Bank of England Governor Mervyn King said inflation targeting has served the U.K. well over two decades and should remain at the heart of monetary policy as officials take on powers to ensure financial stability.
“The case for price stability is as strong today as it was 20 years ago,” King said in a speech at the London School of Economics in the U.K. capital today. “The key principles underlying flexible inflation targeting are credibility, predictability and transparency of decision-taking, and they will remain the cornerstone of successful monetary policy.”
King’s comments reviewed 20 years coinciding with the time he spent helping to build the current regime, delivered just as the central bank takes on unprecedented powers over the banking system and regulation. King, whose tenure is now drawing to a close, fought back against suggestions that policy makers were clearly wrong to have kept interest rates as low as they did before the financial crisis struck in 2007.
“The big challenge to monetary policy before the crisis was a serious mispricing in long-term interest and exchange rates,” King said. “It is arguable, though not certain, that in the absence of a macro-prudential regime or tighter fiscal policy, persistently higher interest rates might have been a second-best strategy. It would though have been a big gamble.”
King, in a defense of the U.K.’s inflation targeting, pointed to the improvement in the credibility of monetary policy in the past two decades. He highlighted inflation expectations as measured by the difference between yields conventional and index-linked gilts. In 1992, it was close 6 percent, while today it is around 2.5 percent.
“Predictability of the price level is greater because over a long period inflation has on average been close to the target,” King said. “Even if inflation deviates from target -- as will often be the case -- it is expected to return to target, and so inflation expectations are anchored. That is why since 2007 the U.K. has been able to absorb the largest depreciation of sterling since the Second World War.”
King said that macro-prudential tools that the central bank will gain would have helped to mitigate “excessive leverage and risk taking in the banking and wider financial sector” though it would be “optimistic” to rely on them alone in future.
“It would be sensible to recognize 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,” he said. “Monetary policy cannot just ‘mop up’ after a crisis.”
King said that it is “too soon to bury ” inflation targeting, which played a key role in bringing price stability to the U.K.
“We forget the lessons of the 1970s and 1980s at our peril,” he said. “In the end, the essence of central banking is to maintain confidence in, and the value of, paper money.”
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