What should be the inflation target?

Sometimes the media debate catches up with us. Admittedly this is something we have looked at for years and they are only doing it because a Prime Ministerial candidate and in particular the front-runner in the stakes has suggested it. From the Financial Times.

Foreign secretary Liz Truss, frontrunner in the race to become the next British prime minister, said she would look to change the Bank of England’s mandate to ensure it controlled inflation.
Speaking at a hustings of Conservative party members in Cardiff on Wednesday, she argued that inflation had been caused by “huge” supply side shocks after the pandemic and the Ukraine war and said she wanted to review the mandate of the central bank, which has a target of maintaining 2 per cent inflation.

Next we got this as well.

She told the event: “The best way of dealing with inflation is monetary policy and what I have said is I want to change the Bank of England’s mandate to make sure in the future it matches some of the most effective central banks in the world at controlling inflation.”

The latter part of that statement creates a little head-scratching as that presently is a very short list. Especially if we recall her past statements on this issue.

A candidate to succeed Boris Johnson as UK prime minister, Truss said late Sunday that the government needed to “look at best practice around the world” when determining the target of the BOE and cited Japan as an example. ( Bloomberg)

So the Bank of England should set a negative interest-rate, buy a lot more government bonds as well as lots of equities?  That part of the  plan has clearly not been thought through. Japan has low inflation in spite of the efforts of its central bank not because of them.

Also this is just plain wrong and you might reasonably think that the Financial Times would point it out.

Truss added: “The last time the mandate was looked at was in 1997 under Gordon Brown. Things are very, very different now.”

There have in fact been 2 main changes. The first came in 2003 when both the inflation measure ( RPI was replaced by CPI) and the target itself ( from 2.5% to 2%) were changed. That looks superficially to be a tightening but it was not as I have argued many times as 1.5% would have been required I think. The numbers right now highlight the issue with the RPI at 11.7% being some 2.3% higher than CPI at 9.4%.

Also in 2013 the then Chancellor George Osborne changed the balance by deemphasising the inflation target and raising the importance of supporting government policy. That may seem arcane but we have have seen an enormous deployment of monetary action followed by high inflation. So it turns out that our supposed  guardians have helped create the inflation.

Inflation Mandate Changes

Firstly let me remind you that there is no theoretical basis for the 2% per annum inflation target which was chosen because it seemed right. Next comes the fact that changes are usually to ease policy and give us a higher inflation rate.

Notably, the Fed changed its language on inflation, replacing its 2 percent inflation target commitment, and instead said it will “[seek] to achieve inflation that averages 2 percent over time.”

This change is a substantial departure from the previous flexible inflation-targeting regime. ( Dallas Fed)

It continues

By adopting average inflation targeting, the Fed is communicating that 2 percent is not a ceiling for inflation and that it may let inflation exceed 2 percent modestly and temporarily to make up for past low inflation. The key aim of this policy shift is anchoring inflation expectations.

With the US CPI at 9.1% some two years later how is that going?

The Bank of Canada also changed things and the significant change here to my mind echoes the UK.

actively seek the level of maximum employment needed to sustainably achieve the inflation target. The Bank will consider a broad set of indicators to gauge the health of the labour market and to inform its assessment of the economic outlook.

You cannot target both inflation and employment as they have found out rather quickly because this happened only last December and we now find them doing this.

Bank of Canada increases policy interest rate by 100 basis points, continues quantitative tightening.

With Canadian CPI at 8.1% I guess they are finding that no-one is especially interested in its preferred core measures which are between 4.6% and 5.5%. Anyway they too are quite a bit above the inflation target.

The generic claim here used to be for an increase in the inflation target to either 3% or 4%. That is currently much quieter than usual because some at least have the sense to realise that the present burst of inflation has reminded people of how badly it affects their lives. In essence the argument is that at the lower bound for interest-rates they need policy flexibility. What they never answer is that it is the policies they support which got us where we are! Instead they sing along with Andrea True Connection.

More, more, more
How do you like it? How do you like it?
More, more, more
How do you like it? How do you like it?

There is a particular irony in this from the Bank of Canada which was only from last December, and the emphasis is mine.

use a broad set of monetary policy tools, as well as the 1 to 3 percent inflation-control range, to deal with the likelihood that the Bank’s policy rate will be at its lowest possible level more often.

It has raised interest-rates 4 times since then with the first happening less than 3 months after that statement.

Comment

I do not believe it is a coincidence that we are seeing an inflation burst after so many central banks relaxed their inflation targets. Below is another example from July last year.

New strategy adopts symmetric 2% inflation target over medium term. ( ECB)

The change was the use of the word symmetric whereas before they targeted just below 2% ( which was once defined as 1.97%). As it is now 8.9% they are of course miles off.

Rather curiously they were considering a change which I would see as an improvement.

Governing Council confirms that HICP remains appropriate price measure and recommends inclusion of owner-occupied housing over time.

The problem is that central banks so rarely look at the actual costs of owner-occupied housing. They instead prefer to fantasise that owners pay rent to themselves and in the US that represents 24% of the CPI. It is hard to believe that they have been allowed to rig the numbers like this but there are many who should know better willing to claim that it represents reality. That has had a rough year with house price growth exceeding rents by such large amounts ( around 14%). The simple fact that people buy a home to avoid paying rent gets ignored.

So that is one route and the other is to lower the inflation target as after all price stability is 0% and not the 2% claimed. The inflationistas have claimed that when inflation rises people can switch goods or more formally substitute them. For example I recall Danny Blanchflower assuring us that people could switch from butter to margarine. As the price of the latter soared he has gone rather quiet on that front. But this phase has reminded some and taught others ( as younger people have never experienced anything like this) that inflation causes real economic pain and hardship.

On the other side of the coin well there is this from Mary Daly of the San Francisco Fed.

JUST IN: Fed President Mary Daly has said: I don’t feel the pain of inflation anymore. I see prices rising but I have enough… I don’t find myself in a space where I have to make tradeoffs because I have enough, and many Americans have enough. ( @unusual_whales)

One of her ex-colleagues has just got a new job after leaving the Fed under a cloud.

PIMCO Hires Richard Clarida as Managing Director and Global Economic Advisor ( @chigrl)