With inflation surging to new heights, the search for a scapegoat is well under way. Questions are now being asked about the monetary policy regime itself: that is to say, targeting the inflation rate. It is perfectly reasonable to be asking searching questions about the established policy regime. But would it be wise to reject inflation targeting?
A possible alternative as a target is Money (i.e. nominal) GDP. This is superficially very plausible. Money GDP is an amalgam of the quantity of output and the general price level. Targeting this measure makes some sense because interest rates and other policy levers have a bearing on overall money expenditure, rather than directly on inflation itself.
Nevertheless, a Money GDP target would suffer from some serious problems. At present, Money GDP data is only published quarterly and even then with a considerable delay. I suspect it would be possible to publish monthly data, but I doubt whether this could be done with as little delay as the CPI inflation data. And publishing such data more frequently and more quickly would almost certainly intensify a second problem with Money GDP – the data is often revised, sometimes by a considerable amount. By contrast, the CPI data is never revised.
Moreover, people don’t readily understand Money GDP. It is not the subject of frequent discussions down the Dog and Duck. By contrast, people at least broadly understand what the official published inflation rate is supposed to be measuring. Indeed, they frequently moan about how it does not accurately reflect changes in their cost of living - including in the pub.
Furthermore, it would be extremely difficult to know what target to set for the growth of Money GDP because that would require an estimate of the sustainable rate of growth of the economy. For that, you could plausibly come up with figures anywhere in the range of 0-2pc. So, assuming that you were still aiming to keep inflation at about 2pc, that means that the target for Money GDP could plausibly be anywhere in the range of 2-4%. And if you got the underlying growth rate of the economy wrong you would systematically deliver policy that was either too loose or too tight.
Supposedly, a Money GDP target would make it easier for the Bank of England to avoid raising interest rates when the economy is suffering from high inflation and yet is very weak. Other things being equal, that is true. But is this necessarily a good thing? Sometimes the Bank needs to raise interest rates to get on top of inflation even when the economy is weak.
In any case, even under the current system the Bank has the ability to “look through” what it thinks are short-term surges in inflation and to take account of the weakness of the economy. This is what it did in the years immediately after the Global Financial Crisis.
Moreover, in 2020/21 a Money GDP target would not have given warning of the inflationary pressures that lay ahead. Indeed, since output collapsed during the pandemic, this would have put pressure on the Bank to have injected even more monetary stimulus. It is not obvious, to put it mildly, that this would have been a good thing.
A second possible target variable is the money supply. It has a ready appeal. Anyone who has taken an elementary course in economics understands that inflation is caused by “too much money chasing too few goods”. But even the elementary textbooks recognise the problems with this apparently convincing formulation. The trouble is that in the modern world, money is a very slippery concept.
And it is clear that whatever happens to the money supply, the demand for money (what old school monetarists used to call “the velocity of circulation”) can vary considerably.
Nor are these objections merely theoretical. In the 1980s we underwent a live experiment in steering by the money supply. The Thatcher government believed that if it brought down the growth of the money supply, then inflation would fall inexorably. In the event, despite raising interest rates to a peak of 17pc in 1979 and continuing to keep them high for several years, it failed to achieve much of a moderation in the growth of the money supply.
Nevertheless, the inflation rate fell dramatically. Evidently high interest rates and a strong exchange rate, buttressed by budgetary discipline, did the trick. Surely we don’t need another experiment like that to realise that the growth of “the money supply” can be a wayward mistress.
Having said that, the way that for many years now the Bank of England has completely neglected the money supply is remarkable. I am not a monetarist myself. Nevertheless, that doesn’t mean that I believe that money doesn’t matter at all. At times it clearly matters a great deal. The trick is to interpret the monetary data in the context of what is going on more broadly in the economy and to pay it due regard.
In 2020, driven by the policy of Quantitative Easing, the annual growth of broad money burst out of the 2-4pc range it had occupied in 2018/19, surging past 10pc and heading for a peak of over 15pc.
You didn’t need to be a card-carrying monetarist to realise that this at least posed an important question that needed to be answered. But the Bank apparently didn’t.
So my recommendation is that there should be an investigation into the Bank’s record, the membership of the MPC and its methods, including how much attention it pays to the growth of the money supply, how much weight it places upon the output of its own macro-economic model and how much attention it pays to both outside analysts and businesspeople across the country. But the inflation target should be left well alone. Particularly at a time of high and volatile inflation and fragile confidence in financial markets, you tamper with it at your peril.
It’s dangerous to scapegoat the Bank of England’s inflation target – tamper at your peril
There are alternatives – but they come with their own pitfalls