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Inflation? No, Growth Says Bank of England

New governor Mark Carney swaps price stability for economic growth...
THERE were some positive aspects of Mark Carney's first speech as the new Bank of England Governor in Nottingham last week, writes former Bank of England member Andrew Sentance on his Hawk Talks blog, in an article first published by City AM.
It was broadcast over the internet. He took questions from the audience and then gave a press conference afterwards. All this was accessible to the public at large via the Bank of England's website. This is a more open and media-friendly style of governorship – showing the Bank is moving with the times in terms of its communications strategy.
But the content of the speech was more worrying for those who suspect that the Bank of England is drifting away from its objective of targeting low inflation. Yes, the inflation target was mentioned from time to time. But Carney's speech made clear that monetary policy is now being directed to support economic growth – and this is the primary motivation behind the new policy of "forward guidance", shorthand for keeping interest rates at current extremely low levels.
Monetary policy can support growth by helping the economy ride out a financial storm, as we saw in late 2008 and 2009. Then, central bankers around the world showed that they had learned the lessons of the 1930s when their predecessors were reluctant to ease monetary policy in the face of a major financial crisis. In 2009, emergency monetary policies – dramatic interest rate cuts and Quantitative Easing – succeeded in stabilising economies and providing a platform for a return to growth.
But this encouraged central bankers to believe that they could do even more to support growth – despite the fact that the monetary accelerator was already pressed hard to the floor with interest rates at near-zero levels. This is unrealistic. There are limits to what monetary policy can achieve in supporting growth and the longer the time frame becomes, the less effective it is likely to be.
Conventional economic theory suggests that the main effect of changing monetary policy is "intertemporal substitution" – economic-speak for shifting spending to/from the future. When interest rates are raised, individuals and businesses postpone spending. And when rates are cut, spending is brought forward. But this trick cannot be repeated indefinitely. Once interest rates have been cut to near-zero, borrowers have brought forward as much spending as they would like. And once the realisation of a near-zero interest rates world is appreciated by savers, they are likely to cut back on spending as their interest income declines, countering the growth benefits of the low interest rate policy.
So even though the objective of the new monetary policy of "forward guidance" is to support growth by promising continued exceptionally low interest rates – it may not be effective and might even be counter-productive. Indeed, the financial market reaction to recent Bank of England statements has been to push up longer-term interest rates. This is a worrying response as it suggests that the new policy of "forward guidance" lacks credibility – perhaps because stronger growth, higher inflation or rising interest rates globally will knock the policy off course.
Monetary policy should do what it says on the tin – controlling the value of money, and maintaining price stability. Once it strays into the territory of trying to fine-tune economic growth, there are dangers ahead, as we discovered when inflation ran out of control in the 1970s and when loose monetary policy supported the credit boom which preceded the recent financial crisis. Let us hope we are not going to make the same mistake again under the Bank of England's new policy of "forward guidance".

Now senior economic advisor to PricewaterhouseCoopers and part-time professor of sustainable economics at the University of Warwick in England, Andrew Sentance is a British business economist who from 2006 to 2011 served on the Bank of England's Monetary Policy Committee. Consistently calling for higher interest rates to combat rising inflation during his last 12 months in the role – and overwhelmingly outvoted each time – Dr. Sentance today shares his views on macroeconomic and monetary developments in his weekly blog, The Hawk Talks. His previous roles include senior economist at the Confederation of British Industry (CBI), chief economic advisor to the British Retail Consortium, and chief economist at British Airways.

See full archive of Andrew Sentance articles

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