Inflation targets & credibility

Should the UK abandon its inflation target? The case for doing so is that inflation targeting works badly when an economy is hit by supply shocks, as it is now, with food and oil prices soaring. Such shocks depress economic activity anyway, so attempts to control inflation by raising interest rates exacerbate the downturn.
Inflation targeting works best when inflation is the result of demand fluctuations. When this happens, the Bank can both control inflation and stabilize demand by cutting rates in a downturn and raising them in a boom.
So, what's the case for keeping the inflation target now? This chart shows it. It shows that when we've had a credible monetary policy - inflation targeting recently or Bretton Woods in the 60s - inflation has been lowly or negatively serially correlated. By contrast, when we had no such credible policy in the 70s and 80s, inflation was positively correlated.
Back then, people reacted to high inflation by thinking: "Our costs are going up. We need to raise our prices or wages to cover them." So inflation fed on itself. By contrast, a credible anti-inflation policy makes folks think: "The Bank is going to raise interest rates. So if we raise prices or wages, demand for our services will fall."  Rises in inflation are then only temporary. 
Better still, because inflation stays low because people keep prices and wages down voluntarily, the Bank doesn't actually need to raise interest rates  to control inflation. We therefore don't get policy-induced recessions as we saw in 1980 and 1990.
It's no coincidence that a low serial correlation of inflation - recently and in the 60s - was accompanied by stable growth, whilst positive serial correlation was associated with output volatility. For this reason, some believe more credible monetary policy has been a major cause of recent macroeconomic stability.
Herein lies the case for retaining the inflation target. Abandoning it will change wage and price-setters' expectations, causing them to expect high inflation to persist. The result will not just be higher inflation, but greater economic volatility as - eventually - bigger rises in interest rates will be needed to bring inflation down.
Luckily, though, we don't need to formally abandon the inflation target anyway. The Bank of England's remit (pdf) acknowledges that inflation can depart from its target as a result of "shocks and disturbances", and that rigid targeting in such circumstances "may cause undesireable volatility in output." This is why the penalties the Bank must pay for such deviations - a mere letter of explanation - are so small.
I would expect Mervyn King to draw attention to this clause.
His problem is two-fold. First, it might be that the negative serial correlation of inflation might have been due less to credibility than to dumb luck (pdf) - shocks to prices happen to have been short-lived since the mid-90s - which is running out. Second, policy credibility might be diminishing anyway; the eight-year breakeven inflation rate is 3.45%, implying that the gilt market expects the inflation target to be consistently breached.
Mr King's dilemma, therefore, is that if he relieves the economic pain now by cutting interest rates, he faces a much bigger job in future, because inflation will be harder to bring under control.
There's no simple solution to this.

Comments

[kinglear]

The greatest central bank was the Bundesbank through the late 60s 70s and even the 80s. Then they got snookered by Kohl, who, despite being told ( and promising) that he should do the Ostmark exchange at not less than 3 to 1, promptly gave a speech saying it would be 1 to 1. It took them ten years to sort that one out - and then got hit by the Euro - which arguably has taken them another 10 years. Now, of, of course, having been about 20% overvalued, they are the most undervalued in Euroland - and grew at a whopping 1.5% in the last quarter.
Of course, the Bundesbank had kept monetary growth steady over the whole period - which meant inflation was low and they regularly had to increase their rate of exchange under Bretton Woods.
What they didn't do was expand at 10% then 20% then at 2% then at minus 3% then at plus 25%.
It was more like 2.5% pa all the way through.
Worked a miracle. Merv should do the same.

[Bob B]

S&M - Good analysis and a robust case for the BoE to stick with the existing inflation remit IMO. Changing the target will likely open can of worms by removing anchor to inflationary expectations.

I don't think that it is sufficiently widely appreciated that the government's decision in December 2003 (against BoE wishes at the time) to substitute an inflation target defined on the CPI for the previous target defined on the RPIX effectively eased the stringency of the inflation target, not least because the CPI doesn't include house prices, unlike the RPI. This ONS graph shows how the two measures of inflation subsequently diverged:
http://www.statistics.gov.uk/CCI/nugget.asp?ID=19

Re the (? successful) monetarism of the Bundesbank: I'm not convinced that would work in Britain for several reasons, among which: openness of the London FOREX market to foreign exchange movements (over $700 billion traded daily in the London foreign exchange market according to Krugman) and concerns about the stability of the demand function for money, which is a necessary condition for monetarism to succeed.

Setting interest rates as the policy instrument has been relatively successful in curbing inflation in Britain and the brief experiment with setting money supply targets in Britain back in the early 1980s was not conspicuously successful. As I recall, the IMF wrote the obituary on monetarism back in 1996:

"...instability of monetary demand, especially in the context of supply shocks and declines in potential output growth, complicated the task of monetary authorities. As a result, during the 1980s most central banks – with some notable exceptions – either abandoned or downplayed the role of monetary targets".
IMF World Economic Outlook, October 1996, p.106.

[Bob B]

Readers may be interested to learn of a critical attack in a blog by John Redwood MP on maintaining the BoE's inflation target in the present phase of the business cycle. He argues that in current circumstances, setting interest rates with regard to maintaining output or jobs should take precedence over curbing inflation:
http://www.johnredwoodsdiary.com/

Perhaps the initial interesting questions are whether he is just being mischievous and, if not, whether the change in target will become official Conservative policy - after all, in the US, the FED has a remit from Congress to have regard both to inflation AND employment.

A new policy target for the BoE set by the Conservatives would be interesting because they lay claim to introducing inflation targeting in the first place - during Lamont's tenure as Chancellor with Alan Budd as chief economic adviser - even if GB went on to legislate for the BoE's indpendence, the structure and function of the Monetary Policy Committee and to formally embody the inflation target in a remit from Parliament to the BoE.

Besides the issue of whether the policy target set to the BoE should be changed, JR also makes a series of criticisms of the BoE for claimed errors of commission or omission in its economic commentary and policy decisions. However this discussion unfolds politically, it's certainly arguable that the economy is moving into territory where a debate will become timely.

[Matthew]

The BoE's target is also to support the policy of the government, i.e growtn and employment, but without prejudicing the inflation target.

I find Redwood's comments a bit strange. Some of his ideas for strengthening BoE independence sound good, but he used to oppose it entirely, believing Chancellor's should set interest rates. Furthermore given Tories have been complaining for ages that the move to the CPI was designed to weaken the fight against inflation, to say now that the CPI and RPI are flawed because they include goods whose prices are going down (I assume he means like flat screen TVs) seems perverse, and however you dress it up a move to other policy objectives will be seen - as it is - as a further weakning of the battle against inflation.

[Bob B]

"to say now that the CPI and RPI are flawed because they include goods whose prices are going down (I assume he means like flat screen TVs) seems perverse"

"Perverse" puts it tactfully - although I must admit that I've not actually come across that complaint by Tories.

We agree here that changing the BoE's remit right now would be widely interpreted as weakening the fight against inflation but we say that now before the full effects of the credit crunch and the economic slow-down have yet to work through and with expectations that the US economy is not going to sink into a deepening, U-shaped recession.

I suspect we might want to soften that a mite if forecasts for the UK economy started to signal full-blown stagflation with falling real GDP and a rising rate of inflation. However, since the BoE's interest rate decisions reputedly take account of what will likely happen two years downstream, presumably if clear expectations of a deepening future recession were to emerge then that would influence the BoE's decisions about interest rates.

By way of contrast with the UK government's clear, unambiguous remit to the BoE to focus on maintaining the inflation rate, as measured by the CPI, at 2 per cent with +/- 1 per cent margins, I'm intrigued by the (ambivalent) statutory mandate set by the US Congress to the FED which requires the latter to take account of both price stability and employment [1]. Logic and theory are on the side of the clear remit to the BoE but American economists are surely fully aware of the fudge in the remit to the FED.

[1] FED chairman Bernanke's reflections in 2006 on the policy objectives of the FED:
http://www.federalreserve.gov/newsevents/speech/bernanke20060224a.htm

[Matthew]

Redwood said:

Even the RPI at 4.2% does not reflect the full pain of the very high increases in the prices of the basics that we have to meet day by day, owing to the weightings of cheaper and lower inflation goods in the RPI.”

I don't understand why 'cheaper' goods would make any difference to an inflation rate, but presumnably 'lower inflation goods' means things like flat screen TVs etc. But this simply misundersands the nature of an index, doesn't it?

[Bob B]

Absolutely. That does raise questions as to whether Redwood really understands what inflation targeting as an objective of central bank monetary policy entails.

His excuse, I suppose, is that his degree and All Soul's fellowship relate to history, not economics. Even so, he might have read up Bernanke on inflation targeting as he was regarded as a leading expert on the policy prior to his appointment as FED chairman. IMO Redwood's fundamental problem is that he lets his partisan zealotry cloud his capacity for clear thinking.

From this report in The Economist, George Osborne, the shadow chancellor, is evidently not mired in Redwood's confusion, something which the reporter would have been quick to pick on in the context:
http://www.economist.com/world/britain/displaystory.cfm?story_id=11293970

And Osborne is certainly alert to questions about what items should be included in the price index used to measure inflation. The BBC's business editor, Robert Preston recently focused on Osborne's reflections on what central banks, like the BoE, should do about discouraging asset price bubbles:
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/04/osborne_and_the_next_crunch.html

" . . . Osborne is therefore attracted to a proposal put forward last year by a former member of the Bank of England’s monetary policy committee, Charles Goodhart, whose effect would be to impose restrictions on how much banks can lend during years of strong economic growth and would ease those restrictions when the economic cycle turns down."

Reviving that old monetary policy option of contracyclical variations in the reserve ratios of banks to dampen asset-price booms is certainly an "interesting floater" - especially with global finance markets - although almost anything Charles Goodhart says about banking has to be treated seriously. Btw Goodhart's book: House Prices and the Macroeconomy (OUP 2007) proposes that house prices should be included in the measure of inflation targeted by the BoE - as, indeed, they were until GB decided in December 2003 to define inflation by the CPI instead of by the RPIX - contrary to the advice of the BoE at the time, it should be said.

[Bob B]

Do read Robert Preston's blogging today on his interview with Jean-Claude Trichet, president of the European Central Bank. Trichet warns that the downstream consequences of the credit-crunch aren't nearly over yet:
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/05/trichet_beware_the_oil_shock.html

Trichet is saying that if central banks don't continue to curb inflation in the face of rising global energy and food prices then we would have to cope with the entrenched high levels of unemployment and inflation that followed the hike in oil prices in 1973/4. Evidently, he wasn't persuaded by John Redwood.

[Bob B]

Update for those still following this topic:

Pressures to relax or scrap the BoE's inflation target of 2 per cent, as measured by the CPI, are widening and deepening; witness these quotes:

"The Government must consider re-writing the Monetary Policy Committee's remit or leave the UK to face an unnecessarily deep and painful economic slump, according to Peter Spencer, chief economist of Ernst & Young Item Club."

And:

"Nobel prizewinner Joseph Stiglitz argued, on the other hand, that: 'The weaker economy and higher unemployment that inflation targeting brings won't have much impact on inflation; it will only make the task of surviving in these conditions more difficult.'"
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/16/cnbank216.xml

But I'm still going to need an awful lot of convincing that raising the BoE's inflation target is going to help curb inflation.

George Soros thinks the worst is yet to come:
http://news.bbc.co.uk/1/hi/7408620.stm