Hamish McRae: Events have overtaken inflation targets

Economic View

Sometimes things change with a bang; more often they creep up on you. The change in global monetary management that is taking place now is the second sort.

When sterling came off the gold standard in 1931 it was clear something very big had happened. When the Bretton Woods fixed exchange rate system broke up during 1972 and the world moved to floating rates we were aware that a big change had begun, though the abandoning of the peg was a progressive movement taken by different countries at different times. And at the time hardly anyone saw the catastrophic surge in inflation that would be associated with the break-up.

The return to monetary discipline during the latter 1970s and early 1980s was also a progressive movement, as was the switch from money supply targets to inflation targets in the 1990s.

Now we are in the middle of another change, for inflation targets are being downgraded and replaced with the more mushy aim of trying to maintain growth. But because it is a progressive change rather than a big bang, we have hardly begun to think through the consequences.

There has to be some framework for central bankers to make decisions about interest rates, bank capital requirements and so on. Under the Bretton Woods fixed exchange rate system the prime rule was to maintain the currency within 2 percentage points on either side of a central value. Domestic output and inflation were subsidiary objectives beside the one of maintaining the external value of the currency. When there was no objective, as during the 1970s, the central bankers lost control.

You can catch a feel for this from the chart, which shows inflation in the UK since 1750. The data is from official sources but this is taken from a website called Safalra, which enables people to work out how much you should multiply money at a specific date in the past to see what it is worth today. For example, a pound in 1880 was worth £100 in today's money. More scarily, a pound in 1939 would be worth £55 today.

A few points stand out. One is that the long period of overall price stability between 1820 and 1913, the high years of the gold standard, actually saw big swings in inflation from one year to another. Another is that Bretton Woods did bring reasonable stability in prices, even though that was not an explicit objective. And a third is that the inflation of the 1970s and early 1980s was unprecedented. Peak inflation, in 1975, was 24.2 per cent and in 1980, the first full year of the Thatcher government, it hit 18 per cent. It was not until the early 1990s that inflation came back under reasonable control – I say reasonable because price levels have doubled since then.

So there has to be discipline. The question is what is most appropriate. When the emphasis was switched from money supply targets to inflation targets in the 1990s the argument was that it was better to have a direct target rather than a subsidiary one. Not all central banks adopted an inflation target – the US never formally did so – but the broad aim that inflation should be somewhere around 2 per cent a year became the de facto global standard.

Unfortunately, it proved a false friend. The explosive impact of China entering the global economy, exporting goods at much lower prices than the West could match, put downward pressure on inflation rates in the developed world. Central banks preened themselves at their success in controlling inflation and pumped up the money supply to try and keep inflation up. The result, coupled with deregulation of the banking system, was an asset boom. There was very little inflation in goods and services but huge inflation in assets, particularly property. The inevitable bust resulted.

The response of the central banks to that has been to print money. So far that has not shown through in much inflation at a goods and services level, but we have had a modest recovery in asset prices. House prices in the US are now recovering and in Britain in many places are just about back to their previous peak. Share prices in most of the developed world are close to their previous peak too.

But inflation targets are clearly a discredited tool. No one quite wants to say that, but they have in effect been abandoned in the UK, while in the US the Federal Reserve now regards reducing unemployment as a key objective and will not tighten policy until it comes down further.

Here, we have new guidelines for the Bank of England, which in effect accept that the single target of holding inflation around 2 per cent has been overtaken by events. In Japan they are adopting an inflation target, the aim being to end deflation. So the Bank of Japan is going to spray money around too.

The only major central bank holding out is the European Central Bank. It, too, stoked up an asset boom in peripheral Europe, increasing divergence in the eurozone – so having exactly the opposite of the effect that the advent of the euro was supposed to do. Overall it has achieved its inflationary objectives but at the cost of massive deflation in some areas. But its de jure mandate of holding inflation close to, but below, 2 per cent has been supplanted by a de facto one of preserving the eurozone at almost any cost.

So what the world is doing is to say: "Look, inflation targets have proved an inadequate benchmark for policy and while we don't dare abandon them altogether, we will supplement these with other vague aims, of which the most important will be to boost growth."

Many of us expect this will eventually result in another burst of inflation and we will have to reintroduce monetary discipline. But not yet.

Start your day with The Independent, sign up for daily news emails
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Guru Careers: Financial Director / FD / Senior Finance Manager

Up to 70k DOE: Guru Careers: We are seeking an experienced Financial Director ...

Recruitment Genius: Junior / Apprentice Sales Executives - OTE £50,000

£11000 - £50000 per annum: Recruitment Genius: This financial company offer ma...

SThree: Recruitment Consultant

competitive + incentives + uncapped comms: SThree: Did you know? 98% of our di...

SThree: Trainee Recruitment Consultant

competitive: SThree: Did you know? 98% of our directors started with SThree as...

Day In a Page

Turkey-Kurdish conflict: Obama's deal with Ankara is a betrayal of Syrian Kurds and may not even weaken Isis

US betrayal of old ally brings limited reward

Since the accord, the Turks have only waged war on Kurds while no US bomber has used Incirlik airbase, says Patrick Cockburn
VIPs gather for opening of second Suez Canal - but doubts linger over security

'A gift from Egypt to the rest of the world'

VIPs gather for opening of second Suez Canal - but is it really needed?
Jeremy Corbyn dresses abysmally. That's a great thing because it's genuine

Jeremy Corbyn dresses abysmally. That's a great thing because it's genuine

Fashion editor, Alexander Fury, applauds a man who clearly has more important things on his mind
The male menopause and intimations of mortality

Aches, pains and an inkling of mortality

So the male menopause is real, they say, but what would the Victorians, 'old' at 30, think of that, asks DJ Taylor
Man Booker Prize 2015: Anna Smaill - How can I possibly be on the list with these writers I have idolised?

'How can I possibly be on the list with these writers I have idolised?'

Man Booker Prize nominee Anna Smaill on the rise of Kiwi lit
Bettany Hughes interview: The historian on how Socrates would have solved Greece's problems

Bettany Hughes interview

The historian on how Socrates would have solved Greece's problems
Art of the state: Pyongyang propaganda posters to be exhibited in China

Art of the state

Pyongyang propaganda posters to be exhibited in China
Mildreds and Vanilla Black have given vegetarian food a makeover in new cookbooks

Vegetarian food gets a makeover

Long-time vegetarian Holly Williams tries to recreate some of the inventive recipes in Mildreds and Vanilla Black's new cookbooks
The haunting of Shirley Jackson: Was the gothic author's life really as bleak as her fiction?

The haunting of Shirley Jackson

Was the gothic author's life really as bleak as her fiction?
Bill Granger recipes: Heading off on holiday? Try out our chef's seaside-inspired dishes...

Bill Granger's seaside-inspired recipes

These dishes are so easy to make, our chef is almost embarrassed to call them recipes
Ashes 2015: Tourists are limp, leaderless and distinctly UnAustralian

Tourists are limp, leaderless and distinctly UnAustralian

A woefully out-of-form Michael Clarke embodies his team's fragile Ashes campaign, says Michael Calvin
Blairites be warned, this could be the moment Labour turns into Syriza

Andrew Grice: Inside Westminster

Blairites be warned, this could be the moment Labour turns into Syriza
HMS Victory: The mystery of Britain's worst naval disaster is finally solved - 271 years later

The mystery of Britain's worst naval disaster is finally solved - 271 years later

Exclusive: David Keys reveals the research that finally explains why HMS Victory went down with the loss of 1,100 lives
Survivors of the Nagasaki atomic bomb attack: Japan must not abandon its post-war pacifism

'I saw people so injured you couldn't tell if they were dead or alive'

Nagasaki survivors on why Japan must not abandon its post-war pacifism
Jon Stewart: The voice of Democrats who felt Obama had failed to deliver on his 'Yes We Can' slogan, and the voter he tried hardest to keep onside

The voter Obama tried hardest to keep onside

Outgoing The Daily Show host, Jon Stewart, became the voice of Democrats who felt the President had failed to deliver on his ‘Yes We Can’ slogan. Tim Walker charts the ups and downs of their 10-year relationship on screen