Back in May, the FT’s Chris Giles wrote a provocative column arguing that:
With the benefit of hindsight, the first 15 years of BoE [Bank of England] independence should be seen as a well-intentioned failure, so it is all the more surprising that the central bank is about to be granted greater powers over system-wide financial stability and banking supervision.
Sir Mervyn King, in a major speech this week, responded not quite so much to the charge that BoE independence since 1997 had failed but to the wider issues around the Bank’s inflation targeting regime, which is now 20 years old. (The full speech is worth a read and is available here, the Bank’s own summary is here.)
Given the current Governor was closely involved in the design of the inflation target, it is hardly surprising that is gave a somewhat robust defence of the core of the approach – arguing it had delivered 15 years of stability and 5 years of ‘turbulence’.
On the narrow measuring of the target succeeding in keeping UK inflation low and stable, he offered the following chart:
Which is certainly impressive, although when viewed in context with inflation in other advanced economies (graph below, data from the IMF) it becomes harder (I think) to argue that low inflation 1992-2007 was primarily driven by the UK’s monetary policy regime.
But the more interesting sections of the speech were not the defence of inflation targeting but the acknowledgements of its limitations and the interrelationships between inflation targeting in the short run and financial stability in the longer run.
The governor identified three potential problems, first that economic developments can be driven by misperceptions and these misperceptions can lead to ‘unsustainable spending’ and build ups of debt. Second, that macroeconomic stability might breed complacency about future risks and here he noted the huge increase in banking sector leverage in the years before the crisis. Finally he noted, that low short term interest rates might encourage investors to take greater risks than they otherwise would as they ‘search for yield’.
This section of the speech owed a great deal to the work of Hyman Minsky and as the proud owner of a Minsky t-shirt (seriously), I found it especially interesting.
Minsky is best known for his ‘financial instability hypothesis’ which argues that long periods of perceived stability encourage excessive risk taking and unsustainable levels of private sector borrowing – in effect macroeconomic stability breeds future instability.
The Governor argued that addressing these issues required a macro-prudential policy of the time the Bank if now assuming. With hindsight he said, there should have been a leverage cap on the banking sector in place by 2007.
For what’s it worth, I think some of the best analysis of the underlying problems building up in the financial system during the ‘great stability’ has been produced by the Bank of England. A 2011 Financial Stability Paper, taking an explicitly balance sheet centric approach found that:
there were linkages between many of the macroeconomic puzzles of the day and the balance sheet developments that led to financial instability. It further argues that approaches to macroeconomics that stress the importance of balance sheet linkages might be helpful in spotting building financial fragility.
If macro-prudential policy is continuing to work I think it will have to proceed on this basis – taking private sector debt, asset prices and balance sheets across the economy (the financial system, households and firms) seriously.
Two days ago though Sir Mervyn went further than simply arguing the case for a macro-prudential approach towards the end of this speech he stated that:
it would be sensible to recognise that there may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises
Faisal Islam, blogging after the speech, write that these were words, ”I would never have imagined from a sitting BoE Governor”.
The inflation target works in theory because it acts as an anchor, a self-fulfilling virtuous circle where all players in an economy: workers, businesses, the markets, and the government, they all know that the aim is to hit the target, currently set at 2 per cent CPI. Now, the governor says or admits that the anchor is flexible.
Whilst this is not an abandonment of the target, I do think this will evoke a real political debate about the ongoing relevance of this target. Remember, actually setting the target is a political decision.
I think Faisal is completely correct to emphasise the political challenge thrown down by the Governor’s words.
The argument for central bank independence has traditionally relied on it being ‘instrument independent’ (i.e. it should have control of its policy levers and the ability to set interest rates) but ‘goal dependent’ (i.e. the target should not be set by the central bank).
The fifth guiding principle, so basic to democracy, that the public must be able to exercise control over government actions and so policymakers must be accountable, strongly suggests that the goals of monetary policy should be set by the elected government. In other words, a central bank should not be goal independent.
I couldn’t agree with this more principle more – if we are going to hand over control of monetary policy to unelected technocrats, we should at the very least have some say of what they are trying to achieve.
The Governor didn’t go into detail about exactly when it was acceptable to aim ‘off target’ or what the process would be – but at the very least one would hope it would be discussed with the Chancellor of the day. The notion that the Bank might decide to change its legally set target with out such consultation does raise ‘interesting’ questions.
As Paul Mason wrote back in January, ‘Central banks are part of the state’. Something that politicians often seemingly fail to acknowledge:
while there is much statistical information published by the central banks, and while some are now even putting themselves up for ritual grillings by journalists, it’s very hard to find a hard-edged discussion of the economic, political, diplomatic and strategic role of central banks within the current system. Politicians meanwhile often simply shrug their shoulders: “The bank’s independent, what’s it to do with me?” they ask.
Politicians are starting to discuss the limitations with the inflation target (see for example Ed Miliband’s recent speech to Policy Network) and potential problems with the Bank’s governance following the expansion of its role (both Ed Balls and Andrew Tyrie have been especially strong on this) and this is to be welcomed but this needs to be a bigger debate.
With QE and funding-for-lending the traditional divide between monetary and fiscal policy is breaking down, with the move towards macro-prudential risk management the Bank is taking on sweeping new powers and with a wide spread recognition setting in that inflation targeting may have reached its limits as policy framework, something needs to be designed to replace it.
But the debate so far has been almost exclusively amongst economists. We need to remember, as Paul put it, that ‘central banks are part of the state’ and this isn’t a debate that economists alone can resolve.