Wednesday, October 11, 2006

King on Monetary Policy

Mervyn King, the most charming central banker I know, offers his views about monetary policy in a globalized economy:

Some of you may be tempted to think that because the growth of the Chinese economy has affected key prices in our own economy, inflation in Britain is now largely determined overseas. Low inflation in industrialised countries, it is argued, is made in China. As with the Arthurian legends, epitomised by King Arthur’s Round Table above us, that too is a myth. Despite large changes in relative prices, the average change in prices – inflation – has been remarkably stable. Indeed, it is striking that in a decade in which prices moved so much, overall inflation was more stable than in any decade for a hundred years. It was a decade that in my first speech as Governor, I described as NICE– a non-inflationary consistent expansion.

How can inflation be stable when individual prices move around so much? The explanation is that inflation is the result, in the old adage, of too much money chasing too few goods. Inflation arises when the total amount of money spending (or nominal demand) in the economy is greater than the value today of the available goods and services. When the Bank of England changes Bank Rate to keep consumer price inflation close to the target of 2%, we influence – albeit imprecisely and with a time lag – the amount of money spent in the economy and so the inflation rate.

In short, inflation is made at home.