The three ages of inflation targeting

Since the Bank of England was granted independence back in 1997, there have been, roughly speaking, two ages of inflation targeting.

The first ran from 1997 to 2007: inflation was almost peculiarly and reliably on target, whether that’s RPIX, the measure the Bank’s Monetary Policy Committee used to target, or CPI, which it moved over to in 2003. Interest rates also moved within a relatively narrow band: ignoring the first year or so, they were somewhere between 4% and 6% – which most economists would regard as fine tuning. And as such there was a good degree of clarity on where the Bank would move rates at a given point in the future.

The second age of inflation targeting ran from 2007 to the end of 2012. In this period, inflation was far more volatile and unpredictable. It lurched up above target and, during the recession threatened to drop back beneath it. Monetary policy was similarly wide-ranging, with interest rates coming down from just below 6% all the way to zero – not to mention going effectively below zero when you include the monetary impetus of quantitative easing.

But the key thing about this age of inflation targeting was that the Bank of England devised a means of signposting its future decisions which, over time, became rather well-proscribed. There was, as I wrote in 2009, a “trick” to reading those smoke signals – the Kremlinology of Threadneedle Street.

If the Bank’s Inflation Report predicted that inflation would be below target in two years’ time (the length of time it takes, roughly speaking, for an interest rate change today to take full effect on the economy) it generally meant that the Bank would try to stimulate the economy more. This might mean lower interest rates, it might mean quantitative easing, but, sure as night followed day, a signal of this sort implied action would follow in the coming months. And vice versa: if the inflation forecast signalled inflation would be higher than the 2% target two years hence, it would imply that the Bank would tighten policy: raise rates or reverse quantitative easing.

Which brings us to this year, and the beginning of the third age of inflation targeting at the Bank of England. Check out the graph below.

This is the latest Bank inflation forecast. Look at where inflation is most likely to be in two years’ time (the darkest part of the red fan chart, at that dotted line). It’s above target. Now, hitherto, this would have been regarded as a “tightening chart”: that because inflation was above target in two years’ time. However, the steer delivered by the Bank at the press conference was clear: there will not be any tightening any time soon.

Then, in the minutes to this month’s MPC meeting, published earlier this week, we learnt that not only was this not a “tightening graph”, Sir Mervyn King judged it to be a “loosening graph”. He voted for £25bn more quantitative easing – the kind of action he would only have taken previously when he expected inflation to be heading below target.

Now, this may all sound rather academic, but it’s a fundamental part of Britain’s economic plumbing. Signalling your future rate movements is a key element of a country’s monetary policy framework. Those smoke signals matter – they provide investors and policymakers with an indication of how cheap or otherwise it will be to borrow in the medium term.

And what’s happened in the past few weeks is that that signalling system seems to have been abandoned. Now, there are some mitigating factors – among them the fact that the Bank is trying, for the purposes of inflation targeting, to ignore the part of inflation caused by higher tuition fees, transport costs and gas bills.

But nonetheless, it does feel as if we’re moving from  an age of predictable inflation targeting to another more unpredictable era. There are big question marks over whether the new Bank Governor, Mark Carney, will want to change the target, even if it does only amount to fiddling at the edges. And all of the above is one of the reasons why the pound has fallen so much in recent weeks. In part it’s because investors think there could well be more QE. But in part it also reflects a deeper concern, that the long-established system of predictable monetary policy in Britain might be going out of the window.