The Governor is changing, so why not the Bank of England too?

BY Joey Simnett   /  1 August 2019

It’s been nearly six years since Mark Carney took the reins of the world’s eighth-oldest bank, and he’s due to leave next year. With fresh blood comes fresh eyes, so what better time to fundamentally change how the BofE should operate?

It’s no secret there are those who have been very unhappy with how the Bank of England have behaved since the financial crisis. Unpredictability and lack of transparency from a central bank is highly disruptive to markets, and they had that in spades when it came to QE.

But this is just one example of a systemic problem in the Bank of England, and at some point one has to wonder if there’s a better way to manage our money.

Currently, the BofE operates under a system known as “inflation targeting”. The Monetary Policy Committee (MPC) meets eight times a year to review economic data, and they initially use a limited amount of policy tools to make sure inflation stays at two percent.

A manageable inflation level is indeed necessary for economic stability, as any Venezuelan will tell you, but a policy of inflation targeting means the MPC will try to reach that cherished two percent inflation rate, even if it’s not what the economy needs.

If inflation is above two percent, the BofE deems the economy to have “overheated”, and they raise interest rates to reduce demand and therefore inflation. If inflation sinks, they lower the interest rates to bring demand and inflation back up.

The problem is that what we call “inflation”, or price changes, doesn’t just change when demand does.

Let’s say Greta Thunberg was completely right, and London suddenly flooded. This would represent a catastrophic supply shock and prices would skyrocket. Would it be appropriate to suddenly tighten interest rates to keep prices down?

Absolutely not. The central bank can’t do anything about a supply side shock, it’s simply a reflection of underlying conditions rather than more arbitrary fluctuations in activity. The higher prices are a signal to show resources have become more scarce.

If the Bank of England raised interest rates in that situation, you would have a double whammy of both lower demand and lower supply, which would most likely tank the economy.

Now, the clever people at the MPC know this, so they try their best to make sure they only respond to demand-side shocks. The problem is that inflation targeting forces central banks to discern between the two, and it’s often the case that these differences are far more subtle than London flooding.

Sometimes the BofE gets it right, like when they refused to tighten monetary policy in the years following the 2008 crash. We needed to avoid a negative, self-sustaining demand spiral that would have made recovery difficult.

But in the early 2000s, immigration skyrocketed thanks to an oversupply of labourers from Poland, which resulted in a lower inflation level in the UK through a positive supply shock. Yet, the BofE increased inflation in response to meet its target, which arguably contributed to the financial crash.

So what sensible person leaves the fate of our economy to people whose right decisions often correct their wrong decisions? What happens next time there’s a crisis and the BofE guesses wrong? Prolonged economic agony for everyone, that’s what.

We need a system which can respond to our economic needs in a neutral, predictable manner which is free from human error. Thankfully, this system exists, and it’s called Nominal Gross Domestic Product targeting.

Simply put, NGDP targeting is where you create a target for NGDP growth, which is economic growth without adjusting for inflation. You then take the amount of real economic growth for a time period, and adjust the inflation rate to reach the target.

Let’s imagine the NGDP target is four percent, and there’s a low rate of real growth in the economy, say one percent. The BofE would attempt to create a three percent inflation rate. If there was a high rate of real growth, say six percent, the BofE would make inflation minus two percent.

Under the current system, the immigration in the early 2000s represented a potentially dangerous deflation that the BofE needed to stabilize. Under NGDP targeting, NGDP would have gone up, and so prices would have fallen to reflect increased productivity.

NGDP targeting does the decision making for the BofE; it would create an automatic stabilizer for the economy that markets know about in advance. No more random jumps to QE that disrupt market planning: it’s all known in advance.

This is a much more accurate and reliable way of conducting monetary policy. Bad management of money can prolong or even cause depressions, so why leave it to chance? We’re automating more and more jobs every day, it’s time the BofE followed suit.


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