Stephen King: Time to reconsider Bank's interest rates mandate

Managing an economy is difficult at the best of times and inflation targeting over-simplifies the process
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Has the Bank of England let the sceptical cat out of its inflation targeting bag? The latest set of minutes suggests that, at its last meeting, the Bank's Monetary Policy Committee (MPC) discussed a much more flexible approach to inflation targeting. In the Committee's words, "in order to deter households from accumulating unsustainable levels of debt and so reduce the risk of larger deviations ... of inflation from the target further ahead, it might be necessary to accept inflation remaining a little below target over the two-year horizon".

Why would they think this? The Committee's view effectively says that inflation targeting is not the Holy Grail of macroeconomic management after all. I agree. Managing an economy is difficult at the best of times and inflation targeting over-simplifies the decision-making process. It might be wise to regard low inflation as a necessary condition of decent macroeconomic performance but the evidence increasingly suggests that it is in no way sufficient. Did you know, for example, that Japanese inflation averaged just 1.6 per cent per year in the second half of the 1980s? An exceptional performance, perhaps, but not sufficient to prevent the emergence of one of the biggest bubbles of all time.

The current approach to inflation targeting in the UK can be examined in three different ways:

First, is 2.5 per cent the appropriate rate at all times? Under current circumstances, there are good reasons to doubt this view. Assume, for example, that the current weakness of the global economy and strength of sterling are no more than temporary factors that, in time, will go away. Assuming that domestic demand is ticking along at its "sustainable" rate, this is likely to mean an undershoot of the inflation target. Under current arrangements, the Bank has to cut interest rates to push domestic demand above its "sustainable" path. Consumer spending booms in the short term. There is, however, a longer term cost: by bribing consumers to borrow more through lower interest rates, there is the potential for a permanent deterioration in the household balance sheet, exacerbated if the housing market eventually topples over. Under these circumstances, it might be better to allow inflation to undershoot for a short period of time.

Second, is the "two-year ahead" time horizon appropriate for the achievement of the inflation objective? I have doubts about this and, to be fair, it looks as though some members of the MPC do as well. The "two-year ahead" framework is based on two standard economic assumptions: changes in interest rates take roughly a year to feed through to changes in economic activity: and changes in economic activity take roughly a year to feed through to changes in the inflation rate.

To my mind, this approach contains significant weaknesses. In particular, it may be the case that hitting a "two-year ahead" target may actually be inconsistent with hitting a "five-year ahead" target. In other words, getting something right in the short term may reduce your chances of getting things right later on.

This issue boils down to a question about stocks and flows. In an environment of global economic weakness and sterling strength, the flow of consumer spending needs to pick up to ensure that the inflation target is met two years ahead. By doing so, however, the stock of household debt starts to rise, perhaps quite quickly. The more that debt increases, the more the consumer becomes vulnerable longer term to a combination of higher interest rates, rising unemployment, lower real wages and more restrictive lending practices from banks and building societies. An adverse change in one or more of these factors could seriously undermine the performance of consumer spending: overburdened with debt, consumers may not respond favourably to any amount of interest rate cuts. As a result, the economy weakens in a possibly uncontrollable way. Under these circumstances, the achievement of a "two-year ahead" target leads to a dramatic – and undesirable – undershoot of the inflation target a few years later. In effect, attempts to meet the inflation target on a two-year horizon have forced consumers to borrow from the future, creating a potential demand black hole later on.

Third, to what extent should the inflation target be augmented with an additional target for other objectives? After all, the European Central Bank has an objective for monetary growth. The Federal Reserve has objectives – if not formal targets – for long-term interest rates and for employment. Should the Bank also be thinking about these things? There are two obvious objections. First, if you have only one policy instrument – in the Bank's case, short-term interest rates – then you can only consistently hit one policy objective at a time. Second, having more than one target simply confuses financial markets. What's the central bank going to focus on this month? Money supply? Or inflation? Or maybe employment? This kind of uncertainty could send financial markets all over the place.

These arguments are all perfectly valid. However, there are also arguments in the opposite direction. The exclusive focus on inflation may lead to inappropriate market behaviour and, in particular, a mis-pricing of risk. This may have been true of the US in recent years during the equity bubble and may become true in the UK, particularly within the housing market. If people are led to believe that inflation is the only significant macroeconomic problem, its defeat may been seen as a sign of ongoing economic health. As a result, asset prices may rise until they are "priced for perfection". When something does eventually go wrong, there may be a dramatic un-winding of asset values, leaving consumers and companies with excessive debt levels.

This mis-pricing is reminiscent of another period of apparent macroeconomic success, namely the full employment era of the 1960s. Then, there was one overriding objective, namely the avoidance of unemployment. Government promises to achieve that objective again led to mis-pricing, this time in the form of inappropriate wage and price increases. By simplifying the economic objective too far, a false impression may be created of economic security that, over the long haul, may not be fully justified.

Given these arguments, the time has come for the Bank to be brave. It is time to admit that economic policy is a complicated affair. There is no one yardstick of economic success. The tightly defined inflation targeting approach of recent years may have served the MPC very well in establishing its credibility in the first place but it is now time to move on. The MPC can now afford to have a more flexible approach to policy. Its inflation target could be an objective for "the medium term" rather than for two years ahead. It could be a lot more open in the extent to which it believes that inflation should deviate away from target. And it should not be embarrassed to write to the Chancellor to explain why, as a result of a more flexible approach, it is allowing inflation to move outside of the 1 per cent bands on either side of the 2.5 per cent central objective. After all, it is these decisions that will ultimately confirm that the Bank of England truly is an independent central bank.

Stephen King is managing director of economics at HSBC.

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