In an article in the Independent today, I argue that it is about time the Bank of England changed UK interest rates. But they should go down, not up. The essence of the argument is there remains a significant risk that we have substantial deficient demand. Even if the probability of this is below 50%, if it is true the costs of it persisting far outweigh the costs of some mild inflation overshooting.
One point I do not consider in the article are the implications for nominal GDP (NGDP) targeting. Here is the picture.
I use nominal GDP per head, because that is robust to changes in migration flows, which for the UK have been important and variable. The serious arguments are for a levels target, so I’ve drawn in a reference path for 4.25% growth. That is a combination of 2% output price inflation and 2.25% real growth per head, the latter being the 1955-2008 average rate.
If the Bank of England had adopted a NGDP target, as many have recommended, the MPC would be tearing their collective hair out right now trying to stimulate the economy. There would be zero talk of interest rate increases. So there seem to be just two possibilities. Either NGDP targeting is nuts, or monetary policy has slowly gone off the rails by focusing on CPI inflation alone.
Time will tell. But if the possibility that the UK could really grow quite fast right now without inflation getting out of control turns out to be true (and the argument I make in the Independent is just that there is a non-trivial possibility that it might be true), what will history say? I suspect they will talk about Goodhart’s law, which says “when a measure becomes a target, it ceases to be a good measure”. Targeting inflation and ignoring output seemed like a good idea, because of what is called the divine coincidence. I talked about this in what I think is one of my better posts. Goodhart’s law applied to this case says CPI inflation ceases to be a good indicator of both the state of the economy and maybe also the costs of inflation when you try using it as a target.