detailed minutes and voting records just two weeks after each meeting, a practice that has encouraged markets to anticipate policy changes.

The bank's success has given the British model newfound weight in Europe and the U.S. The European Central Bank shifted noticeably over the past year to address complaints that its policy was too ambiguous and conservative. ECB officials now insist that, like the Bank of England, they regard their inflation target as symmetrical and that their real aim is to keep inflation between 1 and 2 percent, rather than the official target of 0 to 2 percent. With the ECB conducting a thorough review of its policy framework in the first half of this year, some economists are urging it to come more closely in line with the British by setting a new symmetrical target of 2 percent.

In Washington key members of the Federal Reserve Board have begun lobbying for the Fed to adopt an inflation-targeting policy like the U.K.'s rather than rely on the intuitive skills of Chairman Alan Greenspan to set interest rates. Ben Bernanke first proposed the idea when he was appointed to the Fed's policymaking Open Market Committee last year, and the suggestion was endorsed last month by Federal Reserve Board governor Edward Gramlich. Bernanke and Gramlich believe that inflation targeting will ensure the credibility and clarity of Fed policy after Greenspan retires. Already, the traditionally secretive Fed has moved in the British direction on transparency, deciding last March to release the members' vote immediately after each FOMC meeting.

The bank's procedures are "widely admired" in central banking circles, says Andrew Crockett, a former Bank of England official who serves as general manager of the Bank for International Settlements in Basel. "Over the past ten years, there has been an increasing realization of how important transparency is."

THE IDEA THAT THE BANK OF ENGLAND MIGHT serve as a model for the Fed or the ECB would have seemed laughable a decade ago, when Sir Eddie became governor. Founded in 1694, the world's second-oldest central bank (Sweden's Sveriges Riksbank opened in 1668) was long on history but short on real power. Her Majesty's Treasury set interest rates, and the politicized monetary policy had given the U.K. the worst inflation record of any Group of Seven country except Italy over the previous 30 years. An attempt to fix the problem by pegging the pound to the deutsche mark collapsed in September 1992 as speculators forced the U.K. out of Europe's exchange rate mechanism, an event that earned George Soros the moniker "the man who broke the Bank of England." The bank fared no better as a regulator, drawing flak for failing to avert the collapse of the scandal-plagued Bank of Credit and Commerce International. The government would later strip the bank of its banking supervisory duties, handing them to Britain's Financial Services Authority in 1997.

After the September, 16, 1992, Black Wednesday devaluation, the Conservative government of then­prime minister John Major shifted the focus of monetary policy from its discredited exchange rate target to an inflation target, then a new concept being pioneered by the likes of New Zealand. The U.K. Treasury continued to set interest rates, with the aim of keeping inflation -- then about 2.5 percent -- within a range of 1 to 4 percent. Crucially, the Treasury set rates after monthly meetings between then­chancellor of the Exchequer Kenneth Clarke and Sir Eddie.

The bank buttressed its role with the introduction of a quarterly inflation report in February 1993. The brainchild of King, who had joined the bank as chief economist two years earlier, the report gave a thorough assessment of the outlook for inflation and the economic factors affecting it. The report was a politically clever method of constraining the Treasury by exposing policy options to full public view in layman's language and building a constituency for low and stable inflation. King's purpose was to ensure that "no government in the future could get the inflation genie back out of the bottle," says John Llewellyn, chief economist at Lehman Brothers, who has known King since studying economics with him at the University of Cambridge in the early 1970s. The inflation report, and King's hourlong press conference introducing it, remain must viewing for economists today. "We look at it pretty closely because it's one of the cornerstone pieces of analysis," Llewellyn says.

Sir Eddie and King proved to be a powerful duo in restoring the bank's authority. The grand old man of central banking, having worked at the Bank of England since earning his degree in economics from Cambridge in 1962, Sir Eddie is known as a pragmatic operator rather than a monetary theorist. He gained international experience and contacts during secondments to the BIS and the International Monetary Fund in the 1960s and '70s. In the 1980s he was the key link between the central bank and the City of London's financial industry as head of monetary policy, market operations and banking supervision.

"Eddie is a central bank technician. He knows the nuts and bolts of the plumbing better than just about anybody in central banking," says an official who knows him well.

Sir Eddie is also politically astute. He used his influence with the government to lobby patiently and discreetly for greater autonomy for the central bank. He began discussing the issue with Blair and Brown two years before Labour came to power.

King, by contrast, is an economist's economist whose professional colleagues almost universally consider him to be the best man for the job. After gaining his doctorate he did econometric modeling at Cambridge under the late Sir Richard Stone, who won the Nobel Prize for Economics for developing systems of national accounts that form the basis for macroeconomic analysis. As a professor at the London School of Economics in the 1980s, King recognized the booming City of London as a source of funding and an avid consumer of research into financial markets and helped establish the school's Financial Markets Group in 1987. "He's absolutely straight and straightforward, deeply intelligent and somewhat of a perfectionist. He tended to hold on to papers too long," says Charles Goodhart, an LSE colleague who served a three-year stint as an external member of the bank's Monetary Policy Committee.

But, unlike the diplomatic Sir Eddie, the more controlling King has ruffled some of his colleagues on the MPC. He rebuffed demands by the committee's external members for more resources to conduct their own research until the central bank's governing Court of Directors ruled in favor of the externals in 2000. Some MPC members have occasionally criticized his central projections for inflation and growth in the inflation report as too conservative, and he has been forced to acknowledge dissent by including rival forecasts in the report.

Despite the disagreements, however, King's reputation for top-notch economic analysis remains intact. His quarterly press conferences are a model of clarity in explaining the intricacies of monetary policy. Admirers say the gaffe-prone president of the European Central Bank, Wim Duisenberg, would do well to study these briefings.

"He can communicate at almost every level and do it brilliantly, from the most abstruse level for his academic colleagues to putting underlying arguments in plain language for the public," Goodhart says. "He does it without speaking down to people."

The work of Sir Eddie and King paid off in May 1997, when the incoming Labour government agreed to grant rate-setting powers to the bank only five days after taking power. The surprise announcement was a coup that paid immediate dividends. Although inflation had remained tame for five years at a little below 3 percent, market expectations of future inflation remained stuck at more than 4 percent in early 1997, leaving real long-term rates high. After the announcement, though, inflation expectations dropped overnight and have since hovered between 2.5 and 3 percent, as investors judged that the central bank would prove more successful at containing inflation. Long-term rates also tumbled, with yields on ten-year government bonds falling to about 20 basis points over comparable German bonds today, compared with 75 or so basis points in 1997.

"It's a great success," says Lars Svensson, a monetary economist at Princeton University. "The outcome is much better than anyone would have anticipated. The markets and the general public actually believe that the Bank of England will be successful at keeping inflation at 2.5 percent. If you get to that stage, half the battle is won."

Just as important as independence was the new policy framework at the bank. The government chose a precise inflation target of 2.5 percent, rather than a range, to make policy as clear as possible and ensure that the central bank did not sacrifice growth in the pursuit of extremely low inflation.

"It's not the old monetarism, it's pro-growth," says Ed Balls, the economic adviser to Gordon Brown who crafted the new framework.

The bank demonstrated its growth sensitivity when it cut rates quickly in the autumn of 1998, in response to Russia's debt default, and again in 2001, when it lowered rates seven times by a total of 2 percentage points to counteract the effects of the global economic slowdown. The 1998 cuts "really brought home to the public the symmetry of it," says Christopher Allsopp, a University of Oxford economist who sits on the MPC. "That clearly adds to public acceptance of the overall framework."

A government-set inflation target violates the definition of central bank independence in Europe's Maastricht Treaty, but in the U.K.'s case, it carries definite advantages. The most obvious is to give democratic legitimacy to the bank and its conduct of monetary policy, something the ECB in Frankfurt lacks in the eyes of many Europeans.

"People clearly like the idea that day-to-day decisions have been taken away from politicians. But they also like the idea that the broad economic strategy is something they can influence through their vote," says King.

The fact that the government sets the target reduces the risk of an inflationary binge in public spending and makes it more likely that fiscal policy will support, rather than conflict with, monetary policy. "This is actually a better system than a fully independent central bank," says DeAnne Julius, an American who was chief economist at British Airways before joining the MPC; today she's a member of the bank's governing Court of Directors. "That target set by the chancellor binds him as well as the MPC. He would be blamed for any resulting rise in interest rates."

THE CLOSE RELATIONS BETWEEN THE CENTRAL bank and the Treasury stand in stark contrast to the state of affairs in the euro zone and are one big reason why Gordon Brown is reluctant to give up his monetary regime for membership in the single currency. Gus O'Donnell, the permanent secretary, or top civil servant, at the Treasury, attends the monthly meetings of the MPC and gives the committee advance briefings about fiscal policy. That was particularly important last April, when O'Donnell told the committee that the Treasury would raise payroll taxes to finance a big part of its massive public spending plans. That reassurance helped persuade the MPC to keep rates steady rather than raise them. In Europe the ECB shuns any suggestion of cooperation with finance ministers to avoid appearing to compromise its independence. Many economists believe that the ECB delayed rate cuts last year because of fears that governments would exceed their budget deficit ceilings.

"We can talk about the policy mix, whereas the ECB is very uncomfortable with the idea," says O'Donnell. "We know how they will respond to any changes in fiscal policy. That's important for us."

Sir Eddie has actually praised Brown for boosting government spending. The fiscal stimulus should help sustain growth and is a key reason why, unlike some analysts, Sir Eddie doesn't fear a sharp slump if the U.K's debt-burdened consumers retrench. "That's something which, as a central banker, I'm supposed to frown upon," he said of the spending hike in a speech in January. "But I must confess to you that it is something that I positively welcomed in the immediate situation."

The Bank of England's other distinguishing characteristic is the presence of four external members on the nine-member MPC, which was created in 1997 to set interest rates. This ensures that the policymaking process reflects a broad range of views rather than a pensée unique.

In December 1999 the two leading easy-money advocates on the committee, external members DeAnne Julius and Sushil Wadhwani, won the policy argument for the first time. They persuaded three of the internal MPC members, including Sir Eddie, to vote for no change in rates. King, who as deputy governor and former chief economist tends to steer MPC debates, opened the policy discussion by recommending a quarter-point rate hike, only to find himself outvoted 6 to 3. More recently, the dovish camp has been led by Allsopp and Stephen Nickell, an economics professor from the London School of Economics, who have both voted to cut rates in each of the past four months as insurance against a weak global economy.

The external members "made the committee come alive," says O'Donnell, who, with his Treasury colleague Balls, selects them. People like Julius and Wadhwani, a former Goldman, Sachs & Co. analyst and research director at Tudor Proprietary Trading, are "strong characters, and they broadened the debate in important ways."

Nonetheless, the dissent by external members has exposed a key fault line within the committee and raised questions about King's ability to lead the MPC as effectively as Sir Eddie. In contrast to King's firm anti-inflation stance, the dovish case is argued most strongly by Wadhwani, who has sharpened his critique of policy since finishing a three-year stint on the MPC last May.

Wadhwani believes that the threat of inflation in the U.K. has receded more than historical models would suggest. Central bank independence itself has reduced British inflation prospects because consumers and companies believe that the bank will succeed in its remit, he contends. As a result, short-term changes in things like exchange rates or oil prices don't feed through to retail prices as they did in the past. Moreover, the competitive pressure spurred by globalization is restraining companies' ability to raise prices, he says. And structural changes in the British economy, particularly labor market deregulation, have reduced the level to which unemployment can fall without triggering upward pressure on wages and prices, he argues. In 1995 a Treasury survey estimated that the so-called nonaccelerating inflation rate of unemployment (Nairu in economists' jargon) was 7 percent. After several years of declines, unemployment has steadied at 3.1 percent for the past year, based on the number of people claiming benefits, while inflation has remained subdued.

"The committee has over the years tended to have too gloomy a view about the Nairu and, therefore, systematically overestimated the inflation pressure," Wadhwani says.

The data makes a case for Wadhwani's argument. Since early 1999 the annualized retail price index targeted by the bank has been higher than 2.5 percent in only six months and lower in 42 months, including a low of 1.5 percent last June. The index averaged 2.17 percent during that period, noticeably below the 2.5 percent target. The conclusion is clear to Wadhwani: The bank has kept policy too tight. If the MPC had kept interest rates a quarter-point lower on average from 1999 to 2001, he says, inflation would have averaged just below 2.5 percent, and output would have been 0.5 percent higher than it actually was at the end of 2001.

David Laws, a member of the House of Commons Treasury Select Committee, which monitors the bank's conduct of monetary policy, says he believes that the MPC regards 2.5 percent as more of a ceiling in practice than the midpoint of a target range. "One suspects that the mind-set is still that undershooting is better than overshooting," he says. Even MPC members have difficulty explaining the low inflation result. "At first sight, that's a sign of failure," says Kate Barker, a former chief economist at the Confederation of British Industry who was appointed to the MPC in 2001. "It does raise questions as to whether we're voting symmetrically. But in reality the undershoot is very small."

Barker and other MPC members reject the suggestion of any policy bias and insist they aim to hit the target over a two-year time horizon. Sir Eddie says the amount by which inflation has come in below target has been "absolutely tiny."

King dismisses the disputes between hawks and doves on the committee as "absolutely trivial." The average difference between the level of rates advocated by the most hawkish and most dovish members of the committee over the past five years is about an eighth of a percentage point, he estimates. "No one can claim that the performance of the British economy would have been dramatically different if interest rates had been 12 or 13 basis points higher or lower on average," he adds.

The bank's top officials concede, however, that they have erred in recent years by anticipating a decline in the value of the pound, which until recently failed to occur. A drop in the currency should translate into higher import prices and, ultimately, inflation.

"It's been a consistent forecasting error rather than a policy-objective bias," Sir Eddie says. "I think we underestimated the strength of sterling, particularly against the euro." The governor also acknowledges that low unemployment hasn't produced the sort of upward pressure on wages and prices that most committee members had expected.

The bank has reduced the impact of the exchange rate on its inflation forecast to adjust for its error, and it is in the process of revising its macroeconomic model, which it uses to compile its forecast and set policy. A new report by prominent Australian econometrician Adrian Pagan, commissioned by the bank's Court of Directors in response to prodding by Wadhwani, found that the existing model was outdated and failed to accurately reflect actual inflation and output. But Pagan concluded that the bank's economists and the MPC had adjusted for those defects "very creditably," and that the tendency of their forecasts to overstate inflation was "probably as small as one could reasonably expect."

ERRORS IN ECONOMIC MODELING CAN BE corrected, of course, but King's record as an inflation hard-liner will pose a challenge when he takes over the leadership of the bank and the MPC. The pragmatic Sir Eddie has voted with the majority on the MPC through two cycles of raising and lowering interest rates. He describes interest rate decisions as "pretty marginal judgments" based on incomplete and often contradictory data. As governor he has tried to influence policy debates on only half a dozen occasions, usually preferring to encourage a wide-open discussion and then voting last after the others have shown their hands. MPC members laud him for fostering a full and free exchange of views.

"He demonstrates that he wants to hear different viewpoints to help him make up his own mind. He would constantly encourage me to comment on a variety of issues. That's what a good chairman should do," says Wadhwani.

King, by contrast, is a man of firm opinions whose role, and personal inclination, has been to try to steer the committee to his viewpoint. At times, his stance has provoked dissent, with some MPC members occasionally disagreeing with the central forecast in the inflation report. At other times, as in last June's 7-to-1 vote, he has failed to sway opinion and found himself in the minority. Could a governor King be on the losing end of such a lopsided vote without losing his authority? Many think not.

"It would damage the credibility of monetary policy if he were in a minority," says Laws of the House of Commons. "He's either going to have to take a stronger leadership role than Eddie George did or he's going to have to accept there might be occasions when he has to allow a majority view to prevail."

King, however, promises to remain his own man as governor. "Everyone knows the incentive they have is to vote for the outcome they think is the right thing to do to meet the inflation target," he says. "There's no point laying down a marker, or making a gesture or going with the majority to have a quiet life. You should vote for what you think is the right thing to do. Once you start to give up on that, you lose your soul."

A shifting economic tide may vindicate King. Inflation jumped above the target to 2.8 percent in December, fueled largely by housing costs, before easing to 2.7 percent in January. Some analysts believe that the rate could rise above 3 percent this year, which could make it easier for King's anti-inflation views to prevail. Already, his hawkish stance seems to have helped seal his designation as the next governor. Gordon Brown announced the appointment in November at the same time that he unveiled forecasts for a sharp rise in government borrowing. King's tough reputation helped reassure financial markets and offset potential concerns about Brown's fiscal policy. In any event, King clearly enjoys Brown's confidence, say aides to the chancellor. King, says the Treasury's O'Donnell, is a "very, very good economist. He has a very high international reputation. He's someone who's been involved in inflation targeting since its inception. He's very surefooted in public."

King and his MPC colleagues will need deft footwork in coming years. In reality, they are grappling with two increasingly divergent economies. The U.K.'s manufacturing industry is stagnating because of weak global demand and a strong exchange rate. Output in the third quarter of 2002, the most recent period for which statistics are available, stood at just 99.1 percent of the 1995 level and was down 6.8 percent from its peak in the fourth quarter of 2000. But with unemployment at historically low levels, consumer spending remains buoyant -- it grew by 4.2 percent in the third quarter from a year earlier. And the country's service industries, ranging from financial services to transportation and communications, are in robust health, growing by 2.5 percent in the third quarter.

The impact on inflation has been stark. The prices of services are increasing at a rate of about 4.5 percent a year, whereas goods prices are falling by approximately 1 percent. That gap of 5.5 percentage points is way above the historical difference of about 2 percentage points. How to deal with this gap is the bank's biggest dilemma. Raising interest rates might slow the growth of consumer spending but would hurt manufacturers and risk putting upward pressure on the pound, exacerbating British industry's competitive difficulties. Cutting rates might weaken the pound, but that would risk fanning an even stronger consumer boom.

So far the MPC has come down on the side of the consumer, believing that, in the words of Sir Eddie, "unbalanced growth is better than no growth at all." Despite its worries about the strength of consumer demand, the committee cut rates in 2001, to offset weakness in the global economy, and held rates steady in 2002 even as growth recovered. But the two-speed economy clearly worries policymakers. The Financial Services Authority warned last month that one in five British households was finding it difficult to service its debt, leaving the economy vulnerable to a retrenchment by consumers.

"The challenge," says King, "is that by building up the imbalances in order to have some average growth rate close to trend and keep inflation close to the target, you know that at some point a correction will come, and when it comes, it could be very sharp. The difficulty for us is that we simply don't know how big that correction will be, when it will come, how sharp it will be and whether, in fact, it would be difficult to offset."

The biggest source of British inflation, and the biggest area of concern to the bank, is the housing market. Home prices have more than doubled on average over the past six years, according to the Nationwide Building Society's index, and surged by a record 25 percent in 2002. Homeowners are eager to cash in on their fast-growing wealth, so much so that home equity withdrawals now account for an unprecedented 6 percent of disposable income. At the same time, the nonpropertied classes are furiously bidding prices up to get in on the game, or despairing of ever setting foot on the real estate ladder.

The bank assumed in its November inflation report that housing inflation would gradually ease toward zero over the next two years. But to many economists, the feverish activity in the housing market reeks of a bubble as potentially destabilizing as the boom and bust in technology stocks. Already, prices have started to ease in parts of London. Andrew Oswald, an economist at the University of Warwick, predicts that prices could plunge by as much as 30 percent and trigger a full-blown recession.

Some economists think that the risks are so great that the bank should consider raising rates, or at least using rhetoric, to cool the housing market before it's too late. "A clear signal from monetary policymakers that they would, other things being equal, react to a bubble if one clearly emerged would make the continuance of strong house price growth less likely now," Wadhwani argued in a speech to British economists last year. So far, however, bank officials have resisted any action and echoed the defense offered by Greenspan in his Jackson Hole, Wyoming, speech last year, when he sought to justify the Fed's hands-off attitude toward the Nasdaq boom. Asset price bubbles are almost impossible to identify except in retrospect, they say, and it is hard to justify taking risks with the economy to prick a bubble when inflation -- the bank's main target -- is under control.

Using monetary policy to control asset prices is "never likely to be successful, because you'll never know by how much you need to raise interest rates in order to reduce asset prices," King says. "What is the theory that tells you how a small movement in interest rates affects irrational behavior? There isn't one."

For all of the difficulties posed by asset prices, the bank's rhetoric has been inconsistent. King has warned of the potential negative impact if house prices feed into broader inflation or collapse and undermine consumer confidence, but others have shown less concern. Housing prices may be at record levels relative to earnings, but the cost to consumers of servicing mortgages at today's low interest rates is well below the peaks reached during the U.K.'s last housing boom, in the late 1980s.

"It's not altogether surprising if households feel more secure and think they can take on more debt," Sir Eddie says. "You can, I think, legitimately argue that to some degree what we're seeing now in house prices is a level change." As a result, the governor rules out any attempt to jawbone the housing market. "My attitude is certainly that you can't talk these things. You can't draw lines on a bit of paper and say, 'Well, that's not going to happen.' "

THE OTHER BIG CHALLENGE FACING THE BANK is the debate over whether the U.K. should adopt the euro. The question appeared to fade as a live issue last year because of the strong performance of the British economy relative to that of the euro zone and because of the negative attitudes of voters, who oppose the move by a margin of almost two to one in recent surveys. But aides to Blair say the prime minister remains determined to lead the U.K. into the euro. The New Year's announcement that Denmark will hold another referendum on the currency after Sweden votes on the issue this fall means the U.K. could end up as the last holdout among the European Union's 15 members and under increased pressure to join.

The November decision by Brown to appoint King as Sir Eddie's successor seemed a clear signal against the euro. King is widely regarded as opposing its adoption and once said it would take 200 to 300 years' worth of data to prove that the U.K.'s economy had converged with the euro zone's.

"If Brown is gearing up for a fight with Blair [over the euro], Mervyn is the right guy to have," says David Begg, an economics professor at the University of London's Birkbeck College.

But King rejects the anti-euro label and vows to stay out of the political debate. "If you were organizing the yes campaign in a referendum, you would expect the Bank of England to be ready to enter the euro, to make sure we could take part in the way monetary operations were conducted in the euro area and contribute to the debate on monetary policy," says King. "If you were the organizer of the no campaign, you would expect the Bank of England to be fully prepared the day after the referendum to have an MPC meeting to continue the strategy of monetary policy, to make it work with just as much credibility as it had before. We have to be ready to do both of those."

But Sir Eddie also shows little enthusiasm for policy in the euro zone. He blames a lack of supply-side reforms for holding back growth in the euro area. And he shares Brown's view that Europe's Stability Pact, which sets a budget deficit ceiling of 3 percent of gross domestic product for all 12 euro countries, is too rigid. He believes that the U.K.'s fiscal rules, which allow for higher deficits in low-growth years as long as the budget is balanced over the business cycle, are better. "I'm quite happy with the arrangements we have here. If those arrangements prove to be kind of robust, then I think people may review the arrangements within Europe," he says.

The apparent skepticism is hardly surprising. Bank of England officials are enjoying a degree of success and influence rarely achieved in the institution's 300-year history, and they aren't keen to give it up. But they also know that their future will depend on their ability to wield influence in Frankfurt if the U.K. opts for the euro, which would give King a vote on the ECB's governing council. "We've had relative success over ten years, but it's not guaranteed," Sir Eddie says.

For a central banker, that's about as good as it gets.


THE BANK'S BRAIN TRUST

The U.K. government handed control over interest rates to the Bank of England in 1997 -- and should have few regrets. The central bank has targeted a 2.5 percent inflation rate, and its success in meeting that goal has gained it great credibility, Chancellor of the Exchequer Gordon Brown reminded Parliament in November. "The Bank of England has the capacity to make the right decisions at the right time for the long-term interests of the British economy."

Who makes those decisions? The central bank's nine-member Monetary Policy Committee. The MPC is, in effect, two committees: the internal members, who are the bank's top five executives, and the four external members, drawn from the ranks of the country's top academic and business economists. Though they don't vote as separate blocs, the internals tend to share views because of their close working relationships in running the bank's operations. Even their offices emphasize the difference. The internal members (with the exception of Paul Tucker, who sits with the bank's markets division) have sumptuous ground-floor offices in the Parlours, the suite of rooms around the bank's central courtyard. Originally designed for the directors by the architect Sir John Soane in the 19th century, when the bank was a private institution, and rebuilt in the 1920s, these rooms are richly adorned with rosewood floors, marble fireplaces and intricate plaster moldings. The externals occupy plain, oak-paneled offices on the third floor of the bank.

The bank's governor and his two deputies are appointed for five-year terms by the queen on the advice of the prime minister, but in practice Brown controls the process. He announced Mervyn King's selection to succeed Sir Eddie George as governor in Parliament. The governor names the other two internal members, while the chancellor of the Exchequer appoints the four externals. The biggest complaint about the setup is the short, three-year terms of the externals. "If people are here today, gone tomorrow, and competing with bank people who've been there for years, it's not a particularly level playing field," says David Laws, a member of the House of Commons Treasury Select Committee. -- T.B.

INTERNAL MEMBERS

SIR EDDIE GEORGE, 64

A bank lifer, he has been governor since 1993 and chairman of the MPC since its June 1997 inception. A pragmatist, he votes with the majority, rarely exerting his authority. His deft handling of the bank's relations with the Treasury and financial markets may be missed when he retires in June. "If I contribute anything, it is just experience which influences judgment," he says.

MERVYN KING, 54

The former professor at the London School of Economics joined the bank in 1991 and has been an MPC member since 1997. He succeeds Sir Eddie as governor in June. An anti-inflation hawk, he stresses the uncertainty surrounding interest rate decisions and insists that transparency is the bank's best weapon. "We can say quite openly that we don't have the ability to forecast the future. We make judgments about what we think is more or less likely. That's what we have to do."

CHARLES BEAN, 49

The former head of the economics department at the London School of Economics joined the MPC in October 2000, when he was named the central bank's chief economist. Though his views resemble King's -- he has warned of the risk that inflation in the housing sector could fuel excessive consumer spending -- he has tended to vote with the majority rather than instigate moves for rate changes, and he declined to join King in calling for a rate hike last summer.

SIR ANDREW LARGE, 60

Joined in November 2002, when he was appointed deputy governor for financial stability. A commercial banker who is expected to focus on the central bank's oversight of financial markets rather than monetary policy, Large came from Barclays Bank, where he was deputy chairman. He previously chaired the Securities and Investments Board, predecessor of Britain's Financial Services Authority.

PAUL TUCKER, 44

Joined in June 2002, when he was promoted to executive director for the bank's market operations. A banking technician, not a monetary policy expert, he follows the majority. Tucker joined the bank in 1990 as private secretary to then-governor Robin Leigh-Pemberton. He later served as head of the bond and money markets division and as deputy director for financial stability.

EXTERNAL MEMBERS

CHRISTOPHER ALLSOPP, 61

He was appointed in June 2000. A leader of the doves, who favor easing rates, he believes that central bank independence has given a permanent disinflationary impulse to the U.K. economy. Allsopp has voted unsuccessfully for lower rates since last October as insurance against global economic weakness. He continues as a fellow in economics at the University of Oxford's New College, and as editor of the Oxford Review of Economic Policy. He has written extensively about European monetary union and criticizes the Stability Pact, asserting that its rigid deficit rules are exerting a deflationary influence in Germany.

MARIAN BELL, 45

Appointed in June 2002. She has voted with the majority so far. Bell is not known to fall into any particular camp on monetary policy and was selected for her financial markets experience. She was head of capital markets research at Royal Bank of Scotland during the 1990s and previously worked as an economic adviser at the Treasury.

KATE BARKER, 45

Appointed in June 2001. A former chief economist of the Confederation of British Industry and chief European economist at Ford Motor Co., she holds the MPC's de facto industry seat. Industry traditionally lobbies for lower rates, but Barker usually votes with the majority, telling business leaders that the MPC sets policy for the entire economy. "We do look at housing, we do look at metal bashers, we do look at service industries, and we add all those things up," she says.

STEPHEN NICKELL, 58

Appointed in June 2000 and, like Allsopp, his term ends in May. A specialist in labor markets, he initially sided with King in 2000, voting for higher interest rates to offset potential wage inflation, but recently has voted with Allsopp for lower rates. He has argued that risks to global growth and the bank's forecast that inflation will be slightly below 2.5 percent in 2004 call for a reduction. Nickell is president of the Royal Economic Society and teaches at the London School of Economics.

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