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A Minsky moment for the BoE?

Will the Bank of England’s mandate to target low inflation become one of the casualties of the Great Recession?

Mainstream economic thinking is coming round to the view that targeting consumer price inflation is inadequate because it doesn’t allow (or even incentivise) policymakers to tackle emergent asset bubbles, excessive credit and current account imbalances. Hence it cannot secure macroeconomic stability or lasting prosperity. The case is well made by Stephen King, chief economist of the HSBC, in The Times (£) today and in a chapter from IPPR’s forthcoming book on new economic thinking by Tony Dolphin, our chief economist.

Followers of Hyman Minsky and other heterodox economists have been arguing for years that the pursuit of stable, low-inflation equilibria is a chimera of neoclassical economic models, but it has taken the financial crisis to bring the full force of those insights to bear, challenging the fundamentals of textbook economics. Yet although the Bank of England has been given a new macroprudential remit, via the creation of the financial policy committee, no political party is yet proposing to amend its core inflation mandate. As Tony Dolphin notes:

‘[T]he framework in which the [monetary policy committee, or MPC] operates has not changed. The governor is still writing letters to the chancellor every three months explaining why inflation is so far above its target rate and why the MPC feels no action is needed to bring it down. The presumption is that once the economy has recovered, quantitative easing will be reversed and the MPC will go back to nudging interest rates up and down in response to its best guess about growth and the output gap. The fact that this framework did nothing to prevent the deepest recession for almost 70 years and was thrown out in the crisis appears to count for nothing.’

Stephen King argues that the Bank of England could be given a remit to tackle emergent asset bubbles and current account imbalances by requiring the governor regularly to answer three key questions:

  1. is inflation at, or close, to target?
  2. if yes, has this achievement been accompanied by widening financial imbalances (excess credit growth, deteriorating balance of payments position etc)?
  3. what actions are additionally required to deal with said imbalances?

The Bank’s mandate could also be revised to embrace measures of inflation that best capture excess credit creation, suggesting a role for asset prices, notably house prices.

These would be important steps forward. But economists of the left have also long argued that the Bank of England should target both employment and inflation, as the US Federal Reserve does. Before 2008, the UK achieved high levels of employment without triggering higher inflation, and in present circumstances the danger of a 1970s-style wage-price inflation spiral is close to zero. So bringing employment levels into the Bank’s mandate should not be inimical to low inflation.

Importantly, full employment would also help to reduce macroeconomic instability, by providing higher levels of consumer demand for goods and services, taking the pressure off households to leverage themselves to maintain their living standards, and giving capital productive channels for investment, rather than the speculation that generates asset bubbles.

At present, interest rates are on the floor. They have fallen steadily since the early 1980s in the UK and the rest of the G7 and, at some point in the future, they will rise. Monetary policy will not be able to take as much strain as it has in the past in supporting economic demand following downturns. So in addition to counter-cyclical fiscal policy, new models of sustainable economic growth need to be developed. Employment will have to be at the heart of these.

G7 policy interest rate

G7 policy interest rate

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