Mervyn King: Monetary policy – practice ahead of theory Text of the Mais Lecture 2005 by Mr Mervyn King, Governor of the Bank of England, at the Cass Business School, City University, London, 17 May 2005. The references can be found on the Bank of England’s website. I am indebted to James Proudman, Gertjan Vlieghe, Tony Yates and Richard Harrison who have worked closely with me on this lecture and are effectively co-authors. Alan Mankikar and Tim Taylor provided excellent assistance in preparing the empirical and historical research that support this lecture. *  *  *  Introduction Monetary policy is aimed at maintaining price stability. That may seem self-evident. Thirty years ago it was not. From the end of the second world war until the mid to late 1970s, the majority view of academic economists and policy-makers alike was that monetary policy had rather little to do with inflation, and was largely ineffective as an instrument of demand management.1 The intellectual basis for that view was never clear. And painful experience taught us that price instability led to costly fluctuations in real output and employment. Far from being ineffective, a monetary policy aimed at price stability has proved to be the key to successful management of aggregate demand. Fortunately, the theory and practice of monetary policy in the UK have changed out of all recognition in the past twenty-five years.2 We have moved from the Great Inflation to the Great Stability.
But, by anchoring inflation expectations on the target, it can alter the transmission mechanism by reducing the persistence of inflationary shocks. And it does so without pretending to commit to a rule that is incredible because it is not expected to last. The implications of an inflation target for central bank communications are natural enough. First, the clarity of the inflation target focuses attention on the case for price stability which must be made continuously. Second, each forecast must be accompanied by an explanation of the current thinking behind the MPC’s views; in essence the “model” underlying the MPC’s thinking is changing all the time. Third, there is no point trying to communicate a time-invariant policy reaction function when that does not exist. The regular commentary on its thinking published in its Minutes and Inflation Reports is part of a process by which the MPC communicates with the general public. A reputation for communicating openly and honestly about the range of possible outcomes matters, because it makes it more likely that people will continue to listen. What are the main challenges for inflation targeting in the future? The most immediate stems from its very success. Although it is now widely accepted that there is no long-run trade off between inflation and output, the ability of monetary policy to affect output in the short run means that there is, in principle, a permanent trade off between the volatility of inflation and the volatility of output, which might be represented by the line AA in chart 6.