Economic quagmire adds pressure for monetary policy change

January 14, 2013

–Darren Williams is Senior European Economist at AllianceBernstein. The opinions expressed are his own.–

Bank of England governor-elect, Mark Carney, has raised hopes that the central bank may soon switch to a nominal GDP target. Although the costs seem to outweigh the benefits, the attractions of a radical new approach will grow if the economy remains stuck in the doldrums.

In recent years, the Bank of England has been among the world’s most proactive central banks. It has reduced official interest rates to 0.5% and boosted the supply of central bank money by 18% of gross domestic product (GDP). This is considerably more than in either the US or the euro area over the same period.

This aggressive monetary expansion has been accompanied by a huge decline in the exchange rate. Since the first half of 2007, the pound has fallen by 20% in trade-weighted terms, far more than the drop in the US dollar (11%) or euro (5%) over the same period. Yet the UK economy has still performed poorly.

In more than three years since the business cycle trough, the economy has expanded by just 3.5%. This is similar to the euro area (+3.4%) but worse than the US (+7.5%). Indeed, the level of output is still 3.0% below the peak of the last cycle, making this the most protracted slump since the 1920s.Against this backdrop, several analysts have started to wonder if the Bank of England’s inflation-targeting framework might change soon.

The speculation has been stoked by the incoming Carney. In a recent speech, he did not suggest that central banks should abandon inflation targeting – either in Canada or the UK – but he did acknowledge the central bank must sometimes go further, for example by using a target for the level of nominal gross domestic product (NGDP). This suggestion has raised eyebrows in the UK.

Since January 2004, the Bank of England has targeted a 2.0% rate of inflation for the consumer-price index (CPI) two years ahead – though this horizon has gradually become more flexible. This framework is consistent with conventional thinking about the definition of price “stability” and the lags with which monetary policy is thought to affect the economy. Importantly, the extent to which the Bank hits or misses its target has only limited influence on future policy decisions.

Nominal GDP would be different. First, because it is made up of real GDP growth and inflation, using nominal GDP growth as a target would extend the Bank’s mandate beyond the traditional domain of price stability towards the real economy – similar to the US Federal Reserve’s dual mandate. Second, because the target is a level rather than a change, past deviations from target would affect future policy decisions.

When Carney becomes Bank of England governor in July it is reasonable to expect some changes, particularly with respect to communication, transparency and his willingness to experiment with unconventional tools, such as forward policy-guidance. Moreover, against a backdrop of sustained economic weakness, it’s clear that the outlook for UK monetary policy is still skewed towards further easing.

But a revolutionary change in the Bank of England’s monetary-policy framework at this early stage is unlikely – partly because it is not clear that Carney really favours such a radical shift. Still, this decision ultimately rests with parliament and the longer sluggish growth continues, the more appealing it will become to a government still struggling to stabilise the public finances. The latter would benefit from higher nominal GDP growth, even if this took the form of higher inflation.

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