Sir Mervyn King, the Governor of the Bank of England has suggested in a speech that the central bank could drop inflation targeting from being the central focus of monetary policy.
He said that in certain circumstances the central bank should have the freedom to move away from an inflation target in order to protect against the dangers of a future financial crisis.
Sir Mervyn said: "It would be sensible to recognise 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."
In a speech to mark the 20th anniversary that the bank has focused on inflation targeting, Governor King characterised this period as “fifteen years of stability and five years of turbulence – the Great Stability and the Great Recession”.
By focusing on trying to keep inflation in check, the UK averaged an inflation rate of just 2.1 per cent over the past 20 years. Sir Mervyn asks “did we pay too high a price for this achievement?”
The governor admitted that “the past five years of financial crisis and turmoil in the world economy have raised serious questions about the adequacy of inflation targeting”.
Sir Mervyn explored whether the events of the last five years and before that in the build up to the financial crisis led to him to ask the question “should monetary policy go beyond targeting price stability and also target financial stability?”
He introduced three potential factors as to why chasing an inflation target in the short-term could increase the possibility of financial instability in the longer term.
Firstly, Sir Mervyn argues that misconceptions over the future direction of the economy can lead households, banks and firms can lead to unsustainable spending where high debt levels can quickly build up.
Sir Mervyn argues that “when those misperceptions are eventually corrected, they lead to sudden large changes in asset values, a synchronised de-leveraging of balance sheets, a large downward correction to spending and output, and defaults”.
Secondly, he says that the stability seen in the 15 years since 1992 “bred complacency about future risks”. Partly as a result, “the leverage of our banking system rose to unprecedented levels”.
Thirdly, he argues that monetary policy itself could influence financial sector risk taking. “Short-term policy rates, especially when they are, as now, exceptionally low, may encourage investors to take on more risk than they would otherwise wish as they ‘search for yield’ ”, he said.
Following his speech, in a Q&A session, the governor warned that monetary policy cannot be used as a support to the UK economy forever and that an export-led recovery of the economy will be particularly difficult to achieve when most other countries are attempting to achieve the same thing.
Talking about how long the Bank of England could follow its programme of quantitative easing, Sir Mervyn said: "There is no technical limit on the asset purchases but I think there is a deeper question about whether there are limits to what monetary policy as such can do."
"It's still the case that there are significant imbalances, particularly within the euro area, but also in other parts of the world economy. The strategy of reducing domestic spending and relying more on external demand is facing a real problem because not everyone can do it at the same time."
Sir Mervyn said that in future, macroprudential regulatory tools could be used to defend against a future financial crisis, where the aim would be to regulate overall banking systems rather than individual banks.