Publication - Speech given by Mark Carney, Governor of the Bank of England, at the London School of Economics.
Good evening. It is a pleasure to be at the LSE and an honour to share the podium with Amartya Sen. Professor Sen is rightly recognised for his many contributions, not least to welfare economics and social choice theory. He has posed, and in many cases answered, some of the most fundamental questions facing economists. For example, given the diversity of people’s preferences, is it possible to arrive at coherent aggregative judgements about how society is arranged? If there are as many preferences as there are people, is reasonable social choice possible at all? And how do we value public goods?
His work underscores the value of empirics – informational broadening – to help make the interpersonal comparisons necessary to understand, and act upon, the force of public concerns about poverty, inequality, even tyranny. And his insights have been applied to the most pressing economic and ethical questions, such as the prevention of famines.
His insights are also relevant to social choices about macroeconomic stabilisation, including inflation control, and what society is prepared to do to achieve it.
What level of inflation does society wish to achieve? How aggressively should inflation stabilisation be pursued when doing so imposes costs in terms of lost output and higher unemployment?
Low, stable and predictable inflation is a public good. It is not merely that rising prices mean households have to shop around or businesses have to update their prices periodically. High inflation hurts those, particularly the worst off in society, who don’t hold equities or property as well as those whose incomes are fixed in nominal terms. It distorts price signals, inhibits investment, and can ultimately damage the productive potential of the economy.
Equally, deflation can imperil growth and employment. In a highly indebted economy, deflation raises real interest rates, increases debt burdens, lowers wages, and reduces growth. In the extreme, these can morph into debt deflation, causing very high and persistent unemployment and financial collapse.
The happy medium is low, stable, predictable inflation over the medium term. A little inflation ‘greases the wheels’ of the economy, for example by helping real wages adjust more smoothly.1 Moreover, a positive inflation rate gives monetary policy space to deliver better outcomes for jobs and growth when shocks hit, without the distortionary costs of high and volatile inflation.2
Recognising the social value of inflation control is one thing, delivering it is quite another. In the past, many societies could not. This is because the instrument that affects inflation most powerfully – monetary policy – also affects output and employment, at least in the short run. That influence tempted authorities to promise low inflation in the future, but then to renege in order to boost activity. Electoral cycles reinforced this predisposition.3 Firms and households began to anticipate these incentives, however, and eventually pre-empt them. The economy ended up in a worse equilibrium with higher inflation and unemployment.4 Such time-inconsistent policies contributed to excessive inflation and higher structural unemployment in the UK during the 1970s and 1980s (when inflation averaged 9.5% and unemployment over 7.5%).
In light of similar experiences, many societies came to recognise that macro outcomes can be improved by having society first choose the preferred rate of inflation and then delegate operational responsibility to the monetary authority to take the necessary monetary actions to achieve that objective.5 By “tying the hands” of authorities, time inconsistency is resolved and better outcomes for both inflation and unemployment become possible.
Inflation targeting, as practised in the UK, represents the most comprehensive adoption of these insights. By delegating monetary policy to an operationally independent central bank, inflation control becomes a more technical, ‘engineering’ problem, as described in Professor Sen’s work on ethics and economics.6 The committee responsible is given a clear remit – with a lexicographic preference for inflation control – and is charged to do what is necessary to achieve the inflation target over the policy horizon. For example, the Monetary Policy Committee (MPC) of the Bank of England must deliver price stability over the medium term, as defined by 2% CPI inflation. The inflation target is symmetric (meaning we care as much about returning inflation to target from below as from above), and it applies at all times.
To be clear, although the method by which the Bank of England achieves the inflation target may be a technical exercise, the UK’s monetary policy framework is grounded in society’s choice of the desired end. These ethical determinations are encoded in the monetary policy remit, from which the MPC takes its orders and against which it is accountable. Society chooses the ends, and, within pre-set boundaries, the MPC determines the means to achieve them.
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