LONDON – Speaking in the happier economic times of 2005, Mervyn King – then, as now, Governor of the Bank of England – stressed the importance of entrenching public expectations of stable, low inflation. He warned that, “if you let inflation expectations drift too far away from the target, you can end up in quite serious difficulty with a costly process to bring them back again.” King must now be a worried man.
The Bank of England’s own commissioned quarterly surveys of public attitudes reveal that the credibility of its Monetary Policy Committee (MPC) has now been impaired. For the last 15 months, the 2% inflation target, which is set by the government and is supposed to be enforced by the Bank of England, has been exceeded by more than a full percentage point. For most of this period, the British public expected inflation in the coming year to be lower than in the previous year, thanks to the MPC’s strong track record on price stability. That confidence has now dissipated: inflation expectations have caught up with the actual inflation rate of 4%.
There is no mystery about what is going on. The price-stability mandate has been trumped by concerns about growth. The fear is that tightening monetary policy to bear down on inflation could snuff out the faltering economic recovery.
So not only has the MPC kept interest rates at a rock-bottom 0.5% since 2009, but policy has been loosened further by the Bank of England’s so-called “quantitative easing” – that is, expanding the monetary base by the stroke of a pen in the hope of reinvigorating domestic credit markets. But the United Kingdom is now faced with the worst outcome: stagflation. The economy is incurring the inflationary costs of the Bank’s policy while missing out on the intended benefit of growth.
In the US, where the Federal Reserve is running a similarly loose monetary policy, the situation looks rosier – at least at first sight. The US economy is staging a more convincing recovery than the UK, and, in contrast to the Bank of England and the European Central Bank, the Fed is not explicitly mandated by Congress to achieve a specific inflation target.
Thus, compared to the Bank of England, the all-important credibility of the monetary authority seems less vulnerable in the case of the Fed. But, even in the US, policy-setting officials, such as Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, express concern that inflation expectations may become unanchored, owing to the massive expansion of government debt and the Fed’s balance sheet since the financial crash in 2008.
All the major Western central banks – including even the traditionally “hawkish” ECB – appear to be sticking their heads in the sand. But there is something they can do to ensure the benefits of inflation-targeting rules (credibility and well-anchored inflation expectations) while also supporting recovery: raise the stated target.
The case for doing so can best be shown by Britain, where the situation is particularly delicate. The UK authorities have decided to prioritize fiscal consolidation while running a loose monetary policy to contain risks to the recovery from higher taxes and lower government spending. The thinking is clear (if rarely spelled out clearly by politicians): whereas a loss of market confidence in the British state’s solvency would most likely trigger a depression, above-target inflation can be rectified at a relatively tolerable cost to living standards (though higher than it should have been).
Granting, for the sake of argument, the force of this logic (and even its critics could hardly deny its coherence), it would be foolish to underestimate the risk of runaway inflation and underplay the economic and social harm it would cause. To the extent that tolerance of above-target inflation also reflects a desire to erode the real value of public and private debts, market interest rates could soar, leaving indebted governments and households in even greater trouble.
Many commentators believe that governments’ huge budget constraints will force them to rely on inflation. If so, it is better to do it transparently, unlike the Bank of England. Simply put, in order to anchor inflation expectations effectively, inflation targets must be realistic.
The current high-stakes conundrum faced by policymakers suggests that they should apply inflation-targeting principles more flexibly in the context of a major economic shock. This would involve raising the target to a level in line with the actual inflation rate observed in the post-crisis period – a level that the public would perceive as realistic, honest, and credible.
Doing so would reduce the debt and tax burdens on future generations, while crucially limiting the risks of much higher inflation in the nearer term. Moreover, a higher inflation target – and the restoration of credibility that it would imply – would enable central banks to return to a lower inflation target without creating a recession once debt levels had been reduced and aggregate demand had recovered.