WHAT COMES AFTER INFLATION TARGETS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

What comes after inflation targets

By Samuel Brittan

Published: July 1 2010 21:55

There is more to economic policy than bank regulation, which so often (like other regulation) amounts to closing the stable door after the horses have bolted. We must not forget the traditional aim of providing a framework for economic growth with low inflation. The main instrument for achieving this has been inflation targets pursued by semi-independent central banks by means of a very short-term official interest rate. As Robin Pringle, the editor of Central Banking, remarks in the latest issue of that journal: “The current dominant framework of monetary policy may not survive its association with the crisis, and perhaps does not deserve to.” There is every sign that many central banks want to cling leech-like to this failed framework. Yet I doubt if they will be able to avoid a rethink.

The old regime failed for many reasons. The most common criticism was that it focused on inflation to the neglect of growth. Moreover, it focused on only one type of inflation – consumer prices – to the neglect of asset prices. But above all it engendered a false sense of security. There is no magic formula that remedies all these defects. But I have long been in favour of a regime that would be a step improvement. That is to replace our regime of using monetary policy just to target inflation with an approach targeting the flow of spending in the economy, or nominal gross domestic product.

A big obstacle to its adoption is the hideous name it has been given by economic professionals. But it should not be a mystery to anyone who can live with the more familiar GDP. It is easy to overlook the manipulation that raw data go through to take inflation or deflation out of the estimate to get real GDP. All that nominal GDP means is income and expenditure at actual prices without this manipulation. It can be presented as demand management with an inflation lock, or as a money supply target adjusted for velocity.

During the Great Moderation of the 1990s and early 21st century, nominal GDP growth hovered in the UK at just over 5 per cent per annum. At the low point of the recession last year it dipped to minus 5 per cent. According to Bank of England estimates it is now growing at 3.5 per cent, but this represents renewed inflation more than real activity. This illustrates perhaps the most important property of a nominal GDP objective. At low rates of inflation it is a growth objective and would be a check on the excessive cautionary zeal now so fashionable in Group of 20 countries. But at higher inflation rates, growth has to recede in favour of price stabilisation.

The answer to “How do you achieve the nominal GDP objective?” is through the normal instruments of monetary and fiscal policy. All nominal GDP can do is to give some sense of direction. It is important not to oversell the nominal GDP. It is no use, for example, to the short-termist. Estimates for this variable are published in the UK every three months, with a lag of a further two. Doubtless if there were sufficient interest, the data could be improved. Even so, it would still fluctuate erratically from quarter to quarter; and, to obtain a meaningful trend, it would be best to take a moving average. Nor would it avoid the need to watch for asset bubbles as a separate concern. There are also questions about whether to have a national or international objective and how far an individual country can go out on a limb. Then the old dilemma of whether and how to make formal forecasts arises. Above all there is the question of what to do about “base drift”. Do we need a period of above normal nominal GDP growth to make up for the recent recession? Or do we let bygones be bygones? Of course, similar questions arise in relation to alternative goals such as monetary targets or real GDP.

Too many policy discussions concentrate on means without specifying ends. They are like arguments about which route to take without saying where one wishes to go. Nominal GDP at least spells out a destination.

Copyright The Financial Times Limited 2010.