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 100.

    What a joke. Government gives the bank of England targets. When it meets them it bathes in praise. Now it can't meet them, there's something wrong with the targets. So targets need changing to something easier to achieve. Sums up the government all over. School targets need meeting, make exams easier. Inflation too high, change the way its measured . Unemployment too high, create unreal jobs.

  • rate this

    Comment number 99.

    More pontificating and looking for an answer that has glared the world in the face for the past 30 + years - free market, monetary policy has largely bankrupted the world. If it hasn't quite gone that far in other places, then it has surely saddled them with a lifetime of debt. Socialism wasn't the answer and neither it seems is rampant capitalism. There has to be new fairer way of economics.

  • rate this

    Comment number 98.

    "Will this time be any different? I wonder"

    Perhaps we could use the ouija board instead of the MPC to determine monetary policy. It could hardly do a worse job.

  • Comment number 97.

    All this user's posts have been removed.Why?

  • rate this

    Comment number 96.

    Let's hope Dr Carney has carefully studied that thoroughly researched and most excellent work "Making Money" by leading economist Terry Pratchet. A salutary warning for bankers everywhere.

  • rate this

    Comment number 95.

    "Dr 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"

    This new doctor's bedside manner is making me feel worse than I did before ...

  • rate this

    Comment number 94.

    The grand failure of economics, all economics, is it is preached that by trickery a state can avoid the fundamental nature of capitalism. This is what is wrong with all targets.

    Capitalism MUST be permitted to work.

    Risk always has a price that reflects must its nature - attempts to pervert this fundamental ALWAYS fail and are ALWAYS followed by a deeper disaster -SEE JAPAN!

    Bust banks must go

  • rate this

    Comment number 93.

    My view is this whole mess came about by people spending money that never existed.
    The stock market is on example where companies shares are worth a perceived value.
    Credit freely given by the banks vastly surpassed the money the banks had.

    All of it uses non existant money which now has us all in debt for the next 20 years.

  • rate this

    Comment number 92.

    "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."

    Err..... Stephanie? So if house prices go through the roof... isn't that inflation?

  • rate this

    Comment number 91.


    Just one little thing, the cuts are about trying to keep a lid on inflation (ie they're not trying to inflate the debt away).

    The only way they can have any impact on inflation is through gov't spending, little spending they think equals little inflation, which is why they don't know what's going on or what else to do and they can't understand why inflation is as high as it is.

  • rate this

    Comment number 90.

    this is nonsense the debt is more than the money in circulation so the debt will just get bigger its not rocket science its a con wake up sheeple

  • rate this

    Comment number 89.

    Climb Mount Rushmore!

  • rate this

    Comment number 88.

    Any changes they make will be for the sake of 95% of the economy. Which is owned by about 2% of the people.

    Do what you want. I have so little money these days it makes no difference.

  • rate this

    Comment number 87.

  • rate this

    Comment number 86.

    To quote Bill Bonner " If you hire your neighbor to mow his lawn and he hires you to mow his lawn, GDP rises. Gross domestic product includes government spending as a positive. So if the government spends lots of money, GDP goes up. The government could hire lots of people to dig holes and refill them again. Well, GDP would go up and economists would cheer" GDP is an abstraction with no meaning

  • rate this

    Comment number 85.

    Inflate away debt
    Penalise the poor - benefits due to rise by only 1%
    Adavantage property owners
    Hit savers and those on fixed income
    M Carney well respected , but to further the Tory agenda.
    Redefining class differences in the interest of those who have, further marginalising those who have not

  • rate this

    Comment number 84.

    81. Norman ~ The run on Northern Rock was anything but Mary Poppins. That was the thinking behind the banks business model. Much of the Northern Rock saga remains untold.

    It is interesting to contemplate the consequences of NR being left to bust. The knock on effect is what was feared but Lehmans have sailed through bankruptcy. It seems though that Lehmans investors were rubber ducks.

  • rate this

    Comment number 83.

    Stephanie, It is a simple concept, but what is crippling most families and persons on fixed incomes are never ending food and utilities costs.

    Surely what is relevant to economists is the welfare of the people, now and in the future, or is economics just a game of second guessing, changing definitions and and spinning statistics.

    I suggest a BoE prices and incomes policy.

  • rate this

    Comment number 82.

    For years we have herd the politicians sound biting the importance of low inflation. How many will we hear sound bite,
    "We got it wrong. If not for the last 30 years, at least for the 4 or 5"
    I suspect we will not see a Que of politicians old and new at the BBC to tell it as it is.

  • rate this

    Comment number 81.

    it is time for the government to ask one simple robust question. is the BoE fit for purpose? The answer will almost certainly be no. So what do the government plan to do? I for one picture scenes similar to the ones in Mary Poppins when there was a 'run' on the bank.


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