The BoE Unsteady Inflation Policy

By Patrick Corby

Bank_of_England,_London

Last October Sir Mervyn King, governor of the Bank of England, gave a speech to commemorate the 20th anniversary targeted inflation by the BoE which has been set at 2% and set up by Sir Mervyn himself since 1992.

But Mark Carney, the next governor of the Bank of England that is set to take position this year, has openly stated that this may all be about to change as he prepares to take a much more aggressive approach to reviving the UK economy. This may include dropping the long held BoE inflation target.

Mr Carney, currently head of the Bank of Canada, has stated that instead of inflation targeting GPD growth targeting would be far more effective in achieving desired political goals. “For example, adopting a nominal GDP-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting,” he said.

In this case credit manipulation would be used to whatever extent needed to spur growth and secure up a deflationary market post – financial crisis instead of a set inflation rate tool for politicians in which a market must adapt.

The ultimate decision of changes to the UK inflation target would rest with Chancellor George Osborne and be headed by the other eight members of the Monetary Policy Committee. As it stands the chancellor is supporting this debate as healthy towards political goals of reviving the economy through monetary policy.

The Arguments

The first is the focus on inflation targeting gives the security needed to the sinificant market signal of price stability. Removing the volatility associated with credit manipulation and allowing a set rate provides a far better economic climate for business forecasts and therefore further growth in production. Mike Wickens of the University of York has defended this position “monetary policy should be aimed almost entirely at sustaining inflationary expectations.”

In this sense inflation targeting does the job that secures credit policy. Yet in Mr Carney’s view this target gives far little flexibility to the BoE to spur growth whether too inflate or deflate the English currency.

The second argument is that inflation targeting was set in place in the run up to the the 2007 financial crisis and was not effective in controlling its onset. “It failed badly in the run-up to the crisis by allowing too much credit growth in the economy and a housing bubble; it cannot cope with external inflation shocks; and it has been de facto dropped since the crisis deepened in 2009.” Tony Dolphin of IPPR has stated.

Although inflation targeting does provides stability it does not entirely rid the economic system of the instability that comes with a monetary policy of credit manipulation. Inflation may be set at 2% which will provide some stability to business but it cannot control the malinvestments, speculation and the price distortions that are the sharp edge of the political sword. It also does not reduce the volatility of external economic events that increasingly effecting the global market.

The solution to this problem is market orientated regulation that provides more stability through a framework of law instead of monetary policy. This strategy has been implemented in capital requirements in the Basel III act and other tightening of regulations surrounding credit.

The final major problem with inflation targeting is that only addresses domestic inflation and global inflation is quickly shadowing any significance of domestic controls. When inflation arises from global factors in say commodities or energy political tools such as credit manipulation may not hold the power that is needed to steady markets.

The policy response to these kinds of global factors has been to weaken and depreciate the domestic currency to make it more ‘competitive’ instead of allowing it to appreciate and strengthening it to offset global inflation. Sir Mervyn and the committee have leaned far more to a depreciation response than making the Sterling a strong currency that can hold its weight in the global marketplace. In Mr Carney’s view GDP targeting could be used to inflate or deflate Sterling in order to revive the UK economy in a steady fashion.

The BoC under Mr Carney was also the first in the G7 to raise interest rates showing that Mr Carney could in fact prove a more audacious leader in monetary policy. Willing to take the political brunt to give the Sterling long term strength instead of short term competitiveness in appreciation.

Some argue that instead of changes in inflation targeting the BoE must make inflation policy more steady and transparent in order for businesses to respond efficiently. For example the inflation of the Pound Sterling since 2007 has been closer to 3.5% than the set 2% outlined by the BoE. These changes should include a clear strategy and set circumstances for interest rate policy to change. This would create far more predictability and security for a market that is in dire need of such confidence.

George Buckley of Deutsche Bank aggressively opposes the power of GDP targeting against inflation targeting:

“No, and no. Nominal GDP targeting in an era of potentially far slower trend growth could generate sizeable increases in inflation. This could lead to a serious loss of credibility for the authorities, substantially higher long-run inflation expectations and in the long-run a deterioration in the trade-off between underlying growth/employment and inflation.”

 

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