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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

joshua.mccallum@ubs.com

Gianluca Moretti

Fixed Income Economist

UBS Global Asset Management

gianluca.moretti@ubs.com

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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