The impact of changing the inflation target

Readers Question: The task of MPC is to stabilise inflation at 2%. Current inflation is around 5% and the Bank of England has to tighten the Monetary policy to control the inflation. If the Government revises the inflation target and set it to 5%, then what would be the effect on the economy and what would be the role of the Bank of England in those circumstances?

If the inflation target was changed to 5%, you would expect a very dramatic cut in interest rates.

Even with an inflation target of 2%, I think interest rates could fall to 2%. See – case for interest rate cut

Note: As well as targeting inflation of 2%, the Bank of England have to consider wider macro economic objectives

The Chancellor in his letter of 11 March 2008 allows for some flexibility. The
remit says that

“….the objectives of the Bank of England shall be
a) to maintain price stability
b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.”

It also says that :
“The framework takes into account that any economy at some point can suffer from external events or temporary difficulties, often beyond its control.  The framework is based on the recognition that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances.  Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output.”

Quoted in speech by David Blanchflower at Bank of England

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If an inflation target was increased to 5%, the Bank might actually struggle to keep inflation that high. This is because cost-push inflation is falling, so they would need higher growth. However, even a drastic cut in interest rates from 4.5% to 1% may not avoid an economic slowdown. In a recession, there can be a liquidity trap. This is when lower rates don’t increase demand for money (e.g. banks just aren’t willing to lend money.)

If the inflation target was changed to 5% permanently, it would be more difficult for the MPC to target inflation. This is because, inflation of 5%, will increase inflation expectations and increase the volatility of the inflation rate. If we go back to the ‘boom years of 2003-07, if the Inflation target had been 5%, interest rates would have been lower causing an even bigger boom in house prices.

However, maybe changing the inflation target is just a temporary event to reflect  cost-push inflation. You could argue, the government should have changed the inflation target earlier in the year, when oil prices were rising. However, to increase the inflation target now, is too late. The cost-push inflation is over, it makes no sense to target inflation of 5%, when inflation is forecast to fall to 2% anyway.

Also if you change the inflation target, it may reduce the credibility of monetary policy. Some might say, what is the point of having an inflation target if it gets changed when circumstances change?

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