Charles Bean: Nominal income targets – an old wine in a new bottle Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England, at the Institute for Economic Affairs Conference on the State of the Economy, London, 27 February 2013. *  *  *  Good morning! The UK’s inflation targeting regime came into being just over 20 years ago, in the aftermath of sterling’s exit from the Exchange Rate Mechanism. On the surface, the first 15 years looked pretty successful, with steady growth and inflation close to target. But we now know that dangerous financial imbalances were developing below the surface, not only here but also in other advanced economies. Those fault-lines have been brutally exposed in the past five years, which saw the worst systemic financial crisis in a century, followed by a deep recession and a tepid recovery that has left output still some 3% below its previous peak. That experience has fuelled the debate over the extent to which central banks should lean against an asset-price and credit boom. Having discussed the issue elsewhere,1 I do not intend to dwell on it today, other than to say that I believe the right response to such threats is to rely primarily on the more active application of regulatory tools. But there will be occasions – when the excesses are building up outside the regulatory perimeter, for instance – when a more activist monetary policy leaning against the building financial imbalances will also be required.

While the nature of shocks and propagation mechanisms still largely remain on the battlefield of economic theory, empirically observed patterns and the consequences of the materialisation of risks necessitate our reaction, which should be based on our best knowledge and abilities. Allow me to get into more detail here. Optimal policy responses in a multi-country setting require a careful examination of real and financial cycles, both domestic and international. For that purpose, let us look at five important patterns that seem to characterise them. First, financial cycles seem to have a lower frequency and higher amplitudes compared to standard business (real) cycles. Credit and asset price cycles may take long to develop their potential to destabilize the financial system. Further on, such a potential may emerge regardless of watchful micro-prudential supervision or stable inflation. The resulting notion of systemic risk may be identified as the interplay of macroeconomic shocks that make financial sector vulnerable, the contagion resulting from financial interconnectedness and endogenous financial imbalances associated with credit booms, credit leverage and risk taking behaviour of financial institutions 3. Second, there are still no mechanisms in place to engineer sustainable synchronisation of cyclical movements across Europe. The question of cyclical synchronisation arises as particularly important within the international setting. This is the factor that makes policy responses even more complex, especially within a currency union such as the euro area, where the damage of suboptimal policy responses might exceed mere fiscal costs and output losses – they may threaten the future of the euro itself.