-BOE King: Far too soon to bury inflation targeting
-BOE King: May have to ‘aim-off’ inflation target to lower crisis risk
-BOE King: Monetary policy cannot just mop up after a crisis

LONDON (MNI) – It is way too early to drop inflation targeting, but
there may be times when policy should “aim-off” the target in order to
reduce the risk of a financial crisis, Bank of England Governor Mervyn
King says in a speech at the London School of Economics.

King firmly rejects the view that the financial crisis has shown
inflation targeting has been a mistake, but he highlights its limits and
is sharply critical of some of the dogmas of pre-crisis monetary policy.
The BOE Governor says monetary policy cannot simply “mop-up” after a
crisis, and may have to aim to miss the inflation target at times.

He also stresses the importance of using macro-prudential tools to
try and reduce excessive risk taking and excessive leverage by financial
institutions.

The message from King’s speech on 20 years of inflation targeting
is that we should carry on with it but that on its own, and applied
simplistically, it is inadequate and the models policymakers having been
using are inadequate.

King looks at three examples where “a trade-off between monetary
policy and financial stability might arise” and concludes such a
trade-off is clearly possible.

The three examples are, firstly, misperceptions about future income
becoming embodied in key prices, for example when consumers drive up
prices by overestimating lifetime earnings.

He says the Eurozone provides just one example of over optimistic
assumptions about future spending power and “when those misperceptions
are eventually corrected they lead to sudden changes in asset values, a
synchronised de-leveraging of balance sheets, a large downward
correction to spending and output and defaults.”

King says in theory policymakers could act to tackle such problems,
but such action would be fraught with uncertainty.

“If policymakers can, first, identify misperceptions and, second,
correct them by changes in monetary policy – both highly uncertain
empirically – then there is indeed a trade-off between hitting the
inflation target and reducing the chance of a financial crisis down the
road,” he says.

Another problem where policymakers could “aim-off” the inflation is
to tackle the “cycle of confidence”, where success breeds
over-confidence and eventually collapse in the financial system.

King says here, rather than believing monetary policy can offset
all shocks, policymakers should look to strengthen and protect key parts
of the financial system. Such thinking is embedded in plans to force
banks to build up capital buffers and ringfence investment and retail
banking.

The third example King gives is where long periods of low interest
rates boost the “search for yield” and encourage investors to take
higher risks to secure the returns they want.

“The examples I have given suggest the possibility that there is a
trade-off between meeting the inflation target in the short-run and
reducing the risk of a financial crisis in the long run,” King says.

Accepting such a trade-off does not, however, entail dropping
inflation targeting.

“It is far too soon to bury inflation targeting. Together with
central bank independence it played a key role in bringing price
stability to the UK,” King says.

He instead urges the next generation of economists “to rethink the
foundations of macroeconomic theories,” and acknowledge that current
models are “seriously incomplete” in the way they factor in decision
making when economic actors are faced with uncertainty.

He also highlights the failure of economic models to incorporate
fully, if at all, monetary transmission channels.

The speech, on policy frameworks, makes no explicit reference to
the current economic and policy conjuncture here.

-London Bureau; Tel: +44207862 7491; email:drobinson@marketnews.com

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