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Are inflation targets "The End of History?" Samuel Brittan: Political Economy Club 12/01/05 My forthcoming book of essays entitled Against the Flow (Atlantic Press, £25, publication date Feb .4) covers a variety of subjects, from foreign policy and religion, to individualism and the limitations of democracy. I have however decided to focus on the section likely to be the highest common factor of interest to members of this club, namely Part Four which has the thrilling title of "Economic Management". But I would be more than delighted if anyone here who has had an opportunity to glance at the volume were to raise matters arising from other sections. There is a non-cynical reason for my choice of subject. Nearly all the other Parts of the book contain fairly substantial essays drawing the themes together. The part on Economic Management contains mainly short articles. They were written during a period when the British authorities, after decades of experiment, seem to have reached a reasonably successful formula under the headline of "Inflation Targets". In these circumstances, to have elaborated a rival conception would have been pointless. But I am glad to use this opportunity to try to draw a few threads together. My exact title takes off from a lecture given by Sir Alan Budd, formerly chief economic adviser to the Treasury (Black Wednesday - A Re-Examination of British Experience in the ERM, October 5,2004) in which he said that "the current framework for monetary policy in the UK is as close to perfection as fallible man can hope to achieve." I hope there was an element of irony, as well as genuine endorsement, in what he said. Lord Lamont, who was the chancellor who introduced these targets, was fairly modest about his progeny in his contribution to the recent series of lectures by ex-chancellors at the London School of Economics, and remarked that he did not believe that they were "the end of history". Hence my title for this evening’s talk. He was being over reticent, but he had a point. We need however to be precise about the current regime. The UK did have a form of inflation targets earlier on. These were in the context of an "incomes policy" and were used as an inducement for the unions to accept wage restraint. They were based on an over simple cost-plus view of inflation; and when prices rose above expectations, government assurances could boomerang. The present form of inflation targets can best be understood as a version of what is sometimes known as "the new consensus" or more technically as "a nominal framework" (this last term was, as far as I know, invented by Lord Burns to characterise the then novel approach to demand management, which concentrated on nominal variables such as prices and did not attempt to targets real variables such as growth and employment.) It is this idea of a nominal framework which is the common element in the monetary targets which were tried first, then the attempt at an exchange rate link via the ERM, my own still untried nominal GDP objective and finally the new regime inaugurated by Norman Lamont in 1992 which continues to this day. The instrument used for current inflation targets is monetary policy. Some believe that the automatic fiscal stabilisers can play a supplementary role. But pay and price controls no longer come into the picture. The operational independence of the Bank of England granted by the Labour government strengthened confidence in this regime, but did not change its nature. A side effect may have been to foster a belief in the mystical power of central banks over all manner of matters, which is only embarrassing to central bankers themselves. As nothing in this world is perfect, what are the potential weaknesses of the present regime? The first is mainly presentational. When the Bank takes action to counter a potential economic slowdown, it uses contorted terminology about the danger of inflation falling below 2 per cent within the next two year period. This is surely absurd. There would hardly be riots in the street - even Lombard Street - if it was thought that inflation was going to reach 1½ per cent in the near-term future. This curious kind of explanation derives from an exaggerated belief in the short term Phillips curve - in other words that a recession normally goes with falling inflation, so that the one objective of a modest but non zero target inflation rate, achieved over a couple of years, will cover all eventualities. The truth is that while the two are often linked together in this way, sometimes they are not. There can be a below target rate of inflation due to say a much longed-for productivity miracle or a fall in import prices. Neither need be a disaster. Surely it would be better for this or any other central bank simply to say that it is following its brief to support government policy (which in every country includes aspirations for growth and employment) but without accommodating inflation. The next, and already widely discussed, potential weakness of the present regime lies in the limitation of the instruments to very short term interest rates. A year or two ago there was a great deal of discussion, especially in Federal Reserve circles of what was called ZIRB, the zero interest rate bound. Because policy-determined interest rates cannot fall below zero they may not be low enough to fight off a slump, even if the inflation targets permit it. This possibility was first raised by Keynes under the name of the Liquidity Trap. But note that its existence does not require "deflation" in the sense of falling prices. It exists when, for whatever reason, interest rates cannot be brought low enough to maintain effective demand. (There are far-out suggestions of how negative real interest rates could be produced in practice - eg a combination of fixed interest securities sold at a premium on redemption price plus a tax on bank balances. But I would not count on such devices being available when they are needed.) The only occasion when negative interest rates have prevailed in my adult life has been when a large and unexpected rise in inflation has taken market by surprise as in the 1970’s. But to depend on such malfunctioning is surely a cure on a par with the disease. The most cautious adjustment of the regime in a slump would be to allow the central bank to operate on longer term securities and thus affect directly the whole interest rate spectrum. But even that might come against the prohibition against using central banks to finance government deficits. Nor in this situation would it be enough just to relax the rules against government deficit finance, as we see from Japan. The upshot of the debate in the US Fed of the Open Market Committee seems to be that, faced with a large deficiency of aggregate demand, the logical and effective remedy would be budget deficits financed by an increase in the money supply. Neither on their own might be enough. This has been described by the Fed’s Ben Bernanke as the nearest practical equivalent to the Milton Friedman helicopter that drops dollar notes from the sky. Of all the monetary areas, the eurozone is the least equipped to effect such a combination of remedies. (Not only is the ECB be reluctant to expand the money supply, but there is no European government whose deficit it could finance. And if it had attempted to finance either some existing member governments, it would be breaking all the rules from Maastricht onwards. The ECB would have some understandable suspicions that the threat of a slump was being used as a pretext to fund irresponsible spending programmes). But even in the UK such a combined use of monetary and fiscal policy would require a suspension of Gordon Brown’s fiscal framework and the provisions under which the MPC operates. In practice however the biggest alleged failing of the inflation target regime has turned out to be different. It is that it does too little to mitigate asset price bubbles. The central banks’ reply is that they can hardly be expected to underwrite either the stock exchange or property prices. They also say that they do take into account asset prices - including exchange rates - to the extent that the latter influence final price levels, and therefore monetary policy, under an inflation target regime. An objection to this line of defence is that there is extremely long road between asset price bubbles and the ultimate inflation objective. Suppose there is a collapse of house prices in the UK. We would not only have to wait for this to bring about a slump; but that slump would have to bring inflation down below target, which could take a long time especially in a world subject to shocks such as oil price explosions. The main weakness of the present framework is that it implies that the only source of financial instability is inflation or deflation. As one economic analyst put it, "an asset price boom carries with it the risk of a bust that will destroy the value of securities held by financial institutions and thus produce a collateral-induced credit crunch." What are my conclusions? The last thing I am suggesting is that inflation targets and independent central banks should be jettisoned. We have had so many regime changes in rapid succession that we should not rush into yet another one, especially when the present one is still working. But it would help if the central bank operated with some concept of a normal real short term interest rate. This would be perfectly compatible with an inflation target. It merely requires the central bank to be explicit on occasions when it moves above or below a neutral range of interest rates in pursuit of the target. This would take us some way from the present unanchored series of short term policy moves purely dependent on short term forecasts. There are obvious difficulties in determining the neutral interest rate. But it is not more problematic than the so called output gap of which excessive use is made at present. While we may not know the exact neutral real interest rate, we can be pretty sure that anything below two per cent is stimulatory and anything above four or five per cent is restrictive. What I am suggesting is no more than what Alan Greenspan already does - for instance his present moves towards levering up US real interest rates to a more normal range, even though the conventional wisdom still believes that there is a negative output gap and mainstream forecasts are not all that buoyant. There are other ways in which a little more common sense could be shown in interpreting the rules. For instance there could be, as in the USA, an explicit concern for growth, so long as this is not allowed to jeopardise the low inflation objective. And we should also be allowed to talk about how to fight a slump as a hypothetical exercise without predicting one round the next corner. Moreover, the time may have come to reincorporate the National Debt Authority into the armoury of economic policy and widening its present narrow mandate of minimising Treasury borrowing costs. In this country the Bank of England separation from the Treasury is now so well established that some overt cooperation would no longer look like a threat. I have no silver bullet to suggest for asset prices. All I can suggest is that central banks acknowledge some specific duty to watch them - over and above the perhaps remote effect on consumer price inflation. This could perhaps be squeezed into the present British regime in terms of the joint Treasury-Bank-FSA responsibility for financial stability. I would like to end with a more general moral. John Stuart Mill asserted that challenge and debate were just as essential for the exponents of the prevailing wisdom - itself the result of radical challenge a generation back - as for their opponents. For without constant challenge their understanding would atrophy into a formulaic orthodoxy; and it is in this spirit that I would agree that inflation targets are not the end of history.
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