Should the Bank of England’s objective be changed?

January 4, 2013

In our recent report on how to reform the Bank of England, we argued that there had been excessive focus on inflation targeting under Sir Mervyn King at the expense of financial stability and growth. The Bank of England’s new found focus on financial stability has also arguably been an impediment to growth as it has focused on preventing a renewed banking crisis rather than supplying credit to the economy. We suggested that the new Governor be given a mandate to support growth, in particular to ensure that credit once again starts flowing. Mark Carney’s recent discussion of nominal GDP targeting has raised the issue of whether this might be a way to change the Bank’s mandate. It would certainly have the advantage of bringing a focus on growth as well as inflation.

Nominal GDP is simply the amount of output of the economy in current money terms, as opposed to real GDP which strips out inflation. The nominal GDP for the UK in 2012 was likely around £1.5tn. The target discussed by Mark Carney would be for the level of nominal GDP, as opposed to its rate of change. This is a key difference because a level target means that past events will have an impact on current policy. At the moment the Bank of England targets an inflation rate of 2%, which is a rate of change target. With such a target the only focus is it is largely irrelevant what the inflation rate was in previous years the target is to keep inflation in the period ahead (the Bank tends to look two years ahead) to around 2%. That is fine in normal times but when you have a major shock to the economy it can become a handicap.

If we assume that trend nominal GDP growth ahead of the crisis was probably around 4.5%, 2% inflation plus 2.5% real GDP growth then in hindsight policy was probably a little too loose in the run up to the financial crisis, although not massively so as nominal GDP was growing at between 5% and6%. So interest rates might have risen a little faster than under an inflation targeting regime. However, as the recession took hold nominal GDP dropped dramatically, falling by 4.5% in the year to Q2 2008. In other words nominal GDP was undershooting by close on 9%. In contrast inflation initially stayed above 2% and stayed close to 2% thereafter. A nominal GDP target would therefore have given the Bank of England much more scope to be aggressive on monetary policy.

The Bank of England would no doubt counter that they took into account the weakness of the economy, which is why they did so much quantitative easing, without which the inflation target might well have been undershot. Nevertheless, a nominal GDP target probably would have avoided the debate about whether interest rates should rise in 2008 and would have allowed policy to be more aggressive in the early stages of recovery. That is because in targeting the level of nominal GDP the type of loss seen in 2008 is not disregarded but continues to affect policy because the central bank should be trying to get back to trend nominal GDP. Put more simply the near 9% deviation from trend in nominal GDP in 2008/9 would have had to be made up before the Bank could consider tightening policy. That may well have meant that the pause in QE in 2010 and the scaling back of assistance to the banking sector in the early stages of recovery might not have happened.

A nominal GDP targeting regime is not without its problems though. First and foremost to set the target there has to be both an estimate of trend GDP growth (how much the economy can grow over time without triggering inflation) and of the current gap between actual nominal GDP and that trend (known as the output gap). While there are normally disagreements between economists about these, those disagreements are currently substantial. Many believe the financial crisis has imparted permanent damage to the UK economy so that some of the loss of nominal GDP will never be recovered. Equally it is also believed by many that trend growth is probably lower post the crisis, not least because the financial sector (which is such a big proportion of the UK economy) will need to grow more slowly as banks and individuals delever. As a result of disagreements about how much output was permanently lost and what the new trend growth rate of GDP currently is estimates of the gap between actual and trend nominal GDP range from close to zero to as large as 6% of GDP.

The implications for policy from such differing estimates are huge. If trend growth is still thought to be around 2.5% and the output gap 6%, then monetary policy can be very stimulatory. Indeed the Bank should be pulling out all the stops to get growth going. If instead the output gap is thought to be close to zero and trend growth around 1.5% then policy would probably need to be tightened at the first sign of any sustained recovery in the economy.

Such uncertainties are a major issue if we are to consider switching the Bank of England’s objective from CPI inflation to Nominal GDP targeting. Yet they are still relevant even if the Bank is merely targeting inflation, because the outlook for that is also very dependent on the amount of spare capacity and trend growth rate of the economy. Perhaps a better way would be to amend the Bank of England’s objective to mirror that of the US Federal Reserve, where Congress has charged the Fed with targeting maximum employment, stable prices and moderate long-term interest rates . That has recently led the Fed to specify that it would keep rates on hold as long as the unemployment rate remained above 6.5% and inflation was projected to be no more than half a percentage point above 2%, one to two years ahead.

Such a dual mandate would allow the Bank to adjust policy to target inflation and growth without necessarily getting into arcane arguments about trend GDP. Nevertheless, whether it is this approach or nominal GDP targeting that is to be adopted, we believe a change is a good idea, if only to get away from the unhealthy obsession with inflation targeting under Sir Mervyn King. A new target for a new Governor therefore makes a lot of sense.

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