Former Bank of England policymaker Andrew Sentance examines the calls for a rethink on monetary policy...
TWO RECENT developments have sparked a debate on the future of monetary policy in the UK, writes former bank of England Monetary Policy Committee member Andrew Sentance on his Hawk Talks blog.
In a speech on Tuesday 11 December, the Bank of England Governor designate, Mark Carney, floated a suggestion that a nominal GDP target might be more appropriate to an economy where interest rates were close to zero and monetary policy was in danger of becoming ineffective. The next day, the US Federal Reserve issued a statement which set a firm target for the unemployment rate as part of its monetary policy framework:
"The Committee ... anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 per cent longer-run goal, and longer-term inflation expectations continue to be well anchored."
This has sparked a debate in the media and among economic commentators on whether the current UK inflation target framework should be replaced by an approach which gives more weight to the real economy. George Osborne, in his evidence to the Treasury Select Committee on Thursday 13 December, has appeared to encourage this discussion, welcoming the contribution by Mark Carney to the debate on monetary policy and noting that "there was a lot of innovative stuff happening around the world" – though he also commented that the current inflation target framework had "served us well".
So is there a case for a change in the UK's monetary policy framework – in particular shifting away from the current inflation target approach?
The first question to ask is whether the UK inflation target framework has held back the growth of the UK economy? In my view the answer is "No". Before the financial crisis, the UK economy grew extremely strongly. GDP growth from 1997 to 2007 averaged 3.2% a year and consumer spending averaged 3.7%.
These figures compare with a long-term trend growth rate for the UK of 2-2.5%. In other words, for the first ten years in which the MPC was in control of UK monetary policy under the current inflation target framework, UK GDP rose by about 10% more than longer term trends might have suggested, and consumption rose by about 15% more. A rational observer might have concluded a day of reckoning was coming, and it indeed arrived with the onset of the financial crisis.
Not surprisingly, more recent growth performance has been disappointing – but that reflects the big adjustments that the UK economy has been making as the imbalances that grew up in the 1990s and early 2000s are corrected. GDP fell by around 5% in the recession and has recovered only around half of that shortfall so far. But from 1997 to 2012, GDP growth in the UK has averaged around 2% – broadly in line with longer run trends. It is hard to make the argument that over the period when the MPC has been operating UK monetary policy under an inflation target regime, growth has been stifled below long-run trends.
Second, over the period since the financial crisis, the MPC has acted in a very judgemental fashion and has effectively ignored inflation as an input into its longer term decisions. The Committee cut interest rates aggressively in 2008 when inflation had just spiked at over 5%. It also reintroduced QE in 2011 when inflation had just hit another 5% spike.
On both occasions the justification was that inflation was set to fall back to target and was in danger of remaining below it for a sustained period. These forecasts have proved remarkably inaccurate. Instead of inflation falling below target it remains stubbornly above it. The credibility of MPC forecasts of inflation has been seriously eroded. Indeed, a recent review of Bank of England forecasting performance conducted by Dave Stockton from the US Federal Reserve concluded that the Bank's forecast errors had been bigger than other central banks and also larger than other private sector forecasts for the UK economy. (See my review of the Stockton Report)
Third, the UK's unemployment performance through the recent recession has been much better than in previous downturns – in the early 1980s and early 1990s. The unemployment rate has risen to around 8% instead of the 10-`12% seen in the aftermath of the previous two recessions. And job creation has been strong – with over a million new private sector jobs added over the recovery since mid-2009. This partly reflects the increased flexibility of the UK labour market and other structural factors which have changed in our economy over the last 2/3 decades. But it also reflects the very accommodative stance of UK monetary policy through the recession, which has eased some of the pressures on businesses to shed workers.
So what is the case for changing the Bank of England's monetary policy remit? Growth has been in line with past trends, taking good times with bad. And the period of weakest growth performance has coincided with a period when the Bank has largely set asides its inflation target remit. Employment has held up better than we might have expected. To me, this looks like a case for reinforcing the Bank of England's inflation target remit, not changing it.
As for the Fed's idea of setting targets for the unemployment rate. Milton Friedman effectively demolished this idea in his 1967/8 AEA Presidential address. I cannot do justice to his arguments in this blog – but he devoted a long section to rebutting the idea that monetary policy can affect the rate of unemployment on a sustainable basis. I am not aware that Friedman's analysis has been significantly undermined by later research.
In the longer term, most economic research suggests that the level of unemployment and the rate of economic growth are driven by supply side factors, not monetary policy. That might explain why the MPC has been so unsuccessful in promoting growth with their very stimulatory monetary policies. A rethink is needed – not on the inflation target – but on the conduct of monetary policy within the current framework by the MPC and on the government's supply-side agenda for boosting growth.
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