Spencer Dale: Inflation targeting and the Monetary Policy Committee's
forward guidance
Speech by Mr Spencer Dale, Executive Director, Monetary Policy, and Chief Economist of
the Bank of England, at the International Journal of Central Banking Annual Conference,
"Inflation targeting and its discontents", Warsaw, 6 September 2013.
* * *
A central theme of this conference has been to highlight potential shortcomings of inflation
targeting and to consider potential alternatives.
I believe that the traumatic events in the UK economy over the past five years have, in fact,
strengthened the case for inflation targeting. The credibility of the inflation target has played
a crucial role in anchoring inflation expectations over the past five years, a period in which
inflation has been consistently above target. That credibility has been vital in giving the
Monetary Policy Committee (MPC) the flexibility to loosen monetary policy aggressively in
order to support growth and jobs.
But while it has not constrained the MPC's freedom to act in support of the economy, the
inflation target, on its own, has proved less well suited to addressing some of the exceptional
communications challenges posed by the sustained combination of weak growth and
elevated inflation. I would highlight two in particular: the need to make clear the central role
that monetary policy has played in supporting output and employment; and the need to
provide guidance about the Committee's view of the appropriate trade-off between bringing
inflation back to target and stimulating the recovery.
The forward guidance provided by the Committee in August can be seen as a response to
these challenges. To retain the clarity and credibility of the inflation target but to augment the
framework so that monetary policy is better equipped to address the exceptional challenges
currently faced by the UK economy. In this talk, I will provide a post-crisis report card for the
UK's inflation targeting regime and explain how the MPC's forward guidance responds to
some of the areas exposed as having 'room for improvement'. I will also show how a
threshold for monetary policy defined in terms of the unemployment rate is particularly helpful
in addressing two other challenges currently facing the MPC: the uncertainty surrounding the
future path of productivity; and the need to provide greater clarity concerning the setting of
monetary policy as the economy recovers.
A bit of background
Before doing so, it is worth highlighting three features of the UK's economic performance
over the past five years which should be borne in mind when evaluating the performance of
the UK's inflation targeting framework and understanding the Committee's decision to
provide forward rate guidance.
First, CPI inflation has been above target for almost this entire period (Chart 1). Fifty four
months out of the past sixty to be precise. Over this period, CPI inflation has averaged 3%.
And, on the basis of the MPC's central projection in the August Inflation Report, it is expected
to remain above target until the second-half of 2015.
Second, notwithstanding the recent encouraging data, the recovery following the crisis has
proved exceptionally weak. The level of UK GDP is still more than 3% below its pre-crisis
level. This is the weakest UK recovery on record. And with the exception of Italy, the weakest
across the G7 (Chart 2).
Third, the sluggish recovery has been accompanied by extraordinary weakness in
productivity. The level of private sector productivity has actually fallen over the past five
years: the first time since the late 1800s that productivity has fallen over such a timeframe
other than as a result of economic demobilisation following the World Wars (Chart 3).
High inflation, anaemic demand and even weaker supply: an extraordinarily challenging
economic backdrop against which to set monetary policy. So how did the UK's inflation
targeting framework stand up to this challenge?
A post-crisis report card for UK inflation targeting
In short, a bit like my old school reports: good, but could do even better.
The regime's main success is that inflation expectations have remained well-anchored
despite the sustained period of above target inflation. There is no definitive test or measure
of the stability of inflation expectations. But evaluating a wide range of expectations
measures along a number of different dimensions presents little evidence that the stability of
inflation expectations has lessened to any material extent.1
This stability is all the more striking given that monetary policy was loosened very
aggressively during this period. As has been discussed before by many of my MPC
colleagues (see, for example, Bean (2011), Broadbent (2011), Fisher (2013)), to not have
done so would have meant presiding over an even deeper recession and an even greater
rise in unemployment. Rather than a constraint as some claimed, the inflation target and the
credibility it afforded were essential in allowing the MPC to respond as forcefully as we did.
The much vaunted flexibility offered by inflation targeting frameworks - to set policy in such a
way that mitigates damaging booms and busts in activity as well as controlling inflation - can
be exercised only if policymakers' commitment to their target remains credible. Without
credibility, there can be no flexibility.
The experience of the UK economy over the past 5 years has provided a real-time
examination as to how long inflation can remain above an explicit policy target without the
credibility of that target being undermined. Thus far, the UK's inflation target has passed this
test with flying colours. And, in so doing, it has enabled the MPC to provide vital support to
our economy.
But although inflation targeting scored highly against its primary objective - anchoring
people's inflation expectations - there was, as my teachers used to say, some room for
improvement. For me it was speling. For inflation targeting, at least as operated in the UK, it
was in addressing some of the communications challenges posed by the sustained period of
weak demand and elevated inflation.
Room for improvement: explaining our policy choices
The public emphasis that we, as inflation targeters, place on achieving outcomes for inflation
plays a key role in underpinning the MPC's anti-inflation credentials. But this focus can be a
double-edged sword, in that it can give the false impression that inflation is the sole focus of
our monetary policy.
In fact, over recent years nothing could have been further from the truth. Indeed, inflation has
been above target for the vast majority of the period since the financial crisis. Yes: some of
this inflation overshoot might be the result of poor forecasting. For much of this period, the
Committee expected inflation to fall back to target more quickly than it actually did. But much
more important was the recognition that a lower profile for inflation was possible only by
tightening monetary policy at the expense of an even deeper recession and an even greater
rise in unemployment. Throughout this exceptionally challenging period, monetary policy has
consistently been set to ensure that inflation remains on track to return to the 2% target in the
medium term. But, subject to that, we have done everything in our power to support the UK
economy through the aftermath of the financial crisis, using the flexibility afforded to us by
the inflation targeting framework and by our own credibility to the full.
But the nature of our inflation targeting framework - with the primacy it attaches to the control
of inflation - means it is not well suited to explaining our role in supporting growth and jobs.
Policy actions have typically been explained solely in terms of inflation: for example, reducing
the risk that inflation will undershoot the target in the medium term or extending the horizon
over which we intend to return inflation to target. Although, technically accurate, such
explanations don't speak to the distress of businessmen and women worrying about the
future of their companies or to the anxiety faced by families unsure as to whether they will
still be in a job next week.
Make no mistake: inflation targeting provides the flexibility for policy to respond to such
anxieties. And we have fully exploited that flexibility over recent years. But it doesn't provide
a natural framework - a ready vocabulary - in which this flexibility can be clearly
communicated.
This almost exclusive focus on inflation in our communications didn't matter for much of the
first 20 years of inflation targeting in the UK. Indeed, arguably it was one of its attractions.
Prior to the introduction of inflation targeting in 1992, the UK had searched - in vain - to find
a credible anchor for monetary policy and inflation expectations. The simplicity and clarity
provided by a numerical target for inflation helped to establish the credibility of monetary
policy and was instrumental in fostering the period of stable growth and low inflation enjoyed
in the decade or so prior to the financial crisis.
But in the aftermath of the crisis and faced with five years of almost no growth, it is natural for
people to ask what monetary policy is doing to help get the economy going. The control of
inflation is important but so too is supporting the creation of jobs as unemployment rose to its
highest level for almost twenty years. There was a real risk that this would start to erode the
trust and support of inflation targeting; to damage its democratic legitimacy. This was
arguably evident earlier this year in the discussions in the media and amongst some
commentators as to whether the framework of monetary policy should be altered, say to
adopt a nominal GDP target or for the MPC to have an explicit objective for growth. A subtext
of that discussion was that the inflation target was in some way acting as a constraint on the
support that monetary policy could provide to the faltering recovery.
To repeat: such criticism is misplaced. The credibility provided by the inflation target is a
prerequisite for monetary policy to be able to respond so aggressively to the fallout from the
crisis. And with inflation being above target almost consistently over this period, it is hard to
argue that monetary policymakers have somehow been fixated by inflation.
But the forward guidance provided by the MPC makes that support explicit. The primary
objective of monetary policy remains the 2% inflation target. The sanctity of that objective is
guarded by the two price stability knockouts. But subject to those knockouts and the
knockout pertaining to financial stability, our guidance clearly signals the Committee's
intention to maintain a highly stimulatory stance of policy until the economy returns to
something closer to normality.
Abstracting from the precise details of the thresholds and knockouts, the message to
businesses and families should be clear. The MPC intends to keep interest rates low until we
have seen a sustained period of strong growth, rising incomes and higher employment, as
long as that does not pose risks to either price stability or financial stability. To be clear: that
is no different to the approach underlying our policy over the past five years. But forward
guidance provides a framework and a language in which that intention can be made plain.
A closely related issue is the policy trade-off currently faced by the MPC. With inflation well
above target and the level of output still depressed, the Committee has to balance the speed
with which it returns inflation to target and the support it provides to output and employment.
If we attempt to return inflation to target too quickly, by withdrawing monetary stimulus, we
risk undermining the fledgling recovery. But returning inflation to the target too slowly might
cause people to question the MPC's commitment to keep inflation close to 2% in the medium
term.
Again, the issue here is to do with the transparency and accountability of policy, rather than
its actual setting. The need to juggle these two challenges - returning inflation to target and
supporting growth - has been the single most important determinant of our monetary policy
decisions over recent years. But an inflation target, on its own, is not well suited to explaining
the judgements and rationale underlying the Committee's approach. Put bluntly, it speaks to
only one half of the trade-off.
The stakes are high. Our management of the trade-off between returning inflation rapidly to
target and supporting the recovery directly affects businesses and families up and down the
country. It is only right that the Committee be clear about its view of the appropriate trade-off
so that we can be challenged and held to account. Indeed, a noteworthy addition to the
MPC's remit when it was renewed by the Chancellor earlier this year was a request that "...
the Committee should promote understanding of the trade-offs in setting monetary policy to
meet a forward-looking inflation target while giving due considerations to output volatility."
The forward guidance announced by the Committee clarifies its view of the appropriate
trade-off. The primacy of the inflation target makes clear that the long-run objective for
monetary policy hasn't changed, and the inflation forecast knockout provides information
about the minimum speed at which the Committee judges it acceptable to bring inflation back
to target. At the same time, the unemployment threshold provides guidance about what the
MPC is trying to achieve in terms of real activity as the economy gradually normalises.
Moreover, by making clear its view of the desired trade-off, the MPC helps to make our
monetary policy more predictable. This enables financial markets, companies and families
alike to make more informed decisions and so improve the effectiveness of policy.
Let me summarise where we have got to so far. The inflation target served us well during the
financial crisis. Straight A's for preserving credibility and for anchoring inflation expectations.
But the aftermath of the crisis has posed particular challenges of communication and
accountability that, on its own, an inflation target is ill equipped to address. The MPC's
forward guidance is designed to help us to meet those challenges head on.
The role of unemployment in our forward guidance
It is important to be clear what role unemployment is - and is not - playing in the setting of
monetary policy. If you remember just one thing from this talk, I would ask that you
remember this: targeting a particular level of the unemployment rate is not a job for monetary
policy. Monetary policy can't control the level of unemployment in the long run: we can't
generate sustainably higher output or employment simply by printing more money. That way
lies the horrors of the high and variable inflation rates of the 1970s and 80s. We forget those
lessons at our peril. Monetary policy continues to have only one target: the 2% inflation
target. Nor is unemployment a sufficient measure of slack in the economy on which to base
our policy. The 1970s and 80s also taught us the foolishness of trying to control inflation by
responding to movements in a single intermediate target. When we reach the 7%
unemployment threshold, the Committee will reassess the state of the economy based on all
available information and, on that basis, decide whether it should start to withdraw the
current extraordinary levels of stimulus.2
An unemployment rate of 7% is not our intended destination. Nor even is it necessarily the
first turning on the way to our final destination. Rather, it is a conveniently located layby at
which we can pull over, study our economic map in detail, and work out whether we are
anywhere close to our first turning.
Why unemployment?
There are two other challenges facing the UK economy and the MPC which the Committee's
guidance also helps to address: the uncertainty as to why productivity has been so weak and
the extent it will rebound as demand increases; and the need to clarify how monetary policy
is likely to respond as the economy recovers. Defining our guidance in terms of a threshold
for unemployment is helpful in both cases.
Giving supply a chance
When considering the appropriate trade-off between bringing inflation back to target quickly
and supporting the recovery, by far and away the biggest judgement facing the Committee is
the extent to which productivity is likely to recover as demand increases.
If you speak to some economists they are quite optimistic and suggest that productivity
growth is likely to rebound relatively robustly as growth picks up. They note that productivity
is strongly pro-cyclical. They also point to evidence that some companies have retained
employees in anticipation of the recovery, while others have had to use resources more
intensely to generate the same level of orders given the weakness of demand.3
But other economists are less upbeat. They highlight the role an impaired banking system
may have played in contributing to the weakness in productivity. And to evidence that
suggests that a failure to reallocate resources from less to more productive firms has had a
pronounced effect on productivity growth. Such factors may persist even as demand
recovers, suggesting that any rebound in productivity growth may be more muted.4
Both sets of arguments are very plausible. Indeed, it is likely that both played some role in
the weakness of productivity. The challenge for the Committee is weighing up the relative
importance of these different factors. And this judgement is central to the setting of policy.
Too optimistic and we risk stoking up excessive demand that will feed through into higher
inflation and a potential loss of credibility. Too pessimistic and our nation's resources will
remain underutilised for an even longer period, with potentially damaging effects on the
longrun health of our economy.
The design of the forward guidance - in particular the combination of the unemployment
threshold and the knockouts - makes the setting of monetary policy more robust to this
uncertainty, allowing the Committee to learn about the responsiveness of supply as the
economy recovers, without needing to work out the precise cause of the productivity
weakness up front.5
Let me explain.
If productivity picks up strongly as the recovery gathers pace - as the more optimistic reading
of the evidence would imply - this means that we are likely to have a relatively prolonged
period of strong growth, and a relatively prolonged period of low interest rates, before
unemployment reaches the 7% threshold. But if, even as the recovery gathers pace,
productivity growth remains relatively muted, unemployment will likely fall more quickly and
the Committee will need to raise rates sooner.
A threshold defined in terms of the unemployment rate is particularly well suited to dealing
with this uncertainty. As demand picks up, those companies that can use their existing
workforces more intensely or can shift employees to more productive activities are likely to
do so before hiring additional staff. This suggests that to the extent that productivity picks up
in response to increasing demand it should largely do so before unemployment falls
materially. As such, the Committee can remain largely agnostic about the extent to which
productivity is likely to pick up and instead respond to the signal provided by movements in
the unemployment rate.6
At the same time, the three knockouts make clear that the
Committee will continue to pursue such a policy only if it does not pose a risk to price or
financial stability.
Its levels that matter
The second challenge relates to the need for the Committee to explain how monetary policy
is likely to evolve as the economy recovers.
The good news is that after several years of virtual flat-lining, a recovery appears to be taking
hold. The UK economy grew by over 1% in the first half of this year, more than in the
previous two years put together. And it looks set to grow even more quickly in the second
half of this year. The most recent indicators and business surveys suggest that the economy
may currently be growing at an annualised rate of between 3% and 4%.
In the midst of this long awaited growth, there is the risk that people may overreact and
expect the MPC to start raising Bank Rate relatively quickly. Such an overreaction would risk
dampening the recovery, pushing up longer-term interest rates and, more generally, causing
companies and families to pullback from investment and spending decisions for fear of an
imminent rise in borrowing costs.
And based on past experience, there would be good reason for people to behave in such a
way. During the so-called Great Moderation in the15 years or so prior to the financial crisis,
there was a close relationship between changes in Bank Rate and the growth of GDP.
Indeed, my colleague Ben Broadbent, in his former life as a city commentator, used to draw
attention to the startling correlation between the behaviour of the MPC and movements in
growth implied by business surveys.7 The self-same surveys that are currently pointing to
quarterly GDP growth of around 1%, a rate which in the past would have signalled the MPC
was likely to tighten policy.
That type of relationship during the Great Moderation is perhaps not that surprising. During
much of that period, the economy was close to balance and the job for monetary policy
- absent worrying longer-term trends or significant cost or price shocks - often boiled down
to keeping GDP growth close to trend. But this time is different. We start with significant slack
in the economy: the level of GDP is still below its pre-crisis level; there are almost one million
more people unemployed. We need to see a sustained period of robust growth before the
economy moves back into anything resembling balance. Linking the future path of monetary
policy to the level of unemployment makes that clear. Its levels not growth rates that matter.
Likewise, those expecting to see the close synchronisation between UK and US policy rates
that held during much of the Great Moderation to reassert itself as rates begin to normalise
need to remind themselves about the differences in the extent of the recoveries in the two
countries to date. The US economy has been growing for almost 4 years; the UK for barely 6
months. The level of US GDP is 5% above its pre-crisis level; UK GDP is 3% below. Its
levels not growth rates that matter.
I don't know how quickly Bank Rate will begin to rise. That will depend critically on the extent
to which productivity recovers as demand increases. But the MPC's forward guidance makes
clear that, after the worst recession in post-war history and the weakest recovery on record,
this time is likely to be different. Its levels not growth rates that matter.
Conclusion
The financial crisis and its aftermath provided a tough examination of the UK's inflation
targeting regime. And the results slip reads pretty well. In particular, the inflation target was
instrumental in anchoring the credibility of policy, without which the MPC would not have
been able to respond so aggressively. Without credibility, there can be no flexibility. And the
MPC has used that flexibility to the full, providing extraordinary levels of stimulus to support
growth and jobs.
But the nature of the inflation targeting framework meant that it dropped a few marks in terms
of helping the MPC to communicate the role monetary policy played in supporting the
recovery. That risked undermining the democratic legitimacy of inflation targeting. Likewise,
the inflation target on its own was less suited to explaining the MPC's view of the appropriate
trade-off between the speed with which inflation is returned to target and the support
provided to the fledgling recovery.
The forward guidance announced by the Committee retains the primacy of the inflation target
while allowing the Committee to more effectively tackle these communication challenges. In
so doing it enhances the transparency and accountability of monetary policy. The guidance
also provides a robust framework in which the MPC can explore the scope for economic
expansion and helps to provide greater clarity about the likely path of monetary policy as the
economy recovers.
The inflation target remains front and centre in the conduct of UK monetary policy. Price
stability remains the primary objective of monetary policy. The MPC's forward guidance
builds on the clarity and credibility of the inflation target to address some of the exceptional
challenges currently facing our economy. And in so doing it should help to increase the
effectiveness of monetary policy.
References
Bean, C (2011) "The Economic Outlook", speech to the Northern Ireland Chamber of
Commerce.
http://www.bankofengland.co.uk/publications/Documents/speeches/2011/speech497.pdf
Broadbent, B (2011) "Rebalancing and the real exchange rate", Speech at Thompson
Reuters,London.
http://www.bankofengland.co.uk/publications/Pages/speeches/2011/520.aspx
Broadbent, B (2012) "Productivity and the allocation of resources", speech at the Durham
Business
Schoolhttp://www.bankofengland.co.uk/publications/Pages/speeches/2012/599.aspx
Broadbent, B (2013) "Conditional guidance as a response to supply uncertainty", speech at
the London Business School.
http://www.bankofengland.co.uk/publications/Pages/speeches/2013/678.aspx
Fisher, P (2013) "The Outlook for the UK economy", speech to the Cardiff Breakfast Club.
http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech659.pdf
Maule, B and Pugh, A (2013) "Do inflation expectations currently pose a risk to the
economy?", Bank of England Quarterly Bulletin, 2013 Q2.
(2013) "Monetary Policy in a Changing Economy", speech at Bloomberg,
McCafferty, I
London
http://www.bankofengland.co.uk/publications/Pages/speeches/2013/627.aspx
Miles, D (2012) "Monetary policy and the damaged economy", speech at the Society of
Business Economists Annual Conference.
http://www.bankofengland.co.uk/publications/Pages/speeches/2012/576.aspx
Miles, D (2013) "Monetary policy and forward guidance in the UK", speech at Northumbria
University.
http://www.bankofengland.co.uk/publications/Pages/speeches/2013/681.aspx
Taylor, J (2013) "Forward guidance as an incipient policy rule at the BoE and ECB",
http://economicsone.com/2013/08/25/forward-guidance-as-an-incipient-policy-rule-at-theboe-and-ecb/
Tucker, P (2013) "Monetary strategy and prospects", speech at the Association for Financial
Markets in Europe flagship conference on Financing Growth, London.
http://www.bankofengland.co.uk/publications/Pages/speeches/2013/679.aspx
Annex: Charts
Chart 1: UK CPI inflation Chart 2: Recoveries across the G7
Per cent
Index (pre-crisis preak =100)
108
6
106
5
104
102
4
100
3
98
Germany
96
2
France
Italy
94
UK
1
US
92
Japan
0
90
2005 2006 2007 2008 2009 2010 2011 2012 2013
2007 2008 2009 2010 2011 2012 2013
Sources: Eurostat and Datastream
The pre-crisis peak was: 2008 Q1 for Germany,
France, Japan and the UK; 2007 Q3 for Italy; 2007 Q4
in the US; and 2008 Q3 for Canada.
Chart 3: UK labour productivity
Percentage change on five years earlier
25
20
15
10
5
0
1861 1886 1911 1936 1961 1986 2011
-5
-10
-15
-20