Sunday, August 27, 2023
2% is hard - should we move the inflation goalposts?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

An epic battle is underway and has been for more than 18 months. Some say it is being fought with the wrong weapons, others that the outcome is not for us to determine but depends on international factors, but it continues. The battle is to get inflation back down to its official target of 2 per cent.

Though inflation has come down from its peak of 11.1 per cent last October to 6.8 per cent last month, there is a bigger journey to get from here to 2 per cent than that achieved so far. There is nervousness in government about where we go from here, particularly over the next couple of figures, which will determine how much state pensions and other benefits rise in April next year. That will be based on the September inflation rate. Household energy bills are heading in the right direction but petrol prices have been rising again.

The collateral damage from fighting inflation with higher interest rates, meanwhile, which can now be seen in the housing and labour markets and will spread elsewhere, is building.

The latest “flash” purchasing managers’ survey, published a few days ago, dropped well below the key 50 level and was headlined “UK private sector output falls at fastest rate since January 2021”. January 2021, to remind you, was at the start of the third Covid lockdown and monthly gross domestic product fell by nearly 3 per cent that month. Other countries are seeing a similar impact of higher interest rates.

Against that, consumer confidence continues to zigzag, this month reversing its July fall according to the GfK measure released on Friday, with people slightly less gloomy about their own personal financial situation over the next 12 months. Confidence, though, remains historically low, and the hit from higher interest rates has yet to be fully felt.

Is the battle worth the fight? Why do we have an inflation target, and why does it have to be 2 per cent? Would it make much difference if it were higher, say 3 or 4 per cent, is it meant less interest rate pain?

This is a debate that has been running for a long time but remains hot. Only a few days ago Jason Furman, former head of the White House Council of Economic Advisers, wrote in the Wall Street Journal that the Federal Reserve, America’s central bank, should lift its target from 2 to 3 per cent when it next reviews its strategy.

“Whatever considerations led policy makers to conclude that 2 per cent was the right number in the 1990s would lead them to consider something higher, like 3 per cent, today,” he wrote.

A bit of history might be useful at this point. The UK came to have an inflation target by accident just over 30 years ago, in the autumn of 1992. When the pound was forced out of the European exchange rate mechanism (ERM) on “Black” Wednesday in September 1992, the central plank of the government’s economic policy was removed.

In its place an inflation target was introduced. Legend has it that the process was helped by a couple of economists from New Zealand who were on secondment at the Treasury. Three years earlier, New Zealand had pioneered the introduction of an inflation target and an independent central bank given the job of meeting it.

The target, for inflation to be kept in a 1 to 4 per cent range, paved the way for Bank to be made independent in 1997. Its target was 2,5 per cent, for a measure known as RPIX, the retail prices index excluding mortgage interest payments. This was chosen instead of plain RPI because otherwise, the Bank would have been targeting a measure which mechanically went higher every time interest rates were increased.

Things became simpler with the shift to a CPI (consumer prices index) target in the early 2000s. At the same time as the shift, the target was reduced from 2.5 to 2 per cent, reflecting the fact that over time RPIX inflation tended to be about half a percentage point higher than CPI inflation. 2 per cent also became the consensus figure among central banks, though in the UK the target is set by the government, as it has been since 1992.

Why, despite the current difficulties, think about changing the target? After all, and this may surprise you, in its first 25 years of Bank independence, which ran until the spring of last year, CPI inflation averaged exactly 2 per cent, so bang on target. The very high inflation of the past year or so has tarnished the record, so the average since 1997 now stands at 2.4 per cent. Disappointing but not disastrous.

For economists like Furman, one of the strongest arguments for a higher target is that, while is seems like a distant prospect now, when 2 per cent became the inflation target, few expected that we would enter a long period with official interest rates at zero or very close to it. Stimulating the economy the economy meant central banks had to resort to quantitative easing (QE) and other unconventional measures. It is easy to forget now than two years ago, before it embarked on the current run of raising interest rates sharply, the Bank was busy putting negative interest rates into its policy toolkit. A higher target would give central banks more leeway, and more ability to cut rates when necessary, without even thinking of negative rates.

There is another argument, which in the case of the UK is more compelling. This is that, in spite of the record of the past quarter of a century, I am not sure that 2 per cent ever became the natural or “normal” rate of inflation in the UK.
I say this because if you look at inflation over the first 25 years of independence, when the rate averaged exactly 2 per cent, goods-price inflation over that period was a low 1.1 per cent, while service-sector inflation, a better measure of domestically generated price pressures, averaged 3.3 per cent. Goods prices were held down by the China effect and the initial price-reducing impact of the internet, factors which have faded in importance. Neither have prevented goods-price inflation surging over the past 18 months, and not just food and energy.

There is another piece of evidence, from the Office for National Statistics. In new research is has produced data for what it describes as the persistent component of CPI inflation, “that part of inflation which is common to all goods and services in the index”. It can thus be considered, says the ONS, “the general underlying trend or core inflation rate across the whole economy”.

It has calculated this trend or core inflation rate from January 2002 until last month, so a period of more than 20 years, and the average over that period is 2.75 per cent, so closer to 3 per cent than 2, even when the China and internet effects were more powerful.

Shifting to a 3 per cent inflation target would not be costless. For the government it would imply a permanently higher debt interest bill and increased costs in the long-term for uprating state pensions and benefits.

For everybody else is would mean a higher price level. Under a 2 per cent inflation target, if achieved, prices rise by 22 per cent over 10 years. With 3 per cent, it would be nearly 35 per cent. 2 per cent was chosen for the reason that it was a rate which did not interfere with business and consumer decisions. Firms and individuals would not be always trying to beat inflation. That might be true at 3 per cent, but it might not.

Perhaps most difficult would be the adjustment to a higher target, which could not be achieved without a loss of credibility and could not be attempted until inflation has subsided a lot more, probably to 2 per cent, at least for a while. In this respect, moving the goalposts would not help us out of the present difficulties. It might make such difficulties less likely in future.