Forecast to Fail?
Lars E.O. Svensson‘s “best practice” for inflation targeting is to target the forecast – to set the stance of monetary policy such that the forecast of the inflation rate remains on target, even if the current inflation rate deviates. With the inclination towards market inflation forecasts (as opposed to some mathematical model), Scott Sumner dubbed Svensson a “Market Keynesian“.
The Bank of England’s legal mandate does not strictly endorse targeting the forecast, setting their objectives as follows:
- to maintain price stability, and
- subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.
The specific interpretation of “price stability” and HM Government’s economic policy are confirmed yearly in a letter from the Chancellor:
I confirm that the operational target for monetary policy remains an inflation rate of 2 per cent (measured by the 12-month increase in the CPI). The inflation target is 2 per cent at all times: that is the rate which the MPC is required to achieve and for which it is accountable.
The framework is based on the recognition that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output.
(A note to those who call for a higher inflation target: HM Treasury, not the Bank, has the legal power to change the specific interpretation of “price stability” at any time; there would be no need even for Parliamentary approval. It is easier to change the inflation target than to change the fiscal budget!)
The Monetary Policy Committee seem to find enough leeway in their remit to adopt the language of forecast-targeting. For example, in October 2011, with annual CPI inflation at 4.5%, well above the target, the MPC was willing to ease policy, giving the following justification:
The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term. In the light of that shift in the balance of risks, and in order to keep inflation on track to meet the target over the medium term, the Committee judged that it was necessary to inject further monetary stimulus into the economy.
This begs the question how the “medium term” is defined. Fortunately, the Bank publish detailed forecast data. Here is a graph of the CPI forecasts produced at each quarterly Inflation Report, the forecast based on market interest rate expectations is used looking both two and three years out:
Had the MPC been targeting something close to the two-year forecast (red line) they should have eased in 2010. But they did not ease (or otherwise change) policy throughout the whole of 2010, nor through the first three quarters of 2011. Policy was loosened only once the forecasts across the curve dropped precipitously in the final quarter of 2011.
This presents a conundrum, because in 2008 the opposite was true: the justification for tightening in the first quarter can surely only come from an emphasis on the nearer-term forecasts which did spike upwards. Likewise in the third quarter of 2008, the three year forecast drops significantly below the 2% target, which would have indicated easing, whereas the three year forecast remains above – and the MPC fatally held rates at 5% through that entire quarter.
So even if the MPC are vaguely Svenssonian in its communication, it seems that they do exercise discretion over policy; or at least whatever policy rules they follow are kept well obscured.
If only our press corps could hold them accountable for these decisions, rather than imploring Sir Mervyn King to pontificate at length about Moody’s, the Eurozone, and SME financing; the pertinent issues for UK monetary policy makers?