The authorised version of the new guideline was that contained in the Chancellor's Mansion House speech last Wednesday. For the current Parliament, the existing target has had two components - a range for underlying inflation of 1-4 per cent, and a subsidiary commitment to get inflation into the bottom half of that range (below 2.5 per cent) by the spring of 1997. The main change announced last week was to flip these two objectives around. The new target is "to continue to achieve underlying inflation of 2.5 per cent or less". Provided that interest rates are set consistently at the level judged necessary to achieve this inflation target, the Chancellor believes this, in practice, "should ensure that inflation will remain in the range of 1-4 per cent".
This formulation in itself requires a little interpretation, about which more later. But the potential for confusion was enhanced by two other developments last Wednesday. First, in what was presumably just a slip, albeit a careless one, the Treasury put out some written briefing on the new target which said that the 1-4 per cent band would be achieved "most of the time". This is actually just a statement of the obvious, except that it differed from the official version stated by the Chancellor, a difference which enabled the Opposition to claim that the Treasury did not appear fully committed to its own target. In the City, those disposed to see slippage and relaxation relative to the original policy objective (and that is a large band) were given needless encouragement.
Second, in his own Mansion House speech, the Governor of the Bank of England seemed to paint a slightly different gloss on the inflation target by simply referring to the 2.5 per cent limit, adding in very specific terms that the Bank expected its policy advice to be judged relative to that target. There was no mention of the 1-4 per cent band, thus inviting the comment that the Governor's interpretation of the target was tougher than the Chancellor's.
I am sure these minor glitches will soon be forgotten, but it is important for all participants to sing off precisely the same song sheet in future. Otherwise - and this is a consistent theme of this column's recent observations of the Chancellor's behaviour - some of the advantages of a transparent and simple policy framework will be lost.
Now back to the more important question of what the authorised version of the target really means. The key point is that policy will be set so that the expected value of inflation in two years will be permanently below 2.5 per cent. This, of course, does not mean that the inflation rate will never be above 2.5 per cent; in order to be certain of achieving an absolute ceiling of 2.5 per cent, the Treasury would have to aim for inflation at zero or less, so that any possible shock would still leave the out-turn below 2.5 per cent. Thus, if the Treasury aims for something just below 2.5 per cent (say 2.25 per cent) as the expected out-turn, the actual inflation rate will sometimes be above the central target and sometimes below it.
Note, however, that the 1-4 per cent band is not symmetrical around the central objective for inflation, which is "below 2.5 per cent", and therefore below the midpoint of the 1-4 per cent range. Assuming that the target objective is in fact 2.25 per cent, there is much more headroom above the target rate than there is below it. The Treasury presumably decided to accept this asymmetry as a small price to pay for the continuity of keeping the same band in place as before. Furthermore, it could be argued that, at very low rates of inflation, shocks are likely to be asymmetric in an upward direction, since it is increasingly difficult to push the aggregate inflation rate downwards as it approaches zero.
The consequence of formulating the target in this way is that any shock to the price level is fully accommodated by the authorities, who simply reset their future target for the inflation rate back to 2.25 per cent after any shock has taken place. (In fact, the price level under this new regime will follow the path of a random walk with an annual upward drift of 2.5 per cent.) This practice has the disadvantage that, over any period of years, there will still be enormous uncertainty over the expected level of prices at the end of the period.
This problem could have been eliminated by expressing the target in terms of a stable price level rather than a constant inflation rate. But the consequence of this would be that if the price level rises unexpectedly in any period, the authorities would have to set policy so that the price level actually falls in a subsequent period. An absolute decline in the price level - a period of deflation - is very costly and painful to achieve, so the authorities have been wise to express their target in terms of inflation rates rather than price levels.
But can they actually keep inflation within the 1-4 per cent range "most of the time"? The average fluctuation range for inflation has been much greater than 3 per cent in previous cycles (see graph), but this of course was under a different policy environment. Now that the authorities are actively setting policy in order to keep inflation below 2.5 per cent, we can expect to see a narrower range for the actual inflation out-turn than before. But there will still be periods when inflation will exceed 2.5 per cent. According to the Chancellor, this is likely to happen, for example, when a foreign price shock hits the system, which is what is happening now.
In the last year, import prices have risen by around 1 per cent, and this is the prime reason why the underlying inflation rate is likely to move clearly into the top half of the 1-4 per cent band in the next 12- 18 months. Hence we are already seeing how the two sub-targets can co- exist. In the long run, the Government remains committed to getting inflation back below 2.5 per cent. But in the shorter run, while the impact of the foreign price shock is being absorbed, the band will continue to permit room to move - up to 4 per cent.
While coherent in principle, this mix of objectives can risk giving the wrong signals. For example, the private sector might conclude that if the Government is willing to allow inflation to rise to 4 per cent, this rate can be built into wage- and price-setting behaviour. This increases the risk that a temporary "blip" in inflation, caused by a foreign price shock, will in fact result in a permanent rise in the underlying inflation rate - something the Bank of England is correctly worried about in the present environment.
A simpler and more transparent target would have been to aim for inflation at 2.5 per cent or less on a permanent basis, with no bells or whistles. If that is really what the target means, why not say so?Reuse content