A new target for the Bank of England?

Bank of England Mark Carney takes over as governor of the Bank of England in June

The Bank of England has had a formal inflation target since the early 1990s. Is it the time for it to target something else?

That's the debate rumbling among economists these days - a debate that is now getting more attention thanks to a speech this week by the next governor of the Bank of England, Mark Carney, and the Federal Reserve's move to target unemployment. (See my last blog.)

In his speech, Mr Carney said it might make more sense in today's circumstances to target not the growth of prices (inflation) but the growth in the cash value of economic output: nominal GDP.

Academics and policymakers have been drawn to the idea of targeting nominal GDP, off and on, for decades, but they've hardly ever ended up wanting to do it in practice.

Will this time be any different? I wonder. But the liveliness of the debate shows you how concerned many now are about the prospects for economic growth.

Remember how we got inflation targets in the first place: we got them because academic opinion suggested that central banks could not really affect the underlying growth rate. The most that they could do was to provide a stable environment for growth, by controlling the rate of inflation.

In the 1980s we thought the best way to do that was by targeting the growth rate of money, but they could never find a measure of the money supply that had a reliable relationship with inflation. So they decided, in the 1990s, to cut out the middle man and just target inflation.

That was clear and easily understood by the public. It also seemed to work, which is why nearly every major central bank in the world (except the Federal Reserve) ended up with some form of inflation target.

Massive threats

We now know there was at least one big problem with this narrow approach: it encouraged the Bank of England to ignore a lot of other important stuff such as rising asset prices and the build-up of huge debts within the banking system, which weren't causing inflation but turned out to pose a massive threat to our economic stability.

That problem, in theory, is now being addressed, with the creation of the new Financial Policy Committee at the Bank for example. But the economy has done so badly over the past few years that some say the inflation target is leading the Bank to miss something else that is equally important: economic growth.

If the Bank targeted the cash value of GDP then the Bank would become responsible for the overall level of economic activity, not just the annual change in the consumer prices index.

So, to give a concrete example, you might say, instead of 2% inflation the Bank should achieve 4.5% growth in cash GDP every year for 10 years.

Of that 4.5%, you might hope that roughly 2.5% would be real growth in national output and the rest inflation. But under a strict nominal GDP target, the breakdown doesn't matter. You just have to get 4.5% nominal growth.

'Bygones are not bygones'

The other key feature of this approach is that if you fail to achieve the target you have to try to make up the difference in the years that come after.

So, as Mark Carney said in his speech, "bygones are not bygones": past failures affect future policy.

That is a big difference from inflation targeting, which always looks forward and, in effect, treats every monetary policy committee meeting as if it were the first. It is also why monetary "activists" like the idea of a switch, because it would put the Bank under pressure to do more to stimulate growth right now.

Since 2007, nominal GDP growth has averaged just 2.6%. To make up for that lost growth in the next five years, the Bank would need to target growth in nominal GDP of well over 6% a year between 2013 and 2017.

The current OBR forecast has cash GDP growing by just under 4.3% on average over this period. The forecast for 2013 is for nominal growth of 3.3%.

So, a big short-term reason why people like this idea is it gives the Bank license - indeed forces it - to do more, in an environment in which interest rates are already at rock bottom and central banks are finding it hard to persuade businesses that normal rates of growth are going to come back.

In effect, moving to nominal GDP targets would send a signal that the Bank was determined to get back the nominal growth in the economy that has been lost, even if it is at the cost of pushing inflation above 2% for a sustained period of time.

Less concerned

A longer-term reason why some prefer nominal GDP targets is that they would make it easier for the Bank to respond to supply shocks, such as a rise in the oil price, in a way that would not add to the short-term damage to the economy.

In 2008, for example, the European Central Bank raised interest rates just months before the financial crisis because of rising commodity prices and their likely effect on inflation, even though the European economy was already weakening sharply. Rate-setters in the UK considered doing the same as late as August that year. Under a nominal GDP regime, that wouldn't have happened. They would probably have cut rates.

But critics can also some raise some pretty powerful arguments against a change of target, the strongest being that the Bank of England would be giving the mistaken impression that it can control economic growth when it can't.

In the current environment, the change of target might also send a message that the Bank was not so concerned about keeping inflation low. In fact, for the next few years at least, it would be saying that it was not very concerned about inflation at all, if that was what it would take to deliver 6% plus nominal growth.

There are also practical arguments against a new target: such as the fact that nominal GDP is not calculated in a timely fashion and - unlike the CPI - is subject to large and frequent revisions. Also, most of the public don't have a clue what nominal GDP is, which is not a small objection.

But, as I said on Thursday, the biggest argument against that you hear from people at the Bank is that our "flexible inflation targeting" regime already gives you everything you might have wanted from a nominal GDP regime. After all, it's not as if the Bank has stuck slavishly to its inflation target over the past few years. Far from it.

The MPC has "looked through" the supply shocks that have hit the economy and pushed up inflation over the past few years - just as it might have done under a nominal GDP regime. It has done this without ever formally changing its mandate or raising questions about its long-term commitment to low inflation. That is surely preferable, say Bank officials, to a highly visible and possibly counterproductive regime shift.

Perhaps, but what opponents of nominal GDP targets seem to be saying is: "why change the inflation target, when you can just ignore it?" Some of them also seem to be saying that the Bank has actually been following a nominal GDP target for some time, it just hasn't told anyone.

The fact that people don't understand what nominal GDP is seems to me to be a really strong argument against making it a target. The backward-looking nature of this approach is also troubling, even to potential fans of the approach such as Mark Carney. There's a risk that the Bank will always be fighting the last war and thus - possibly - paving the way for the next one.

So, the debate will continue, and the defenders of the current regime have some strong lines of defence. What does not seem to me to be the best argument for the inflation target, given everything that has happened, is the confident claim that the people at the Bank will always be clever enough to know when to ignore it.

Stephanie Flanders Article written by Stephanie Flanders Stephanie Flanders Former economics editor

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  • rate this

    Comment number 40.

    Until we draw a distinction between money and wealth, we will get nowhere.

    It suits the so-called Merchant Banks to blur this distinction because it hides the fact that they are siphoning money from the productive members of our society.

    Money was invented as a means to assist barter. To use it for anything else is an insubstantial confection which erodes trust and facilitates dishonesty.

  • rate this

    Comment number 39.

    On the basis of GDP targets, all the BOE need to do is increase QE in one form or another and GDP will increase. Inflation will probably increase even more and chaos will ensue. I think if you checked Zimbabwe's nominal GDP, it is way in excess of 4.5%.

  • rate this

    Comment number 38.

    Tell the public what GDP is and they may understand.
    I agree with the target should be both GDP and Inflation.

  • rate this

    Comment number 37.

    You sell stuff you don't want abroad and stuff that you want you keep. So nobody will buy the stuff you don't want because if you don't want it they will think there is something wrong with it. So you are still running in the rat race.

  • rate this

    Comment number 36.

    Whatever the target, it is time savers were rewarded and profligacy was

  • rate this

    Comment number 35.

    One assumes that the BoE MPC makes monetary policy. Alas you cannot live in, ride in, eat or keep warm on monetary policy. It's not GDP that needs to be stimulated but our capacity to make useful stuff that we can export and use ourselves so as to reduce imports. We also need to free up our capacity to make useful stuff by sorting our our mess of a tax system. Then GDP will look after itself.

  • rate this

    Comment number 34.

    Who else remembers 15% inflation and the effect on mortgages and borrowing?

    Workers fear it especially when wages don't inflate and big business and stock markets delight in it.

    There has been good reason to control inflation but it seems a new experiment is about to begin to try to inflate the debt away.

    Heaven help us.

  • rate this

    Comment number 33.

    By giving the BoE more political targets it will then in turn says that it needs more powers, is this not just a step towards it becoming an independent version of HM Treasury ?
    If growth in GDP is a target then will it end up investing in UK businesses ???

  • rate this

    Comment number 32.

    “... rising asset prices ... weren’t causing inflation ...”

    Surely the pretence that rising asset prices do not constitute inflation is the problem.

    The definition of inflation is too narrow, not the target.

    Target a much broader definition of inflation and make it cumulative.

  • rate this

    Comment number 31.

    Let me get this right. If real GDP is stagnant for ten years you can still meet your nominal 'cash' GDP growth target simply by increasing the money supply by 4.5%-no doubt with thanks to QE.

    That's not a target: that's marking your own homework and a self fulfilling prophecy rolled in to one but, as Mr Carney might say: 'hey, it's a real doozy.'

  • rate this

    Comment number 30.

    Same old story: the new target is the current problem.

    They weren't particularly good at the last target, were they?

    How about not having targets but a list of priorities?

    Once upon a time central bankers used to be able to think for themselves. Now they seem to want a manual. Doesn't look good at all.

  • rate this

    Comment number 29.

    you couldn't easily unpick the lie sense fee because all those people on 40K would suddenly have nothing and their children would be poor especially if they spent all their income and not saved anything prudently in the boom years and you could not cut taxes when people can't take a pay cut and are a monopoly on vital services and also all those people who will fight for their humanitarian ideals.

  • rate this

    Comment number 28.

    Let me get this straight - it is being suggested that nominal GDP growth should be a target and this is a mix of actual growth and inflation.
    So give the BoE a target nominal GDP growth of 10% (to beat China). Our economy crashes resulting in an actual GDP drop of 5% (due to factors outside of our control).
    Solution is to force inflation to 15% - meeting target.
    Not sure this would help.

  • rate this

    Comment number 27.

    Well, I've been posting on this for over three years & at the risk of boring everyone - again - I have to say that if GO is wise & brave & far sighted, he will say to the BoE/MPC "We are going to take inflation negative & keep it there."

    It will require a team effort because it will involve Treasury - even the Foreign Office if we have to get stroppy with the EU - and it will be hard work.

  • rate this

    Comment number 26.

    There are also some real problems in the economy for example if you do not get out of bed in the morning your neighbour's 4 doors down 5th child may not get breakfast so that makes you unmentionable and just think what would happen if all those people in prison for murder got out and the sanitation and public services stopped running you'd be in trouble then sunshine. Eg. dependency is a problem

  • rate this

    Comment number 25.

    I don't see what's wrong with targeting nominal wage inflation instead (cut out the top 1% of course). I believe 4% is the suggested figure.That puts a lid on inflation, promotes growth and ends all the silliness surrounding if cost-push/demand-pull inflation, given that commodity prices no longer have any relation to our own domestic economy. GDP targeting will be a communications nightmare.

  • rate this

    Comment number 24.

    @15 I have strong reason to suspect the Crash in the US was originally caused by a team of Actuaries who were worried about Climate Change. I have a feeling that unless that aspect is addressed the Global Economy won't be able to recover.

  • rate this

    Comment number 23.

    This isn't a meritocracy where you profit from your own work. We live in an ocracy where if you earn one pound then 60% of it goes to the civil government as they catch every wave in town income expenditure sales property imports and exports if you aren't taxed by one method you are taxed by another in a criss cross pattern fuel alcohol cigarettes tv premium and we are behaviourally economised

  • rate this

    Comment number 22.

    I like the idea.
    With Carney due to take over in June/13, it's important to give him the flexibility he needs. As for Osborne, he says he's open to exploring such new mandates for the bank.
    It seems to me that Carney is coming in like a breath of fresh air; I forecast, 2013 is going to be an exiciting year for Britain.

  • rate this

    Comment number 21.

    Why only target one thing? Maybe GDP and inflation should be monitored as well as maybe balance of payments (unpopular these days to even consider it I know but surely one of the most important things to look at) and perhaps exchange rates and asset prices.


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