The real central bank target is not inflation

IT SEEMS like Mervyn King has abandoned the Bank of England’s (BoE) inflation target, with the consumer price index (CPI) apparently stuck well above 2 per cent. But has King privately taken up a different sort of target altogether? A more credible alternative that continues to gain momentum is to set a nominal GDP (NGDP) target instead. Setting a target for the nation’s gross domestic product unadjusted for inflation (what F.A. Hayek referred to as the “total income stream”) has several arguments in its favour. Such a target allows gains in productivity to reveal themselves in price deflation over the long-term, and it turns the attention of policymakers towards market expectations rather than the previous month’s inflation figures. Scott Sumner’s proposal for the Adam Smith Institute is an interesting investigation of the topic and suggests such a target may well be an improvement, and is worth giving serious attention.

The Economist recently discussed the idea but after listing several arguments in favour warned that it “should not be undertaken lightly”. The main concern is that the BoE has invested heavily in the present policy rule, and anchoring inflation expectations to 2 per cent is no mean feat. Attempting to get the market to buy into something new is not only a challenge but also an uncertain one.

However, long-term inflation expectations of 2 per cent are compatible with NGDP targeting. Most advocates assume that the target for NGDP should be around 5 per cent; if we expect real GDP growth of 3 per cent then 2 per cent price rises would add up. We should expect inflation to be a lot more volatile (especially in the short term), but it would be a case of adjusting the anchor, not removing it.

In fact, with inflation continuing to overshoot the current policy rule, it seems the BoE has already abandoned the official rule. Current Bank policy makes more sense when viewed from an NGDP lens than an inflation-centred one. Whether it admits it or not, the Bank seems more keen on stabilising NGDP than keeping inflation at 2 per cent (see chart).

In the five years leading up to the financial crisis, CPI rose steadily, while NGDP stayed within a range of 4-6 per cent. When the crisis hit, NGDP dropped significantly (and for those who advocate NGDP targeting, this is the main cause of our present woes). CPI dropped too. What is interesting is that once the Bank of England began to utilise its monetary tools, there seemed to be increasing evidence that it was NGDP, and not CPI, that it was attempting to target.

I’m not suggesting we are anywhere close to the NGDP targeting system some advocates propose. However, publicly moving towards it might not create that much of a stir. I’m sure many traders recognise that this is what has already happened.

Anthony J. Evans is Associate Professor of Economics at London’s ESCP Europe Business School, and Fulbright Scholar-in-Residence at San Jose State University.