The Governor elect of the Bank of England has caused a stir through his latest speech as Governor of the Bank of Canada. Whilst the speech comes from the CFA Society of Toronto and is researched and put out by the Bank of Canada, inevitably British audiences are applying its message immediately to UK conditions.
Mr Carney argues that when a Central Bank is running a very low interest rate policy to stimulate a weak economy, it may also need to manage expectations to encourage faster growth. He endorses Canadian and US past actions where the Central Banks have announced the maintenance of low interest rates for a lengthy period, to reassure markets and foster an expansion of money and credit. In Canada the promise of low interest rates was conditional, with a statement that if inflation rose too much they would increase rates anyway. For more severe cases of income and output loss Mr Carney favours an outright promise of low interest rates regardless of the inflation rate.
He went further. He said that when an economy has lost a lot of output (like the UK, which he did not mention) the Central Bank and the government may need to shift from an inflation target to a nominal GDP target. This would allow the Bank to run very low interest rates even after inflation had picked up, if output was still below where the authorities wished it to be.
This is an interesting and challenging new path. As it does not seem to apply to current conditions in Canada, naturally people ask if that is what he is hinting the UK needs. Will he ask the Chancellor to change the target? Will he be willing to turn a blind eye to higher UK inflation in the hope that this could allow more output growth?
The problem with this approach is obvious. Last year the Bank’s inability or unwillingness to control inflation led to a sharp spike in price rises. This meant a cut in people’s living standards, which further depressed real demand. The danger with Mr Carney’s suggestion, if it is aimed at the UK, is twofold. Would higher inflation do too much damage to demand again if allowed? Would shifting targets as fundamentally as this help to undermine confidence in longer bonds, leading to higher longer term interest rates? It is easy to lose confidence, more difficult to restore it. There would be dangers in signalling that the Bank under new management no longer wished to even pretend to curb inflation, in an economy which can be inflation prone.
Meanwhile, on cue, the Fed has stated it intends to create a lot more money, and does not intend to put interest rates up for a long time, until unemployment has fallen substantially, whatever happens to inflation.