Bank of England Governor Mervyn King embraces the Bank of Japan's recently introduced 2-percent inflation target, calling the move "perfectly reasonable."
But the man who has stuck to such targets for nearly 10 years in office told The Asahi Shimbun that a bigger challenge for the central banks of Japan, the United States and Europe is whether they can find enough policy instruments to achieve a recovery and then steer zero interest rates to reasonable levels and normalize their bloated balance sheets.
King, known for taking the lead in the BOE's introduction in 1992 of an explicit target for inflation, warned that monetary policy is not a "panacea" and urged politicians in the industrialized world to understand the limits and refrain from putting political pressure on central banks. What political leaders should understand is the importance of supply-side policies to help bring about a recovery in demand, King added.
In an exclusive interview in Tokyo, his first with a Japanese media organization, King, who has been BOE chief since July 2003, discusses a wide range of monetary issues, including lessons from the BOE's inflation targeting policy and the role of central banks.
Excerpts of the interview follow:
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Question: In 1992, as chief economist at the Bank of England, why did you advise the British government to adopt inflation targeting?
Answer: At that time, Britain pulled out of the exchange rate mechanism, which was designed virtually to fix the levels of currencies toward a united currency system in Europe. The departure from the exchange rate mechanism was a traumatic experience. It was not something the United Kingdom wanted to happen, and it happened. So we had to find a new policy framework for monetary policy very quickly.
All through my career, I have had one simple principle for policy: Keep it simple. The inflation target had the enormous attractions to me of making very clear what the objective of policy was, while creating a framework of what I called “constrained discretion.” We were constrained to be transparent, to explain and to be accountable for our performance on inflation and to come up with good arguments.
If we had good arguments for taking longer to bring inflation back, then they would convince people. It gave us constrained discretion to bring inflation back to target over a flexible period and measure.
Q: It’s been 20 years since then. Have you been successful on inflation targeting?
A: During the past 20 years, annual consumer price inflation in the U.K. has averaged 2.1 percent, remarkably close to the 2-percent target and well below the averages of over 12 percent a year in the ’70s and nearly 6 percent a year in the ’80s. Inflation targeting has spread to more than 30 countries. We should not forget the benefits from the fact that the central bank’s goal is stabilizing prices.
But after 15 years of apparent success, the past five years of financial crisis and turmoil in the world economy have raised serious questions about the adequacy of inflation targeting. In Britain, total output is today some 15 percent below an extrapolation of its pre-crisis trend. In order to avoid a bubble economy, there might be some circumstances where a monetary policy allowing price levels below the target is accepted. But it is more important to prevent excessive growth in asset prices, meaning a bubble economy, by adopting macroprudential policies.
Q: In January, the Bank of Japan adopted inflation targeting in which the bank sets a clear inflation target at 2 percent a year, rather than maintaining a “guideline” at 1 percent. How do you view that move?
A: I think it’s perfectly reasonable to have an explicit inflation target. I think the challenge is: What are the policy instruments to bring inflation up to the target?
The problem that central banks around the world face today is the problem of finding enough policy instruments to achieve a recovery. That’s the big problem that we face, and it is why we ought to be worried about how we are going to get back to normal levels of interest rates.
Japan has had zero percent interest rates for a very long time. It’s had a very large balance sheet for a long time. We in Britain have had low interest rates and a large balance sheet for five years. I don’t know for how long we’ll have low interest rates and a large balance sheet. But I do know that we need to get back to normal sooner rather than later, and I think the big challenge at present is not so much the target as the instruments that we should use to get back to normal.
Q: Politicians around the world are now putting pressure on central banks to loosen their monetary policies.
A: I think in every industrialized economy after this crisis, central banks came under political pressure. I think that particularly where governments felt constrained by their ability to use fiscal policy, because of the size of government debts, it was natural that they would then put pressure on the central bank.
But I think politicians need to understand the limits of monetary policy. Monetary policy is not a panacea. Monetary policy supports demand and output by encouraging households and businesses to switch demand from tomorrow to today. But when tomorrow becomes today, an even larger stimulus is required to bring forward more spending from the future. Obviously, this cannot continue indefinitely.
I think governments in the industrialized world do need to understand the importance of supply-side policies, such as deregulation, in order to ensure that demand will recover, not just in order to make the economy more efficient, but as a mechanism for supporting current demand.
Q: A deflationary spiral obviously depresses the economy. In Japan, pundits are divided on whether very small-size deflation, say a price fall of less than 1 percent a year, could have a depressing effect on the economy. What do you think?
A: I think it is very hard to believe that a very low rate of deflation can have a significant depressing effect. I think the big lesson from the last 20 years is that when you need to get a big change in the equilibrium of the economy, then you need big structural changes, and they are quite hard to bring about.
When inflation is occurring, it is a central bank’s role to take away the punch bowl before the party gets going. But it does not make sense to take independence away from the central bank when you want the central bank to create money under deflation. The challenge facing the economy is not one that monetary policy can easily solve. Other policies need to solve it.
Q: In your January speech, you expressed concerns over “currency wars,” in which countries are seeking to devalue their currencies to maintain their competitiveness in exports. Were you trying to criticize Japan’s monetary policy?
A: No. I think the communiqué published by the G-7 was very carefully designed to make three points. First of all, we don’t target our exchange rates.
Secondly, we don’t intervene in our exchange rates unless in exceptional circumstances there is a consensus among all the countries that we need to do something to adjust exchange rates.
And the third thing is that where countries take domestic policy measures to stimulate their economy, we accept the exchange rate consequences of that.
Those are main messages the G-7 wanted to put out, and that seemed to me completely consistent with what Japan did.
Q: If we continue competitive easing of monetary policy worldwide in advanced countries, what do you think will be the most likely outcome? Could it lead to hyperinflation?
A: The United States is easing monetary policy in order to stimulate the U.S. economy, not in order to get some competitive advantage, and that’s true I think of all the major central banks around the world. If we go on doing it for too long and we create too much money, then we will generate inflation. But I don’t think there’s any immediate threat of that. If you look at the growth rates of “broad money,” or money supply, around the world, I don’t see the immediate threat as being too much inflation.
We are watching very carefully, and if we felt that we would generate too much inflation by creating too much money, then we’d stop immediately.
Q: But history shows that it would cause a disaster if central banks buy government bonds limitlessly. How do you respond to that?
A: It is important to distinguish between “good” and “bad” money creation. “Good” money creation is where an independent central bank creates enough money in the economy to achieve price stability. “Bad” money creation is where the government chooses the amount of money that is created in order to finance its expenditure.
The only thing that stops the good money creation from going too far into bad money creation and inflation is the independence of the central bank with its commitment to price stability. It is the independence of the bank that allows us to create money without raising doubts about our motives.
Q: Even if the independence of central banks is important, they should not behave like monarchs. How can they achieve a balance between their independence and democracy?
A: The central bank is not independent completely, in the sense that it can do whatever it wants to do. In your word, it’s not a “monarch.” Their independence is very subtle. Equally, it’s very important that people understand the central bank belongs to society as a whole. Public support for the central bank is important.
The central bank is not an organization which only does things the government wants it to do. What you need to avoid are politicians saying one thing in public and then doing a different thing in private to the central bank. The central bank has to be able to maintain sufficient independence and transparency that it can resist pressure from the government.
As central bank governors, I think most of my colleagues in advanced countries are in the same position. We are not there to be popular. We are not there to say things that people like. We are there to do what we think is right to realize sustainable economic growth.
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Mervyn King is the Bank of England governor and chairman of the Monetary Policy Committee and Financial Policy Committee. He was previously deputy BOE governor from 1998 to 2003, and chief economist and executive director from 1991. Born in 1948, King studied at King’s College, Cambridge and Harvard (as a Kennedy Scholar) and taught at Cambridge and Birmingham Universities before spells as a visiting professor at both Harvard University and the Massachusetts Institute of Technology. From October 1984, he was professor of economics at the London School of Economics, where he founded the Financial Markets Group. He is scheduled to step down as BOE chief in June.
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