Leverage and Monetary Policy

You do not need me to stand here in Dublin this morning and tell you what profoundly difficult economic times we are going through. As an elderly New York friend of mine enquired of me recently when I offered such a thought “for such pearls we need economists?” I feebly replied that knowing how much of a mess you were in was of some use and (with rather more confidence) that thinking how you get out of the mess was something economics could help with. Today I want to talk about setting monetary policy as we emerge from one mess and how we can reduce the chances of getting into another one. I am going to focus on
the UK but I think much of what I say has relevance here in Ireland and beyond.
That it has been a very bad mess is clear. From the onset of the financial crisis that started towards the end of 2007 real output in the UK has fallen about 10% relative to the upward path it might have been expected to follow. In Ireland the fall in economic activity has been greater: the level of output is about 13% lower than at the end of 2007; if one had expected growth of 3% a year – significantly lower than the average in the preceding 10 years – output is now more than 20% below where it seemed likely to be. I want to ask two questions about monetary policy prompted by the financial crisis and the resultant recession. First, should we fundamentally re-think the inflation targeting framework for monetary policy? Is the focus on a target for consumer price inflation flawed? This is a long-term issue.
There is a second, in some ways more immediate, question. How should monetary policy be set now in what I hope it is not too optimistic to call the aftermath of the financial mess? In considering that issue I will be talking specifically about the UK, as befits a member of the Monetary Policy Committee (MPC) at the Bank of England. I want to start with the longer-term issue of the appropriate goals of monetary policy. The goals of monetary policy:

If one looks at the 10 years leading up to the onset of the crisis – which were also the first ten years of the Bank’s MPC – the outcomes for inflation and for aggregate economic growth in the UK were good. Inflation was – by historical standards – very low, very stable and close to the target. That had not been achieved at the expense of unusually low growth or high unemployment. In Ireland growth had been much stronger and inflation a bit higher. The
aggregate outcomes looked good in both countries (Charts 1-4). In the UK there was a strong consensus that having monetary policy directed at hitting an inflation target was sensible and that it had been successfully implemented.

For the full speech see: http://www.bankofengland.co.uk/publications/speeches/2010/speech451.pdf