I’ve just read an interesting, thoughtful and of course slightly self-serving speech by the Governor of the Bank of England, Sir Mervyn King, for whom I have a great deal of respect. Titled “Twenty Years of Inflation Targeting” it reflects on whether central banks’ emphasis on controlling price inflation came at the expense of allowing a huge financial crisis on the back of asset inflation. King argues (briefly) that the underlying cause of the crisis was in large part the global financial imbalances which kept long term interest rates low and that there are limits to what central banks can do about that. But he says that an additional policy goal, in the form of the Financial Policy Committee which looks at systemic financial matters like overall leverage, should help in future.
What struck me was his analysis of the monetary policy committee’s (MPC) deliberations in the period running up to the crisis (which of course they didn’t know was coming). On page 10 he notes the role of the exchange rate, critical in such an open economy as the UK. There were two views discussed at the MPC. One was that setting higher interest rates would push the exchange rate down because it would deflect capital flows to economies with better growth prospects. The other view was that setting higher interest rates would push the exchange rate up, attracting hot money.
It is astonishing that something as simple and important as the effect of a rise in interest rates (definitely under central bank control) on the exchange rate (not under central bank control) should be seen as indeterminate by a group of the most experienced and thoughtful economists in the land. It is not surprising that the western economies are in a mess.