Monetary Policy Stance under Inflation Targeting
I keep seeing people say the Bank of England is “doing the right thing” because it has shown a willingness to tolerate high inflation. To an extent this is fair – at least the Bank isn’t as bad as the ECB, but it is really not the right way to judge the monetary policy stance.
Lars Svensson, in his paper on Implementing and Monitoring Inflation Targets, says the following on how to hold the central bank accountable:
Adjusting the instrument [interest rate] so the inflation forecast equals the target is the best the central bank can do. Ex post inflation will differ from the target, because of forecast and control errors, for instance due to disturbances that occur within the control lag. If the central bank is competent, the mean forecast errors will be zero, and the variance of the forecast errors minimized. Ideally, if the inflation forecast could be verified, the central bank should be accountable for deviations of the inflation forecast from the target, but not for the unavoidable deviations of realized inflation from the target. This issue is discussed further in section 7.
My emphasis. What people are doing today is exactly what Svensson says not to do: looking at the deviation of the actual CPI rate from the target, not the deviation of the forecast.from the target.
Here is a plot which shows the Bank’s record under inflation targeting from 2004 to the beginning of 2008. On the X axis is the observed current CPI rate known at the time of each Inflation Report. On the Y axis is the Bank’s forecast for the median CPI rate looking two years out, which is generally what the Bank target.
That is, I’d say, really good monetary policy. The Bank has nailed the forecast to around 2%, regardless of what the current CPI rate is. Svensson would have the Bank incorporate an offset into the target to account for any output gap, shifting the target upwards or downwards if the output gap is negative or positive respectively, but I’m not aware that the Bank ever ever done that.
Here is what happened in 2008-2010:
This is really bad monetary policy. As the CPI rate drifts high in late 2008, the Bank allows the forecast to drift downwards. In Q1 of 2009, the Bank are saying the monetary policy stance is very very tight; they are expecting inflation to be barely positive looking two years out. By the last quarter of 2009, they had raised the forecast above 1.5%, but it is still below target, and remains so going into 2010. (By this stage there is also a massive negative output gap.)
Next, let’s look from 2011 to the current data (only current as of Q2, we don’t have the Q3 forecast data yet):
The Bank is targeting roughly 2% for the first three quarters of 2011, so, if we ignore the fact that they should bias the target upwards to reduce the output gap, that’s fine. In Q4 of 2011, they are again saying monetary policy is really tight. This has been corrected somewhat by Q2 2012, but the Bank is still expecting to significantly undershoot its 2% target.
So where is the inflationary bias of the Bank of England, on the very metric that Svensson (et al) say we should hold the central bank accountable under inflation forecast targeting?
I’d say it is very clear there is none. In fact, I’d say it is very clear they have a disinflationary bias: every time the current CPI rate shoots too far up (right on my graphs), they “passively” tighten policy by allowing the two year forecast to shift downwards. And never mind the depression.