Scrap the Bank of England's Inflation Target

New Report calls on Bank of England’s remit to be reformed to move from CPI Inflation rate targeting to a nominal income target and remove discretion over Quantitative Easing. 

• Government should replace the Bank’s 2% CPI Inflation target with a nominal income (NDGP) target
• By moving to NGDP targeting, the Bank of England can credibly maintain a single target in good times and bad
• Forward guidance must be clear and credible, ambiguity creates uncertainty and reduces the effectiveness of monetary policy.
• Clear and consistent action by central banks allows effective financial market reaction and reduces spillover effects in the wider economy 
• Prediction markets, allowing people to trade on bank’s solvency, would punish excessive risk taking and create a more sustainable financial sector 

Ten years on from the financial crisis, a new report by the Adam Smith Institute urges the government to scrap the Bank of England’s 2% inflation target and move to a new system that targets nominal income. 

Conventional monetary policy by central banks used interest rates control inflation, but since the financial crisis a decade ago, the central bank has used emergency asset purchases (i.e quantitative easing). A move to nominal income (NGDP) targeting would mean more accurate and responsive decisions made by the Monetary Policy Committee (MPC) by allowing a single focus on aggregate demand.

The price system is meant to reflect real scarcities – and so supply shocks should be reflected in inflation data with policymakers trained to ‘see through’ them. The central bank itself is described as being the primary cause of demand shocks. As nominal income is demand, NGDP targeting avoids requiring ratesetters to distinguish between supply and demand shocks and increases stability.

Decisions on asset purchases by the MPC at present are discretionary and arbitrary. While forward guidance has been issued, it is sometimes seen as publicly committing the bank to future actions and sometimes seen merely as a forecast of where the economy is headed. Instead the Bank of England should move to a rules-based system, the report argues. The MPC should clearly set out the amounts and types of assets the Bank will hold in each scenario. For example, if the Bank of England owns more than a certain percentage of gilts of a specified maturity, they then extend asset purchases to a pre-announced basket of investment-grade bonds.

Monetary policy since the crisis, including consistently near-zero interest rates have prompted destabilising capital flows and driven large swings in emerging market currencies, increased the costs of pension provision, and encouraged speculation in commodities. With open market operations limited in scope, and financial markets knowing in advance which margins the Bank of England intends to exploit, these spillover effects could be limited.

By being clearer with markets about the intention of monetary policy, the Bank of England’s actions would have stronger intended effects, the paper argues. 

Ten years on from the financial crisis, it’s time to look again at whether we regulate lenders and financial markets correctly. The cat and mouse charade of complex banking regulation, setting banks up against government regulators presumed to know all, is destined to fail, the paper says. Referencing Andrew Haldane’s 2012 speech at Jackson Hole, the paper argues that clear, simple and consistent rules based regulation has a better effect than increasing complication as “you do not fight fire with fire, you do not fight complexity with complexity.”

By replacing bank stress tests that straight-jacket bank behaviour with prediction markets, the Bank of England could also help taxpayers avoid future bailouts. Questions could be posed relating to the banks objectives which could be traded on, the paper argues, and so provide real time probabilities of risks that are transparent to all markets. These markets would end up boosting competition and punishing excessive risk taking efficiently and effectively, more effectively than current regulation allows and far better than that a decade ago. 

Anthony J. Evans, author of the report and Professor of economics at ESCP Europe Business School, said:

“Since the financial crisis monetary policy has played a reasonable role in stabilising the economy, but only because it has strayed from its conventional remit. Given the damage caused by that remit in the first place, the Bank of England should take the opportunity to adopt a new approach. Reforming open market operations and adopting a Nominal GDP target is effective in good times and bad, and provides a coherent, rule-based framework for monetary stability.”

Sam Dumitriu, Head of Research at the Adam Smith Institute, said:

“Monetary policy should be stable, predictable, and rules-based. The extraordinary policy measures the Bank of England took in response to the financial crisis increasingly relied on the discretion and wisdom of policymakers. Now, nearly ten years since the start of the Great Recession, we should take the opportunity to change the Bank of England’s mandate and reform open market operations.”

Notes to editors:

For further comments or to arrange an interview, contact Matt Kilcoyne, Head of Communications, matt@adamsmith.org | 07584 778207.

The report ‘Monetary Policy After The Crash: Lessons Learned?’ is available here.