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The Bank Of England Should Be Given The Binoculars

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But whatever the MPC does in the next few months, the current monetary policy regime needs to be radically overhauled.

We may have grown accustomed to the current set-up, but a quick look at history shows that it is rare for a regime to last more than a decade or two. Time and time again, the policy-makers have thought that they have found the Holy Grail, only for the shortcomings of the new regime to become apparent – usually painfully.

Immediately after the war, the UK had a fixed exchange rate under the Bretton Woods system. This regime lasted until 1971, when the pound was floated – and duly sank.

There was a brief interlude when policy effectively had no nominal ancho. However, when the Conservatives won power in 1979 they put control of one definition of the money supply, Sterling M3, at the centre of economic policy. After a while, all sorts of alternative measures were targeted, from M3 to M4 to other more exotic sounding animals known as PSL1 and PSL2. None proved reliable.

The Chancellor, Nigel Lawson, then returned to an exchange rate regime, by shadowing the deutsche mark, followed by membership of the Exchange Rate Mechanism (ERM) in 1990.

After we left the ERM in September 1992, the era of inflation-targeting was born. Its current format, with an independent Bank of England, was the result of one of Labour's first acts upon gaining power in 1997.

Under this system, the MPC sets interest rates in order to ensure that inflation is kept on target all the time, but the forecast horizon is two years ahead. Asset prices are only taken into account in so far as they affect the outlook for inflation.

For a time, this approach seemed to work very well. In fact, though, all along it had major problems. Most importantly, it seemed to assume that as long as the inflation rate was OK then the whole monetary system would be OK. But, as we have seen, while inflation can stay relatively close to the target for several years, an asset bubble may be inflating.

Moreover, this approach depends heavily on forecasting inflation. The idea is that the central bank looks at a whole range of variables, and on the basis of what it sees sets interest rates in order to achieve the inflation target. When you think about it, this is really rather odd. Forecasting hasn't exactly been a strong point of the economics profession. So trying to get inflation spot-on is a fool's errand.

More importantly, it doesn't actually matter that much if inflation is slightly off the target for a short while. Meanwhile, the influence of asset prices plays out over much longer periods than two years. It is ludicrous for a central bank to think that it has ensured economic and monetary stability because inflation is 2pc when the most important asset of all, namely residential property, is in the midst of a raging boom which is seeing annual price increases of 20pc or more. Asset booms of that size and importance are not compatible with economic and monetary stability over the medium term. They can easily lead to the unleashing of inflation or – when the burst comes – deflation.

The notion that asset prices should be more or less ignored except for the immediate inflation consequences has surely now been discredited. But this still leaves the field wide open as to quite what the new regime will look like. Moreover, as we now know, it is impossible to separate monetary questions completely from matters of financial stability.

So what might the new monetary regime look like?

The least radical option is to stick with using interest rates to meet a narrow inflation target two years or so ahead, and to introduce other ways to prevent asset price bubbles from building up. The authorities could deal with bubbles from a micro point of view, setting a series of rules and regulations governing such things as loan to value ratios and/or directly intervening to prevent financial institutions from lending too much in risky areas. If it was believed that such interventions would do the job well, then there is no reason why monetary policy could not stick to its current role of targeting inflation.

But I don't find this set-up very attractive. The idea that the FSA, which has been supine and incompetent despite the billions of pounds poured down its gullet, should now preside, emperor-like, over the financial system, appalls me. The result would almost certainly be massively inefficient. It might also be ineffective. Can we rely on the FSA to identify where the next bubble is coming from?

An alternative approach would be to introduce some other macro-instruments designed specifically to control lending and asset prices – what Mervyn King has called a "macro-prudential toolkit". The favoured option is variable capital ratios – whereby banks would be forced to hold more capital during the "good times" in order to create a bigger buffer for the inevitable "bad times". Again, if we could rely on such a system then interest rate policy could be left to get on with inflation targeting in the way we have grown used to.

Yet I find this idea unappealing on its own. Who knows what the shape of the next bubble will be? Perhaps it will not involve banks lending large multiples of their capital. Every bubble is different.

Even though such variable capital ratios will help, I suspect that the only way forward is to give the Bank of England a wider brief in the way it sets interest rates. The objective could still be to hit an inflation objective, say 2pc per annum on the CPI, but the Bank would be charged with achieving this only over the medium–term.

In such a regime it would have the power to raise interest rates in the midst of a housing boom even if CPI inflation was modest, on the grounds that in the long run, housing booms are not compatible with monetary stability.

I know that the objection to such a regime is that it gives too much discretion to central bankers.

By contrast, the current regime is beautifully simple in its purity and simplicity. But so what? This regime allowed the Bank to preside over a massive, destabilising asset bubble. There is more to life than measurability and precise accountability.

Whether it is regarding the number of hospital beds or the control of inflation, precisely specified targets are so New Labour – and so last year.

Setting interest rates on guessing what inflation might be in 2 years hence. What genius it's worked so well.

The BoE wouldn't be able to organise a mass alcohol beverage night in a brewery.

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Setting interest rates on guessing what inflation might be in 2 years hence. What genius it's worked so well.

The BoE wouldn't be able to organise a mass alcohol beverage night in a brewery.

get them some gold binoculars and they have chance of controlling the theft of inflation

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  • 420 Brexit, House prices and Summer 2020

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