Because inflation expectations matter to the behaviour of households and firms, the critical aspect of monetary policy is how the decisions of the central bank influence those expectations. As Michael Woodford has put it, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. Indeed, one can argue that the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations. The precise “rule” which central banks follow is less important than their ability to condition expectations. That is a fundamental point on which my later argument will rest. It should be clear that, just as Maradona could not hope to score in every game by running towards goal in a straight line, so monetary policy cannot hope to meet the inflation target by leaving official interest rates unchanged indefinitely. Rates must always be set in a way that is consistent with the overall strategy of keeping inflation on track to meet the target; sometimes that will imply changes in rates, at other times not. Learning and its implication for monetary policy The academic literature on monetary policy rules has performed a great service in emphasising the importance of expectations. But there are two basic problems with the use of rules. The first is that the validity of any given rule depends upon the model of the economy that underlies it being true.
The story of monetary policy in Britain during the intervening period is told by the Mais Lectures. The first Mais Lecture was delivered by my predecessor, Lord Richardson, in 1978, at a point when monetary policy was emerging as the main tool to deal with inflation. Not before time, you might think, since only two years earlier inflation had reached 27%. In 1981 the Chancellor of the Exchequer, Geoffrey Howe, chose as the title of his Mais Lecture: “The Fight Against Inflation”. As he said then, with inflation still in double figures, "squeezing inflation out from an economy which has become accustomed to higher rates over a period of years cannot be an easy or painless task. … the inflationary mentality must be eradicated. … When we have done that we will find that low inflation or even price stability need not be painful". The conquest of inflation was to prove harder than expected. In the decade that followed Geoffrey Howe’s lecture, inflation averaged over 7% a year. Only since 1992 has inflation fallen to levels that could be described as price stability. In retrospect, two Mais Lectures seem to have been of particular significance: those by Nigel Lawson in 1984 and by Tony Blair, then Leader of the Opposition, ten years ago this month. Despite clear differences of view, what stand out from those two lectures are their similarities. Both emphasised the need for a medium-term framework for monetary and fiscal policy.