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

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  • rate this

    Comment number 80.

    £350 billion of new borrowing is needed each year to pay off old loans whilst keeping enough money in existence to enable the economy to function, and this figure needs to grow exponentially year on year as the debt rises inexorably. This is the reason behind our 2% inflation target (a stealth tax on money itself). Any less than that and the economy would crash.

  • rate this

    Comment number 79.

    For sure it's high time Mervyn King was dealt with. He''s failed to meet the target for several years now (probably had a ream of "letters to the chancellor"printed). He continually fails to adjust interest rates in a timely way, allowing debt and property bubbles to inflate to everyone's cost. Under his reign people's savings and pensions have eroded.

    Why is he still in that job?

  • rate this

    Comment number 78.

    As targeting inflation has not worked(or has ceased to working) and as growth is not happening then it makes sense to target growth(or at least something else).
    My humble observation is that many people at the BoE and the Treasury are being very retro-active.
    Surely they should be Pro-active!
    If they have be pro-active then they have failed!
    Pro-active and not good?
    Or just retro-active?

  • rate this

    Comment number 77.

    I always thought the purpose of a central bank was to create a stable inflation and currency environment and the role of the government was to create an environment where businesses would generate growth. Unfortunately we have had several governments who's policies prevent growth and the BoE, after having failed to control inflation, are now considering giving up completely.

  • rate this

    Comment number 76.

    73 Soothsayer, growth is measured as part of inflation and this causes huge confusions and antipathy.


    Hence, one has a quick reference to those who understand monetary doctrine and policy. Governments complicate the equation by following various social and economic doctrines.

    Finance just plays bread now, chaos tomorrow. Banks get silly.

  • rate this

    Comment number 75.

    Even the centralised Chinese government cannot plan for, or control its 'growth'. For BoE to target 'growth' whatever that is will be unbelievably silly, with equally silly results. Including behaviour manipulation to meet targets, eg emergencies kept outside hospital in ambulances so that 'wait for treatment time' targets can be met.

  • rate this

    Comment number 74.

    @50 sarah
    Think you can rest easy on that one. You haven't caused a disaster or made one worse.

    The politicians can do that all on their own without any help from us.

  • rate this

    Comment number 73.

    The state, including the BOE. knows the current intense focus on controlling inflation restricts the scope it has for operating its traditional fiscal fraud. The state wants a revised target so that it can unleash runaway inflation. Inflation robs the saver and rewards the borrower. It robs the prudent and rewards the reckless.

    And the biggest, most reckless borrower in the land is the state.

  • rate this

    Comment number 72.

    "the inflation target is leading the Bank to miss something else that is equally important: economic growth."

    So the farce of the financial sector running the country instead of the Government isn't important?

  • rate this

    Comment number 71.

    This proposal is very dangerous. If you want to hit a nominal GDP target, all you need to do is let inflation take off. That way, you destroy the real value of accumulated debt. Unfortunately, you destroy your credibility as well. Using inflation in this way is real "banana republic" economics.

  • rate this

    Comment number 70.

    #64 A paradox solution.
    If I pay my neighbour to mow my lawn and he pays me to mow his GDP then rises. displays why GDP is waste of time as a metric.
    #69 I believe you are going way over the top on treating economics as a science. consistent failures
    I would bet none of these economists runs their own budget as they suggest for the countries, and the country should deserve a higher standard.

  • rate this

    Comment number 69.

    Perhaps it's about time economists were peer-reviewed. Imagine where science would be if 'everyone' just adopted the latest theory because it sounds nice.

  • rate this

    Comment number 68.

    I can think of a few things that are not working. That are out of order.

  • rate this

    Comment number 67.

    Happy Christmas and all the best for 2012.

    Identifying inflation as a primary target was a legacy of the havoc of the 1970s and 1980s. It didn't stop the havoc of the 1990s and 2000s.

    Data is generally part of the problem, not the solution.
    We only measure what we are looking for.
    Eventually, we forget what we are measuring and why.
    The information is not independent - that's the lesson.

  • rate this

    Comment number 66.

    I do not agree with the change.
    I see it only as obfuscation of our problems.
    Not impressed with "new" direction or appointment of mr Carny.
    Next to last para would be my own target.
    agree with #61 and #62
    JfH continues to make valid point that value of money is one major problem.

  • rate this

    Comment number 65.

    64. SaBelver.... that's part of the paradox we live in. What is good for the individual (self sufficiency, focus on needs, etc) is absolutely terrible for the economy (at least the way we've constructed it).

  • rate this

    Comment number 64.

    Suppose I grow my own tomatoes, instead of getting that nice Mr Sainsbury to ship them from some heated greenhouse in Holland.

    I win: I save money and get tastier, fresher tomatoes.
    The environment wins: think of all the fuel that's not been wasted.

    And yet GDP falls.

    So the brains in charge decree that my savings have to inflated away to force it back up.
    Who here is doing the right thing?

  • rate this

    Comment number 63.

    '..inflation target..the confident claim that the people at the Bank will always be clever enough to know when to ignore it..'
    Today I agree with your delicious implication, MsFlanders

    Have you ever had to sit down and discuss anything much with BoE economists Ms F ?

    Would the BoE not be better off targeting the British weather ?

  • rate this

    Comment number 62.

    Changing the metrics makes no difference. While we depend on never ending "growth" we are at odds with reality.

    We have to shift to sustainability.

  • rate this

    Comment number 61.

    Nominal GDP growth has its drawbacks as a target: one could have high inflation, little real growth and achieve high nominal GDP growth thus undermining international competitiveness.
    Targets aren't the answer. We need a holistic approach: keeping inflation down, reducing trade imbalances, reducing the PSBR and evening out fluctuations in the trade cycle thus achieving steady real growth.


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