Don't give up on inflation targeting in a cost-of-living crisis

Unpublished letter to The Times.  Written Apr 10th 2022. 

Don't give up on inflation targeting in a cost-of-living crisis 

Sir, With households facing price increases well above the inflation target, Ryan Bourne is right to ask whether UK monetary policy could be improved (Targeting inflation alone is not enough when facing shocks to supply, Business, April 7). He suggests replacing the current inflation target of 2% with a nominal GDP target that grows at 4%. The latter implies that the Bank of England would aim to let spending on UK goods and services increase at 4% a year. Unfortunately, this proposal is unlikely to be beneficial. 

In a cost-of-living-crisis, a nominal GDP target will trade off inflation against economic activity. Thus, as Bourne acknowledges, “the Bank would tolerate higher inflation and lower real growth while aiming to keep overall spending growth stable.” Put simply, the Bank of England would give the green light to stagflation: high inflation combined with stagnant, or declining, economic activity. Since the Bank would target neither inflation nor economic growth, we would end up with the worst of both worlds. 

A second problem is that a nominal GDP target leaves inflation and real growth unspecified: any combination of the two growth rates is a bullseye, provided that the sum total is 4%. Contrast this with inflation targeting, where the Bank of England sends the clear message that it wants inflation at 2%, which in turn helps to anchor inflation expectations and wage settlements. Such simple messaging has worked wonders during the pandemic, and it will work on inflation if we let it. 

Michael Hatcher, Associate Professor (Economics),
University of Southampton