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Inflation Targeting: Learning the lessons from the financial crisis

On Tuesday of this week, Spencer Dale, Executive Director and Chief Economist at the Bank of England, used the above title as his talk to the Society of Business Economists, and I will try to summarise his main themes.

 

He noted that the sudden end to a long period of economic stability has led to the inflation targeting framework to be questioned. The Bank had cut interest rates by 4.5 percentage points in just six months, which was twice the size of any reduction made by any other G7 central bank over the past eighteen months. Also, the MPC had decided to purchase £125bn of assets financed by issuing central bank money, which was equivalent to around 9% of annual GDP. It was this “courageous” action which showed the strength of inflation targeting.

 

He stated that the current inflation targeting framework should continue to be central to the design of macroeconomic policy in the UK, but that it was not sufficient in itself to counter asset price rises and economic bubbles as we have seen recently. It has been suggested that the Bank take note of such developing movements in the future, but this may mean making interest rate movements against a perceived problem which might take years to reveal itself to the nation. Such a policy would be difficult to operate in practice – something he calls ‘leaning against the wind’.

What lessons have been learned from the financial crisis?

What lessons have been learned from the financial crisis?

 

He asks, at which point did it become clear that sub-prime lending had ceased to be a beneficial financial innovation to allow those who found access to credit difficult the chance to buy their own house, and instead become a source of international financial instability? Such judgements involve “second guessing” outcomes generated by financial and economic markets. He therefore argues that “leaning against the wind” to prevent a bubble inflating might seem that the Bank was responding to phantom concerns. The required policy of raising interest rates, undershooting the inflation target and inflicting what would appear unnecessary economic hardship would undermine faith in the inflation target and the MPC.

 

He thus argues that a range of new instruments will be required to deal with asset price bubbles and economic imbalances and allow interest rates to be the primary tool to hit the inflation target in the short-to-medium term.

 

He also looked at some criticisms of the Bank’s asset purchase programme. One of these criticisms was that these purchases have been too heavily skewed towards gilts and that more private sector debt should have been bought. However, he argues that given the modest size of corporate credit markets, such purchasing would not have improved their functioning, and large scale asset purchases could risk crowding out private debt markets.

 

A second criticism was that some of the gilts purchased have been from foreign investors and that these funds would not have been allocated back into sterling assets. He argues that even if that were the case there is still the effect of a lower exchange rate as sellers sell sterling to buy assets in other currencies and that this is a key channel through which the monetary easing may be transmitted.

 

The final criticism he deals with concerns the need to articulate an exit strategy by the MPC. He says that the when economic prospects recover, the MPC can tighten policy both by raising Bank Rate and selling assets. The most difficult issue concerning an exit strategy is the question of timing as far as tightening policy is concerned. He says: “Although that decision will be highly uncertain and subject to intense scrutiny, the strategy guiding the decision – and the primacy of the inflation target within that strategy – should be clear.”

 

To read the full speech, click here.

 

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Posted in Bank of England, Banking, crowding out, Exchange Rates, Interest rates, Monetary Policy Committee, sterling

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