It is time for Lamont's baby to come of age
Thursday 23 February 1995
It could be considered odd that the target is up for review so soon: it is an economic policy child that is less than two and half years old.
Its youthful innocence has charmed the City; the fact that it has been untainted by the poor behaviour of older policy siblings such as the exchange rate mechanism has led everybody to place a good deal of trust in it. And things have apparently turned out well since it was introduced.
In its infancy, not even the Bank of England paid much attention to the clause about getting inflation into the "lower half of the range". Most forecasters assumed the target would be breached early on.
In fact, inflation remained within control, and so the target has had the appearence of being effective. Some people even appear to attribute the good inflation performance to the fact that inflation targeting was introduced at all.
But while it has arguably worked well, the inflation target was very much an unplanned baby. It was hastily conceived by Norman Lamont within three weeks of the pound leaving the ERM, and offered to the Treasury and Civil Service Select Committee as evidence that Britain had a new monetary policy framework. As a result of its premature delivery, however, certain problems quickly emerged.
First there was the choice of inflation index. The RPI excluding mortgages (so-called RPIX) is neither a good measure of the cost of living - which does include mortgages - nor of underlying inflation pressure.
The big tax increases of the 1993 budgets had the perverse effect of deflating the economy but inflating the target inflation measure. The Bank of England quickly resorted to the adoption of another index, RPIY, which excluded tax effects, in parallel to RPIX .
The second problem was that although Norman Lamont thought he was providing one target, he in fact provided two. The first was "1 to 4 per cent"; the second was "the lower half of the band", i.e. "1 to 2.5 per cent". The Bank of England has dropped the 1 to 4 per cent target for all significant operational purposes. But while the Government has reaffirmed the 2.5 per cent target, it has yet to stake its reputation on it, nor has it implied the 4 per cent target is obsolete.
Either way, the situation is unsatisfactory. If the true target is 4 per cent, it is unfortunate that the Bank of England is unaware of that. If, as seems likely, the target is 2.5 per cent, it is unfortunate that the authorities are trying to steer such a large economy into such a small space. A band of 1 to 2.5 per cent leaves little room for error. As the table shows, few other countries attempt to fine-tune their inflation rates so precisely.
Given these problems, it is popularly suggested that the Chancellor should modify his inflation target. It is suggested, first, that he adopt RPIY, and second, that he drop the target band by 1 percentage point: from "1 to 4 per cent", to "zero to 3 per cent". That way, we could dispense with the confusing "lower half of the band" business.
The only problem with that move is that it is a clear relaxation of current policy. Although it moves the middle of the effective target range down from 1.75 per cent to 1.5 per cent, it moves the top of the range up from 2.5 per cent to 3 per cent. As the top of the range determines how much the target constrains policy, it would be easier to stay within the new target than the existing one. There would be the inevitible claims that the Government was cheating. And, facile as such claims would be, given the solid technical arguments for change, the mere fact such claims would be made is a good reason to avoid that course of action.
So is there a better way of targeting inflation?
Well if you look at what other countries do, there appears to be a split. Most, like Britain, specify their target as a range, or they give an upper inflation limit. But others aim to steer inflation to a particular rate, a "point" (or alteratively a range so narrow that it compresses to something like a point).
It is a dilemma as to which is better. A specific inflation number has the advantage of providing clearer direction. You know when to put interest rates up, down, or keep them as they are. You always set policy so inflation is heading for the target rate. It is much less ambiguous to aim at 1.5 per cent inflation than to aim somewhere between zero and 3 per cent, or to aim at "below 2 per cent".
However, a target range also has an advantage: it makes it easy to expose the authorities as having failed to deliver the low inflation they promised. It is the fact that they can be seen to have failed - to have slipped outside the range - that gives the authorities the incentive to make sure they do not fail. For this purpose, a single figure-inflation rate provides too exacting a target. It would be madness to hang a Chancellor who fails to deliver, say, 1.5 per cent inflation exactly. Instead, you need reasonably wide boundaries, beyond which inflation must not be allowed to go.
Now, if there are advantages to using a specific number, and advantages to using a range, why not use both?
An effective inflation target for Britain would be a specific inflation rate - probably 1.5 per cent with a tolerable band of error on either side, perhaps 1.5 per cent above or below - something which has been lacking in recent British history. Given a forecast for inflation, it tells the Bank, and the pundits, how rates should move, and it removes a little of the room for fudge that creeps in with a target range. But it also gives us all a chance to judge economic policy-makers on how they have done. It allows us to deem them to have been successful or unsuccessful on the inflation front.
We should never fall into the trap of believing that because we have an inflation target we have successfully fought inflation. But the target has established itself well. Now that we are all used to it being around, it would be a good idea to get it right.
Germany Upper limit of 2%
France Upper limit of 2%
Spain Upper limit of 3%
Portugal 3 to 4.25% range
Finland 2% target rate
Canada 1 to 3% range
New Zealand 0 to 2% range
Australia Average of 2 to 3%
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