Fluctuations in the exchange rate can be an important source of such trade-offs, as they can exert pressures on consumer price inflation without proportional effects on activity.27 A simple way to represent formally how the policymaker optimises the trade-off is in “linear-quadratic” form – a set of linear constraints describing the behaviour of the economy, and quadratic preferences that penalise deviations of inflation from its target and output from its potential. The relative weight the policymaker places on output stabilisation, relative to inflation stabilisation, is often denoted 𝜆 – or ‘lambda’. A lambda of zero would imply no weight on the stabilisation of real activity – so-called “inflation nutter” preferences. A positive lambda implies a willingness to strike at least some trade-off between output and inflation stabilisation; a higher value indicates that relatively more weight is given to output stabilisation, so that more of the effects of any shock flows through to inflation. In this framework, the value of lambda should vary over time in light of the nature and persistence of the shocks hitting the economy and features of the economy. The MPC’s remit explicitly builds in such flexibility. It recognises that in exceptional circumstances, when shocks to the economy may be particularly large, persistent or both, the MPC is likely to be faced with more significant trade-offs.
And the required adjustment still has a long way to run – few of the largest banks in the United Kingdom managed to reduce their leverage ratios through 2008, which remain at historically high levels. Third, interconnections between institutions create potential fragilities across the system, as we saw last September. Fourth, the risks associated with large-scale proprietary trading are probably harder to control in limited liability companies. So we need instruments to prevent the size, leverage, fragility and risk of the financial system from becoming too great. The resulting “macro-prudential” toolkit will contain a number of instruments to reduce risk, both across the system and over time. It must not be put together in a hurry. And I share the concerns of many of you that we are a long way from identifying precise regulatory interventions that would improve the functioning of markets. As far as individual banks are concerned, we face some uncomfortable choices about the structure and regulation of our banking sector. If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure. Something must give.