After 20 years, time to change Merv’s medicine?

It is too early for Sir Mervyn King to be demob happy. The process of finding his replacement may be down to “four or five” appointable candidates. But tonight he decided to opine on the two decade anniversary of inflation-targeting.It’s exactly twenty years after Black Wednesday since a formal visible inflation target became the anchor, the fundamental axiom of British macroeconomic policy.

And if the record had ended at 15 years in 2007, then there would be little debate that it would be seen as a rousing success. But the five years of stagnation, or near-depression has cast a doubt on its effectiveness, and of what went wrong.

Sir Mervyn’s central case is a defence of inflation targeting. However, he uttered words that I would never have imagined from a sitting BoE Governor: “It would be sensible to recognise that there may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises.”

The inflation target works in theory because it acts as an anchor, a self-fulfilling virtuous circle where all players in an economy: workers, businesses, the markets, and the government, they all know that the aim is to hit the target, currently set at 2 per cent CPI. Now, the governor says or admits that the anchor is flexible.

 Whilst this is not an abandonment of the target, I do think this will evoke a real political debate about the ongoing relevance of this target. Remember, actually setting the target is a political decision.

Thinkers in both coalition parties have been pondering about a move to a different type of target, a nominal GDP target which involves targeting a bit of inflation and a bit of growth (indeed the Bank, post QE seems to have done this anyway). There are others: a price level target, or an employment/real GDP target which has effectively been adopted in the US by the Federal Reserve.

Alternatively the inflation target could be set higher, at say 4 per cent. Some of the most brilliant minds in economics currently believe a nominal GDP target is the way to go, and that was the mood at the Jackson Hole meeting a few weeks ago.

All of this is wrapped up into the strange world of quantitative easing. Inflation targets sit uneasily with QE. The Bank of England believe that the mere existence of a credible commitment to the target has anchored inflation at 2 per cent, even as £375bn of money has been created out of thin air. Even when inflation topped 5 per cent, it did not stay there, even as electronic printing presses rolled.

 But what if the Bank of England has massively overrated its powers? What if low inflation is explained more by a total absence of wage bargaining power, not the inflation target?

The end result of this debate, is whether politicians in Britain want to engineer near-zero interest rates for years to come, irrespective of inflationary pressures. Today’s sluggish UK numbers from the IMF, ONS and Niesr (albeit an indication of that the recession is over) show just the start of the challenge.

 The first test of this may well come a little sooner than expected, when the first gilts bought under QE start to mature next year. But more on that later.

 For now, Sir Mervyn may have unlocked Pandora’s box. Do politicians have any radical ideas?

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