The time-inconsistency problem that pervades the debate over the balance between rules and discretion in monetary policy (Kydland and Prescott (1977), Barro and Gordon (1983)) is arguably even more acute for prudential policy. This is partly because adverse crisis outcomes are highly non-linear and costly, making it more difficult to pre-commit to avoiding forbearance and bail-out. The low probability of crises may also mean that policymakers are insufficiently tough in tackling financial sector risks when times are good and memories of previous crises distant (Reinhart and Rogoff (2009), Malmendier and Nagel (2011), Gennaioli et al (2015)). This can create political pressures to relax regulations to support shorter-term goals. Public choice theory (Olson (1965)) would also suggest that lobbying pressure is likely to be more acute for regulatory policy than for monetary policy. The private costs of regulation are borne strongly by narrow, but 26  All speeches are available online at www.bankofengland.co.uk/speeches  26  powerful, interest groups in the financial industry. And while higher than target inflation is quickly observable, it may be very difficult to judge in real time that regulation is insufficiently stringent given the difficulties of quantifying the probability of future financial crises. These arguments point to the need for strong institutional frameworks, supported by clear mandates, objectives and instruments, to deliver financial stability policy. Indeed, on conceptual grounds, the need for such a framework appears to be at least as strong, if not stronger, than for monetary policy.

Similarly, the changes in the composition of labour contracts that I mentioned earlier are likely to imply that inflationary pressures might take longer than usual to build up. We need to factor this information into our policy deliberations. At the same time, we need to monitor carefully developments in long-term unemployment, labour force participation rates and hours worked with a view to informing our assessment on the likely evolution of structural unemployment. Should the share of long-term unemployed stabilise at one point, with no convincing signs of further likely downward adjustments, the risks of inflationary pressures starting to emerge at higher levels of unemployment would increase. At this point – when scratches indeed become scars – the level of slack relevant for determining medium-term price stability would decline. Policymakers would therefore need to start tightening policy earlier to remain faithful to their primary mandate. As I mentioned in my introduction, however, there are some who argue that such a response would be premature, since if hysteresis effects can be caused by lack of demand, then they can equally be reversed by excess demand. In a high-pressure economy, for example, firms might be encouraged to dig deeper into the labour market to find recruits, thereby reactivating and retraining some of those workers who were previously thought to be unemployable. Glenn Rudebusch and John Williams therefore conclude that optimal monetary policy would allow inflation to overshoot its target.13 I have some doubts about this view, mainly for two reasons.