Today’s announcement that the Corbyn Labour party is planning to examine to what extent the Bank of England’s inflation target might be modified to take into account factors other than inflation provides a good opportunity to reflect on what inflation-targeting itself has achieved and why the UK might move to a different monetary regime.
(By way of background, although the Bank of England is “instrument independent” – that is, the BoE gets to choose how it achieves its target – the target itself is set by the government – i.e. the BoE is “goal dependent”. Hence, in the event that a Corbyn government is elected, they would have the power to change the measure that the BoE targeted.)
Although one of the main reasons for Corbyn’s decision to re-examine inflation targeting appears to have been due to actual inflation having missed the BoE’s target on a consistent basis in recent years (CPI has been below the 2% +/- 1% band much more often that not recently), it can be argued that this “accuracy metric” is not the most important criterion by which to measure the success of inflation targeting.
Indeed, the main purpose of inflation targeting is to anchor people’s expectations regarding what level of inflation will prevail. As such, the most important metric by which inflation targeting should be measured is the extent to which people’s expectations regarding what the prevailing rate of inflation will be have converged to the level of inflation that has been set as the target. To that end, both Capistran & Ramos-Francia and Gurkaynak et al. demonstrate that targeting inflation leads to a decrease in the range of people’s inflation expectations.
In other words, the fact that a target might have been missed does not matter in-and-of-itself. Instead, missing an inflation target only matters insofar as consistently missing the target would affect people’s expectations of inflation. Thus far, there have not been any signs that people’s expectations regarding future inflation have been affected by the Bank of England missing its target.
Hence, at least one of the motivations regarding a potential move away from inflation-targeting is likely to be flawed. However, that is not to say that the other targets that have been proposed – such as targeting nominal GDP growth, or increasing the level of inflation targeted to, say, 4% per year – would lead to run-away inflation. Indeed, there are some economists that advocate moving entirely to a nominal GDP target would have the benefit of promoting growth (particularly when interest rates are close to the zero lower bound) as well as still preventing anchoring inflation expectations (see, for example, here).
The one word of caution that needs noting is that a nominal GDP target is less transparent than inflation – how will the general public be able to translate a target for nominal GDP into a target for inflation? How will they be able to know what inflation is likely to be when all they have is a nominal GDP target? Hence, it seems likely that a nominal GDP target won’t be sufficient on its own, but instead needs to be accompanied by an explicit inflation target (i.e. a dual target). That seems a much more transparent and easily-accessible policy, particularly given that the main aim in all of this is to anchor people’s expectations.