An interesting comment was made recently by Andrew Lilico at a meeting of the IEA’s Shadow Monetary Policy Committee. He suggested that the Bank of England has given up inflation targeting. This is interesting, of course, given Mervyn King’s speech yesterday arguing that deviating from inflation targeting would be very dangerous. Andrew Lilico’s point was that, instead of targeting inflation, the Bank of England is targeting its inflation forecast. In other words, it has moved to an ‘inflation forecast targeting’ regime whereby it always ensures that monetary policy is set so that its models predict the right level of inflation two years out – and is impervious to any reasoning about the inadequacy of the models.
There is certainly a lot of prima facie evidence for this. CPI inflation has been above target for about three years. And, since it went above target, Andrew Lilico points out that the price level has risen by nearly 10% above the level to which it would have risen had the Bank of England hit the target. At the same time, the Bank of England regularly produces forecasts and, surprise surprise, they always show that inflation will hit the target two years out (two years being the forecast horizon). The November 2012 forecast shows two per cent inflation two years ahead as bang in the middle of the chart of possible inflation outcomes. The November 2011 forecast showed an outcome of about 1.5% inflation two years ahead as the middle of possible inflation outcomes; and the November 2010 forecast also suggested a central projection of just under 2%.
Of course, the Bank reacted to its forecasts being below the inflation target in 2011 by increasing quantitative easing to get its forecasts back to two per cent (whilst inflation continued to overshoot).
When the Governor of the Bank of England misses the inflation target by enough to have to write a letter to the Chancellor of the Exchequer, his reasoning tends to be deeply unconvincing. Indeed, the letters are essentially always the same. He blames the rise in particular prices (though the Bank of England’s remit is to target the inflation rate on average – relative prices will always change) and argues that inflation will come back down to target (which never happens). Policy is then set by the MPC to make sure that the forecast comes back to target.
The problem is that the forecasting model seems to be wrong. There is never any reflection on this possibility in the exchange of letters. Of course, there is a sense in which all models are wrong – and another sense, appreciated by Austrians, in which modelling is impossible. However, the Bank’s modelling was criticised by Kevin Dowd and (separately) by David B. Smith in the IEA book Issues in Monetary Policy. It was suggested, for example, that the Bank’s model was used to implement monetary policy but that there was no role for money in the model! However, it would seem that the model itself has become the article of faith, as suggested by Lilico, and that the Bank of England is happy as long as the model forecasts that inflation will be on target.
As a coda, it is worth adding that, implicitly, the Bank of England seems to be pursuing nominal GDP targeting. King’s speech has been taken as a criticism of his replacement, Mark Carney, suggesting this as a possibility for future policy. But, perhaps, this is already what Mervyn King is doing. Real growth has been lower than the Bank forecast by roughly the same amount that inflation has been higher. As such, the Bank of England’s estimate of nominal GDP has been just about right. Perhaps the problem is not a lack of money in the Bank of England’s model but a lack of a supply side. Officialdom seems to be blind as to the extent to which government policy has undermined the sustainable growth rate.