Select Committee on Monetary Policy Committee of the Bank of England Report


CHAPTER 3: THE CHOICE OF INFLATION TARGET

The benefits of low inflation

3.1  We have already stated in Chapter 1 that the aim of monetary policy is to provide a nominal anchor, and that no matter how this is achieved, by monetary, exchange rate or inflation targeting, the objective is to determine the inflation rate for the economy as a whole. A country may be able to have more control of its own inflation rate if it uses a money supply or an inflation target, but with exchange rate targeting this control is largely surrendered to the country to whose currency the exchange rate is targeted. For countries which for reasons of their own experience persistently high inflation this is one of the main benefits of exchange rate targeting. The average inflation rate in the United Kingdom in recent years has been slightly higher than that of the US and Germany. But once it left the ERM the United Kingdom was obliged to pursue policy with reference to its own inflation rate.

3.2  In defending the choice of a low inflation target in his evidence to this Committee, the Chancellor said that "the public do understand not just that low inflation is something that governments should seek to achieve but they do also understand that this is the pre-condition achieving all our other objectives as well." (Q 5). It may help if we now define what low inflation is before we examine the benefits of price stability in greater depth. Without specifying the precise numbers we may postulate for a country such as the United Kingdom at any time a relevant range above which there is a danger that the inflationary position could begin to get out of control and below which there are recessionary risks which again may become uncontrollable. (The exact upper or lower limits are not central to our argument.) This range may vary over time, and between countries. For example, what would have constituted low inflation in the United Kingdom in the mid-late 1980s would be regarded as high inflation in the 1990s, and what constitutes low inflation in many emerging-market countries today would be considered as high inflation here.

3.3  Various arguments can be made against inflation. It is particularly harmful to those with incomes or wealth that are fixed or lag behind price changes. Many, but not all, pensioners fall into this category. Since wage rates tend to rise closely in line with inflation employees tend not to be affected as much unless they are in the public sector and subject to nominal cash limits imposed by government. Firms in the non-tradables sector may be relatively unaffected by inflation, and if the exchange rate depreciates even the tradables sector has some protection from the need to improve productivity to compete in international markets. Of course, with total real income there will be gainers as well as losers given these effects are re-distributionary. But total real income cannot necessarily be taken as given.

3.4  A major disadvantage of high inflation arises when it is volatile and unpredictable. This makes it more difficult to take correct long-term decisions. It discourages investment the cost of capital is increased through higher real interest rates caused by the incorporation of the inflation risk premium. It also results in more bankruptcies as a result of an alteration in firms' cash flow due to the front-end loading of repayments. The fall in the real value of the principal outstanding is offset by the increase in interest payments, implying that nominal debt is being repaid earlier than planned. For investments with a long pay-back period, the outcome can be disastrous. One solution is to restore the original sequence of real repayments by borrowing to pay the increased interest charges. Banks are, however, often unwilling to lend to companies perceived to be in financial difficulty. These are all good reasons for preferring a low and stable inflation rate to one that is high and volatile.

3.5  The principal argument put forward in favour of the lower end of the inflation range is that it encourages stability. The Chancellor is a strong advocate of this, but he is not alone. Professor Charles Bean pointed out that "There is evidence that inflation becomes more unpredictable when it is high and one might expect this to have an adverse effect on economic performance." (p 303). We have already mentioned similar views in Chapter 1 from Dr Duisenberg and Sir Brian Pitman, the latter of whom has pointed out the relationship between stability and low interest rates. Other arguments were put to us. Martin Weale told us that "One important aspect by which low inflation may improve real economic performance is through its interaction with the tax system" (Q 1053). Certainly, where tax rates and the tax structure are fixed in nominal terms, high and unpredictable inflation can distort economic decision making. Real tax rates, for example, may turn out higher than expected. This could influence labour supply and capital investment decisions in unintended and undesirable ways. An example cited by Weale is that of corporate tax rates which are not inflation neutral and tend to depress investment at high rates of price increases.

3.6  For a number of years it has been said that there is an inflationary bias in the United Kingdom economy which implies a tendency to get too close to the upper controllable point and beyond. More recently it has been stated that there has emerged a world deflationary bias leading to a danger of recession and excessively long periods of low growth and even contraction. If too high inflation can be harmful, so can too low inflation, if it is accompanied by recession. It is possible that circumstances arise in which monetary policy may become inoperative because there is a zero floor for nominal interest rates. In practice, nominal interest rates are extremely unlikely to be negative since, in effect, lenders would be then paying borrowers. The burden of adjustment would have to fall on fiscal policy. Recent events in Japan have shown how difficult it is to escape from a recession when inflation is near zero.

3.7  There were some instances when witnesses before this Committee argued that the pursuit of low inflation was unnecessary. James Dyson saw the fight against inflation as an irrelevance to manufacturers and exporters, who were more concerned about interest rates and exchange rates; and to him, "inflation is unimportant, or at least a marginal concern, if we are making things we can sell." (p 317) To Professor Bean, there was a degree of relativity: "when you consider inflation rates between zero and ten it does not look as if there is very much long run gain from ratcheting it down from 10 per cent down to 2-3 per cent". (Q 1431) His "reasonable" range of 0-10 per cent seems rather wide to us, but we concur that there is some reasonable range worth thinking about.

3.8  More generally, it should be stated that most have welcomed low inflation. The environment of the 1990s, with RPIX inflation at below 3.5 per cent since 1993, has been accompanied by low interest rates. The 7.5 per cent high point of late 1998 was widely criticised for being too high, but such a rate would not have been seen as excessive in previous years, when interest rates have regularly been twice as high. Low inflation seems to be in little dispute as a policy aim. The question is, then, how low should we aim? (This is separate from the question of how rapidly should inflation be brought down from too high a level, when the short term impact of contractionary policy on the real economy has to be considered explicitly.)

The justification for a 2.5 per cent target

3.9  When the Chancellor set the 2.5 per cent target, he was continuing previous policy. When inflation targeting began in 1992, a target range of 1 to 4 per cent was set, which was succeeded by a target of 2.5 per cent or less. So far the inflation rate has kept close to target. Moreover, the original target has been continued: the Chancellor, obliged under the Act to specify each year to the Bank what price stability is to be taken to consist of, most recently undertook this task on 18 May 1999, renewing the previous year's remit. The Chancellor told this Committee that "we reserve the right to look at whether the inflation target should be lower but that is not the position we are taking at the moment" (Q 12).

3.10  The Bank's target rate of inflation of 2.5 per cent is not very dissimilar to that of other central banks which do not set their own target: the Reserve Bank of Australia's target range is 2-3 per cent and the New Zealand Reserve Bank has a target of 0-3 per cent. The ECB has, by comparison, set itself a target of 0-2 per cent. The Bank of England's target is therefore at the higher end of the scale, but not by much.

3.11  Roger Bootle justified the 2.5 per cent target to us as follows: first, "inflation is mismeasured. The official indices overstate it". Secondly, "to reduce inflation below 2.5 per cent would require sacrifices of real output which would not be warranted by the comparatively small gains to society from achieving inflation rates close to zero". This is supported by Professor Bean, who contended that "while low inflation is desirable, there is unlikely to be much gain from pushing it down from 2-3 per cent to zero." (p 303) And thirdly, "a little inflation does you good" (pp 256-257). These arguments have been frequently repeated to us in evidence.

3.12  The degree by which inflation is considered to be mismeasured in the United Kingdom will be elaborated in the next part of this chapter, but that it is mismeasured seems to be accepted by many but not all commentators. For instance, Professor Bean, in supporting the 2.5 per cent target, explained among his reasons that "the difficulty of measuring quality change, particularly in the information technology and healthcare spheres, means that conventional price indices are likely to overstate the true inflation rate." (p 303) Witnesses making such points (for example, Lloyds TSB) frequently cited the American Boskin Report, a highly influential research document, which suggests that US inflation is overstated by more than 1 per cent. (p 205) The Boskin Report is not without its critics especially in regard to its numerical estimates of the overstatement effect.

3.13  The third argument is reflected by the fact that many of our witnesses were more worried by the prospect of deflation than by rising inflation. Professor Bean pointed to the experience in Japan, and was also worried that the ECB's target of an increase below 2 per cent would "end up seeking too low an inflation rate with the possibility of slipping into deflation." (Q 1409) The ECB, aware of this worry, has not explicitly indicated the low point in its range (p 183) and in evidence to us M Trichet, one of the members of its Governing Council, told us that "We consider that we should not, at the level of the European Central Bank, indicate what would be the lowest point possible, and at which we would be running another danger, which would be the danger of deflation." (Q 1352) We have pointed above to the difficult question of whether a national average fully reflects the true position in all regions and sectors, let alone whether an average inflation rate for the whole of the European Union can possibly have meaning for all the constituent countries.

3.14  Before going on more specifically to the measurement of inflation, there is a question of economics which we have to raise. Apparently contradictory propositions have been offered to us by different witnesses: (a) that the real side of the economy is determined in the long run by real forces such as productivity, and monetary policy only affects nominal magnitudes, and (b) that the new monetary arrangements benefit the real economy. There is no doubt that monetary policy has real effects in the short run. Indeed, that is largely how it works. Presumably, the solution to the contradiction depends on the working of the market mechanism, namely that satisfactory monetary policy, by keeping inflation low and stable, aids the working of the decentralised market system, which in turn improves real economic performance. But if that is so, it cannot be denied that monetary policy does influence the real side of the economy and that its influence can be for better or worse. Thus, the effects on the real side cannot be ignored when monetary magnitudes are being set.

3.15  Having noted that, a more limited position is possible, namely that monetary policy only has a significant long-run real effect at or beyond the extremes of inflation we have discussed earlier. Too high inflation, i.e., hyperinflation, so disrupts economic decision making and the working of markets that productivity is affected adversely. Too low inflation involves a dampening down of the economy in that it generates significant unemployment and spare capacity. If that persists the effect may be to lower the growth rate. An implication of this view is that between the two extremes the inflation rate is of little significance as long as it is stable and believed to be so.

3.16  To revert to the actual target of 2.5 per cent, it is neither too high relative to world inflation, but is high enough to enable the relative price adjustments so important to a market economy to take place. Our judgment is that it is within the United Kingdom's ability to deliver without undue economic or social constraints. As noted above, it has been the effective target since 1993.

The measure of inflation used: RPI, RPIX, HICP and whether to include the first-round effects

3.17  It could be argued that the price level is whatever is measured by a price index, and inflation is the rate of change of that index. The trouble with that interpretation is that we would then have as many inflation concepts as we have indices. An alternative is that we recognise that individual prices change, and we wish to measure the extent to which they move together. The purpose of a price index is to measure as best we can, but surely imperfectly, that general movement. Different price indices are then essentially measures of the same thing. That, of course, leads to the problem of deciding whether and in what sense one index is better than another.

3.18  It is against this background that the real debate about the inflation target has taken place. At the moment, the inflation target is set using the RPIX measure. RPIX is derived from the Retail Price Index, the main domestic inflation measure for the United Kingdom. The RPI measures the average change from month to month in the prices of goods and services purchased by most households. RPIX is constructed in the same way but it excludes mortgage interest payments. According to the Office for National Statistics (ONS), "It is a more appropriate tool for monetary policy purposes because by excluding mortgage interest payments it does not reflect the direct impact of interest rate changes made to control inflation." (p 218)

3.19  It has been suggested to us that a more appropriate measure to target would be the Harmonised Index of Consumer Prices (HICP). This is the index that is used by the European Central Bank to measure price stability across the euro area, but it is also calculated in the United Kingdom for purposes of comparison. A detailed analysis of the differences between the two measures is printed in Appendix 3. We now list the principal differences between RPI and HICP.

3.20  RPI is calculated as an arithmetic mean, whereas HICP is calculated as a geometric mean. That is the essential difference. In Appendix 3 the nature of the indices is explained further. It is also shown that the difference between the two is larger, the greater the variation across the inflation rates of the individual components. Thus a shock affecting some prices much more than others, will cause the RPI to exceed the HICP.

3.21  In addition to that fundamental consideration, the coverage of the two indices is different. HICP excludes a number of RPI series, most notably those relating to owner-occupiers' housing costs and some health, education and insurance expenditure, but includes other items such as air fares which are excluded from the RPI. Also HICP measures the cost of new cars, while the RPI measures the cost of used cars.

3.22  Dr Tim Holt, speaking as Director of the ONS, told us that HICP "is economically narrower for the United Kingdom than the RPI or RPIX; there are differences and it only covers about 87 per cent or so of the consumption that would be covered by something like RPIX." (Q 967) In practice, we can calculate each index with the same coverage, whether it be the broader or the narrower one.

3.23  HICP is a new and evolving series, which started in January 1996. The RPI is an established series. HICP is, as the ONS pointed out, in a state of flux: some items are to be added in December 1999. It is generally accepted in the European Union, where it produces figures close to those produced by more traditional consumer price indices; as M Trichet told us, "The United Kingdom is perhaps the only country in the entire Euro 15 with a substantial difference between RPI and HICP." (Q 1353)

3.24  That difference amounts in general to between 0.5 per cent and 1 per cent, with RPIX being the higher. On 20 April 1999, the day that Dr Holt gave evidence to us, RPIX was 2.7 per cent and HICP was 1.7 per cent. He told us that "roughly speaking about half of that 1 per cent difference is ascribable to differences in the actual formula of calculation and the other half per cent is ascribable to the differences in the coverage of HICP to RPIX." (Q 974) In other words, if the RPIX measured the same items that HICP measured, or was measured geometrically rather than arithmetically, one could expect inflation to fall to roughly 2.2 per cent. If both of these took place, inflation would be 1.7 per cent.

3.25  What meaning then is to be attached to inflation in the United Kingdom as measured by HICP apparently being lower than inflation measured by RPIX even when the two have the same coverage? Is there any sense in which one overstates or the other understates "true inflation"? (This is different from the overstatement phenomenon as discussed in Boskin. If, for example RPIX overstates inflation for what might be called Boskin reasons of quality change, substitution questions, and the like, we would expect HICP to overstate it for the same reasons.) The difference between the two should be attributable not to coverage, but to something very different, namely the mathematics of geometric versus arithmetic means. We did not receive any fundamental analysis of any of this in evidence, and it is a topic that needs to be returned to. What also needs to be examined at a later stage is the significance of the point raised in the appendix, namely that HICP is intrinsically more stable as an index than RPIX.

3.26  What cannot be argued is what some witnesses get close to saying, namely that a good reason for switching to HICP is that inflation is slashed at a stroke without having to raise interest rates by a single basis point and enabling the target itself to be reduced! We do recognise the appeal of harmonising the measurement of inflation so as to compare inflation with that in the rest of Europe, and one can see very clearly the reasoning put forward by Sir Brian Moffatt:

"since the United Kingdom economy is increasingly locked into that of the rest of the EU, we should use where possible the same measures to avoid the spurious differences distorting policy perceptions, and lower target and actual measures of inflation would help remove the inflationary expectations still alive in the United Kingdom." (p 285)

3.27  Lloyds TSB agree, but go further: their analysis is that:

3.28  As can be seen, we concur with some of this, but not all. We would wish to be very careful before committing ourselves to what is to be called true inflation. We would be extremely wary of doing anything in the area of measurement which would lead the public to believe that any tricks were being played on them.

3.29  Certainly it must be said that not everyone is convinced by the sort of position adopted by Lloyds. The argument that "HICP is still in a relatively experimental stage" was used by Professor Bean when he told us that he did not "think it should be introduced and used as an excuse for having a more relaxed monetary policy." (Q 1412) This caution is reflected by the Treasury and the Bank and it is very much our view. It should also be said that the perception that inflation would be reduced as a result of switching from RPIX to HICP is actually an illusion since the inflation rates of the individual items will be unaffected. There is also concern about the implications for contracts and pensions indexed on the RPI. Nonetheless, Mr Gus O'Donnell, Head of the Government Economic Service, said that he personally favoured geometric means for price indices. (Q 166)

3.30  We emphasise that many contracts are set out in terms involving RPI and RPIX. This is largely to do with the updating of nominal values. Decisions are taken in anticipation of uprating by the RPI, and in consequence of that. Increasingly, we believe, decisions are being taken at all levels in the economy on the assumption that the inflation target is set in RPIX terms. We do not doubt that change in due course may be desirable, but we utter a word of caution, there must be a great deal more preparation and public discussion before final choices are made.

The choice of a symmetric target

3.31  The target for inflation of 2.5 per cent has a threshold of one per cent either side of it. If inflation exceeds 3.5 per cent or falls below 1.5 per cent the mechanism whereby the Governor must write an open letter is activated. It is important to remember (and this will be discussed later) that, as put by the Chancellor in his remit for the MPC:

3.32  He also has made clear that the deviations from the target are to be discouraged whether they are above the target or below it. He told us:

    "I would emphasise also that it is a symmetrical inflation target and therefore we want that target to be achieved. It is not 2.5 per cent or less, it is not simply low inflation, it is 2.5 per cent. That is why the second part says subject to achieving the inflation target to pursue the Government's objectives of growth and employment. In other words, to under-achieve or some people may say over-achieve on the target to have far lower inflation would not necessarily be pursuing the Government's objectives of growth and employment." (Q 3)

3.33  The Bank is under instructions to ensure that any anti-inflationary aggression should be tempered by a concern for growth and employment. The Bank accept the principle, and in the 1999 Annual Report, the Governor drew attention to the rapid reduction in interest rates from 7.5 per cent to (at the time of his writing) 5.25 per cent, saying:

We are inclined to agree, but continue to emphasise that it is too early to make a final judgment on any of these matters.

The relation between a symmetric target and the distinction between short and long term inflation objectives

3.34  The Chancellor's symmetric target leaves in practice a 2 per cent zone within which the Governor is excused from writing an open letter to the Chancellor. In addition, it has been emphasised that a breach of the threshold will not always constitute a failure of monetary policy: as put by the Chancellor in his remit to the MPC:

We agree with this and elaborate further in Chapter 7. It is certainly our view that the event of an open letter is not, on its own, to be considered a failure on the Bank's part, at least by the Treasury.

3.35  The issue of shocks will be considered in more detail in the next chapter, but it is worth considering the question of how quickly the MPC is required to act in the event of difficult inflationary pressures. The dilemma of short-term versus longer-term requirements was summarised by Professor Bean:

      "If inflation is above target, the MPC can seek to get it back to target quickly, but only if they are willing to incur a sharp recession. Alternatively they can do it more gradually, so limiting the depth of any recession, but inflation will be away from the target for longer." (p 303),

adding in his oral evidence that "it is a recipe for very bad monetary policy if you are completely obsessed with inflation even in the very short term." (Q 1424)

3.36  Drawing on his recent Antipodean experience, Professor Bean compared the recent experience of Australia, with its medium term target and New Zealand, with its short term target:

    "a very tight objective for inflation like that of New Zealand may have the effect of encouraging the central bank to place too little weight on smoothing output. Some support for this view comes from the fact that the variability of output there in recent years has been roughly twice that of either Australia or the United Kingdom, whilst the variability of inflation has been correspondingly lower." (p 304)


15  
Bank of England Annual Report, p.4. Back


 
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