Or it could be that the spare capacity is exerting little downward pressure, because businesses with limited access to credit are unwilling to run the risk of reducing their cash flow by cutting prices in order to boost market share. Moreover, even though pay growth has been muted, unit wage costs have nevertheless risen quite sharply because businesses have held onto skilled labour through the recession, rather than lay it off. So the firmness in underlying prices may just be the flipside of the better-than-expected labour market outturns. Despite these uncertainties, it seems likely that the margin of spare capacity will be sufficient to pull inflation back towards the 2% target from its present elevated level, as the near-term effects of the restoration in VAT and sterling’s past depreciation work through. Our latest projections, contained in the February Inflation Report, are shown in Chart 9. The risks of inflation being above or below the target are roughly balanced by the end of the forecast horizon. It should, I hope, be clear from my remarks that, although a recovery of sorts may have commenced, there are still considerable doubts about its strength and durability and about the accompanying path of inflation. The road ahead is likely to be bumpy and there is still the risk of further adverse shocks.
Most of the time, the best projection of asset prices at that horizon is for them to be broadly flat. Consequently, I suspect that our policy choices would not have been radically different had we been tasked with targeting an inflation measure that included a measure of owneroccupied housing costs. Finally, there is something of a logical error in moving from the indubitably correct observation that successful inflation targeting is insufficient to guarantee either macroeconomic stability or financial stability to the conclusion that monetary policy should in addition, or instead, be focussed on some other objective. There is a real danger in overburdening monetary policy if it is expected to achieve both price stability and financial stability simultaneously. With two objectives, one needs two independent means of achieving them. The assignment of instruments to targets then revolves around which instrument is most effective at achieving which objective. Though loose monetary policy, particularly in the United States during 2001–5, arguably contributed to the build-up of the financial imbalances, it was but one of many causes, including a plethora of failings within financial institutions. These include: inadequate care in the extension of loans to risky individuals, when those loans are then sold on; the inappropriate use of off-balance-sheet vehicles to circumvent capital requirements; reward packages that encouraged an undue focus on short-term returns; excessive complexity and opacity in some asset-backed securities; and distorted incentives facing ratings agencies.