Economist Insights 11 February2
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Transcript of Economist Insights 11 February2
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7/29/2019 Economist Insights 11 February2
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Economist InsightsMoving target
11 February 2013Asset management
The announcement last November of Mark Carneys
appointment as the next Governor of the Bank of England
was accompanied by much lauding. We have been reminded
that he was voted Central Banker of the Year 2012 bynumerous magazines including the Wall Street Journal and
EuroMoney. Chancellor George Osborne described him as
[t]he outstanding central banker of his generation.
The markets were looking for some sort of momentous
announcement when Governor Carney faced public cross-
examination by the UK parliaments Treasury Committee
last week. In previous speeches he had indicated some
interest in quite revolutionary ideas. In the event, markets
were disappointed; Governor Carneys comments were quite
measured and he left his options open. Those hoping for big
changes in UK monetary policy may have been excited by
Governor Carneys calls for regular reviews of the monetarypolicy framework. Before anyone gets too excited it is worth
remembering that such reviews were undertaken at the Bank
of Canada and the framework was left basically unchanged.
The big changes to the framework that some are calling for
are a switch to either price level targeting (PLT) or nominal
GDP targeting (NGDPT). Both these ideas have been much
discussed in the market and in the financial press over the
last year.
The idea behind PLT is that the inflation rate shouldnt just be
close to target, but should average close to the target overtime. So if inflation is above target for a few years, under PLT
the central bank would need to have inflation belowtarget
for a few years so that it balances out. Under normal inflation
targeting the central bank would just try to get inflation back
to target but would stop inflation going below. For long-
term investors, PLT should give more predictable inflation
outcomes than inflation targeting.
The challenge to implementing PLT in the UK is that inflation
has been above target for several years resulting in a big
positive gap from the price level (see chart). This would
require the Bank of England to hike rates immediately to
correct for the overshoot not a policy that anyone really
wants. This is why the focus has generally been on nominal
GDP targeting.
Joshua McCallum
Senior Fixed Income Economist
UBS Global Asset Management
Gianluca Moretti
Fixed Income Economist
UBS Global Asset Management
Source: ONS, UBS Global Asset Management
Governor Mark Carney, soon to take up his
appointment as next Governor of the Bank of England,
gave evidence to the UK parliaments Treasury
Committee last week. The market may have been
looking for an announcement of big changes for UK
monetary policy, but Governor Carneys commentsleft his options open. He stressed the importance of
flexible inflation targeting, but did not go as far as
recommending price level targeting or nominal GDP
targeting, which some commentators were looking for.
Un-level
Percentage deviation of price level or nominal GDP from hypothetical
targets (starting point is May 1997 for both RPIX with 2.5% inflation
and nominal GDP with 5% growth, and December 2003 for CPI with2% inflation).
-15
-10
-5
0
5
10
1998 2000 2002 2004 2006 2008 2010 2012
RPIX Gap CPI Gap (Dec 2003) Nominal GDP Gap
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NGDPT targeting is based on the idea that the central bank
cannot choose whether increased liquidity will end up as
higher inflation or higher real growth. Since nominal GDP is
effectively the sum of real growth and inflation, as a target
it is arguably more appropriate. If real growth is moving
around trend, there is little to distinguish NGDPT from PLT.
Where NGDPT differentiates itself is in a recession. Unlike
inflation targeting, NGDPT could actually require the central
bank to loosen policy even if inflation is already at or above
target. Higher inflation would then be acceptable because it
is offsetting the shortfall in real growth. The hope would also
be that further monetary stimulus could even spur a recovery
in real growth. In contrast to PLT, recent UK experience
suggests that a NGDPT regime would require even looser
monetary policy for a very long time (see chart).
So NGDPT would allow for looser monetary policy even while
inflation is above target. If you think this sounds remarkably
like what the Bank of England has been doing for the last
few years, then you are absolutely right. Yet this is widely
accepted; after all, the recession is a good reason for the
Bank of England to keep monetary policy loose not only
to help the economy and job creation, but also becauseweak growth should eventually bring down inflation. In
other words, a sufficiently malleable inflation target can be
a pretty good proxy for NGDPT. This is exactly the point that
Governor Carney made when he stressed the importance of
flexible inflation targeting.
The key idea that Governor Carney put forward last week
was that flexible inflation targeting requires the central bank
to meet the inflation target at some point in the future, but
the central bank can explicitly change that time horizon if
necessary. Traditionally the Bank of England has aimed to
get inflation down to target over a two year horizon, but
flexibility could allow it to extend that time horizon so that
policy could stay loose for longer in order to support growth.
The big drawback of nominal GDP targeting is that the
average consumer, or average employer, or even average
investor, has no idea what the level of nominal GDP is.
However, they do have a pretty good idea of what inflation
is because they experience inflation when they go shopping.
There is a risk from NGDPT that inflation expectations
become unanchored because monetary policy remains loose
even after the economy has recovered (to make up for the
shortfall in nominal GDP during the recession). The 1970s
demonstrated quite clearly that rising inflation expectations
can spiral out of control. This could paradoxically lead to a
central bank with a NGDPT regime being forced to tighten
policy to shrink real GDP before the economy has recovered.
If you want nominal GDP growth of 5% per annum but
inflation is spiralling out of control at 8% you actually need
real GDP toshrinkby 3%.
There is a parallel between NGDPT and the idea of credible
irresponsibility (seeEconomist Insights, 17 September 2012).
A commitment to nominal GDP would allow a central bank
to credibly ignore inflation. This would be most important for
a country where inflation expectations have been anchored
belowwhere the central bank wants them. This is not the
case for the UK, but it does suggest that if any country
should be first to try NGDPT it is Japan.
Another explanation for Governor Carneys focus on flexible
inflation targets is that he knows that to change the central
bank regime now would look like opportunism. Investors
and consumers would come to doubt the governments
commitment to any monetary regime if they change the
regime at exactly the point when it is most convenient forthemselves. If they change it once, might they not change
it again? Here is the advantage of the regular reviews
that the Bank of Canada has in place changes look less
opportunistic when they follow a pre-scheduled review.
So if we are not going to see the introduction of NGDPT in
the UK, what changes will the new Governor put in place?
The first change would likely be an explicit variation in the
time horizon over which the Bank of England will aim to
get inflation down to target at the moment, that will be a
lot longer than expected, and this would be communicated
explicitly. The second change could be more explicit
conditional commitments to keep rates low until certain
criteria are met, much like the Federal Reserve has done. The
third change is likely to be that Governor Carney will be more
focused on longer-term inflation expectations than short-
term inflation expectations (for example, looking at 5 year
-5 year forward breakeven inflation). All of these measures
would make the Bank of England look a lot more like the
Federal Reserve, but maybe that is the objective?
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