From the TUC

Dropping the Inflation Target?

13 Dec 2012, by in Economics

Could the UK be seriously considering changing the Bank of England’s inflation target?

The Chancellor certainly didn’t rule it out in an appearance before the Treasury Select Committee today and, as the FT’s Alphaville blog notes, under the terms of the Bank of England Act 1998, changing it is relatively straightforward.

The UK specific speculation follows a speech by Mark Carney (who’ll take over the reins at the BOE in the summer) in which he speculated on the potential need for a change in the monetary regime.

Carney specifically mentioned the notion of nominal GDP (NGDP) targeting:

From our perspective, thresholds exhaust the guidance options available to a central bank operating under flexible inflation targeting.

If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP

Following this speech the FT’s Chris Giles wrote that:

Unless the chancellor wants to turn the next governor into a busted flush before he arrives, item one on the March Budget agenda will be public consultation over the MPC’s remit.

So what exactly is NGDP targeting?

Sky’s Ed Conway has a good summary on his Real Economy blog (for those wanting a more detailed look the best source is Giles Wilkes’ 2010 paper ‘Credit Where it’s Due’)   Simply put, NGDP targeting would mean that rather than just targeting the rate of CPI inflation the Bank would instead be targeting real GDP growth plus inflation. As Ed notes:

If the UK was following an NGDP targeting policy, the Bank of England should arguably still be stimulating the economy through more quantitative easing. By contrast, the inflation figures, which show prices are still well above target, indicate that the Bank shouldn’t have been carrying out quantitative easing at all in the past year and a half.

It’s important to note that the exact wording of an NGDP target would matter a great deal. If the Bank were to target an NGDP level (rather than just a growth rate) – and I think that is what Carney meant by ‘make up for past misses’ – then such a target could involve very radical monetary policy indeed. Targeting a level would imply that if the Bank undershot in one year it would have to try and boost NGDP by even more the following year.

This could make a significant difference to UK monetary policy at present.

As I wrote following the Bank’s most recent Inflation Report, the Bank has essentially thrown in the towel on further support for the economy. It now believes that weak growth is unlikely to bring inflation down and hence further QE is hard to square with its inflation target. A switch to NGDP targeting would open more space for further stimulus.

The timing of Carney’s speech shouldn’t come as a great surprise, as I wrote back in October (following a speech from the Current Governor on the inflation targeting approach):

Politicians are starting to discuss the limitations with the inflation target (see for example Ed Miliband’s recent speech to Policy Network) and potential problems with the Bank’s governance following the expansion of its role (both Ed Balls and Andrew Tyrie have been especially strong on this)  and this is to be welcomed but this needs to be a bigger debate.

With QE and funding-for-lending the traditional divide between monetary and fiscal policy is breaking down, with the move towards macro-prudential risk management the Bank is taking on sweeping new powers and with a wide spread recognition setting in that inflation targeting may have reached its limits as policy framework, something needs to be designed to replace it.

I’m glad this debate seems to be taking shape in the UK and I wonder to what extent it will be influenced by the decision of the Federal Reserve last night to specifically target unemployment.

The Fed has now openly specified that it will keep monetary policy in expansionary mode until unemployment has fallen below 6.5% (as long as inflation is 2.5% or below). This strikes me as a welcome development even if it is, in the words of Paul Krugman, merely a promise from the Fed that ‘it won’t do anything stupid’ such as hiking rates before the recovery is secure.

And it’s not just in the UK and the US where change is in the air – as the Bond Vigilantes blog note, changes are happening to central bank policy regimes globally.  The turn is away from straight inflation targeting and towards growth.

In a world where unemployment rates are well above pretty much anyone’s estimate of the natural rate, and in many geographies well above 10%, the need for growth is seen as much more pressing that the fear of missing the 2% inflation targets. 

There is a strong case for looking again at the Bank’s mandate – especially in extraordinary times such as these.

But we should also be aware of three limitations before we allow ourselves to think that a change in monetary regimes is a panacea for our current plight.

First, there is a question of how much impact a changed monetary regime would actually have. I’ve always found the chart below somewhat depressing:

As Paul Mason explained two years ago:

One logical conclusion would be that the credit cycle is uncontrollable. Indeed a graph in the Haldane et al paper [the above graph] shows it to be relatively immune to policy since financial capital emerged in the 1870s.

Secondly we shouldn’t fall into the lazy thinking that monetary and fiscal policy are close substitutes for each other.

The government seem, again implicitly, to argue that monetary and fiscal stimulus are close substitutes for each other. It doesn’t matter if the government is cutting back as the Bank can extend support.

I’m afraid I don’t really agree with this. Leaving aside my doubts on the effectiveness of a conventional (and QE is the ‘new’ conventional) monetary stimulus at a time when the financial system’s operations are impaired, fiscal and monetary stimulus impact upon the economy in different ways.

… even in ‘normal’ times fiscal and monetary policy will impact upon different sectors in a different way.

Yes, any active policy to increase demand is to be welcomed at the moment – but we shouldn’t pretend that monetary easing will automatically offset fiscal tightening.

There is only so much monetary policy can achieve in the current climate and whilst a switch to NGDP targeting, or a employment target, might be welcome it still would be unlikely to offset the full impact of fiscal tightening. There is no monetary magic bullet that can end our current woes.

Finally while the target matters so do the tools used to hit it. Question can be asked about the effectiveness of QE has a policy given the current structure of our financial system. Even if an NGDP target allowed the Bank more room stimulus, it might not have a huge impact without wider reforms to the banking sector. As Giles Wilkes argued back in 2010:

‘Credit risk’ money could be usefully invested in many areas of the economy still struggling from a credit crunch, such as loan guarantee schemes that have already proven a success; funds offering finance to smaller companies; a National Infrastructure Bank; and further infusions of equity into the banking sector.

Or as the ex-MPC member Adam Posen argued for this week:

He also called on the Government to create a far more diverse credit market to enable small businesses to rely on more sources of funding than just banks.
He also labelled the lack of competition in the banking sector in the UK market as “extraordinary”, as well as calling for the creation of a small business bank.

Adam recognises that monetary policy alone is not enough and has also called for fiscal expansion through the provision of tax credits for investment and more infrastructure spending.

The renewed debate on the UK’s monetary policy regime is a welcome development (and it probably matters a great deal in the long run) but it shouldn’t breed a false complacency – I struggle to think of any monetary regime that could restore decent growth alongside the government’s current fiscal policy.

4 Responses to Dropping the Inflation Target?

  1. Richard W
    Dec 13th 2012, 5:46 pm

    Duncan, David Beckworth and Bill Woolsey write some good stuff on targeting the level of NGDP.

    This was a good article by Scott Sumner.

    Some papers here.

    If the central bank does its job properly targeting NGDP we would not be in a situation like now with the economy growth path widely diverged from the 2008 trajectory. The problems we are in is due to the gap between our current trajectory and where we should have been.

  2. Regime change at the Bank of England? « Left Outside
    Dec 13th 2012, 10:57 pm

    [...] Dropping the Inflation Target? from Duncan Wheldon [...]

  3. Why Are We Still Stuck in 1981? « uneconomical
    Dec 14th 2012, 8:27 am

    [...] don’t want to stretch the analogy too far.  But when I see comments like this, from Duncan Weldon: The renewed debate on the UK’s monetary policy regime is a welcome development (and it probably [...]

  4. Rob
    Dec 14th 2012, 1:17 pm

    “even in ‘normal’ times fiscal and monetary policy will impact upon different sectors in a different way”

    I see this argument a lot, and whilst it’s obviously true, it needs to be accompanied by more detail if it’s to be a useful consideration. Which sectors benefit most from monetary expansion, and which benefit most from fiscal expansion? For that matter, can we really talk in abstract terms about “monetary” and “fiscal” expansion as if there’s only one kind of each? Fiscal policy could be tax cuts or spending increases; the tax cuts could be regressive or progressive, and the spending could be on higher benefits, more infrastructure, increased public sector pay or employment, or some scheme to increase bank lending, and so on. Monetary policy can also take several forms, although these are definitely harder for laypeople like me to reason about (and trained economists don’t seem to do much better, judging by the level of disagreement).

    A possible crude interpretation here is that monetary policy works (toward the goal of increased demand) by boosting private sector activity and fiscal policy (of some kinds) works by boosting public sector activity. As such, one would expect the TUC to favour fiscal policy because this is most likely to be beneficial for its members – fiscal policy is more likely to involve creating more jobs or higher pay for public sector workers. I stress that this is a crude interpretation, but this looks like it might be one of the battle-lines over which the fiscal vs. monetary debate is fought.

    Maybe it’s all a lot more obvious than I think – I’m not an economist and so perhaps there are some fairly straightforward reasons why fiscal policy trumps monetary policy, or at least why monetary policy cannot work alone. But whilst I see people alluding to this idea (Adam Posen is quoted asserting it), I rarely see anyone explain why in terms that make sense to me.