SAY NO TO ‘INFLATION NUTTERS’: NEW MONETARY POLICY FRAMEWORK PERMITS THE BANK TO BEHAVE SENSIBLY

The new UK monetary policy arrangements, and the Chancellor’s remit to the Bank of England in particular, have been criticised on the grounds that they apparently instruct the Monetary Policy Committee (MPC) to worry about inflation and nothing else. Writing in the November Economic Journal, Professor Charles Bean of the LSE argues that this view is mistaken. He also estimates that inflation is likely to diverge more than one percentage point either side of its 2½% target about 40% of the time.

Bean notes that the remit gives the MPC a degree of discretion over how quickly to correct deviations of inflation from target, and allows it to limit movements in output and unemployment, albeit at the cost of greater volatility in inflation. But although the remit does not explicitly instruct the MPC on the relative emphasis it should place on output vis-à-vis inflation, in practice, Bean argues, the balance it should strike is fairly clear.

Bean describes how under the new monetary arrangements the Chancellor’s annual remit to the Bank details the objectives it should pursue. As presently specified, that remit is an inflation target for the RPI (excluding mortgage interest payments) of 2½%, although over an unspecified time horizon. Without prejudice to this target, the Bank is expected to set monetary policy so as to support the general economic policies of the government, including for growth and employment. It is explicitly recognised that the target will not be hit exactly, because of shocks and similar unavoidable ‘control errors’. But it is expected that inflation will average 2½% over a reasonably long period.

If inflation deviates more than one percentage point either side of the target, then the Governor must write an Open Letter to the Chancellor explaining the reasons for the divergence and how long it is expected to last. The associated 1½%-3½% band is explicitly not a target range, but simply defining when an Open Letter is triggered.

While the consensus among economists is that there is no long-run trade-off between the levels of output and inflation, most accept there is a short-run trade-off. The consequence is that there is a long-run trade-off between the volatility of output and the volatility of inflation. So we can have inflation staying relatively close to the 2½% target most of the time, but only if the Bank is willing to accept relatively large movements in output around its ‘normal’ level - the ‘inflation nutter’ case. Alternatively, if the Bank is willing to accept larger fluctuations in inflation around the 2½% target (so that Open Letters will be triggered more often), then smaller fluctuations in output will be required.

The remit makes clear that the Bank must be mindful of the effects of its interest rate decisions on growth, but it is not specific about the relative weights it is supposed to place on the volatility of inflation compared with the volatility of output around its normal level - or the speed at which it approaches the inflation target of 2½%. The remit thus has the aspect of an ‘incomplete’ contract, and the question is whether this is something to worry about - whether the Bank is likely to pursue policies that produce excessively volatile movements in output in order to keep inflation close to 2½%.

Bean explores this issue in the context of a model that in essence embodies the world view of the Bank: interest rates affect activity with roughly a one-year lag, while activity (strictly speaking, the output gap) in turn affects inflation with roughly a one-year lag. Thus, the best the Bank can do is try to control inflation at a forecast horizon of two years or more ahead. However, because of unpredictable shocks both to demand and supply, this control will be at best imperfect.

Bean uses the model to construct a ‘policy frontier’ that maps out the minimum volatility of output achievable for any given volatility of inflation. Using a mix of econometric techniques and information on past Treasury forecasting errors (to calibrate the size of unpredictable movements in demand and supply), his analysis suggests that little is lost by the government failing to prescribe explicitly the relative weight the Bank should place on output versus inflation. The Bank really only needs to know that the government’s preferences are not ‘extreme’ to know roughly the policy it should follow.

Bean also examines how often we can expect inflation to lie outside the 1½-3½% band and thus trigger an Open Letter. Initial calculations imply that inflation will be more than one percentage point above or below the target about 60% of the time. But this may be a somewhat pessimistic evaluation: evidence across countries, as well as for the UK over time, suggests that high average inflation is associated with highly volatile inflation. One source of supply (inflation) shocks is volatility in expectations about future inflation on the part of those setting wages and/or prices. This source of shocks is likely to be less prevalent in a low inflation economy, and where the monetary regime is likely to ensure that inflation stays both low and reasonably stable.

Bean therefore concludes that it is quite plausible to suggest that the variance of inflation shocks will be lower than in the past. For example, if the standard deviation of inflation shocks were to halve, then an Open Letter would be triggered slightly less than half the time. But even if inflation shocks were to disappear entirely, the continued presence of demand shocks would imply that Open Letters would still be triggered more than 40% of the time. Open Letters will be a rarity only if aggregate demand also becomes significantly less volatile, and there seems no particular reason to expect this to happen.

Note for Editors: ‘The New UK Monetary Arrangements: A View from the Literature’ by Charles Bean is published in the November 1998 issue of the Economic Journal. Bean is Professor of Economics at the London School of Economics.

For Further information: contact Charles Bean on 0171-955-7291 (fax: 0171-955-7595; email: c.bean@lse.ac.uk); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or mobile 0468-661095 (email: romesh@compuserve.com).