Failure to meet the inflation target has been the fault of successive Chancellors, not the MPC

Osborne and Brown have ignored the target

Fathom Consulting argues that keeping CPI inflation down to 2 per cent would have come at the cost of risking more unemployment and deeper recession. Broadly speaking, I agree: it would have been a mistake to try to keep CPI inflation to 2 per cent. “Eh?“, I hear you cry.  “Weren’t you the one that wrote this and this and this, urging repeatedly that the Inflation Target has lost all credibility? Haven’t you been voting for half-point rises in interest rates at the Shadow MPC for about a year? Have you suddenly gone soft on us?”

Yes, I did write those things. No, I haven’t changed my position. You see, the fundamental problem with the UK’s monetary policy isn’t that CPI inflation is over 4 per cent. It is that it is 4 per cent when the stated target is 2 per cent, and there is no official admonishment of the Monetary Policy Committee. Credibility is about keeping to what you’ve promised, not about making the same promise every time. In the UK we use inflation targeting. Under an inflation targeting regime the authorities set a target level for inflation (state that they will try to get inflation to that target) over a particular time period: one year – every year the Chancellor of the Exchequer sets a new target for the forthcoming year.

The very essence of inflation targeting – what distinguishes it from other monetary policy regimes such as price-level targeting – is that the target can be set at a different level the next time you set it. The flexibility of inflation targeting and the concreteness of the periods of the target are its great virtues. Because the target is only for a year, we can look and see whether the target has been met, and then admonish the Bank of England if it is not. And because the target is for only one year (and because bygones are bygones – misses on past targets are not carried forward), we can change it to whatever target would now be appropriate.

The UK’s inflation target has been changed three times: the first target, which applied for a period of four and a half years from September 1992 to April 1997, was for inflation, on the RPIX measure (the cost of living excluding mortgage interest payments) to be between 1 and 4 per cent throughout the period to the end of the 1992-97 Parliament, and between 1 and 2.5 per cent by the end of the Parliament in April 1997. That target was always met. The target was changed in 1997, in three ways. First, that it should apply yearly instead of over a Parliament. Second, that there was to be a continuous preference for the centrepoint of the range, at 2.5 per cent, rather than a preference for the lower half of the range (as before). Third, that the range would be reduced to 1.5-3.5 per cent (instead of 1-4). That target was always met.

The target was changed again in 2003. As part of trying to achieve convergence with the euro area (so we could join the euro – this was explicitly the reason) the measure of inflation was changed to the European Harmonised Index of Consumer Prices (HICP), as used by the European Central Bank. We re-baptised the HICP the CPI, and set the preferred centrepoint of the target at 2 per cent, with the new range being 1 to 3 per cent.

The third time the target was changed was less formal than the other two. In April 2007, for the first time in its fifteen year history, the UK missed its inflation target, with CPI inflation rising at 3.1 per cent. Mervyn King was forced to write a letter to Chancellor Brown explaining why. Given that this was a target miss, one might have expected the Chancellor to admonish King, to tell him he expected the target not to be missed again, to ask for a detailed rectification plan. But, what with being about to take over from Tony Blair as Prime Minister and not wanting to leave as Chancellor on a sour note, Brown did no such thing – setting a precedent, for no subsequent Chancellor has admonished the Governor for any miss, either. Instead, the Monetary Policy Committee went around making speeches explaining that we had all “misunderstood” the inflation target, and that actually there was no requirement to keep inflation below 3 per cent or above 1 per cent. Of course, we hadn’t misunderstood at all. But because the Monetary Policy Committee was permitted by the Chancellor to do this, the target was effectively redefined – not, this time by the Chancellor, but instead by the Bank of England. The new target was for CPI inflation to be 2 per cent, with no constraint over how far inflation should be permitted to deviate from this 2 per cent figure in the short term.

Since the inflation target has explicitly been changed twice (and in practical terms changed a third time), it obviously can’t be unthinkable to change it. In 2008, and again in 2011, I and a few others urged that the target should be changed again. Since it would be undesirable to try to get inflation to 2 per cent – Fathom is right about that – the target should either (a) have been set, for the year to come (2008 or 2011) at a level that was desirable (e.g. perhaps 4 per cent); or (b) the target should be changed back to one that included a maximum level by which inflation was permitted to deviate from the target in the short-term – e.g. by saying that for the year April 2011 – March 2012, the target is 2 per cent, and inflation should be no more than 5 per cent and no less than 1 per cent, even in the short term. Either way, once announced at a credible level, the target should be enforced.

The failure to set a target one wants the Bank of England to try to meet, rather than a target one hopes they will not try to meet, is down to the Chancellor of the Exchequer, not the Bank of England. It is for the Chancellor to set the target and to hold the MPC accountable for meeting. When I say the Bank of England lacks credibility, I am not saying it would have been better if inflation had been 2 per cent – with all that would have entailed. I am saying that the inflation target should have been (and should now be) set at a level the Chancellor desires and is willing to enforce.