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The inflation genie must not leave the bottle

Economic Report

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There is an on-going debate in the UK regarding the merits of nominal GDP targeting. Of course, “out-of-the box” thinking is welcome given the disappointing pace of economic recovery. However, we believe the risk of switching to a new policy framework is high because it can permanently destabilise inflation expectations. Besides, the current policy target offers enough flexibility for the Bank to ease monetary policy without threatening its inflation-fighting credentials.  

The evolution of monetary policy

Economists often admit that monetary policy is more art than science. Throughout the past century, central banks have changed numerous policy targets with the aim of increasing economic welfare. The era of the gold standard, which de facto ended in 1914 after some decades of turbulence gave way to fixed exchange rate regimes during the Bretton Woods period (from 1944 until 1971). The shortcomings of monetary targeting and exchange rate targeting that came after (high inflation rates of the 1970s and the subsequent costs of disinflation combined with currency crises in the early 1990s) led to the birth of what is known today as ‘flexible inflation targeting’ (FIT). This new regime provided central banks more short-run flexibility (as opposed to rigid rules such as fixing the exchange rate or the growth of money supply) to stimulate growth without endangering the long-run price stability objective.

New Zealand was the first to adopt FIT (1989) and by the end of the 20th century most major central banks had received the explicit mandate to deliver low and stable inflation [1]. And they definitely did deliver on that promise. Table 1 shows that inflation rate amongst the advanced countries dropped substantially over the past two decades and became significantly less volatile. For example, the history of UK’s volatile inflation prior to FIT shows how important this new regime has been (figure 1). 

Table 1: Post-war inflation rates
Table 1: Post-war inflation rates
Figure 1: History of inflation in the UK
Figure 1: History of inflation in the UK Source: Reuters EcoWin, BoE, Rabobank

Inflation targeting was found to be the magic recipe that gave way to a period of high growth and stable inflation (formally known as ‘the Great Moderation’ era). But this feast came to end when the financial crisis made landfall. After the freefall of global growth in 2008/09, major central banks tried conventional and unconventional policies to support the recovery and safeguard price stability. Policy rates were lowered drastically and central bank balance sheets ballooned (figure 2) as a result of quantitative easing (QE) measures and enormous liquidity provision.

Figure 2: Unconventional monetary policy 

Figure 2: Unconventional monetary policy

Source: Reuters EcoWin, IMF

Footnotes

[1] ^ FIT was quickly adopted by canada (1991), Israel (1991), the UK (1992), Sweden (1993), Finland (1993), Australia (1993), and Spain (1994). 

Is FIT fit for purpose?

The aggressive response of central banks in the major advanced countries failed to push the economies to ‘escape velocity’, whereby growth becomes self-sustaining. Recoveries remain disappointing five years into the crisis and the outlook is not much brighter. The failure of the current policy framework has reinvigorated the debate amongst economists and policymakers about the merits of jumping to a different monetary regime altogether. The idea that has received the most attention is nominal income level targeting [2] (NILT). To be sure, this is not an entirely new proposal. The British economist James Meade was the first to argue for such a move in 1978 [3]. Robert Hall and Greg Mankiw (1994) were also supporters in the US [4]. But what really got the debate going was the recent endorsement of this policy by the governor-designate of the Bank of England (BoE), Mark Carney. In a recent speech, Mr. Carney claimed that when economic conditions are weak and policy rate is stuck at the zero-lower bound, there is a case to be made for introducing a temporary nominal GDP target. More recently, Mr. Carney clarified that the “the bar for change [of inflation targeting] is high but there should be a debate”.

Footnotes

[2] ^ By definition, nominal income/GDP equals the product of real GDP and the price level.

[3] ^ Meade, J. (1978). The meaning of internal balance. The Economic Journal, 88.

[4] ^ Hall, R.E., and Mankiw, N.G. (1994). Nominal Income Targeting. In Mankiw, ed., Monetary Policy, University of Chicago Press: 71-93.

Must Carney shake things up?

UK’s dismal economic performance is the main reason for this debate in Britain. Nominal GDP is still way below its pre-crisis trend. In a simple exercise we show that even if UK’s real GDP grows in line with the IMF’s forecast and inflation averages 3.5% every year (current target is 2%), then it will take another 5 years or so for nominal GDP to return back to its pre-crisis trend (figure 3).

Figure 3: Nominal GDP of the UK

Figure 3: Nominal GDP of the UK

Source: Reuters EcoWin, Rabobank

Against this backdrop, some argue that Mr. Carney must move towards (a temporary) NILT. With such a policy regime ‘bygones are no longer bygones’; meaning that, as the gap between nominal GDP and its pre-crisis trend accumulates, the private sector should anticipate that monetary policy would remain loose for a longer period until the target is reached. 

Scenario 1: An ideal world

Let’s assume that Mr. Carney introduces the NILT upon arrival in July. The optimistic scenario would be that the private sector realises that “there is a new sheriff in town” who will take whatever measure necessary to stimulate nominal GDP growth. This should unleash animal spirits and create an incentive for extra spending. Consumers will loosen their purse strings once they are more secure about their jobs/incomes and companies will invest more given better sales prospects. Another positive effect is a temporary rise in inflation expectations. Usually, this would be undesirable. But in a situation where nominal interest rates are constrained by the zero-lower bound, a small increase in expected inflation could be helpful. Real interest rates for a given level of nominal rates would fall as a result, and this should encourage households and businesses to not postpone spending.

Both effects will shift the economy to a higher gear and Mr. Carney might not even have to do much to boost growth. By managing expectations, the mere change of policy goal can become self-fulfilling. Once the target is reached, the policy rate can be raised to avoid economic overheating. Mission accomplished!

Scenario 2: Back on earth

Now we must consider what would happen if potential output growth is permanently lower in the aftermath of the crisis. We must not forget that real GDP has been more or less stagnant between Q3 2010 and Q4 2012. And output is still 3.3%-points below its pre-crisis peak (Q1 2008). Clearly, the 525 basis points rate cut since the crisis and the GBP 375bn of assets purchased by the Bank has not had the desired effect. So why should the public believe that a new policy target will be any more helpful in such a weak macro environment? 

It is safe to assume that the private sector will continue to have difficulty front-loading spending while repairing damaged balance sheets. Meanwhile, banks may not want to increase lending until capital buffers are raised and economic conditions improve. What’s more, the aggressive austerity drive by the public sector will continue to weigh on growth for a few more years at least (figure 4). And the external sector may be unable to support growth when global demand is weak. Amid these strong headwinds, the Bank’s looser monetary policy may do nothing to bolster real GDP growth.

Figure 4: Public sector retrenchment

Figure 4: Public sector retrenchment

Source: IMF, Rabobank

Actually, the opponents of NILT argue that the difficulty of estimating (potential) real GDP growth rate (in real time) is a major limitation of this regime. There are two other noteworthy drawbacks that cannot be ignored. First, GDP data are published with a long lag and are constantly revised. Regularly moving goalposts can make life difficult for central bankers. Second, nominal GDP is probably less transparent than inflation for the public. This can make the central bank’s communication strategy challenging. 

Stealthy inflation

Against the weak macroeconomic backdrop in the UK, some rightly fear that to reach the nominal GDP target, the monetary authorities will tolerate higher inflation. In fact, sceptics argue that inflation will stay high even after the target is met. Given the high private and public sector debt level in the UK [5], the Bank has enough incentive to keep policy loose to reduce the real value of debt.

If so, inflation expectations may be permanently unanchored due to lack of policy credibility. The economic pain suffered during the 1980s should serve as a precautionary tale that putting the inflation (expectations) genie back into the bottle will come at a high price. Between March 1978 and November 1979, the BoE hiked the policy rate by a whopping 10.5%-points to combat inflation. As a result, real GDP contracted by 2% and 1.25% in 1980 and 1981, respectively. The jobless rate almost doubled from 5.4% in 1979 to 11.8% in 1984. Another economic cost is the risk that investors dump UK’s government bonds due to higher inflation expectations. Figure 5 shows that the market-based inflation expectations in the UK, measured by inflation-linked swaps (5 years), have increased recently from an already high level. Worries of higher inflation can push up government bond yields and, therefore, undermine fiscal sustainability. Not to mention that interest rates in the private sector will also rise since government bond yields serve as the ‘risk-free’ benchmark. Naturally, the rise in nominal rates will negate the beneficial effects of a temporary rise in inflation expectations, which is supposed to lower real interest rates.

Figure 5: Inflation expectations

Figure 5: Inflation expectations

Source: Reuters EcoWin, Rabobank

Footnotes

[5] ^ The UK’s total gross debt was 536% of GDP in 2012. This was the third highest in the industrialised world (after Ireland and Japan). 

Why not use current policy flexibility?

Thus, any gains made by the BoE in the interim by switching to NILT will be lost if inflation expectations become permanently destabilised. As mentioned above, this would require a painful re-establishment of inflation credibility in the future. In our view, a better approach is to fully utilise the current policy flexibility. Indeed, the BoE has interpreted the ‘flexibility’ embedded in FIT quite literally. Between January 2008 and December 2012, inflation has only been 6 months at or below the 2% target (figure 6). That is around 10% of the time. And during this period, average inflation was 3.3%. Of course, much of the rise in inflation can be explained by temporary factors such as VAT hikes, rising commodity prices, sharp depreciation of the pound, and so forth. In any case, the BoE has had quite a lot of flexibility in allowing inflation to surpass its target, at times by a wide margin, without jeopardising its inflation-fighting credentials.

Figure 6: UK’s recent inflation performance

Figure 6: UK’s recent inflation performance

Source: Reuters EcoWin, Rabobank

Concluding remarks

UK’s economic recovery has been disappointing, to say the least. As such, we are delighted to see that the governor-to-be is willing to have a debate about the merits of inflation targeting. Certainly desperate times require desperate measures. But this is not an open invitation for taking foolhardy decisions in an attempt to jumpstart the economy amid strong headwinds. Instead of a knee-jerk reaction, it’s best to use the current policy framework fully and experiment with new measures such as the recently enacted “Funding for Lending” scheme, which is already proving to be more successful than the QE measures taken until now. The fiscal authorities can also lend a helping hand by easing their foot off the brake pedal. This way the economy gets a chance to reach ‘escape velocity’ and the inflation genie stays firmly in the bottle, as it should.  

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