A single-minded pursuit of inflation targets to the exclusion of everything else will produce occasional absurdities

Margaret Thatcher’s valedictory remark “It’s a funny old world” applies quite well to the present economic religion of inflation targets.

British shoppers who have had to pay more for meat because of foot-and-mouth disease might regard the outbreak as an unmitigated calamity. Yet for the Bank of England, it is apparently good news. For it postpones the time when Sir Edward George, the Bank’s governor, will have to write a letter apologising for the inflation rate falling by more than 1 percentage point below the 2.5 per cent target.

Even more bizarre is the reason why the Bank is in such a position. This is Gordon Brown’s decision in his March Budget to put on hold the usual increases in alcohol and petrol duties. There was an obvious attraction in doing so before the forthcoming general election. The effect was to put more spending into the economy, and to reduce both the headline inflation rate and the target one, known as RPIX, which excludes mortgage interest.

The chancellor’s decision may have been justified either by the favourable state of the UK public finances or by the threat of a recession emanating from the US. But the peculiar side-effect has been to make it look as if the Bank of England has been too tight in its monetary policies.

Even before these events, a search had been going on for a core rate of inflation index that is less affected by chance events. And, sure enough, Joanne Cutler, an economist working for the independent members of the Bank’s monetary policy committee, has produced such a core index: RPIXP (see chart). Moreover, her presentation has a rare clarity.*

Core inflation is defined as “the durable and persistent component of aggregate inflation”. She did not find the obvious core indices, which exclude items such as food or energy, to be very satisfactory in the UK - although they do better than RPIX on its own. What she has done is to weight the components of the official index “by their past persistence” and thereby give a lower weighting to the more volatile items.

Her criterion is the contribution of the core index to predicting the inflation rate for six, 12 and 24 months ahead. Her index also does better on my own preferred criterion, which is that of ironing out the obvious past erratic peaks and troughs.

But there is no such thing as a perfect index which can replace human judgment. In the suggested new index the prices of beef and lamb and other meats are given a higher weighting than in the official index because non-seasonal foodstuffs have had “a highly persistent inflation rate” - except, of course, for this year. The weights in RPIXP are changed to reflect changed price behaviour, but inevitably a year in arrear. No index can adequately allow for “acts of God” such as foot-and-mouth disease.

At this point, I cannot help noticing that, on Ms Cutler’s own table of predictive power, another index which is already published by the Office of National Statistics at the request of the Bank does, if anything, slightly better. This is RPIY, which simply removes the effects of changes in indirect taxes.

There is a great deal going for almost any core index as a supplement to the official RPIX, which removes only one type of distortion. But I cannot agree with the inference drawn by many commentators that Ms Cutler’s new “core” inflation index shows that monetary policy was too tight in 1999-2000. To say this presumes that, in spite of all the indications of growing labour shortages and repressed inflation, the economy would have benefited from a faster growth of demand than it actually experienced.

If the Bank had acted on this belief, Britain would have had even more of a bubble in property prices and in credit than it has already had. On top of this a lower pound, which would have been part of the objective, would have injected new spending into the manufacturing sector over and above the high rate of spending experienced in services.

To put all this in the language of inflation targets: if policymakers go by an indicator that produces an apparently lower inflation rate than the official one, this should also affect the targets at which they aim. Admittedly, the chancellor’s directive cannot be changed too frequently, but the operational target used by the MPC can still be adjusted.

The lowest UK inflation rate of all is shown by the harmonised European Union index which has been running for some time at below 1 per cent. It differs from RPIX partly because it excludes all owner-housing costs and also because it is based on a geometric rather than an arithmetic mean.

But now, however, switch attention to the euro-zone. Here the harmonised index has been running at more than 2.5 per cent. That is above the 0-2 per cent inflation target of the European Central Bank and helps to explain why the ECB has been so reluctant to reduce interest rates. The ECB does not have the wealth of core inflation rates that are available in the UK; but clearly, a core index that eliminates the effect of the recent rise in oil prices has been well within the ECB target inflation range (see chart). All that the ECB hawks can find to justify maintaining a tight stance is the very gradual increase in the core index during the last 15 months.

Of course, most of this argument is shadow-boxing. Mr Brown has put the real objective much better in his debating speeches when he talks about “avoiding boom and bust”, even though he exaggerates the extent to which this is possible. Indeed he puts too much emphasis on the Treasury 2001 forecast of 2½ per cent real growth.

More seriously, however, both in the euro-zone and in the UK there is too much confidence that a monetary policy based only on an inflation target can do all that is humanly possible to avoid boom and bust.

In principle the US Federal Reserve is better advised in following a less tidy objective which allows explicitly for economic stabilisation so long as this can be achieved without touching off a fresh inflationary wave. But there is no magic in the Fed approach or even in the instincts of Alan Greenspan, its chairman.

As Marcus Miller, a British economist, has pointed out, Mr Greenspan would have done better to have taken restraining measures when he first spoke about “irrational exuberance” instead of putting so much faith in the magic of the so-called new economy**.

Anyone who can suggest some guidelines for monetary policy that are neither too mechanistic nor dependent on the judgments of a super-Greenspan but can be achieved by ordinary mortals should send me suggestions on a very small postcard and not expect an acknowledgment. In the meantime, we shall have to live with booms and slumps.

* Core Inflation in the UK, Bank of England, External MPC Unit

** marcus.miller@warwick .ac.uk