BoE after Boris Johnson: Should the inflation target be raised? | Howard Davis

TThe performance and mandate of the Bank of England has become a central issue in the competition to succeed Boris Johnson as leader of the Conservative Party, and thus as Prime Minister of the United Kingdom. But with recent reviews of other leading central banks offering little guidance amid today’s high inflation, it may make sense to revive an old idea of ​​fixing the prevailing anchor of monetary policy.

Not surprisingly, the bank’s performance is in question, given the central bank’s 2% annual inflation target. With UK inflation currently at 9.4% and expected to exceed 13% later this year, it is clear that something has gone wrong. But some Tory leadership candidates, notably front-runner Liz Truss, have gone as far as to criticize Andrew Bailey, the bank’s governor, for taking his eye off the ball. They talk about changing the goals of the bank, or even its very position. Truss has pledged to change its mandate to sharpen its focus on inflation, and one of her aides questioned whether the bank was “fit for purpose in terms of its complete exclusionary independence from interest rates.”

No, I don’t know what that means either – but it seems like a threat. Others spoke of being “more directive in preparation [the Bank’s] Mandate” and noted that some of the inflation today is caused by growth in the money supply. This hints at the possibility of reintroducing money supply targets, which were in vogue under the Margaret Thatcher government in the early 1980s.

As it happens, I had the wonderful job title of “Major Monetary Policy” at the Treasury in those distant days when the government set interest rates to meet money supply growth targets. Things did not go well. We have tried several different procedures but none of them are reliable. This validated (Charles) Goodhart’s law: When a measure becomes a goal, it ceases to be a good measure.

While there is no clear alternative to the bank’s inflation targeting system, which has been in place since 1997, some kind of review seems likely. In fact, the bank is a bit unusual among the leading Western central banks because it hasn’t been “reviewed” in recent years. The Bank of Canada, for example, undergoes such an exercise every five years. The latest revision, at the end of 2021, left the 2% inflation target for the bank, although there is some new wording about the focus policymakers should place on unemployment.

In New Zealand, on the other hand, the central bank’s governance has changed dramatically last year. A committee, rather than a unilateral governor, will make monetary policy decisions, and the bank will pay more attention to housing prices. Similarly, Australia’s new Labor government recently launched an external review of the Reserve Bank’s mandate.

The two most important Western central banks – the US Federal Reserve and the European Central Bank (ECB) – did not suffer anything inappropriate as an external evaluation, and were allowed to do their homework. The Fed’s review in 2020, when US inflation was persistently low, took its mandate as set but concluded that “after periods when inflation has been consistently below 2%, monetary policy is likely to aim The occasion is to achieve moderate inflation above 2% for some time.” The Fed has certainly achieved it over the past year, although I doubt 9.1% annual inflation was exactly what he had in mind. I suspect the term “average inflation”, like “future guidance”, will now be thrown into the pastures.

The ECB review, which was also conducted against the background of low inflation, came to a similar conclusion. The bank made the 2% inflation target the same, which it always should have been, and added a few words about taking into account asset prices (particularly home prices), reducing the role of cash aggregates, and looking forward to “a transition period in which inflation will be moderately above target.” On this final measure, the ECB also somewhat outperformed — but the cure has proven worse than deflationary disease.

Therefore, there is little in these other reviews that can provide a useful model for the Bank of England in the current circumstances. But there is one idea that is worth studying, although it was also conceived at a different time and for different problems. When he was chief economist at the International Monetary Fund, Olivier Blanchard argued that the 2% inflation target was too low because there may be long periods when interest rates are at zero, meaning that any additional monetary easing necessitates quantitative easing, with unimaginable results. Confirmed. With a 4% inflation target, those periods would be much shorter, and monetary authorities could retain the ability to manipulate interest rates.

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One could argue that such a change would be more appropriate for a time when inflation was very low. But nonetheless it could have some significance today. Pressing double-digit inflation out of the system will almost certainly be costly in terms of lost production and jobs. Some of the froth may disappear as energy prices stabilize, even at high levels. But getting inflation back to 2% will be difficult, given the way inflationary expectations have become so embedded in wages and prices.

We may need something approaching former Federal Reserve Chairman Paul Volcker’s attack on the double-digit interest rate, which brought US inflation down sharply in the early 1980s. But even Volcker declared victory when he cut annual price growth to 4%.

The risks of raising the inflation target when price increases get out of control are clear. But doing so could give central banks more flexibility, and lead to a more stable monetary policy regime in the long run, for the reasons Blanchard outlined. Such an outcome would certainly be better than bringing interest rates back into political control.

Sir Howard Davies, the first head of the UK’s Financial Services Authority, is Chairman of the NatWest Group. He held the position of Director of the London Stock Exchange and served as Deputy Governor of the Bank of England and Director General of the Central Bank of Iraq.

© Project Syndicate

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