Mr. George gives a central banker’s response to the Asian crisis Speech by the Governor of the Bank of England, Mr. E.A.J. George, at the Foreign and Colonial Emerging Markets Conference, in London, on 28/5/98. Thank you, Mr Chairman. I’m delighted to participate in this Emerging Markets Conference, sharing the platform with such distinguished company. I am particularly pleased to be joined in this session by Guillermo Ortiz - my colleague from the Bank of Mexico. The particular examination question which you set me is: “How did an OECD central banker respond to the Asian crisis?”. I have to confess that it’s a somewhat embarrassing question. If I’m brutally honest I have to acknowledge that I didn’t see it coming; I played a modest role in helping to contain its immediate impact on global financial stability; and I’m still struggling to understand its implications, in terms both of its economic after-effects, and of the lessons we must all learn to reduce the risks in the future. I would only plead in mitigation, your honour, that I was by no means alone in all of that; and I beg leave to join in my defence all my central banking colleagues, governments and Finance Ministry officials, in Asia and elsewhere, the international financial institutions, and the world’s financial markets. The storm last year in Asia struck essentially the ASEAN four - Thailand, the Philippines, Malaysia and Indonesia - spreading subsequently to South Korea and intermittently battering Hong Kong and elsewhere.
It is an irrefutable empirical fact that inflation variability rises with the level of inflation, which in turn increases uncertainty for investors and long-term interest rates through a rise in the inflation risk premium. A permanent increase in inflation curtails, rather than stimulates, long-term growth. A considerable body of empirical research finds that the Phillips curve has a negative bent in the long run: inflation and inflation volatility penalise capital formation and thus detract from the economy’s growth potential. Empirical evidence confirms this negative relationship, with a 100 basis point permanent increase in inflation being associated with a 10–30 basis point decrease in trend output  2  BIS Review 22/2010  growth. Hence, if this is applied to the euro area, a 4% inflation target would shave no less than half a percentage point per year off trend growth! As for using monetary policy to manage macroeconomic risk, it should be recognised that this would introduce harmful asymmetries. It avoids policy restriction when positive supplyside shocks reduce inflation, fuelling asset price booms; and when the asset price boom finally turns into a bust, it leads central banks to overreact to negative demand-side shocks. So, financial instability meets two formidable multipliers, the first being a pro-cyclical monetary response to expansionary disinflations in good times and the second being moral hazard in financial markets, namely the expectation that the central bank will aggressively protect the markets from “tail events” in bad times. These expectations encourage markets to tend towards risky strategies, over-exposures and exuberance.