Rachel Lomax: Inflation targeting - achievement and challenges
Speech by Ms Rachel Lomax,1 Deputy Governor of the Bank of England, to the Bristol Society at the
University of the West of England, Bristol, 18 February 2004.
* * *
Ladies and Gentlemen, it is a great pleasure to be here in Bristol tonight.
Bristol and the Bank go back a long way. Our Agent in the South West, the late Michael Knight, was a
founder member of this Society. And nearly two centuries ago - in 1827 to be exact - Bristol was one
of the first branches that the bank established outside London. Not that it was plain sailing. The Bank's
first Agent in Bristol, Mr John May, resigned after only a few years complaining of the unhealthy
situation of the branch premises, situated as they were next to the City Poor House and a pool of
stagnant water, at risk of cholera and - this was the time of the great Reform Bill - riots and fire. By
these standards, our present Agent, Kevin Butler, has no grounds for complaint.
My subject tonight is a more recent episode in our economic history: the improvement in economic
performance associated with the adoption of inflation targets just over a decade ago. I'll look first at
why this approach to monetary policy seems to work, and then consider what challenges remain for
policy makers.
Historical overview
One of the more dramatic developments in the final decades of the last century was the sharp fall in
inflation worldwide. This remarkable phenomenon brought inflation almost everywhere to levels not
seen for the best part of fifty years. Set against the long sweep of history, it is the 1970s and 1980s
that now stand out - as a major, but time limited, episode of high global inflation.2 In the UK, the period
since 1992 has seen a shift to low and stable inflation combined with sustained economic growth, and
steadily falling unemployment. Slightly miraculous as these developments may still seem to the
generation that came of age during the Great Inflation of the 1970s - remember 'stagflation'? - the
happy fact is that for anyone in their mid-thirties, low inflation, steady growth and low interest rates are
the norm.
Success has many parents, and the trend to low inflation is no exception. But there is a broad
consensus that better monetary policies run by more independent and more open central banks can
claim a significant share of the credit. The Short History of Twentieth Century Monetary Policy goes
roughly as follows. For the first time since the collapse of Bretton Woods - arguably since the Gold
Standard - after decades of unhappy experiments with fine tuning, incomes policies and monetary
targets, buffeted by the explosive growth of financial markets and often misled by economic dogma,
governments have finally found an approach to monetary policy that seems to work. And it works by
setting clear limits on the role of governments themselves.
This is of course a caricature. But it is certainly true that the 1990s were a period of considerable
reform and innovation in central banks across the world; many new central banks were established
and many established central banks were given greater independence from their governments, often
in exchange for a clear commitment to meet specific targets for inflation. From the time when we left
the Exchange Rate Mechanism in 1992, the UK has led this wave of change. Looking back, the
adoption of formal inflation targets in 1992 marks a decisive break with the past.
The other key date is 1997, when the Bank of England was granted operational independence; the
institutional framework then put in place entrenched and enhanced the credibility of inflation targeting,
and has been widely admired. Moreover, in the UK, as in many other inflation targeting countries, a
track record of success, built up over more than a decade, has progressively reinforced the credibility
of these targets. As a result, people and firms have increasingly come to expect inflation to stay close
the official target - a belief which itself helps to keep it there.
Clearly the world has changed. For sure, there is still much we do not understand both about the
ebbing of global inflationary pressures over the past decade and about the impact of low inflation on
the way that people behave. And there have been crises, such as the stock market crash and
September 11. By past standards, though, modern monetary policy is a less melodramatic affair.
Has policy making become easier? I don't think so, though I suspect it looks that way. But let met give
a fuller answer by setting out how the present approach to setting interest rates works; and outlining
some of today's challenges.
The policy framework
I'll start with inflation targeting, as it has been implemented in the UK since 1997.
The institutional framework is set out in some detail in the 1998 Bank of England Act. This is extremely
clear both about the aims of monetary policy and about the respective roles of the Government and
the Bank. On the one hand, the Bank of England is required set interest rates so as 'to maintain price
stability and subject to that to support the economic policy of HM Government, including its objectives
for growth and employment'. On the other, the Government is required to specify what its economic
objectives are, including what is meant by price stability. The remit of the Monetary Policy Committee
(MPC) must be set out in writing at least annually and it must be published.
The remit has always had important elements of flexibility. For example, while the MPC is directed to
aim for the target 'at all times' and to treat deviations from target symmetrically, it is not expected to
react mechanically. Instead, if inflation deviates from target by more than 1%, the Governor is required
to write to the Chancellor explaining the circumstances and setting out what action the MPC considers
necessary to return to target. No letter has been written so far, but only because circumstances have
not warranted it.
There is an explicit understanding that operational independence must be accompanied by
transparency and clear accountability to Parliament and the general public as well as to Government.
Inflation
The Bank's forecasts are published in the quarterly Report, the minutes of MPC meetings are
published within two weeks, and the nine members of the MPC appear regularly in front of
Parliamentary committees as well undertaking between them some 50-60 regional visits a year to
different parts of the UK.
The Committee has a distinctly individualistic bias, in contrast to the consensus seeking traditions of
many other central banks. It includes four external members who are appointed for their expertise, not
as representatives of interest groups; and all members are individually accountable for their votes,
which are made public with the minutes. Both the markets and the press take a keen interest in the
pattern of voting, and members will often find a way to explain their thinking in more detail.
All this adds up to a powerful set of incentives for members of the MPC to focus on maintaining price
stability; to pay attention to all relevant information; to weigh up the risks; to take timely decisions; and
to explain them clearly. Moreover, clarity about the aims of policy and the transparency of the decision
taking process give the MPC significant scope to influence the longer term interest rates set by the
market. It's a far cry from previous policy regimes, when the main players faced very different
incentives. Prior to 1997 the key decision makers were politicians, who both set objectives for
monetary policy and took responsibility for the technical judgements needed to meet them. Politicians
can rarely afford the luxury of focussing on one objective to the exclusion of all others. Attempts to win
credibility by constraining their discretion, notably through setting monetary targets, were a fairly
comprehensive failure.
Interest rate decisions have been the subject of some famous tussles between Number 10 and
Number 11 Downing Street under successive Governments. Here is Chancellor Denis Healey, writing
in his memoirs3 about a spat with the Prime Minster of the day:
'At this time my own relations with Jim were shaken by an incident just after the
Party Conference. On October 6 I had asked him to let me raise interest rates by
another 2 per cent to the then unprecedented level of 15 per cent...He refused. I
said I wanted to take the matter to Cabinet that morning. 'All right' he replied 'but I
will not support you.' Nevertheless I insisted...'
In the event this did not prove necessary: Callaghan backed down, leading Healey to comment wryly
that
'This was the only time I have ever used the threat of resignation to get my way.'
The new framework has taken the politics out of interest rate decisions without sacrificing democratic
accountability or oversimplifying the policy process. It is an elegant institutional solution to the lengthy
debate between those who favoured untrammelled discretion and those who advocated rules (such as
monetary targets); one, moreover, which manages to respect the constitutional priorities of a
parliamentary system.
Achievements
Performance over the six years since the Bank became independent has been impressive. Against the
target of 2.5% for RPIX which ran from 1997 until December 2003, average inflation was 2.4%. For 68
out of the 79 months, inflation was within 0.5 percent of the target - below it for 42 months, above it for
30, and on target for the remaining seven. Notwithstanding the stock market crash and the slowdown
in world activity, the UK economy has continued to grow steadily and employment has remained
strong.
On a longer term view, the decade of inflation targeting since 1992 looks remarkably stable by
post-war standards.4 The recent slowdown has been exceptionally mild compared with all previous
slowdowns since the beginning of the 1970s, and since 1992 growth in both real GDP and consumer
spending has also been significantly less volatile, with 46 quarters of positive growth, and no
significant downturn in consumption since mid 1994. Prior to the 1970s, recessions were virtually
absent, but real GDP was much more volatile than it has been in the past decade.
Of course, better monetary policy and low inflation are only part of this story. It matters that monetary
policy has been supported by fiscal discipline. Just as important are the many labour and product
market reforms that, over a long period of time, have given us a more flexible and competitive
economy, which is capable of adapting quickly to sudden change without prolonged periods of
unemployment and under-utilised capacity.
Attitudes towards inflation
American economist Alan Blinder once said: "Price stability is when ordinary people stop talking and
worrying about inflation". Has low inflation entered our bloodstream yet? This is a hard one but there
are some clues.
Expectations about future inflation seem to have fallen steadily over the past decade and are now
clustered around the Bank's target. This is supported by survey evidence, including surveys of trade
union officials, and evidence drawn from financial market prices. A recent Bank of England survey of
the general public5 pointed to interesting though small differences across age groups, with younger
people expecting lower inflation on average than their parents. When it comes to inflation, people have
very long memories.
The evidence also suggests that firms and wage bargainers are now more disposed to expect inflation
to revert to target if something happens to throw it off course: in that sense inflationary expectations
are better anchored. This should make the task of policy makers easier. After all, if wage bargainers
and firms themselves act as if the Bank will take action to offset any potential disturbance to inflation,
actually
the need for the Bank itself to change interest rates will be that much less. This, in a nutshell,
is the intuitive reason why a credible policy regime should help to produce more stability in output as
well as inflation.
Challenges
Inflation is low, expectations are well anchored, and the real economy works better as a result. These
achievements are important and they were hard won. We mustn't take them for granted. But nor can
we live in the past. So what are today's challenges? I see these in three main areas: assessing current
economic developments; effective communication; and understanding the new trends that will shape
the future.
(i) Assessing current developments
Broadly speaking, the task for the MPC is to control inflationary pressure by ensuring that the level of
aggregate demand in the economy is more or less in line with aggregate supply. The first and most
basic challenge comes in translating this deceptively simple idea in to practice.
It is hard enough to estimate how fast demand is growing now from incomplete, preliminary or just
plain puzzling information. It is harder still, and even more important, to look ahead over the two or
three year horizon relevant to setting interest rates. But that's only part of the story. The rate at which
demand can be allowed to rise without leading to an upturn in inflation depends both on how much
spare capacity there is in the economy now and on factors that determine the future growth in supply,
such as productivity and labour availability. And finally, we need to consider what effect our own
actions will have on longer-term interest rates and through them on the wider economy.
Inflation targeting provides a credible framework within which these complicated issues can be
properly considered. That's important, but it does not change the need to make judgements, or even
make the judgements any easier. Data get revised; models over simplify; forecasts are fallible. It's
essential to invest in state of the art techniques; indeed the Bank has just introduced a new macro
economic model. But progress depends just as much on recognising all the uncertainties and allowing
for them in a systematic way.
The monthly interest rate decision requires a complex assessment of all the evidence. We need to be
both sceptical and open minded, if we are to avoid major error: sceptical when it comes to interpreting
the data, but alert for signs that we may be getting it wrong. The decision to raise rates in February,
while inflation was still well below the new target, reflected a top line view that inflationary pressures
were likely to build over the next couple of years. While this has been the emerging picture for some
months now, we have been surprised by a number of developments pointing in different directions,
which have needed careful evaluation - notably, the resilience of household spending and the strength
of the exchange rate. We have also had an opportunity to reconsider earlier judgements, especially
about the amount of spare capacity and the likely growth in potential supply. That is the nature of the
exercise.
March will be another month. There can be no foregone conclusions when it comes to setting interest
rates. Every month I may have a fairly well developed view not just about this month's interest rates,
but about where interest rates are likely to need to go in the future, to achieve the inflation target. But
that view may - indeed should - change in the light of new information, better research, another set of
forecasts, perhaps a different view of the risks. In that sense every month is a fresh decision. What
doesn't change is what we are trying to achieve. This clarity about aims is what gives us the flexibility
to learn, so important if we are to avoid major error.
(ii) Effective communication
Maintaining this clarity through effective communication is critical. The MPC aims to be as open and
straightforward as possible. Sometimes this involves lengthy explanations of rather arcane issues. A
recent example is the change in the inflation target. As you probably know, in January the Chancellor
replaced the target of 2.5% as measured by the RPIX by a 2% target as measured by the new CPI.
We have used speeches, Parliamentary appearances and short articles to set out as clearly as
possible the nature of this worthwhile but essentially technical change, in order to underline one simple
message: that the change in target in no way weakens the commitment to price stability, and indeed
has no material implications for monetary policy.
It has been harder work to explain our thinking about the altogether more newsworthy subject of the
strong growth in household spending, and its relationship with escalating house prices and household
debt. Bad memories of boom and bust in the late '80s and early-'90s get in the way of more nuanced
explanations which try to reflect how the world has changed in the past decade. The truth is that the
present situation is rife with uncertainties. For example, while it is not difficult to think of reasons why
the level of house prices relative to income might have risen significantly in recent years, at no less
than 40% above their long average, current levels definitely stretch the imagination. Are people
behaving rationally? Hard to say - individuals are notoriously prone to over-optimism about their own
prospects, but it is not obviously misguided to base decisions on a view of the future which reflects the
record of macro economic stability I described earlier. What clearly is irrational is to assume that
current rates of house price inflation will continue indefinitely.
It has also been a challenge to explain how house price inflation and borrowing fit within an inflation
targeting framework. One commentator has claimed that they are 'the targets that dare not speak their
name'. This is not so. True, the Committee has debated endlessly how far a strong housing market
can explain the resilience of household spending, and the risk that a sharp correction in house prices
will dent consumer confidence, and administer a nasty deflationary shock. Inevitably such questions
do not have clear cut answers - for example, the relationship between house prices and consumer
spending, never well defined, has shown tantalising signs of weakening over the past few years.
But the message we have tried to get across is that house prices and borrowing are part of the wide
range of evidence we review monthly in assessing the outlook for inflation. They have also been
important in shaping our view of the balance of risks. They do not have a special role, as targets, in
driving interest rate decisions.
(iii) Detecting future trends
Let me come to my final set of challenges: understanding the new forces that are shaping the future,
or, if you prefer, detecting the bends in the trends. This is what successful businesses have to do, and
we need to share their insights. There is an important role here for the Bank's regional Agents. Their
most valuable input to the MPC can be the stories that illuminate their regular surveys of their 8000
contacts around the country and bring to mind Nobel prize-winner George Stigler's quip that 'The
plural of anecdote is data'.
Let me give you an example. Since the 1996, the National Accounts have painted a picture of a boom
in household spending, with the volume of personal consumption growing by 3 3⁄4 per cent a year on
average, compared with real GDP growth of 2 3⁄4 per cent. But for the past couple of years at least, the
Bank's Agents have been talking about a much tougher world 'out there', with demanding shoppers on
a ceaseless 'search for value' using new technology to search out bargains as well as to make
purchases, driving an endless round of discounting across a wide range of consumer goods.
value
It's a fact that in terms, the growth in household spending has been slowing since the middle of
2000. Much of the strength in the volume of consumption reflects lower prices which have boosted
consumers' spending power, for given incomes. Since 1998 the price of durables has fallen by 14%,
while the price of other goods and services has continued to rise. The falls have been spread across a
range of categories, including cars, clothing and sports goods, though the fall has been particularly
marked in IT/audio visual goods. So it is not surprising that spending on durables accounts for virtually
all the growth in the volume of consumption - an average of over 8 per cent a year compared with
around 2 per cent on other goods and services.
The interesting questions are why this has happened, how far it will go and how long it will last.
We know that the UK's terms of trade have improved substantially since the mid 1990s, as the price of
our imports has fallen more than the price of our exports, boosting domestic spending power. But this
seems to be partly an IT story, much of it concentrated in capital rather than consumer goods; and
lower prices may be related to exchange rate changes, which could be temporary.
Clearly new technology is playing an increasing part in helping consumers to search out bargains as
well as to make purchases. While the total value of on-line sales remains relatively small, it is clearly
growing very rapidly. Comprehensive data is still hard to come by, but one source suggests that
on-line sales have risen more than ten fold over the last four years. Several recent reports have
pointed to a sharp acceleration in the second half of last year, as the habit of e-shopping spreads.
Structural changes within the retail sector are also part of the story. High street retailers are facing stiff
competition from the major supermarket groups across a wider range of products.
What is driving these changes? No doubt there are many factors at work, but I find the Agents' picture
of an increasingly demanding consumer quite thought provoking. We live in a consumer society, and
shopping, in one form or another, is what many people do much of the time; helped by technology,
why wouldn't they learn to do it rather well? And indeed one of the benefits of low inflation is that price
signals carry more information, making price comparisons worthwhile.
Understanding what is happening is relevant to monetary policy. To the extent that a fierce competitive
struggle is squeezing retail margins, it is likely to affect the shortrun outlook for inflation. While such a
squeeze won't have an effect on inflation in the longer term, it could herald a lasting improvement in
productivity across the sector as a whole.
This brings me to my final issue: whether productivity in the UK will accelerate as it seemingly has in
the US.6 Since 1995 the growth of US productivity has doubled and the improvement has been
sustained through the stock market crash. This is directly relevant to current thinking about
US monetary policy. If faster productivity has indeed helped to create a high level of spare capacity
and contributed to a higher growth in underlying supply, holding interest rates at historically low levels
for some time should not add to inflationary pressures, even if demand grows rapidly. This is a key
reason why the Fed believes it can be 'patient' in raising interest rates.
The US evidence does seem to suggest that productivity has accelerated and that ICT has played a
substantial role in raising productivity in non ICT sectors. This answers one puzzle, neatly posed by
US economist Robert Solow when he commented that 'You can see computers everywhere but in the
productivity statistics'. But it also raises the equally interesting question of why no such acceleration
has yet been detected in the UK (or continental Europe) despite huge ICT investment in the late
1990s.
The possible answers to this question cover the full range from the pessimistic - it is never going to
happen because there are institutional and other barriers to realising the benefits of ICT, in the shape
of regulations, planning restrictions, or restrictive labour practices - to the optimistic - it will definitely
happen given time, but the lags are long and variable.
The truth is, of course, that we don't really know, despite much research both in the US, here and
elsewhere. For what it is worth, I take it as read that realising the benefits from investment in ICT is
about much more than buying kit. As anyone who has ever run a business knows, investment in ICT
must be accompanied by changes in the way the job is done. Managing change is a notoriously costly
and disruptive business. So some temporary slowdown in productivity growth in the wake of heavy
investment in ICT is not surprising.
If that's right, the questions for monetary policy makers become harder: namely, when, where and by
how much will productivity growth eventually pick up? What's the likely impact on potential supply? As
it happens the projections in the February Inflation Report do project a pick up in supply over the next
few years, but that reflects improved labour availability rather an assumption that there is an ICT led
productivity miracle in the making. But we could easily be wrong. Given recent experience, there is
clearly some risk of undue pessimism, though it has to be said that past policy errors have more often
been the result of too much optimism. One thing is for sure: we can't afford to sit back and wait for the
data to tell us the answer. By the time we have that degree of certainty policy will have moved on. So
productivity will remain a key issue for us over the coming years.
Conclusion
Which brings me to my final challenge for policy makers: how to handle uncertainty in taking and
presenting policy decisions.
The MPC has met this challenge head on from the beginning. Within the discipline imposed by a
shared inflation target, the Committee has been very open both about uncertainty and about the
disagreement that is likely to go with it. Published MPC forecasts have explored rather than glossed
over risks and uncertainties. The individual accountability of MPC members reduces the incentive to
search for consensus. MPC members have always voiced their different views in public, and while this
is not without risk to the clarity of the message, and has occasionally led to an uncomfortable
personalising of decisions, I see it as an inherent part of system not a quirk of particular personalities.
The big prize is long term credibility, and nowadays there is no credibility without openness. This is
what gives the present framework the flexibility to respond to changing circumstances, and allows
members of the MPC to change their minds in the light of experience. And in an uncertain world this
openness to learning is a precondition for success under any policy regime.