At Budget time, the Chancellor specifies a target for inflation for the Bank of England for the coming year. This year, he should change the way that target works.
The UK's current inflation target is 2%. There are two key weaknesses in this:
a) There is no timescale over which the target is to be achieved.
b) There is no constraint over how far from target it is permissible to deviate in the short term.
The consequence of these two flaws in the target is that nothing counts as a definitive failure to meet the target. If a rule cannot be broken, it has no binding force. If it cannot be definitively broken, those tasked with meeting it cannot be held to account.
Does it really matter how far inflation deviates from target in the short term, provided that it is returning to target over the medium-term? Yes, very much so. Let us take, as an example, the situation in June 1978. At that point, RPI inflation was 7.4% and had been falling for some time. By June 1983 it had fallen further, to 3.7%. Now imagine that in 1978 the Bank of England had been set an inflation target of 4% on the RPI measure. Do we think that the fact that inflation fell to 3.7% in June 1983 should be interpreted as meaning that the Bank of England's monetary policy was too tight from 1978 to 1983? After all, it undershot its target! Or perhaps we think that 3.7% is pretty close to 4%, so the Bank should be seen as having met its target?
Irritating folk like myself might point out that inflation rose to 21.9% in May 1980 - less than two years after our imaginary target was set – and that the price-level rose 70% over the five years to June 1983, versus the 22% it would have risen if a 4% target had been met throughout, meaning that money lost an additional one third of its value relative to continuous meeting of a 4% target. But under the UK's inflation target such "short-term fluctuations" in inflation are not seen as constituting any definitive "miss" of the target by the Bank. Inflation reaching 2.1% is a "miss"; inflation reaching 21% is just a bigger "miss". Neither constitutes a definitive failure of the Bank to meet its target.
RPI inflation reached 5.5% in February - not so terribly far from the 7.4% of June 1978, really. CPI inflation reached 4.4%. Now, I submit that if inflation were to reach 20 per cent within two years from now, everyone would think that constituted a huge failure of monetary policy. But the way that the UK's inflation target is structured, it would not constitute any more definitive a miss of the target than when CPI inflation was 1.9% in November 2009. It would merely be a larger miss.
If nothing counts as a definitive miss of the target, then the target does not constrain policymaking. All it does is to provide a reference point against which policymaking is explained. But an inflation target works best as a framework of constrained discretion, not simply as an explanatory device.
To make a target a proper constraint, something must definitively count as failing to meet the target. To achieve that, we need the target to include two elements: a specific timescale over which it is to be achieved; and a maximum deviation from the target permitted even in the short term. The target should say something like: "You must aim to reach 2% over the year April 2011 to April 2012, and are permitted to allow inflation to be no higher than 4% or lower than 0% even in the short term." Then if inflation is 3% in April 2012, you failed. And if inflation reaches 5% in September 2011, you failed.
To make this really work, the target-setter (the Chancellor) must be willing to vary the target in response to events. If it would be macroeconomically damaging to try to get inflation to 2% by April 2012, then don't set an inflation target of 2%! Set it at something that it would be a good idea to try to meet. The one merit of using an inflation (as opposed to price-level) target is that an inflation target is set on a year-to-year basis and so can be varied. One problem with not specifying any timescale over which the target is to be met is that it becomes difficult to change it. If the target is just vaguely "2%" over "the medium term" then if we change the target to "3%" economic agents might assume that meant it was "3%, over the medium term". Whereas if the target includes a specific timescale, then it applies only over that timescale, and over the next time period we can use something else.
The UK's inflation target is bust. It does not constrain policy – it merely explains it. Everyone knows it. And with inflation rising, the issue of how to get inflation under control will become a major policy challenge and dominant political issue over the next eighteen months. It will be much easier and less painful to get inflation under control if we have a credible monetary policy framework. It will be difficult to switch to a price-level target in an environment in which inflation is now under control. So before we can contemplate switching to price-level targeting, we should re-establish the credibility of the inflation target. Chancellor Osborne should start on that tomorrow, by setting out, in his letter stating the inflation target:
- a number for the inflation target that he believes it would be a good idea to meet (no-one believes that number is 2% at the moment);
- a timescale over which the inflation objective should be met;
- a maximum deviation from the target permitted in the short term.