There is a great deal of slack in the economy. Around three-quarters of a million jobs (net) have been lost. And most surveys have firms working well within capacity (Chart 8). The MPC believes that that will tend to bear down on wages and consumer price inflation over the next few years, warranting our substantial monetary stimulus. But the recession will obviously impair the economy’s productive potential. Investment plans have been shelved and some discouraged people are likely to leave the workforce. Those effects are likely to accumulate over time. But there are important temporary factors too. Typically when monetary policymakers talk about the potential supply of the economy, we have in mind the slow-moving accretion in productive capacity determined by growth in underlying productivity, the workforce and firms’ net investment in the capital stock. Right now, that mindset would not quite capture what is going on. There are a number of reasons for thinking that the “effective supply” capacity of the economy has been depleted temporarily due to the shock to credit supply and confidence (Chart 9). How much, and how temporary, are major uncertainties. In the months immediately after the Lehman crisis, the cutbacks in lending and in trade credit insurance were so severe that some firms were probably unable to maintain production at previous levels. Working capital is, after all, an intermediate input. 2 Those constraints have probably reduced over the months.
In setting a course for nominal demand, we are usually trying to stabilise inflation in line with our target over a horizon of 2–3 years. Of course we care about longer horizons. As a number of us have argued over the years, 13 that is nicely captured by approximating our objective with a so-called quadratic loss function that gives weight to deviations of inflation from target and deviations of the level of output from its sustainable course. In that set up, the policymaker cares about future volatility (or uncertainty) about the inflation rate and the “output gap”. Sizeable imbalances create precisely that uncertainty, threaten precisely such volatility. All very useful as an abstract framework for thinking about policy. The trouble is that there is not a policymaker anywhere who has much of a clue about how to operationalise it in actual interest rate decisions. This matters because not all imbalances are associated with credit booms that pose a threat to financial stability. The development of a set of macroprudential tools would not be sufficient to insulate our economies from imbalances. But I do believe that it is necessary.