Sunday, February 28, 2010
Don't mess too much with inflation targets
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


At some stage those who run economic policy will shift from managing this crisis to ensuring they are doing enough to prevent the next one. Before the crisis, it all seemed so simple. Most countries adopted inflation targets implicitly or explicitly and nudged a single instrument, the interest rate, to ensure it was met.

I often had to explain to younger readers that monetary policy in Britain had not always been about nine people sitting round a table at the Bank of England each month and deciding whether to change interest rates by a quarter of a point.

Britain was not the first to adopt such a target but it, and an independent central bank, were the cornerstones of UK economic stability and success. Were we deluded? An International Monetary Fund paper published this month suggests, in part at least, that we were.

Written by IMF chief economist Olivier Blanchard and two colleagues, its essential point which will not surprise non-economists is that we were not as good as we thought. The period before the crisis, the "great moderation", or "great stability" was not, after all, proof that policymakers had cracked it and, as Tony Blair and Gordon Brown kept telling us, eliminated boom and bust.

"As the crisis slowly recedes, it's time for a reassessment of what we know about how to conduct macroeconomic policy," said Blanchard, launching the paper, Rethinking Macroeconomic Policy, available on

"We now realise that economists and policymakers alike were lulled into a false sense of security by the apparent success of economic policy ahead of the crisis."

Inflation-targeting, some believe, was the source of many of the problems of excess we are suffering from. Low and stable inflation, and the absence of nasty surprises on interest rates, encouraged lenders and borrowers to take more risks than they should have done. Stability on the surface concealed huge instability. If inflation and interest rates had been more volatile, things would not have got so out of hand.

So should the lesson of the crisis mean we should no longer target inflation and build in a bit more volatility? No. Aim for volatility and you will get more of it than you can handle. Inflation-targeting, while far from flawless, has been the most effective model for UK monetary policy in modern times, and for many other countries.

The mistake, as the IMF paper points out, was that low and stable inflation was assumed to be both necessary and sufficient for wider stability. Those at the top at the Bank of England ignored the concerns about financial stability raised by their own experts and were not alone.

All this must change. We should keep inflation targets but they have to be augmented. Central banks were guilty of ignoring something that should have been near the top of their agendas: what was happening in the banking and shadow banking system. Money and credit were seen as only important for inflation, not whether they were creating dangerous market bubbles. We will not see a return to old-style credit controls but new so-called macro-prudential tools, to constrain the banks' ability to bankrupt the economy. That has to happen.

Where the IMF paper has got it badly wrong, I think, is in its suggestion that it would be sensible to raise the inflation target in Britain and elsewhere from 2% to 4%. Its argument is that, just as a 2% inflation target was associated with a normal interest rate of 5%, so a 4% target would be associated with a rate of, say, 7%.

When crisis strikes, there is more room for cutting rates from 7% than from 5%. The "zero bound" interest rates cannot normally go negative is a lot further down.

Why is this idea wrong? After all, 4% is not much higher than 2% and might not make an enormous amount of difference, particularly if adopted by all countries.

It is wrong because, while I am no inflation nutter, adopting a target that doubles the price level every 15 years seems to me irresponsible. It is wrong because it would endorse every suspicion in the bond market that governments will seek to inflate their debt away, rather than go through the hard job of raising taxes and reining back spending. It would be a surefire way of igniting a huge sell-off in government bond markets.

Most of all, I think it is technically wrong. Imagine if, over the past 10 years, Britain had had a 4% inflation target. Most of that period, inflation was below 2%. To inflate up to the higher target, interest rates would have needed to have been lower rather than higher. A 4% inflation target might have been associated with a typical Bank rate of 2% or 3%, rather than 7%. The future will be different from the past but perhaps not that much. A higher inflation target would have meant an even bigger boom is asset prices.

Indeed, I would draw the opposite conclusion from the IMF. For Britain at least, the Bank should have aimed lower on inflation. I say this not for the usual trite arguments about the inclusion, or not, of house prices in the consumer prices index (CPI).

The old pre-December 2003 inflation target, the retail prices index excluding mortgage interest payments, included a house-price element but did not signal inflationary problems any sooner than the CPI, even as late as 2006 and 2007.

No, the argument is a different one. From the adoption of inflation-targeting in late 1992, it had always been a tale of two inflations in the UK. On one side was domestically generated, mainly service-sector inflation, which stayed closer to 4%. On the other was goods-price inflation, much of it reflecting import prices, which was zero or negative.

The Bank took the benefit of favourable goods-price inflation to achieve, or better, the target it was set. The Bank was too easily satisfied. It should have got domestically generated inflation down to 2%. That would have meant higher interest rates and, perhaps, rather less credit-generated exuberance.

However, some of those favourable goods-price developments, the "China effect", have faded. Though the Vat increase complicates it, goods-price inflation is now at 3.9% versus 3% for services.

When the dust has settled, 2% is still a pretty good target. The Bank's medium-term aim, when the economy is strong enough to take higher rates, has to be to get domestically generated inflation down to that. But don't mess about with the target.

PS: It may be seasonal but a certain bleakness has descended, notwithstanding Friday's welcome upward revision to growth in the fourth quarter from 0.1% to 0.3%. Revisions to earlier data made this the deepest recession (6.2% peak to trough) in the post-war period, while the details raised doubts about whether the upturn can be maintained. It is not sensible to get too hung up on this, given that further data revisions are inevitable but, as I say, the mood has darkened.

Hopes of an investment-led upturn look sick, with official figures showing a drop in business investment of 5.8% in the final quarter, for a 24.1% plunge on a year earlier. Other data have been downbeat, though the CBI thinks the high street bounced from its January lows.

The gloom was there from Mervyn King and his Bank of England colleagues in evidence to the Commons Treasury committee, confirming that the debate on whether to add to the 200 billion of quantitative easing was close and there could be more to come. The recovery is merely "nascent" and the Bank's worry is that any export-led upturn will be snuffed out by weakness in Europe.

When central bankers are gloomy, as Ben Bernanke, Federal Reserve chairman, was last week, it raises the question of whether they know something we don't. I suspect they are programmed to take a glass half-empty view of things. Few of them saw much that was over-exuberant in the credit boom.

Their mood does tell us they will be slow to raise rates. Three members of the shadow monetary policy committee, which meets under the auspices of the Institute of Economic Affairs, think the Bank should raise rates to 1% this week. Much as I love the shadow MPC, I don't think that will happen.

From The Sunday Times, February 28 2010