Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 8 January 2013

Is there a case for inflation targets? The UK versus the US.

One of my projects for the year ahead is to come off the fence (one way or another) on nominal GDP targeting. As an experiment, I’ll try and track my progress on this project with blog posts, although only if my thinking might be interesting to others. It is going to be a long process, because there is a lot involved: levels vs rates of change, GDP deflator vs CPI, nominal GDP versus its price component, and uncertainty about the natural rate to name some of the most obvious issues. However there is also another issue that may be just as important, and that is whether we need targets at all. In this post I just want to think about this last issue in relation to inflation targets, and not any other kind of target.

An obvious way for a macroeconomist to approach this is to imagine a world in which the central bank acts in society’s best interests, and has as good an idea as anyone else what those interests are. (The policy maker is benevolent, and knows the appropriate measure of social welfare to maximise.) Actually, for both the US and UK I do not think that is such a bad place to start. Let’s also suppose, as is standard, that society’s best interests involve getting inflation close to some desired level, and getting the output gap close to zero. Call this a dual mandate if you like. In such a world, why impose a target on the central bank? In other words, why do what is done in the UK rather than do what is done in the US?

By target, I mean something the central bank is required to try and hit. I am not talking about the central bank’s communication strategy. I take it as given that it is a good idea for the central bank without targets to be transparent about what its goals are, including what it thinks the desired inflation rate is. That is why this is effectively a comparison between the UK and US where in both cases transparency is fairly high.

The standard academic story involves time inconsistency and inflation bias. (Those familiar with this can skip the rest of this paragraph.) Essential to the inflation bias story is that a positive output gap (output above trend) is better for society than a zero output gap, for given levels of inflation. If you think this is obvious (more output is always better), remember more output means people working longer hours. If you think a zero output gap must be best, think about monopoly distortions or the impact of distortionary taxes. If a positive output gap is best, then a central bank may be tempted, once inflation expectations are formed, to try and temporarily raise output above the natural rate, knowing that the impact on inflation will be modest because inflation expectations are given. However rational agents will anticipate this, and the implication that their expectations about inflation will therefore be wrong. So they raise their inflation expectations above the central bank’s desired level, to a point at which the central bank no longer wants to raise inflation still further to get a positive output gap. The difference between this level of inflation and its desired level is inflation bias.

Although there is a huge literature on this, I have never been that persuaded of it’s continuing relevance in a world of long standing independent central banks. Central bankers, or academics on the UK’s Monetary Policy Committee, know that it is foolish to try and go for a positive output gap in this way, so they will avoid doing so. If the public nevertheless thought otherwise and therefore set inflation expectations above desired levels, the central bank would not settle for the inflation bias equilibrium (the time consistent or discretionary equilibrium), but would deflate the economy to get inflation down. This would soon convince the public that it was not trying to achieve a positive output gap.

Even if I’m right on this, we can still use the inflation bias argument in reverse. By this I mean that the public in ignorance will want the central bank to raise output above the natural rate, and the inflation target protects the central bank from this pressure. I mention this not because I think it is that convincing, but because this ‘using targets to protect the central bank from public pressure’ argument may have much more validity when we come to level targets. Of course the time inconsistency problem is more general than just inflation bias, but effects how the monetary authority responds to shocks (often called stabilisation bias), but here again levels targets may be more useful than inflation targets. 

I suspect the actual reason for inflation targets where they exist is more political. They increase the accountability of the central bank, and in some cases (like the UK) they allow politicians to set the target. These may be important advantages, particularly at the beginning of a new policy regime.

I also suspect that many macroeconomists have traditionally assumed (as I did) that the costs of inflation targeting were small, because if that target was achieved flexibly, it was quite compatible with optimising some combination of inflation and the output gap. The reason is of course the Phillips curve, which says inflation cannot be stable in the medium to long term if the output gap is non-zero. So a regime that targeted some fixed inflation target over the medium term would automatically achieve a zero output gap over the same time horizon.  Flexibility means leaving the choice of any particular short term combination of excess inflation and non-zero output gap up to the central bank.

This rather sanguine attitude has been tested by recent events. Some countries have experienced a whole series of positive inflationary ‘shocks’, some of which just reflect fiscal policy decisions. In the UK this has exhausted any flexibility that the MPC may have felt they had in not meeting the inflation target, so that their plans now involve meeting that target (or, indeed, expecting to slightly undershooting it), even though they forecast a large negative output gap to persist. Aiming to achieve the inflation target conflicts with what a benevolent policymaker would do. In contrast, the Fed in the US has (albeit only recently) explicitly countenanced exceeding their desired inflation level in an effort to get the output gap down. In other words, the inflation target in the UK is stopping the MPC doing what the Fed signal they are prepared to do.  

As a result, monetary policy in the US is better than in the UK, as a direct result of the impact of the inflation target in the UK. A related problem is the measure of inflation used. As I have pointed out before, the CPI is particularly susceptible to inflationary shocks like tax changes or higher commodity prices. As it is not obvious what the correct measure of inflation is from a welfare point of view, focusing on a measure that over a period is persistently higher than others may be distorting policy. The more this bias is hard wired in through mandated targets, the more sub-optimal policy may become.

So, my own view at the moment is that I prefer the flexible dual mandate approach in the US to the explicit inflation targeting regime in the UK.[1] Now of course this view is predicated on US monetary policymakers being fairly close to the benevolent ideal. If instead policymakers without a mandated target acted as if they all they cared about was CPI inflation (as in the ECB, for example), the disadvantages of an inflation target fall away. Nevertheless, what my view implies is that – all other things equal – the case for a nominal GDP target relative to the current regime is rather stronger in the UK than it is in the US right now. 

[1] A possible half way house has recently been suggested by Kate Barker, who was a member of the MPC, This would be to target a range (say 1%-3%), where the point chosen within that range by the MPC would depend on other factors, like the output gap. 


  1. Before asking the question: what should be the aim of monetary policy? one should ask the question: what should be the aim of economic policy? Remember, monetary policy is just one component of economic policy. Other components are fiscal policy, international trade policy, competition policy, etc.

    Many if not most economists, especially macroeconomists, argue as if overall economic policy is synonomous with monetary policy. The whole NGDP debate is actually a debate about economic policy.

    Over the past 3 decades, economists have been able to identify the responsibility of monetary policy within the broader economic policy sphere. It can be summarised as: price stability and financial stability taking cognisance of the broader economic environment. Exactly how this is achieved is still being debated, but I support targets with some level of flexibility.

    Why is there no such explicit statement of responsibilities (and associated targets) for fiscal policy, international economic policy, competition policy, etc??

    The efficacy of monetary policy actions has been severely decreased since they has to take up the slack from the failure of fiscal policy. Indeed, the failure of competition policy has created the TBTF banks that compromise financial stability.

  2. Good post. I was sitting on the fence (for Canada) just like you, around a year ago.

    "I also suspect that many macroeconomists have traditionally assumed (as I did) that the costs of inflation targeting were small, because if that target was achieved flexibly, it was quite compatible with optimising some combination of inflation and the output gap."

    Yep. That was me. I thought that if the BoC was successful in keeping inflation on target, at around a 2 year horizon (not each and every month), then it would also be successful at preventing recessions. Well, it turned out the BoC came very close to success on the first measure, but failed on the second measure. I was wrong. There was a recession, and NGDP fell well below trend path at the same time. That very strongly suggests that if the BoC had been targeting NGDP level path, rather than inflation, there would have been a much smaller recession, if any.

    1. Might it not also have meant that there would have been a recession anyway, just one with more inflation ?

  3. Nice post; a couple of comments:

    1. You say the BoE are forecasting a -ve output gap, but the BoE don't actually publish a specific forecast for the output gap. Mostly MPC members have been saying that they don't think it likely that faster demand growth in the short run will increase output.

    2. The discussion of flexible targets is very interesting. If you look at the BoE's inflation forecasts over the last few years, there are periods when they are expecting inflation to fall well below 2% on the two year horizon or beyond. Early 2009 and late 2011 in particular. There are no periods in which they expect inflation to exceed the 2% target on a 2 or 3 year horizon since early 2008.

    I find it hard to agree that the BoE lacks target flexibility on that basis. They are flexible but only in the wrong direction, sadly.

  4. 1. Playing with inflation simply can be useful in certain situations (getting the air out of an asset bubble for instance). It is a good mechanism herefor better imho than QE as it does it in a more natural way. In the sense that after the 'act' price level is in a 'natural' equil. and not in an inflated one like with QE.
    Anyway flexibility in general is a very useful tool if you want to obtain certain objectives.

    2. By using the words: 'maximising social welfare' however you come on political surface. Which opens questions about the democratic legitimacy of CBs and its decisions.
    As at the other hand powers were moved to CBs as politics made a mess of it, a good balance between the 2 should be found.

    3. It looks a recent trend that governments want again more influence on CBs policies. Reason probably mainly that politics doesnot get away so easy with decisions of other non-elected bodies anymore. It has simply become more difficult to blaim the EU or the CB if things remain substandard.

    4. Markets most likely prefer for most stuff standards as it gives more certainty. For very unusual situations (the not earlier considered) they simply want a solution and a quick one, even if it fits in the overall system is hardly important at that point.

    In how far it is possibile and benificial will mainly depend if a proper balance can be found between the above aspects.
    I could imagine a split in long term and shorter term objectives and try as much as possible to keep the social stuff out. The more social consequences choices have the more likely politics want a say (whether that is positive is another issue).
    Anyway a system with checks and balances works in general best in the public domain on important functions (and CBing is simply one of those).


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.