In this article I shall argue that there has been a significant failure
of political leadership, from Gordon Brown and Alistair Darling,
regarding the UK’s inflation target. The significance of this failure
is becoming magnified in the difficult policy situation we face in
2008, has already undermined, and threatens to undermine further, the
hard-won credibility of UK monetary policy.
The Bank of England Act (1998) specifies the Bank of England’s goals in
respect of monetary policy (interest rates, money supply, exchange
rates, and so on) as
(a) to maintain price stability, and
(b) subject to that, to support the economic policy of Her Majesty’s
Government, including its objectives for growth and employment.
What “price stability” means, and what the “economic policy of Her
Majesty’s Government” is are political matters, to be specified by the
Treasury. Current practice is for a letter to be sent, at the time of
each Budget, from the Chancellor to the Governor of the Bank of
England, defining “price stability” in terms of a target for the next
year’s annual inflation rate.
The idea is that what the Bank of England’s target should be is a
proper matter of political debate, whilst how it goes about achieving
that target is, under this scheme, treated as a technical/operational
matter best left to the Bank’ Monetary Policy Committee (MPC) (and
hence, as it were, at arm’s length from politics). There has been past
political debate over the Bank’s inflation target — for example, the
Conservatives went into the 2001 General Election promising to reduce
the inflation target (from 2.5% to 2%), whilst the change of the
inflation index from the Retail Prices Index to the Consumer Price
Index in 2003 was criticised by the Conservatives.
As specified by the Chancellor, the UK’s inflation target is currently for consumer prices to rise annually at 2%, and if inflation deviates by more than a percentage point from the target then the Governor of the Bank of England must write a letter to the Chancellor explaining why. In April 2007, for the first time, Governor Mervyn King wrote such a letter, after the March 2007 consumer prices index rose 3.1%. In a recent speech, Governor King predicted that two more such letters might be required in 2008, implying inflation possibly being above target for three or more months.
When inflation went above 3% in 2007, members of the MPC were keen to emphasize in speeches that this did not mean that they had missed their target. In the most formal sense this was correct: the remit letter from the Chancellor to the Bank states explicitly that:
“The thresholds do not define a target range. Their function is to define the points at which I shall expect an explanatory letter from you because the actual inflation rate is appreciably away from its target.”
So, the MPC members told us, the inflation target is 2%, not 1%-3%. There is no material difference between inflation of 2.9% and inflation of 3.1% — all that the latter means is that we must explain ourselves to the Chancellor, which we did, and he was happy with our explanation.
But once we go beyond the most formal interpretation of “target”, I submit (and shall shortly explain) that what the MPC argument here amounts is either (a) they have changed their target for themselves; (b) the Chancellor has changed their target; (c) their target was not what everyone thought it was. Here is why.
Inflation targets were introduced around the world in the early 1990s. (The first was, as it happens, introduced by New Zealand.) The UK inflation target came in in 1992 following the pound’s famous ejection/withdrawal from the ERM. In the early days of inflation targeting there was a debate between those that preferred to have a target band (say, a target of 0-2% or 1-3%) and those that thought it best to have a point target (say, 2.5%). Each of these approaches had significant drawbacks. If the target is a point of 2.5%, say, then we almost always miss the target (even if monetary policy were so precise that inflation could be kept at an absolutely precise level — which it is not — we would not want to do so anyway, because things would become very rigid, creating unnecessary unemployment and stifling growth). Since we will always miss, the target might lack credibility, and since for practical reasons we would not mind missing most of the time, it would be unclear to what extent policy was actually constrained by the target — by how much is it okay to miss on any one occasion? Would 10% inflation be okay, this year, provided that we say we aspire to get inflation back to 2.5% sometime-or-other? An inflation target would then become, at most, a communication device, rather than any sort of rule or constraint on how interest rates should be set.
So perhaps a band would be better (this was what most countries did, initially)? But the problem with giving the central bank a band of discretion was that it would tend to allow inflation to drift towards the top of the bank, even in relatively benign times (after all, it was precisely because, left with discretion, policy-makers tend to allow a bit more inflation than is best, that we have things like inflation targets at all). So, in New Zealand, where the inflation target was initially 0-2%, inflation tended to be around 1.8%. But then if even minor things went wrong, inflation went above the top of the band of discretion, the target was missed, and credibility was lost.
So it seemed like neither a band nor a point was really the way to go in terms of the inflation target. This led to the one particularly attractive feature of Labour’s 1997 monetary policy reforms: the use of an inflation target that involved, in some sense, both a point and (something like) a range. When I used to lecture in monetary policy, that was how I (and everyone else) understood the UK’s inflation target. The target was 2%, with a range of discretion of 1-3%. (Indeed, Ben Bernanke (Governor of the Fed), in his well-known book on inflation targeting, even refers to inflation targeting as a regime of “constrained discretion”.) Because the target was 2%, that meant that inflation should not indefinitely tend towards the upper end of the range of discretion. But because the range of discretion was 1-3%, we knew exactly how far it was acceptable for inflation to be from target at any one point in time (so 10% was not acceptable). The understanding of the letter-writing process was two-fold. First, it was the formality by which a failure to meet the target was acknowledged and responded to by the government. Second, there might be some force majeure that excused going outside the normal band of discretion on this one special occasion (for example, if there were a large earthquake that led to shortages and price rises, we wouldn’t want the MPC to whack up interest rates in response). But it was definitely supposed to be that inflation of 3.1% was to be considered much more worse than 2.9% than 2.9% was to be considered worse than 2.7%.
But apparently, given what MPC members said in 2007 and what they are saying now, the MPC does not understand its target in this way. It considers that it’s fine to allow inflation to go above 3% in 2008 — indeed, despite giving speeches saying that this is likely to happen, the MPC is cutting interest rates rather than raising them! And inflation did not go above 3% in 2007 because of some unanticipated force majeure — the effects of student fees and oil prices on inflation had been known long in advance, and the Bank itself, some eight months beforehand, stated that it believed there was a material chance of inflation going above 3%, yet did not adjust interest rates to address that. Similarly, MPC members are now saying, well in advance, that inflation may well go above 3%, despite their having time to enact policy to avoid that. It isn’t that they couldn’t stop inflation going above 3% (above their band of discretion); it’s that they don’t believe it is appropriate to do so.
But (and this is the key political point) it is not a matter for the MPC to interpret its own target. The target is set politically. The MPC just enacts it. Unless the Chancellor is not telling us something, no-one has told the MPC that inflation of above 3% in 2008 should be considered okay, because (say) it is more important to address the slowdown in economic growth than the rise in inflation. It may be that it is indeed better to allow inflation to rise at this time (though I consider that doubtful, at best), but it is not for the MPC to decide that. The MPC’s job is to meet its inflation target, and its mandate under the Bank of England Act is to put price stability ahead of growth and unemployment. If it would be best, this year, to target 3% inflation rather than 2% inflation, that is something that the Chancellor should be telling the Bank of England. Otherwise what has happened to our inflation targeting framework? If the Bank writes letters every month saying “4% inflation is okay this time”, and “5% inflation is okay this time”, and that’s it, then what content is there in the annual inflation target at all?
The problem that has arisen here is a failure of political leadership. Last year, when inflation went above 3% and the MPC went around saying that was okay, Gordon Brown was silent. Indeed, even in his formal reply to Mervyn King’s letter explaining why inflation was greater than 3%, Gordon Brown effectively said “Yes, sir. No, sir. Thanks very much for explaining that to me, sir, a humble ignoramus in these matters.” That was not how the letter exchange had ever been imagined — at the very least, one had expected the Chancellor’s reply to be stern, saying something along the lines of “Very well. I understand that it was impractical to avoid inflation going so high on this occasion, but do make sure it doesn’t happen again unless absolutely necessary!” Last year we needed Gordon Brown to confirm whether he understood the inflation target in the same way as the MPC members: that we have a point target without any limited band of discretion, that there is no policy significance of inflation being just above as opposed to just below 3%, that the supposed advantages — which I and others used to wax lyrical about — of the UK’s inflation target over the older-fashioned band or point targets used in other countries were always an illusion, that inflation targeting is not (as we had all thought) a regime of constrained discretion at all.
It is for the Chancellor to set and interpret the inflation target. But he failed to do that in 2007, and without that necessary political leadership, the Monetary Policy Committee has had no choice but to define its target for itself. And since MPC members clearly consider that their target for 2008 should not be 2%, but, instead, something higher, they have felt obliged to reinterpret their inflation target s so that achieving 3% (or more) falls within the target.
We need, as a matter of urgency, the Chancellor to answer the following questions (which I believe that George Osborne would be well-placed to ask):
- Does the Chancellor agree that it is for the government, and in particular him, to set and interpret the inflation — not the Monetary Policy Committee?
- Does the Chancellor share the Monetary Policy Committee’s interpretation of the inflation target — that it is a point target of 2%, and that there is no difference, in policy terms, between being just below and just above 3% inflation — or does he regard the target as consisting of a point target (2% CPI inflation) and a +/-1% band of discretion within which the Bank has freedom of manoeuvre, but outside which inflation should not be permitted to stray if policy can prevent it, except in the most extreme of circumstances?
- Does the Chancellor consider it acceptable if inflation goes above 3% in 2008?
- If it is acceptable for inflation to rise above 3% in 2008, how much above 3%? Would 5% be acceptable? And will the Chancellor amend the 2008 inflation target to reflect his view that inflation above 3% is acceptable this year?
Whilst these questions remain unanswered, markets are unable to interpret what the UK’s inflation target means. For nearly 15 years, from 1992-2007, UK inflation never once went outside the band of discretion that its inflation target provided. This made the Bank of England unique among major international inflation-targeting monetary authorities. As a consequence, inflation expectations in the UK were heavily anchored at 2.5% (following the old RPIX target), and the Bank was able to adjust policy, quite dramatically at times, to keep growth going almost always at above 2%, in good times and bad, with splendid consequences for the British economy. But since inflation exceeded 3% (since, as most of us understand matters, the inflation target was breached for the first time) inflation expectations have drifted up. If inflation goes above 3% for a sustained period during 2008, inflation expectations will rise again. We desperately need political direction. Are Gordon Brown and Alistair Darling up to providing it?