The Bank of England Should Keep Its Inflation Target

And it should use it much more judiciously...

LAST OCTOBER, the UK passed the 20th anniversary of inflation targeting, writes former Bank of England Monetary Policy Committee member Andrew Sentance. 

Since 1992, a target of low inflation has been the key anchor for our monetary policy framework. Though there have been a couple of slight adjustments to the target – in 1997 and 2004 - for more than 20 years the UK has benefited from a remarkable degree of consistency in our monetary policy framework.

We have to go back to before the First World War – under the Gold Standard - to find such a long period of stability in UK monetary policy. Since then, the only other period which comes close was 1949-1967, when the value of the pound was pegged at $2.80 against the Dollar.

Mervyn King marked the 20th anniversary of inflation targets last October with a speech broadly supportive of this approach. But not long after that, his successor Mark Carney suggested that a nominal GDP target might have some advantages. And the Chancellor of the Exchequer appeared to encourage this debate on the objectives of monetary policy – suggesting some change might be on the cards.

There are three main strands to the argument for change. The first is that by focussing on inflation, Central Banks stifle growth and contribute to high unemployment. However, this view is not borne out, either in theory or practice.

In theory, the argument for focussing on an inflation target is that it builds confidence – in business, in financial markets and with the public more generally - that price stability will be maintained. This creates a much better climate for wealth creation and economic growth over the medium-term, removing a key source of uncertainty and volatility.

In practice, the British economy has performed relatively well under an inflation target regime. UK economic growth in the two decades to 2012 averaged 2.3%, despite the impact of the financial crisis - a respectable rate of progress for a mature western economy. Unemployment has averaged 6.8% of the labour force in the inflation target era, compared with 8% in the two decades before. And in the aftermath of the financial crisis, unemployment has not risen as high as it did in the 1980s and early 1990s, and job creation in the private sector over the recovery has been impressive.

It would also be hard to argue that the inflation target has held back the Bank of England from injecting economic stimulus. In response to the financial crisis, the Bank has cut UK Bank rate to its lowest level in recorded history and kept it at this exceptionally low level for nearly four years. It has also undertaken a substantial programme of Quantitative Easing – accumulating £375bn of bonds on its balance sheet.

A second argument levelled against inflation targets is that this was the dominant paradigm for monetary policy in the run-up to the global financial crisis. So why was monetary policy not more effective in preventing such extreme and damaging economic events?

The short answer is that while an inflation target approach should help to stabilise economies, it does not remove all sources of economic and financial instability. In the highly globalised economy we now live in, there are many other sources of volatilty, notably in the financial sector. But the solution lies in addressing these problems at source – with better financial regulation and international co-ordination. To expect monetary policy to address all these sources of instability single-handed is totally unrealistic.

A third problem frequently cited with inflation targets is that they do not distinguish between domestic and global sources of inflation. If inflation arises from global energy and commodity price rises – as it has recently – it may require a different response from inflation driven by a domestic wage-price spiral, as long as the resulting inflation does not become self-sustaining.

This argument makes sense for genuine one-off shocks. But what if these shocks to energy and commodity prices are repeated, as they have been over the past decade? One approach is to look to an appreciating exchange rate to offset these global inflationary forces.  However, that has not been the policy of the Bank of England. Instead, Mervyn King and other key MPC members have generally emphasised the benefits of a weaker, rather than a stronger pound.

Any monetary policy framework needs some degree of flexibility to deal with unexpected shocks. But in the UK, the Bank of England has persistently accommodated inflationary shocks from a wide range of different sources, with inflation averaging close to 3.5% over the past five years. And the public now appears to be expecting future inflation to continue at around 3.5% as a result.

Rather than shifting away from an inflation target, we need to make our current monetary framework more transparent and more credible.  That should include setting out more clearly the Bank's strategy for containing the inflationary impact of global energy/commodity prices and a weak pound and making clear the circumstances in which interest rates would start to rise.

There will be an opportunity to do just that in the next few months when –as seems very likely – inflation exceeds 3% and the "Open Letters" between the Governor and the Chancellor resume.  In the past, these letters have offered little indication that the MPC was prepared to take action to bring inflation back to target and the Chancellor has not raised any issues with this "hope for the best" approach. In future, both parties should aim to make this correspondence much more substantive and informative about future policy and the commitment to price stability.  

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