Mervyn King: Monetary policy - many targets, many instruments. Where do we stand?
Remarks by Mr Mervyn King, Governor of the Bank of England, at the IMF Conference on
"Rethinking macro policy II: first steps and early lessons", Washington DC, 16 April 2013.
* * *
I would like to thank Charlie Bean, Alex Brazier, Spencer Dale, Andy Haldane and Iain de Weymarn for helpful
comments and suggestions in preparing these remarks; and in particular Tim Taylor who I regard as a co-author,
although he is absolved of any errors in the current draft.
Introduction
The past five years has been an extraordinary period for central banks. The breadth and
scale of our operations has expanded in ways that were previously unimaginable as we
responded to a crisis in the banking sector and the wider economy. In monetary policy, we
have moved into uncharted territory. But has our notion of what central banks should do, and
how, changed? Now is a good time to reflect on where we stand.
I want to focus my remarks on two areas. First, I want to draw out what have we learned
about the objectives of monetary policy. Second, I want to reflect on the implications of the
proliferation of instruments that have been used to meet those objectives.
Objectives
For over thirty years the objective of central banks was clear. It was to set monetary policy to
achieve long-run price stability. But the events of the past five years have raised questions
about how central banks manage the trade-offs between price stability, output stability and
financial stability in order to meet our overall macroeconomic objectives.
Throughout the era of inflation targeting, the importance of the trade-off between output and
inflation stabilisation in the short term has been well understood. Monetary policy was seen
as aiming at a target for inflation in the long run, which was to be achieved by bringing
inflation back to target over a suitable time horizon so as to avoid excessive volatility of real
variables such as output and employment. Optimal monetary policy was seen as a choice of
how best to navigate the short-run trade-off while ensuring that the long-run objective was
met.
Failure to deliver price stability is costly, as UK experience amply demonstrates. Chart 1
shows the variance of inflation and of the output gap in the UK, using quarterly data for two
periods.1 Contrast the performance in the 35 years up to 1992 with the first 15 years of
inflation targeting. Better policy can take some credit for this improvement, as the anchoring
of inflation expectations led to a huge reduction in inflation volatility.
It was tempting to think that we had moved onto the "Taylor frontier" - which maps feasible
combinations of the smallest variances of the output gap and inflation. The Great Stability
appeared to be a permanent break from earlier periods - periods when monetary policy
exhibited more unpredictable behaviour and left the economy to the north-east of the Taylor
frontier (Chart 2). And in one important sense it was - the dark days of double-digit inflation
were consigned to the past.
But the Great Stability was not representative of a new normal. The variance of the output
gap - though not inflation - has been much higher over the past five years as the financial
crisis generated a deep recession (Chart 3). So what have we learned?
The banking and broader economic crisis has demonstrated that macroeconomic policy can
face an additional trade-off between ensuring the soundness of the financial system in the
medium term, and keeping output in line with potential output and inflation on target in the
near term. Such a trade-off arises because financial vulnerabilities can build even while
output is growing steadily and inflation is low and stable.
Let me give three examples of the sort of underlying mechanisms at play. First, persistent
misperceptions of future spending power may generate a mix of demand that proves to be
unsustainable. I believe this was an important factor underlying the crisis. Although output in
deficit countries - like the UK - appeared to be growing at a sustainable rate, that gave a
misleading impression of the sustainability of the Great Stability. In fact the level of domestic
demand was too high and the level of net exports correspondingly too weak. Second, as
Hyman Minsky described, periods of stability encourage exuberance in credit markets,
leading eventually to instability. And third, low short-term policy rates may encourage
investors to take on more risk than they would otherwise accept as they "search for yield".
It is arguable that monetary policy paid insufficient heed to the potential impact of such
financial vulnerabilities. Financial shocks are costly because their effects can be too rapid for
policy easily to offset, and because they hit potential supply so creating a trade-off between
output and inflation. In other words, the Taylor frontier is less favourable (further from the
origin), when account is taken of financial shocks, than we might have believed. Taking the
entire period of inflation targeting - including the recent past - might give a more accurate
indication of where this "Minsky-Taylor" frontier lies than using data for the Great Stability
period alone (Chart 4).
What implications does this have for monetary policy? Possibly none - if we can rely now on
macroprudential tools to ensure financial sector resilience. But set those tools to one side for
a moment. Monetary policy could be used to reach a point more like P in Chart 5, with less
variation in the output gap and more variation in inflation than we have actually experienced
over the past 20 years. Put another way, higher interest rates in the run up to the financial
crisis might have reduced the impact of the subsequent bust, at the cost of below-target
inflation and below-trend output before the crisis hit.2
In practice new macroprudential tools and better micro-prudential supervision will improve
the possibilities available to monetary policymakers. Having additional instruments in effect
brings about a favourable shift in the Minsky-Taylor frontier (or surface) which defines the
possibilities open to policymakers.3
Nevertheless, consistent with the new remit4 given to the Monetary Policy Committee by the
UK Government last month, the experience of recent years suggests that there may be
2
A more detailed appraisal of this argument is contained in "Twenty years of inflation targeting", a speech by
Mervyn King (2012), available at http://www.bankofengland.co.uk/publications/Pages/speeches/2012/606.aspx.
3
A social planner would use both instruments together to pick the welfare maximising point on the frontier /
surface, and in the UK the Monetary Policy Committee is expected to work closely with the Financial Policy
Committee which has the statutory power to deploy macro-prudential instruments.
4
The relevant passage in the Monetary Policy Committee's remit states: "Circumstances may also arise in
which attempts to keep inflation at the inflation target could exacerbate the development of imbalances that
the Financial Policy Committee may judge to represent a potential risk to financial stability. The Financial
Policy Committee's macro-prudential tools are the first line of defence against such risks, but in these
circumstances the Committee may wish to allow inflation to deviate from the target temporarily, consistent with
its need to have regard to the policy actions of the Financial Policy Committee. The full remit is available here:
http://www.hm-treasury.gov.uk/d/chx_letter_to_boe_monetary_policy_framework_200313.pdf.
circumstances in which it is justified to aim off the inflation target for a while in order to
moderate the risk of financial crises.
Instruments
For institutions generally regarded as conservative or even hidebound, central banks have
been remarkably innovative in their creation of new instruments during the crisis. Lowering
official interest rates virtually to zero was extraordinary in itself. But the wholesale redesign of
frameworks to supply liquidity to the banking system, the expansion of the monetary base by
multiples of its pre-crisis level through the purchase of assets held by the non-bank private
sector, and the involvement of central banks in risky credit easing operations have all raised
serious questions about the role of central banks - and even challenged the idea of central
bank independence.
Table 1 shows just how large has been the scale of central bank expansion. The monetary
base has risen by unprecedented proportions as we tried to prevent a collapse of broad
money and credit as happened in the US during the Great Depression and today in Greece.
And central bank balance sheets have risen across the industrialised world, as shown in
Table 2. That expansion has reflected both money creation through asset purchases and
lending against collateral. All major central banks have created new ways to lend against
collateral.5 Far from their image as conservative creatures, are central banks at risk of
throwing their traditional caution to the wind and ignoring the limits on monetary policy?
Two limits are relevant in current circumstances. First, no matter how much liquidity is thrown
at the banking system, lending and the economy will not recover if the banking system is
inadequately capitalised and suffering from excessive leverage. That is why the Bank of
England's Financial Policy Committee has placed weight on the need for the weaker UK
banks to raise capital. It is not surprising that the more strongly capitalised banks in the UK
are expanding lending and the poorly capitalised banks are contracting lending.
Second, there are limits on the ability of domestic monetary policy to expand real demand in
the face of the need for changes in the real equilibrium of the economy. I do not believe that
the present problems in the United Kingdom stem only from a large negative shock to
aggregate demand. In common with many other countries, our problems also reflect the
underlying need to rebalance our economy, requiring a reallocation of resources both within
and between nations. It is not simply a question of boosting aggregate demand, but of
helping to bring about a shift to a new equilibrium. That in turn implies the need for both large
changes in relative prices, especially between tradable and non-tradable goods and services,
and a shift in the relative levels of domestic demand at home and overseas. There are,
therefore, limits on what any one country's domestic monetary policies can achieve without
the support of others.
Despite these limits, circumstances have demanded that central banks take extraordinary
measures. Such measures can risk moving into territory more normally associated with fiscal
policy and, in doing so, put at risk their hard-won independence. There are, it seems to me,
three threats to central bank independence.
First, there is the risk of appearing to promise too much or allowing too much to be expected
of us. With constraints on other policy instruments, central banks are seen as "the only game
in town". But failure to make clear the limits to monetary policy risks disillusionment with
central banks and the inevitable political pressure on them that would follow.
Second, at the zero lower bound there is no clear distinction between monetary and fiscal
policy. But it is still important to ensure that central banks do not take on to their balance
sheets risks to the taxpayer that are properly matters that should be decided by elected
politicians. To ensure price stability in the long run it is vital to maintain the operational
independence of a central bank. Any decisions that put taxpayers' money at risk must be
made by finance ministries, and central banks must protect their balance sheets by imposing
appropriate haircuts on collateral, and avoiding the purchase of risky private-sector assets.
Third, and important even when we move away from the zero lower bound, the expansion of
central bank responsibilities to include macroprudential policy and, in the case of the Bank of
England, responsibility for regulating the banking system, has made independence much
harder to define. The deployment of responsibilities outside monetary policy cannot be
divorced from the government in the same way as is possible for monetary policy. For
example, in the area of financial stability and banking supervision, there will be times when
public funds may be put at risk when rescuing or resolving a failing institution - and that
decision is properly one for the finance ministry. It is far from straightforward for a central
bank governor to be completely independent in terms of monetary policy, somewhat
independent in terms of financial stability, and not at all independent in terms of operations
that risk taxpayers' money.
The financial crisis has challenged our understanding of the objectives of monetary policy
and exposed its limits. And, through the proliferation of instruments and resulting increase in
responsibilities, it has complicated the question of central bank independence. So how
should we respond to this more complex environment? We must keep sight of three
important principles. First, although they should be realistic about what can be achieved, it is
right that elected politicians and parliaments decide on the objectives of policy. Second, as
we learned in the 1970s, if the central bank is to achieve price stability - its fundamental role
- it must be sufficiently independent. And third, in order to protect that independence, its
limits should be very clearly circumscribed, and we should be exceptionally careful with
decisions that put public funds at risk.
The challenge remains, as it was twenty years ago, to make "constrained discretion" work in
practice. But it has got harder.
Chart 1: UK inflation and output gap variances
3
1958-1992
2
variance
1
Inflation
1993-2007
0
0 1 2 3
Output gap variance
Chart 2: The UK's pre-crisis trade-off?
3
1958-1992
Stylised 'Taylor frontier'
2
variance
1
Inflation
Chart 3: The 'Great Stability' and crisis periods
3
1958-1992
2
variance
1
Inflation
2008-2012
1993-2007
0
0 1 2 3
Output gap variance
Chart 4: The true trade-off for the UK over 20 years?
3
1958-1992
2
variance
1
Inflation
1993-2012
2008-2012
Chart 5: A preferable outcome?
3
1958-1992
2
variance
1
Inflation
P
1993-2012
2008-2012
1993-2007
0
0 1 2 3
Output gap variance
Table 1: Monetary base
Data are month averages for UK, US, Japan and end month for the euro area. Sources: Bank of England,
Federal Reserve, Bank of Japan, ECB.
Table 2: Size of central bank balance sheets
UK US Japan Euro area
Mar 2013
26 19 34 31
(% nominal GDP)
Increase since Dec 2007
20 12 13 18
(pp of nominal GDP)
Sources: Datastream, Bank of Japan.
BIS central bankers' speeches