The goals of monetary policy If one looks at the 10 years leading up to the onset of the crisis – which were also the first ten years of the Bank’s MPC – the outcomes for inflation and for aggregate economic growth in the UK were good. Inflation was – by historical standards – very low, very stable and close to the target. That had not been achieved at the expense of unusually low growth or high unemployment. In Ireland growth had been much stronger and inflation a bit higher. The aggregate outcomes looked good in both countries (Charts 1–4). In the UK there was a strong consensus that having monetary policy directed at hitting an inflation target was sensible and that it had been successfully implemented. BIS Review 133/2010  1  But if you now view the mess that we are dealing with after the financial crisis as substantially reflecting monetary policy decisions, you would take a completely different view of how well policy had been run. The charge is that policy in the UK was inappropriate given the huge build-up in many asset prices, and particularly in debt, or leverage. The fact that monetary policy could be very successful in terms of hitting an inflation target – and in the UK it was 1 – but not prevent a very serious financial crisis, and one that has been followed by much more variable inflation, is taken by many as a clear demonstration that the inflation-targeting framework is flawed.
BIS Review 133/2010  9  In thinking about variations in the value of the assets held by a bank with a diversified portfolio of loans then variation in real aggregate income is arguably a much better guide than volatility in particular asset classes (eg property, equities). In some simple asset price models the real value of assets which are a claim on a stream of income is proportional to aggregate incomes (see, for example, Barro 2006). If we use that as a rough rule of thumb the Table suggests that occasions when generalised falls in real asset values might be 5% or more occur roughly once every 15 years. Falls in value in excess of 10% might be about once every 40 year events. Declines of 15% or more are once-every-80-year events. This suggests that banks would need far more capital than has been usual in recent years to be truly robust. Why bank capital might not be expensive? Of course if having quite substantially more capital generated much higher cost in intermediating funds through banks – and there are no close alternatives for bank financing – that extra robustness would come at a high price. But calculations undertaken by the Bank of England (2010), the BIS (2010) and academics (Kashyap 2009, and Admati et al 2010) suggest this is not the case. It is worth considering why.