• Log in
• Register free
• Subscribe
• Help
• Tour & Trial IC Advantage

The end of inflation targeting?

Created:

29 January 2010

Written by:

Chris Dillow

Did the Bank of England get it badly wrong in 2008? Adam Lent at the Trades Union Congress thinks so. Interest rates, he says, "were held too high for too long"; as recently as September 2008, Bank rate was at 5 per cent.

However, the Bank has a powerful defence against this charge. Its job is to target inflation, not growth. And if we judge it by what it's paid to do, the Bank's performance in 2008 looks very different. Consumer price inflation is now 0.9 percentage points above its 2 per cent target, which suggests rates were too low in 2008. Granted, it might be harsh to judge the Bank by what will almost certainly be a short-lived blip; economists expect inflation to be back around target later this year. If we look beyond the blip, monetary policy was about right in 2008.

We have, then, a conflict. Output growth tells us monetary policy was too tight in 2008. Inflation tells us it was either too loose or about right.

However, this conflict wasn't supposed to happen. The Bank of England says: "When the Bank of England changes the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation."

On this view, targeting inflation and targeting growth amount to the same thing. If a boom is approaching, the Bank should raise interest rates to cool economic activity and hence reduce the inflation it will cause. And if a recession is coming, the Bank should slash rates to ameliorate the downturn and so stop inflation dropping.

What's more, the Bank has a rough idea of the chronology here. It says: "The maximum effect [of interest rates] on output is estimated to take up to about one year. And the maximum impact of a change in interest rates on consumer price inflation takes up to about two years."

In this sense, stabilizing output and targeting inflation fit together nicely.

Our current experience, however, suggests this cosy view might be wrong. If forecasters are right, inflation will end this year at 1.9 per cent, which is exactly where it was when the credit crunch started in 2007. The worst recession for 80 years, then, has not reduced inflation. Which means we should rethink the conventional idea that aggregate demand drives inflation and so interest rates can determine the latter by affecting the former.

So, what's the problem?

One possibility is that the Bank has got the mechanism right, but the lags are longer than it thinks. Maybe it takes more than two years for weak demand to depress inflation.

There are two reasons for this.

One is that foreign exchange markets might respond to a downturn by selling the pound, which would raise import prices and hence inflation. One reason why inflation is high today is that the pound fell in late 2008.

Secondly, firms don't necessarily cut prices if demand is falling. They do so only if the price-elasticity of demand is high. In a recession, however, it might be low - because the marginal customer (the one who would otherwise be looking for a new supplier) is not spending money. This means that price wars might be less likely (pdf) in slumps than in booms. And it means firms that are desperate to raise cash might raise prices - because they need some cashflow now, not more cash in the future, after they've gone bust.

If we take this view, inflation this year tells us not that monetary policy was too loose in 2008 - because it's too soon for that to have affected inflation - but that it was too loose in 2006 or 2007 (or even earlier). It could be, then, that Mr Lent will be proved right; maybe policy was too tight in 2008, because inflation will fall markedly in 2011 or 2012.

However, this implies that the conventional view of monetary policy - that rates should be set with a view to where inflation will be in two years' time - needs rethinking. Maybe the lags are such that rates can't affect inflation much in this timeframe, and they should instead be set with regard to inflation three or four years' hence.

There is, though, another view. This says that fluctuations in demand are only part of the story. There are also fluctuations in supply potential. These can cause economic activity to fall and inflation to rise. The most obvious of these are rises in commodity prices; higher oil prices raise inflation and reduce growth. But it's also possible that lower productivity of capital or labour, or just of a few big firms, might also reduce growth and raise inflation.

The very fact that inflation is high now and output low is perhaps - only perhaps - evidence that we have been hit by some kind of supply shock; a big surprise about this recession, after all, is the fall in productivity.

If these shocks hit the economy regularly, then monetary policy becomes a very different beast. Far from it being a source for more stable short-term activity, it can actually become a destabilizing force - because if interest rates rise in response to higher inflation, they might actually deepen the downturn caused by the productivity fall that has generated the inflation.

All this suggests we might need a radical rethink of macroeconomic policy. Over what time horizon does monetary policy affect inflation? Do interest rates stabilize both inflation and activity - as happens if the economy is hit only by demand shocks - or might they control one only at the expense of the other, as happens with supply shocks? If the answer is - at least sometimes - the latter, then does this suggest that governments need some other policy tools? But if so, what, given that fiscal policy likely to be directed towards reducing government debt in the next few years?

I don't the answers here. But I do know that the recession has raised doubts about the conventional view of inflation targeting. The basis of macroeconomic policy has become an issue again.

• Share Tips
• Trading
• Companies
• Markets and Sectors
• Columnists
  • Bear Bull
  • Chris Dillow
  • No Free Lunch
  • Simon Thompson
  • The Trader
  • Your Opinion
• Stock Screens
• Funds Data
• Research Tools
• Investment guides
• Events
• Q and A

requires IC Advantage

---

Subscribe today

Celebrate our 150th anniversary with fantastic savings on a joint magazine and IC Advantage subscription.

Subscribe today and save £150