Is the UK’s Inflation Target Already “Flexible”?
Some eyebrows have been raised after Mark Carney used the phrase “flexible inflation targeting” to describe the current UK monetary policy regime. I don’t think that should be a surprise, and I do think it’s correct to call the current regime “flexible inflation targeting”.
I keep saying it, but I think the source of confusion here is a failure to appreciate that inflation targeting is (and monetary policy generally can only be) forward-looking. Below I’ve quoted from a speech made by Mervyn King back in 1994 when he was merely the Bank of England Chief Economist, explaining this key point (after dismissing the need for an “intermediate” target for money supply growth alongside the formal inflation target):
The use of an inflation target does not mean that there is no intermediate target. Rather, the intermediate target is the expected level of inflation at some future date chosen to allow for the lag between changes in interest rates and the resulting changes in inflation. In practice, we use a forecasting horizon of two years. It is absolutely crucial to understand that the inflation target does not mean that policy is set according to the current rate of inflation. The latest inflation rate is relevant only in so far as it affects the projection for inflation some two years ahead.
My emphasis added. I can only hope that people read and re-read those last two sentences until the impact fully sinks in. To concentrate the mind, imagine that you are on the MPC in the Autumn of 2011, when the CPI rate is nearing 5%, and almost the entire press corps is berating you for printing too much money and being “too flexible” about the 2% target.
The policy regime King was following in 2011 is the same policy regime he was talking about in 1994, and that’s broadly the same regime that the Bank has followed every year since it gained independence in 1998.
King’s speech gives a standard explanation of flexible inflation targeting, or “inflation forecast-targeting”; where the monetary authority is flexible to the point of ambivalence about the current, observed rate of inflation. The Bank’s aim is to set policy such that its own forecast for inflation is at 2% at some point in the future. The Bank tends to use the two year horizon, although the MPC never specifies that precisely.
Flexibility Does Not Imply Discretion
I am rehashing an old post here, but this is where things get interesting. If you accept this interpretation of the current policy regime – be flexible about the current CPI rate, and keep the forecast of the CPI rate on target, we get a simple measure of the Bank’s policy stance: the deviation of forecast inflation from desired inflation.
To simplify a bit, I think it’s correct to say that “flexibility” in this specific sense does not involve the Bank exercising “discretion”; the choices the MPC make should be predictable and derive from the regime itself, plus their forecast model. A “neutral” policy stance should mean that Bank is always targeting 2% inflation.
If the Bank has set policy such that their forecast of inflation is not on target, they are exercising some kind of discretion, following a different policy than prescribed by the regime.
The chart below shows what the Bank’s own published data says about their policy stance over the last nine years under the 2% CPI target, showing the forecast for CPI inflation looking both two and three years forward, at each quarterly Inflation Report:
This shows the significant variation in the median forecast on the two and three year horizon in recent years. Those two downward spikes in late 2008 and late 2011 are exceptional. The Bank was not targeting (i.e. had not set policy such that the forecast equals) 2% inflation on the two or three year horizons at those times. Why not? An obvious correlation is that current observed UK CPI inflation was very high, exceeding 5% in exactly those same time periods; late 2008 and late 2011.
In my opinion this is evidence of a discretionary, disinflationary bias in the MPC. Specifically, monetary policy has been almost continually “too tight” even if you accept that “target 2% inflation on the two year horizon” is the optimal policy regime. There are two obvious counter-arguments:
a) “The Bank is impotent at the ZLB. They can’t raise inflation whatever you say about their forecasts.”
b) “The Bank may be able to affect inflation and demand at the ZLB by printing money, but their forecasting model can’t capture the effects of QE so they are unable to make the forecast dependant on their actions.”
I think (a) is obviously false, but more importantly the Bank think it is false; otherwise they would not have done QE, stopped QE, started QE, etc, etc. This is also no excuse for the November 2008 forecasts being so far off target when interest rates were around or above 3% right across the yield curve, with no zero bound in sight.
(b) might actually be true, I’m not sure. If it is true, this is even stronger evidence of discretionary behaviour; the MPC has no basis on which to choose whether to do £100bn of QE or £50bn if they have no way to model how that money affects inflation and demand outcomes.
Back to the Future
The Inflation Report will be a fun one this week, and I’m looking forward to reading the minutes from this month’s MPC meeting. The unusual statement which accompanied the MPC decision implies their own forecasts have the CPI rate back above 2% on the two year horizon. The last time this happened was Spring of 2011 when the hawks were fighting to raise rates; the wording in the statement implies perhaps that the hawks have declared a cease fire. I’m using the language of discretion, here, of course.
I have to end this rambling post with an irresistible quote from Milton Friedman in 1960 which King used in his 1994 speech:
‘The failure of government to provide a stable monetary framework has thus been a major if not the major factor accounting for our really severe inflations and depressions’.
King gave his future self a get-out-of-jail-free card, insisting that “real shocks” can also have the same effect as bad monetary policy… a position which looks rather convenient for the UK’s top central banker in 2013. I’d bet future historians will go with Friedman.