Has inflation targeting had its day

First published: 27 February 2013

Just over two decades ago, New Zealand adopted a new approach to monetary policy where a declared rate of inflation was targeted and decisions to achieve this target are made publicly available. This aims to anchor inflation expectations. It has since spread to more than 25 countries across all stages of development.

The Treasury Committee will ask the next Governor of the Bank of England, Mark Carney, to explain whether the bank should drop its inflation target. It is unlikely that this most august of institutions will make such a bold decision; however, are there any advantages to getting rid of the inflation target?

Is the popularity of inflation targeting deserved?

Inflation targeting is based upon the idea that predictable low inflation is a good thing;

High inflation harms growth

In the past, high inflation has resulted in a price-wage spiral where any potential for growth is used to pay higher wages. Is this still true?

• Job security is likely to be more of a priority, particularly with people retiring later
• Low predictable inflation has led to an expectation that salaries will at least increase in line with inflation and reduced flexibility for companies to differentiate between employees and reduce real wages when necessary

In fact, an argument could be made that high inflation can encourage growth:

• Large price increases are more acceptable on new rather than existing products and it is easier to differentiate between great and good products
• There is more appetite to invest in riskier projects rather than leave money in “safe” assets that might not provide inflation protection both by companies and individuals considering start ups
• It is easier for the UK economy (and individuals) to adapt to inflation spikes in commodities such as oil and food where the price can depend on the developing markets
• Less predictable pricing/costs mean poorly run zombie companies are more likely to fail with the best run companies rising to the top

 Promotes the equitable distribution of income

It would appear that nothing can halt the inexorable rise of the gap between the haves and the have nots. Certainly not inflation targets! In fact in a “predictable world” of inflation targeting, the have nots are encouraged to play safe as the consequences of a loss are too dramatic and the opportunity to recoup any losses minimal as returns are low.

Meanwhile, the UK debt burden makes it more difficult to provide support to those most in need with more and more of the national income going towards debt repayments.

 With the focus now being on growth is this relevant now?

At the moment, inflation targeting does provide the markets with some comfort that, even if the UK Government may be attempting to inflate away some of the debt burden, there commitment to the inflation target and the independence of the Bank Of England will hopefully prevent inflation from getting out of control. However, in global markets do we really have that much control over inflation or, by attempting to keep it in line with a low target, are we just putting ourselves at a disadvantage to other countries that are prepared to allow more flexibility and rely on wider global markets to work together reduce the risks of run away inflation.

I am not proposing that inflation is left to its own devices only that there is a more flexible target that takes into account growth and global inflation.