Both monetary and fiscal policy are inherently counter-cyclical, and arguably never more so than when we face a shock of the scale of a global pandemic. But at the core of the argument for central bank independence is the evidence from the past that without an independent institution operating monetary policy the overall effects of economic policy were dangerously pro-cyclical at times, leading to bad outcomes. In the face of what may be the deepest recession since 1709, with a collapse of economic activity alongside very low inflation, the question we ask ourselves is what should an inflation targeting central bank do in this situation? The lessons of history don’t change. The answer is to respect our remit and our target, no good will come of ignoring that. The logic of counter-cyclical policy is that all the tools should be applied to raise activity and support employment and the welfare of the public, all of which is consistent with an inflation targeting monetary policy. In practice, doing so has meant using tools to keep financial conditions sufficiently accommodative to offset as best we can such a large shock. This has been essential to support the flow of credit to businesses, which has been very substantial, and has called on both the monetary policy and financial stability tools of the Bank of England. This has also helped to lessen any longer term economic damage from the pandemic, resulting from longer term unemployment and business failures.
In the last decade or so, the shocks have been larger and the variance of inflation in a number of countries has at times increased, but with a tendency to undershoot. This has been less marked for the UK, but here still we currently face a period of below target inflation. And, as discussed previously, we have moved into a period of inflation targeting in the face of much larger shocks. To be clear, this does not for a moment call into question the benefits of targeting inflation. Indeed, it is notable that over the same period inflation expectations in the UK have not become de-anchored or more volatile, despite the greater economic volatility. But this shift has required central banks to be somewhat more flexible in the way we go about seeking to hit the inflation target, and the tools we use to do this. This is apparent in a number of approaches used by central banks: the adoption of an averaging over time mechanism to calculate the relevant inflation target, thereby allowing some catch-up to account for past inflation shortfalls; allowing inflation to return to target over a longer period of time where there is a trade-off of weaker activity and above target inflation; or using forward guidance such as the MPC is at present in the face of very great uncertainty, so that we make clear that we will need strong evidence that inflation is likely to return sustainably to target before policy should be tightened.