In response to certain kinds of developments – in the jargon, so-called “supply shocks” that move output and inflation in opposite directions – inflation can be returned to target relatively slowly in order to minimise harmful fluctuations in output. But this is subject to the “constraint” that inflation ultimately has to be returned to the target and has to be done so in such a way that maintains the target’s credibility. Inflation targeting is not a sham: the discipline of the inflation target is paramount. But it can be operated in a manner that also supports output and employment as long as – and only as long as – our credibility is maintained. Without credibility there can be no discretion. This concern with the consequences for growth and employment within an inflation targeting regime is sometimes referred to as “output smoothing”. Monetary policy does not have the ability to affect the level of output in the long-run, but it can help to smooth out cyclical variations. More recently, it has underpinned references to “flexible inflation targeting”: the MPC has the flexibility to vary the speed with which inflation is returned to target depending on the circumstances.
Most colourfully was the observation, again made by Mervyn King, that an inflation target does not compel policymakers to behave like “inflation nutters”: there is scope to care about stabilising output and employment as well as controlling inflation.3 That monetary policymakers should be concerned with the implications of their actions for the real economy – for the growth of output and for the strength of employment – must surely seem right to all of us. The late Eddie George – who, together with Mervyn King, perhaps did more than anyone to cement the importance at the Bank of England of low and stable inflation – stressed repeatedly that low inflation “is not an end in itself .... [it is] a necessary means to the end of sustainable growth of output and higher living standards”.4 It’s important that we don’t lose sight of this overriding aim. Eddie was equally clear that, in the long run, the best contribution that monetary policy could make to achieving a prosperous and vibrant economy was to deliver enduring price stability. He had seen at first hand the pernicious costs of the high and variable inflation of the 70s and 80s: companies and households unable to budget and plan efficiently; resources misallocated; long-term contracts avoided for fear that large swings in inflation would end up biting one party or the other. The value of hard-earned savings eroded.