Former Governor: Central Banks Have a ‘King Canute’ Theory of Inflation Mervyn King – News Couple
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Former Governor: Central Banks Have a ‘King Canute’ Theory of Inflation Mervyn King


Mervyn King, the former governor of the Bank of England, said central bankers were surprised by the price hikes that debunked the “King Canute” inflation theory.

In a powerful attack on how policymakers around the world are reacting to the Covid-19 crisis, Lord King accused them of relying too heavily on models that showed inflation always returns to its target no matter what the level of interest rates.

“This is King Canute’s theory of inflation. A thousand years ago, King Canute of England set his throne on the seashore and ordered the incoming tide to stop. The tide continued to rise and broke above his feet and legs driven by the laws of nature,” said the former ruler in a lecture given at the International Monetary Research Institute. .

Pathological inflation cannot take the form of ‘inflation will remain low because we say it will happen’; it must explain how changes in money–whether directly through quantitative easing or indirectly via changes in interest rates–affect the economy.

This month, the Bank of England left interest rates at a record low of 0.1% while forecasting that the annual rate of inflation will continue to rise, peaking at 5% next spring. Threadneedle Street said it then expects inflation to ease, returning to the government’s 2% target over the coming years.

King, who was in charge of the bank from 2003 to 2013, said he was not critical of individual decisions made in recent years, but was concerned about the intellectual basis for central bank policy.

“When King Canute sat before the coming tide, his aim was to show to his entourage that he was not omnipotent and could not by words alone undo the forces of nature. It is better for central banks to show the same humility.”

Under King’s direction during the global financial crisis in the late 2000s, the bank lowered interest rates and pumped money into the economy through quantitative easing, a bond-buying program.

The former governor cited a House of Lords report suggesting that quantitative easing has since become central banks’ first resort for bad news of almost any kind. The failure to withdraw quantitative easing in response to good news, or even a lack of bad news, escalated central bank balance sheets, something King said was “unsustainable”.

King’s successor as governor, Mark Carney, introduced a forward guidance system under which Threadneedle Street gave companies, households and financial markets strong guidance that official borrowing costs would remain low.

“The danger now is that although financial markets may have lost faith in the future guidance given to them, central banks themselves continue to believe in them and cling to a narrative about the future course of interest rates that is no longer credible with inevitable problems for the clear communication of policy decisions,” King said.

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The former governor added that future guidance could be seen as a complacency. The central bank should not be shy about admitting that it does not know where interest rates will be in the future because it cannot know where the economy will go in the coming months and years.

“Futures guidance markets and the economic agents they need is an unwavering commitment to price stability.”

King said there had been a decade of sluggish economic growth despite the biggest monetary stimulus the world had ever seen and that “certainly the time has come to recognize that many, if not most, economic problems are not amenable to monetary policy.”



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