Tom Spencer is a Young Voices Associate, and the Chief Organiser of the London New Liberals.
Predicting what the Bank of England is going to do next is impossible. Despite strong signals that it would tighten at the last meeting, the Monetary Policy Committee (MPC) chose to maintain rates. Such misleadings create uncertainty and chaos in the financial market. The Treasury must change the Bank’s mandate asking that it targets gross domestic product (GDP) to provide certainty, and thus stability, to the economy.
Rules do exist governing the actions of the Bank. For example, its mandate holds that it’s required to maintain price stability and help meet the Government’s economic policy objectives — namely, strong, sustainable and balanced growth. Though maintaining price stability and economic growth sounds simple, it’s a job that brings much controversy. For example, we’re seeing rising inflation at the moment, but growth remains lower than what was projected pre-pandemic. It’s unclear based on the current mandate how the bank should respond to such a turbulent period.
The recent actions of the MPC symbolise these problems very well. Before the meeting, members such as Huw Pill backed limits on quantitative easing and warned about the risk of inflation exceeding five per cent. This signalled one thing: that they were going to tighten monetary policy. As a result investors purchased sterling, hoping to take advantage of the higher return on savings as the value of the pound increased. Thus, when the Bank surprised them by maintaining rates and purchases, it caused the pounds’ value to plunge by more than one per cent.
Instability like this is extremely damaging to investor expectations and consumer confidence. According to Nobel prize-winning economist James Buchanan, the ability to predict the value of a currency allows for greater economic coordination lending itself to better economic outcomes. Buchanan’s theoretical observation is consistent with more recent empirical analyses. For example, a 2014 paper in the Journal of Economic Dynamics and Control found that rules-based eras of central banking are associated with higher levels of economic performance.
The best idea of how to bring about this rules-based system is one popularised by American economist Scott Sumner. He argues that rather than the Bank having discretion to do what it likes based on its idea of what stable prices and strong growth means, it should have a simple target: to ensure that GDP rises at a given percentage annually.
The main benefit of this is that it is a much more accurate measure of the business cycle. When we’re in danger of overheating, GDP will rise, leading to the Bank tempering the market by raising rates; meanwhile, if the economy needs stimulus, then the Bank will provide it. Under the current regime we simply don’t have this level of protection. Currently, if growth is low and inflation is high, then we always have uncertainty and debate over whether we care more about growth or employment.
GDP targeting would resolve the need for those debates and provide more certainty to all. This would lead to better outcomes in the long-run. According to an article in The Quarterly Review of Economics and Finance, this mandate could reduce volatility by as much as 25 per cent relative to the current approach.
This will be particularly important during times of economic crises. Leading up to the Great Recession monetary policy was rather tight despite a massive fall in GDP, due to fears of inflation. This resulted in a crash in asset prices causing highly leveraged companies like Lehman Brothers to fail. It wasn’t until this failure that the real economy was impacted — resulting in a financial crisis becoming a Great Recession. Had the Federal Reserve intervened by loosening money supply earlier, then we likely wouldn’t have seen the global crisis that we did.
Even if the recession does hit, then GDP targeting is better placed to help resist it. In 2011 when the Great Recession was peaking an oil shock, similar to what we’re seeing now, resulted in temporarily higher levels of inflation globally. Despite GDP indicating that there was no risk of overheating, the Bank responded by raising interest rates. Naturally global oil prices fell again, and overheating didn’t occur anywhere. But the nations who accepted the temporarily higher prices continued to recover from the crisis, whilst the Eurozone plunged into a debt crisis.
The current uncertainty manufactured by confusing signals and actions by the Bank is hurting consumers and businesses alike. It is no wonder consumer confidence is at its lowest point since January when we simply can’t make long-run spending plans without knowing how expensive our debts will be in the near future. GDP targeting would take away this uncertainty and provide more stability during turbulent periods. If the Government wants to protect our long-term macroeconomic future, then its best off doing this by changing the mandate to a GDP targeting regime.