Monetary policy, the argument goes, must be directed at a wider set of goals than controlling consumer price inflation – a set of goals that includes the preservation of financial stability. Those who advocate using monetary policy to help preserve financial stability usually argue that preventing, or at least countering, asset price booms is the most effective means to that end. For a clear statement of this view see, for example, Wadhwani (2010). I want to make three points about this argument. First, that not all episodes of rapid asset price inflation – followed by substantial price falls – are disruptive to the wider economy. But when big asset price rises are accompanied by very sharp increases in debt they very frequently are followed by bad economic outcomes. Second, that monetary policy is not the most effective tool to prevent rapid and simultaneous build-ups in both debt and in asset prices. Third, that a much more direct and effective tool to counter a potentially dangerous  1  Inflation in the ten years from 1997 to 2007 never moved more than 1% from the Bank of England’s inflation target. 2  BIS Review 133/2010  build-up in debt is limits on the debt-to-asset ratios of financial institutions – that is limits to leverage, or capital requirements. Let me try to justify these three claims. Reinhart and Reinhart (2010) document the facts around the most serious economic dislocations in modern economic history.
Underlying forces that were created by the financial crisis and that would themselves keep inflation low have been offset by other factors that have kept inflation above target for much of the past year. These factors are well known but it is important not to forget the likely scale of their impact. Around one quarter of the goods that enter the basket for calculating the UK CPI are imported. The 25% depreciation seen since 2007 would – given that imported goods and services account for around a quarter of the consumer price basket – add a bit above 6% to the level of the CPI. Over a three-year-period that would generate 2% a year higher inflation. We have also seen the VAT rate cut and then increased. When the cut was having its largest impact on the annual rate of inflation last year the CPI inflation rate fell to 1.1%. The subsequent rise in VAT at the start of this year has helped push inflation back above the target by about the same amount. At the start of next year there will be another VAT rate increase – and that is likely to keep inflation above the target a bit longer. I am not blasé about that. That is why I said that I thought we face a risk in the UK of not doing enough to bear down on inflation. But there is also a risk of tightening monetary policy too soon.