News Release
Monetary Stability; Rhyme or Reason?
17 October 1996
The Economic and Social Research Council Annual Lecture by Mervyn King
"Inflation is [also] an unnecessary problem. There are far more important real economic problems which face us. Few people enter politics to keep inflation low. Nor should we expect them to do so. Price stability should be part of our economic constitution, common to all parties, which provides a degree of macroeconomic stability to enable governments to devote both the time and energy to debate the great issues of the day."
In this lecture, Mervyn King reviews the intellectual and policy framework which allowed inflation to reach unprecedented levels in the post-war period, analyses the costs of inflation, and argues that a successful monetary policy regime must have at its heart a credible commitment to price stability.
He quotes Kaldor:
"a slow and steady rate of inflation provides a most powerful aid to the attainment of a steady rate of economic progress".
"The flaw in the argument is the implicit assumption that saving rates out of nominal incomes would not change with inflation. Yet in the 1970s that is exactly what happened. Kaldor's view that a little inflation each year is good for growth depended entirely on the ability of monetary authorities to fool investors and savers most of the time. As we have learned to our cost, that is not possible. More generally the failure was to ignore inflation expectations as important determinants of economic behaviour that would respond to changes in the monetary policy regime. It is surprising that those who professed to follow in the footsteps of Keynes ignored both money and expectations to such an extent."
Some economists saw the dangers of creeping inflation:
"And, even when concern translated itself into action, it took the form of trying to suppress the symptom - controls over wages through a series of incomes policies promoted by Conservative and Labour governments alike - rather than tackling the cause itself - too fast growth of nominal demand. One cannot blame politicians for these failures. Alec Cairncross' recent history of economic policy in the 1960s is an indictment of the intellectual framework provided by many economists to policy makers at that time. It is impossible now to read Reginald Maudling's 1963 and 64 Budget speeches without a sense of impending doom. The Budgets were framed to achieve a target rate of growth of 4% a year - well above any previous experience of sustained growth - which, said the Chancellor, "can be attained, and attained without any strain upon our currency, if we as a nation have the will to achieve it". Even in the best of times the will of the nation is no substitute for monetary policy. Economic policy was based on a sort of inverse Say's law - supply would expand to meet the demand created for it."
And the inflation experience of the 1970s could not be blamed on the Oil shock:
"Inflation in the 1970s cannot be blamed solely on supply shocks, especially the rise in oil prices. Inflation had already risen before those shocks occurred. By the early 1970s underlying inflation was over 5% in the US and over 10% in Britain. There was a case for accommodating the oil price shock as a one-off rise in the price level. But, in the absence of a credible monetary regime, accommodating the shock meant that inflation expectations rose and it was impossible to resist the second-round effects on domestic wages and prices without substantial losses of output and employment. By then the costs of allowing inflation to rise were only too apparent."
Mr King's analyses of the dynamic and static costs of inflation suggest that inflation avoidance could carry a high cost for the economy as a whole:
I would suggest that inflation avoidance activities in the form of rent-seeking behaviour and the interaction between inflation and an unindexed tax base for income from capital constitute the major costs of anticipated inflation. Feldstein and others have argued that costs of this order are more than sufficient to outweigh the output costs involved in bringing inflation down to price stability. In that calculus, the cost is temporary and the benefits are permanent. Others believe that such a calculation is artificial. How is it possible to ensure that the reduction in inflation is permanent? Would the acceptance of a sacrifice of output today guarantee the future pursuit of price stability? Fortunately, inflation in Britain today is closer to price stability than for a very long time. The required fall in inflation to bring us towards a measured inflation rate of 2% a year - often associated with price stability - is small. What is most important is that we capture the real benefits of price stability by ensuring that inflation does not rise to levels from which only a costly recession will return us to price stability."
Mr King reviews the arguments of those who still make the case against price stability, including the suggestion that the pursuit of price stability may imply excessive volatility of output and employment:
"I do not believe that to be true. The existence of a Phillips curve, albeit unstable, leads to a long-run trade off between the volatility of inflation and the volatility of output. A central bank can take counter-cyclical actions to reduce fluctuations in output, at the cost of accepting slightly higher volatility of inflation, provided that such actions do not alter inflationary expectations and hence build in a potential inflationary bias. It is precisely the absence of a credible commitment to price stability which has meant that, over the past twenty years, any accommodation of an upward shock to inflation has raised inflation expectations and increased the output cost of meeting low inflation in the long run. A central bank that does not have credibility cannot afford to engage in as much flexibility in monetary policy as can a central bank which has established a track record for a commitment to low inflation. When credibility has been attained then year to year fluctuations in inflation are less important."
"Any central bank that wishes to accommodate temporary shocks to inflation must ensure that private sector agents understand their motives and accept the reasoning for the policy. If the markets suspect that the central bank is not fully committed to its inflation target then the outcome will be either a rise in inflation or a larger loss of output. Transparency and openness of the central bank's actions are a natural partner to its commitment to low inflation and a counter cyclical use of monetary policy."
Note for Editors
The Economic and Social Research Council is a major UK research agency for the social sciences. It is an independent organisation, established by Royal Charter in 1965, and funded mainly by the government. The ESRC's aim is to provide high quality research and data to help the government, businesses and the public to understand and improve the UK's economic performance and social well-being.
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