Asset management

11 February 2013

Economist Insights Moving target
Governor Mark Carney, soon to take up his appointment as next Governor of the Bank of England, gave evidence to the UK parliament’s Treasury Committee last week. The market may have been looking for an announcement of big changes for UK monetary policy, but Governor Carney’s comments left 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. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management

Gianluca Moretti Fixed Income Economist UBS Global Asset Management

The announcement last November of Mark Carney’s 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’ by numerous 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 crossexamination by the UK parliament’s Treasury Committee last week. In previous speeches he had indicated some interest in quite revolutionary ideas. In the event, markets were disappointed; Governor Carney’s 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 Carney’s calls for regular reviews of the monetary policy 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 shouldn’t just be close to target, but should average close to the target over time. So if inflation is above target for a few years, under PLT the central bank would need to have inflation below target 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 longterm 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.
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 with 2% inflation). 10 5 0 -5 -10 -15

1998 2000 RPIX Gap

2002 2004 2006 CPI Gap (Dec 2003)

2008 2010 2012 Nominal GDP Gap

Source: ONS, UBS Global Asset Management

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 because weak 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 to shrink by 3%. There is a parallel between NGDPT and the idea of ‘credible irresponsibility’ (see Economist 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 below where 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 Carney’s 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 government’s commitment to any monetary regime if they change the regime at exactly the point when it is most convenient for themselves. 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 shortterm 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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