Andrew Lilico: Politics, the inflation target, and what Conservatives should say

Andrew Lilico is a Member of the Shadow Monetary Policy Committee and former ConservativeHome columnist.

In this article I shall argue that there has been a significant failure of political leadership, from Gordon Brown and Alistair Darling, regarding the UK’s inflation target.  The significance of this failure is becoming magnified in the difficult policy situation we face in 2008, has already undermined, and threatens to undermine further, the hard-won credibility of UK monetary policy.

The Bank of England Act (1998) specifies the Bank of England’s goals in respect of monetary policy (interest rates, money supply, exchange rates, and so on) as

(a) to maintain price stability, and

(b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.

What “price stability” means, and what the “economic policy of Her Majesty’s Government” is are political matters, to be specified by the Treasury.  Current practice is for a letter to be sent, at the time of each Budget, from the Chancellor to the Governor of the Bank of England, defining “price stability” in terms of a target for the next year’s annual inflation rate.

The idea is that what the Bank of England’s target should be is a proper matter of political debate, whilst how it goes about achieving that target is, under this scheme, treated as a technical/operational matter best left to the Bank’ Monetary Policy Committee (MPC) (and hence, as it were, at arm’s length from politics).  There has been past political debate over the Bank’s inflation target — for example, the Conservatives went into the 2001 General Election promising to reduce the inflation target (from 2.5% to 2%), whilst the change of the inflation index from the Retail Prices Index to the Consumer Price Index in 2003 was criticised by the Conservatives.

As specified by the Chancellor, the UK’s inflation target is currently for consumer prices to rise annually at 2%, and if inflation deviates by more than a percentage point from the target then the Governor of the Bank of England must write a letter to the Chancellor explaining why.  In April 2007, for the first time, Governor Mervyn King wrote such a letter, after the March 2007 consumer prices index rose 3.1%.  In a recent speech, Governor King predicted that two more such letters might be required in 2008, implying inflation possibly being above target for three or more months.

When inflation went above 3% in 2007, members of the MPC were keen to emphasize in speeches that this did not mean that they had missed their target.  In the most formal sense this was correct: the remit letter from the Chancellor to the Bank states explicitly that:

“The thresholds do not define a target range.  Their function is to define the points at which I shall expect an explanatory letter from you because the actual inflation rate is appreciably away from its target.”

So, the MPC members told us, the inflation target is 2%, not 1%-3%.  There is no material difference between inflation of 2.9% and inflation of 3.1% — all that the latter means is that we must explain ourselves to the Chancellor, which we did, and he was happy with our explanation.

But once we go beyond the most formal interpretation of “target”, I submit (and shall shortly explain) that what the MPC argument here amounts is either (a) they have changed their target for themselves; (b) the Chancellor has changed their target; (c) their target was not what everyone thought it was.  Here is why.

Inflation targets were introduced around the world in the early 1990s.  (The first was, as it happens, introduced by New Zealand.)  The UK inflation target came in in 1992 following the pound’s famous ejection/withdrawal from the ERM.  In the early days of inflation targeting there was a debate between those that preferred to have a target band (say, a target of 0-2% or 1-3%) and those that thought it best to have a point target (say, 2.5%).  Each of these approaches had significant drawbacks.  If the target is a point of 2.5%, say, then we almost always miss the target (even if monetary policy were so precise that inflation could be kept at an absolutely precise level — which it is not — we would not want to do so anyway, because things would become very rigid, creating unnecessary unemployment and stifling growth).  Since we will always miss, the target might lack credibility, and since for practical reasons we would not mind missing most of the time, it would be unclear to what extent policy was actually constrained by the target — by how much is it okay to miss on any one occasion?  Would 10% inflation be okay, this year, provided that we say we aspire to get inflation back to 2.5% sometime-or-other?  An inflation target would then become, at most, a communication device, rather than any sort of rule or constraint on how interest rates should be set.

So perhaps a band would be better (this was what most countries did, initially)?  But the problem with giving the central bank a band of discretion was that it would tend to allow inflation to drift towards the top of the bank, even in relatively benign times (after all, it was precisely because, left with discretion, policy-makers tend to allow a bit more inflation than is best, that we have things like inflation targets at all).  So, in New Zealand, where the inflation target was initially 0-2%, inflation tended to be around 1.8%.  But then if even minor things went wrong, inflation went above the top of the band of discretion, the target was missed, and credibility was lost.

So it seemed like neither a band nor a point was really the way to go in terms of the inflation target.  This led to the one particularly attractive feature of Labour’s 1997 monetary policy reforms: the use of an inflation target that involved, in some sense, both a point and (something like) a range.  When I used to lecture in monetary policy, that was how I (and everyone else) understood the UK’s inflation target.  The target was 2%, with a range of discretion of 1-3%.  (Indeed, Ben Bernanke (Governor of the Fed), in his well-known book on inflation targeting, even refers to inflation targeting as a regime of “constrained discretion”.)  Because the target was 2%, that meant that inflation should not indefinitely tend towards the upper end of the range of discretion.  But because the range of discretion was 1-3%, we knew exactly how far it was acceptable for inflation to be from target at any one point in time (so 10% was not acceptable).  The understanding of the letter-writing process was two-fold.  First, it was the formality by which a failure to meet the target was acknowledged and responded to by the government.  Second, there might be some force majeure that excused going outside the normal band of discretion on this one special occasion (for example, if there were a large earthquake that led to shortages and price rises, we wouldn’t want the MPC to whack up interest rates in response).  But it was definitely supposed to be that inflation of 3.1% was to be considered much more worse than 2.9% than 2.9% was to be considered worse than 2.7%.

But apparently, given what MPC members said in 2007 and what they are saying now, the MPC does not understand its target in this way.  It considers that it’s fine to allow inflation to go above 3% in 2008 — indeed, despite giving speeches saying that this is likely to happen, the MPC is cutting interest rates rather than raising them!  And inflation did not go above 3% in 2007 because of some unanticipated force majeure — the effects of student fees and oil prices on inflation had been known long in advance, and the Bank itself, some eight months beforehand, stated that it believed there was a material chance of inflation going above 3%, yet did not adjust interest rates to address that.  Similarly, MPC members are now saying, well in advance, that inflation may well go above 3%, despite their having time to enact policy to avoid that.  It isn’t that they couldn’t stop inflation going above 3% (above their band of discretion); it’s that they don’t believe it is appropriate to do so.

But (and this is the key political point) it is not a matter for the MPC to interpret its own target.  The target is set politically.  The MPC just enacts it.  Unless the Chancellor is not telling us something, no-one has told the MPC that inflation of above 3% in 2008 should be considered okay, because (say) it is more important to address the slowdown in economic growth than the rise in inflation.  It may be that it is indeed better to allow inflation to rise at this time (though I consider that doubtful, at best), but it is not for the MPC to decide that.  The MPC’s job is to meet its inflation target, and its mandate under the Bank of England Act is to put price stability ahead of growth and unemployment.  If it would be best, this year, to target 3% inflation rather than 2% inflation, that is something that the Chancellor should be telling the Bank of England.  Otherwise what has happened to our inflation targeting framework?  If the Bank writes letters every month saying “4% inflation is okay this time”, and “5% inflation is okay this time”, and that’s it, then what content is there in the annual inflation target at all?

The problem that has arisen here is a failure of political leadership.  Last year, when inflation went above 3% and the MPC went around saying that was okay, Gordon Brown was silent.  Indeed, even in his formal reply to Mervyn King’s letter explaining why inflation was greater than 3%, Gordon Brown effectively said “Yes, sir.  No, sir.  Thanks very much for explaining that to me, sir, a humble ignoramus in these matters.”  That was not how the letter exchange had ever been imagined — at the very least, one had expected the Chancellor’s reply to be stern, saying something along the lines of “Very well.  I understand that it was impractical to avoid inflation going so high on this occasion, but do make sure it doesn’t happen again unless absolutely necessary!”  Last year we needed Gordon Brown to confirm whether he understood the inflation target in the same way as the MPC members: that we have a point target without any limited band of discretion, that there is no policy significance of inflation being just above as opposed to just below 3%, that the supposed advantages — which I and others used to wax lyrical about — of the UK’s inflation target over the older-fashioned band or point targets used in other countries were always an illusion, that inflation targeting is not (as we had all thought) a regime of constrained discretion at all.

It is for the Chancellor to set and interpret the inflation target.  But he failed to do that in 2007, and without that necessary political leadership, the Monetary Policy Committee has had no choice but to define its target for itself.  And since MPC members clearly consider that their target for 2008 should not be 2%, but, instead, something higher, they have felt obliged to reinterpret their inflation target s so that achieving 3% (or more) falls within the target.

We need, as a matter of urgency, the Chancellor to answer the following questions (which I believe that George Osborne would be well-placed to ask):

1. Does the Chancellor agree that it is for the government, and in particular him, to set and interpret the inflation — not the Monetary Policy Committee?
2. Does the Chancellor share the Monetary Policy Committee’s interpretation of the inflation target — that it is a point target of 2%, and that there is no difference, in policy terms, between being just below and just above 3% inflation — or does he regard the target as consisting of a point target (2% CPI inflation) and a +/-1% band of discretion within which the Bank has freedom of manoeuvre, but outside which inflation should not be permitted to stray if policy can prevent it, except in the most extreme of circumstances?
3. Does the Chancellor consider it acceptable if inflation goes above 3% in 2008?
4. If it is acceptable for inflation to rise above 3% in 2008, how much above 3%?  Would 5% be acceptable?  And will the Chancellor amend the 2008 inflation target to reflect his view that inflation above 3% is acceptable this year?

Whilst these questions remain unanswered, markets are unable to interpret what the UK’s inflation target means.  For nearly 15 years, from 1992-2007, UK inflation never once went outside the band of discretion that its inflation target provided.  This made the Bank of England unique among major international inflation-targeting monetary authorities.  As a consequence, inflation expectations in the UK were heavily anchored at 2.5% (following the old RPIX target), and the Bank was able to adjust policy, quite dramatically at times, to keep growth going almost always at above 2%, in good times and bad, with splendid consequences for the British economy.  But since inflation exceeded 3% (since, as most of us understand matters, the inflation target was breached for the first time) inflation expectations have drifted up.  If inflation goes above 3% for a sustained period during 2008, inflation expectations will rise again.  We desperately need political direction.  Are Gordon Brown and Alistair Darling up to providing it?

Comments

[Richard]

Shouldn't the Tories call for a return to the old RPIX measurement? Since the CPI has come in inflation has been allowed to rise further because the CPI doesn't show as high a figure as RPIX. Isn't the RPIX rate around 4% at the moment?

[Tony Makara]

Inflation finds its impetus from two sources. Firstly as a result of interest charged on loans to business, which has to be written into the final costs of goods and services, this inevitably adds to the price but as long as interest rates are stable there will be a relative level of price stability. The second, and most damaging source for inflation relates to imported goods, which go up in price whenever our currency weakens. This creates a problem because it means we are forced to adopt a strong pound policy, which in turn weakens liquidity and pushes interest rates upwards. This in turn takes us back to the primary inflationary impetus caused by interest charged on loans to entrepreneurs. So in effect we are caught between the two.

A way out of this impass is to move the economy away from dependence on imports and to establish a steady rate of interest which operates within a certain band, say, 3% to 6% over inflation, allowing for expansion and contraction of the economy but at the same time not restricting liquidity. At the point our economy stands today we cannot cut interest rates when we need to because that is going to import inflation, this is caused by our over dependence on imported goods, in particular foodstuffs and fuel. If we are serious about creating long-term economic stability we must end import dependency and set bands to control interest rate movements. That way we can control the two principle sources of inflation, which in turn will control the knock-on effects of inflation such as wage demands.

[Alex Swanson]

Firstly as a result of interest charged on loans to business, which has to be written into the final costs of goods and services, this inevitably adds to the price

No, you have it the wrong way round. The price is fixed by supply and demand; the money available for interest payments results from businesses which find it profitable to borrow in order to be able to sell goods for that price.

This creates a problem because it means we are forced to adopt a strong pound policy

No government other than a totalitarian one sets the price of its currency; if the pound is weak and imports correspondingly dearer then that is a result of inflation not a cause.

Inflation is actually caused by expansion of the money supply, in turn caused by govt and banks issuing more money than is covered by the actual value of goods and services in the market. Everything else is a symptom.

If we are serious about creating long-term economic stability we must end import dependency and set bands to control interest rate movements.

Oh, we're back to protectionism and state control. It's been tried. It doesn't work, either in theory or in practice.

Tony, I don't wish to be nasty, but economics is clearly not your thing.

[Tony Makara]

Alex Swanson, firstly I don't want to hijack Andrew's thread because its on a serious matter which needs to be discussed, so we will have to save arguments about protectionism for another time.

Alex, are you really arguing that business does not have to cover the additional cost of interest on loans and doesn't write it into the final cost of goods and services? Yes, the response of demand to supply governs pricing to an extent, but achieving price stability isn't that simple. There are many other factors such as interest rates, such as currency fluctuations, etc that all play a part. I can't see how you can object to making interest rates operate within a band, it can only add to economic stability.

[Alex Swanson]

Alex, are you really arguing that business does not have to cover the additional cost of interest on loans and doesn't write it into the final cost of goods and services?

Yes, of course it does, but the cost does not affect prices, it affects profits, and at the margin, it will just result in the goods not being supplied at all. The price itself is outside the suppliers' control because it is set by the market.

There are many other factors such as interest rates, such as currency fluctuations, etc that all play a part

You mustn't make the mistake of mistaking symptoms for causes. Currency fluctuations, for example, are the result of economic instabilities, not the causes.

I can't see how you can object to making interest rates operate within a band, it can only add to economic stability.

Because interest rates are a result of the economy, not an input into it. If you try to artificially keep interest rates somewhere the underlying economy says they should not be, you will only store up problems which will bite you later.

[Tony Makara]

Alex Swanson, if the cost of interest isn't written into the final costs of goods and services business will lose money. You have to admit that the current economic system, one that breaks down under every government needs to be changed. It breaks down because it doesn't work. That is why serious thought has to be given to creating a new economic system, one that allows free enterprise but at the same time will bring discipline to the economy. The primary objective has to be price stability which we will never have with a floating currency, or without imposing sensible controls on interest rates. The current system breaks down time and time again because it doesn't work.

[Alex Swanson]

if the cost of interest isn't written into the final costs of goods and services business will lose money.

That's what I said! But that doesn't mean that the cost can simply be passed on to the customer, nor that this cost can be reduced by simply having the government pass a law saying so.

It breaks down because it doesn't work.

On the contrary, it works amazingly well. It's created more wealth in a few generations than could have been dreamt of.

bring discipline to the economy

Ooh, fascism! Do we get uniforms?

The primary objective has to be price stability which we will never have with a floating currency, or without imposing sensible controls on interest rates.

I've just explained above why this won't work, and hasn't worked in the past when it's been tried. Simply restating the thesis doesn't change this.

[Tony Makara]

"Ooh, fascism! Do we get uniforms?"

Alex Swanson, please try to be sensible, this is a serious subject. Don't ruin Andrew's thread. I have put forward ideas, people will either agree or disagree with them. Have you any ideas to contribute?

PS: The system which you say works 'amazingly well' was really working well last week wasn't it?

[Yet Another Anon]

Shouldn't the Tories call for a return to the old RPIX measurement?
Rather better to produce a new index including Housing Costs, RPIX left a lot of things out and is just as flawed as cpi.

I think replacing the Pound with a new currency would be a good idea, apart from anything it would kick any notion of the UK joining the Euro even further into touch - how about bringing back the Shilling as 5p and then having a new currency based on 100 Shillings - the Century Shilling perhaps.

Inflation must be kept low, energy prices are likely to be higher than other things in the future and some foodstuffs due to global changes in diet and consumption, and use of some edible oils in alternative fuel.

[David Belchamber]

As a layman (but somebody determined to nail Brown for the deceitful politician that I believe him to be), there are two essential points about inflation, the first of which Andrew disposes of to my total satisfaction:

"But (and this is the key political point) it is not a matter for the MPC to interpret its own target. The target is set politically. The MPC just enacts it".

i.e. however much Brown tries to pass the buck, responsibility for inflation clearly lay with him when Chancellor (and as Darling is little more than a ventriloquist's dummy, it still does).

The second point is to question: which index best represents inflation AS VOTERS UNDERSTAND THE WORD?

As council tax, petrol, energy prices, food, etc are going up way above 2%, the index chosen by Brown is purely academic and means nothing to voters, to the unions wanting pay rises that do not represent a drop in earnings and, of course, to pensioners.

Abstruse economic theory is meat and drink to Brown but we need someone living in the real world and the sooner the tories start reminding people about the real rate of inflation under Blair/Brown, the better our electoral chances will be.

The conservatives haven't taken Brown apart (as far as I aware) for his confusing of the CPI and The RPI, when he boasted (last week at PMQs?) that inflation is now 2% but was 10% in the 1990s under the tories.

I am assuming that Brown actually does know the difference: is he therefore lying (sorry "misleading us") or was it another example of this government's incompetence?

Either way, he made a bad mistake and should be punished publicly (though it would have been more effective had DC dealt with it immediately Brown made the statement).

[Tony Makara]

"replacing the Pound with a new currency would be a good idea"

Yet Another Anon, a world currency unit will happen within the lifetime of many reading this. It is inevitable. The cash economy will inevitably be replaced by a credits economy too. Perhaps in the long-run this is what the world needs to end the misery caused by arbitrage and those that make a parasitic living out of forex. Its easy to see a scenario down the line in which north American, European and Asian currency units are merged into one global currency unit.

[Andrew Lilico]

a) Do any of you think that Osborne should ask the questions I propose?
b) Do any of you see a political downside in raising the issue in the way I set out?

[Tony Makara]

Andrew Lilico, its worth bearing in mind that with the pound falling against the Euro the MPC isn't going to do much more that shadow the ECB. When the ECB cuts the BOE will feel confident to cut, the very real danger of a weak Sterling and a strong Euro will send the price of EU goods in the high street rocketing up well above 3%, so the BOE is pretty much tied to the ECB and even if we desperately need interest rate cuts we won't get them unless the ECB cuts too, and the ECB is focused on watching inflation rather than trying to increase liquidity.

[Roger Taylor]

It is, of course, possible to launch into a long diatribe on this. I pointed out in another thread that current official inflation data is highly manipulated to such a degree that it is now far removed from the genuine underlying rate of inflation in the economy. (As an aside, there is a classic footnote on the ONS website stating that the CPI and RPI indices are not meant to provide measures of the “cost of living”, a statement which might perplex many who assume that inflation measures should do exactly that.)

In my view, the official inflation data has been deliberately manipulated in order to purposely understate the true level of economic inflation as that builds in a positive, structural skew to pubic finances.

That aside, there is a real danger in imposing a rigid inflation target on central banks. We are seeing that danger now. Instead, central banks should be tasked with achieving broader economic stability. This is more the role adopted by the Federal Reserve which will base current policy upon the broader needs of the economy. Inflation will be an important input into that decision but will not necessarily be the main driver, unlike the case in the UK. As a result, the Fed can be more responsive to current trends in the cycle. There is a further rationale for not setting a rigid inflation target, which is that inflation is often a lagging indicator at the tail end of an economic cycle. This is exactly the moment at which policy errors are most likely to occur.

Alex, your comments are broadly right. Tony, your desire to control imports is perverse. If currency realignment makes imports more expensive, then, at some stage, you would expect substitution to occur. There is no sound economic protectionist argument to suggest that it is a mechanism for genuinely controlling inflation. After all, the greater the potential source of supply, the lower the likely end cost. In addition, the level of interest rates is a consequence of other factors in the economy. It is not a price that simply be regulated and controlled any more than you can control the price of bread in a modern economy.

Back on topic: My final comment would be that the gap between economic inflation and the manipulated figure is now so great that no incoming government could afford to bring the latter into line with the former. That cost would be measured in terms of massively deteriorating public finances and higher interest rates. The distortion is therefore set to persist.

[Tony Makara]

"If currency realignment makes imports more expensive, then, at some stage, you would expect substitution to occur"

Roger Taylor, this cannot readily occur in terms of foodstuffs, when as a nation we are not producing enough for a nation of our size. We can make do without many manufactured imports but the dependence on imported food and fuel makes us vulnerable to currency differentials. We will be far less prone to imported inflation if we produce most of what we need ourselves. This will also create more jobs for our people and lead to equilibrium price levels as demand and supply will more readily fall into sync as we are able factor out the unpredictability of currency differentials.

[Roger Taylor]

Tony, can you think of an example of any closed economy which supports your view of Nirvana?

[Andrew Lilico]

I am surprised and disappointed by the nature and quality of the discussion here. One of the great merits of inflation targeting was supposed to be that it would focus monetary policy debate onto something concrete, that people cared about - namely what should the rate of inflation be - rather than the arcana of interest rates, exchange rates and so on. Yet none of the commenters so far appears interested either 1) in engaging with the questions I raise in my piece and again in a short message above:a) Do any of you think that Osborne should ask the questions I propose?
b) Do any of you see a political downside in raising the issue in the way I set out?
or
2) engaging in the closely related discussion of what should the inflation target be next year.

You are spending a lot of energy discussing issues about which you manifestly know little. I urge you to focus on the debates I raise, which are the stuff of politics rather than bar-room third-pint-economics discussions/rants.

I'm frankly amazed. It's no wonder we have a Labour government. Brown and Darling are squandering our monetary credibility, and even on a well-known political discussion board like this, with many politically interested contributors, no-one wants to discuss it.

[Tony Makara]

Roger Taylor, I do not advocate a closed Korean style Autarky. Just that we become self-sufficient economically. I believe in free-enterprise and believe there are things we shall always have to import. However importing goods that we can produce ourselves simply because they are transiently cheaper is short-sighted economic opportunism rather than economic expediency which is good for the nation in the long run.

[Tony Makara]

"You are spending a lot of energy discussing issues about which you manifestly know little"

Andrew Lilico, thats a little patronizing isn't it. You are not the font of all economic knowledge and you should show respect for those who contribute here. There have been some very interesting posts here today. My line of work is security, not economics, but that does not mean I'm ignorant of economic matters. The same goes for the other contributors. To equate our opinions with 'third-pint rantings' shows a poor sense of judgment and a egocentric point of reference.

[Yet Another Anon]

Yet Another Anon, a world currency unit will happen within the lifetime of many reading this. It is inevitable. The cash economy will inevitably be replaced by a credits economy too.
I think cash is here to stay for quite some time to come in one form or another, electronic transfers still occur in one currency or another and money is still only as good as the ability to pay of the issuing authority.

As for a world currency, the closest to that is the dollar, a world currency would require some kind of monetary union and every sign is that many countries large and small would not accept such a thing occuring on a global scale and most would not for some time to come, probably hundreds maybe thousands of years.

[Andrew Lilico]

Tony@15:16

I've no objection to your sharing your theories - good on you, and perhaps you will convince everyone that standard economic theory is nonsense. But it remains the case that the issues I raise are straightforwardly the stuff of standard non-technical economic debate, whilst the discussion here has been a technical debate conducted by those without technical expertise. I do not complain about the presence of your economic theories; I complain about the absense of engagement with the (very important) political issues.

[Tony Makara]

Andrew Lilico, it is true that I do not subscribe to the orthodox economists blind faith in the market and its ability to correct itself. Radical economics are more my scene. On the subject of your article, I enjoyed reading it and if I say so it was very well written.

In answer to your question, Yes, I do think you should ask Mr Osborne if he would tolerate a set level of inflation and yes you should ask him whether government is going to play any role in setting the benchmark readings for inflation. You might also ask if Mr Osborne plans to take away the chancellors right to 'intervene if the national interest determines' in any decision taken on interest rates by the MPC, the little known clause that appeared in Gordon Brown's letter to the governor in may 1997. It would be interesting to see if George Osborne is prepared to give the BOE total independence.

[Stephen]

Andrew,

Britain is a country of astounding financial/economic ignorance. Very few study economics at GCSE or A-Level. The majority do not understand money supply, the relationship between inflation and interest rates. Witness how low a level Evan Davis approaches his news items, this is not the case in other countries, i.e. the US.

Do I think it would be politically advantageous to raise the issue of a strict inflation band 1-3% vs. an inflation target 2%, where >3% is okay?

No. I think inflation is an issue like Europe, the public don't understand it. All the public know is that they want low inflation, or perhaps more specifically inflation substantially lower than wage price growth.

Currently the political debate is: "Brown says inflation is low, CPI = 2%, everyone else says inflation is high, RPI > 4%".

The political debate will remain here indefinitely, because the public responds to this as another example of politicians disagreeing on everything and Punch-and-Judy politics. The debate will only move on if CPI and RPI substantially increase, or if someone or a newspaper makes a determined effort to explain the different inflation measures.

I also blame the UK's financial/economic ignorance, for the UK's 1.3 trillion consumer debt and the property asset bubble. No-one aged between 20 and 36, first-time buyers, was of working age through the last house price peak in 1989.

[Roger Taylor]

So, Andrew, to return more directly to your points; you appear to want to keep inflation targeting as the primary tool for determining monetary policy. Why do you consider this preferable to allowing the central bank to set monetary policy appropriate for the overall state of the economy? You might then address the issue of a highly manipulated inflation figure deviating from the true underlying rate of economic inflation. What are the implications of that for the economy, in your view?

[Andrew Lilico]

Roger,

Actually, I prefer price-level targeting, as per

http://conservativehome.blogs.com/columnists/2007/08/two-economic-po.html

and per my books and journal articles on the topic, which go back to 1999.

Furthermore, I was a vigorous critic of the switch from RPIX to CPI as the inflation target, as per
http://www.ncpa.org/sub/dpd/index.php?Article_ID=575

and my journal articles and newspaper and magazine pieces at the time. (Indeed, I also instigated and drafted the Shadow Treasury team's complaints about the switch in the summer of 2003.)

So I'm not particularly apologetic about any of this.

Nonetheless, I do believe that the use of constrained discretion regimes such as inflation targeting is superior to outright discretion for a medium-sized open economy such as the UK. The Fed is a different matter - it's too large an economy to employ inflation targeting (for technical reasons associated with something called "base drift"), though it could use price-level targeting or monetary growth targets.

I could explain these matters in closer detail, but I've already deviated too much from the much more straightforward political issue I raised - that the government, having set an inflation target, is now allowing confusion to reign concerning what the target means, to the detriment of the extremely hard-won UK monetary credibility.

[Conor]

I would also follow on from Roger Taylor and ask why isn't the issue of fiscal policy also being addressed?

[Roger Taylor]

Interesting reply.

As an economist, you must understand the problems associated with setting targets for growth in specific monetary aggregates. Depending upon the level of money supply (i.e. which 'M') you wish to target, you will surely accept that there are a number of factors affecting this which the relevant monetary authority may not wish to seek to control for perfectly sound reasons. I have not read econometric studies of this type for some time yet I suspect that there is no overwhelming evidence that this approach is necessarily a superior method of policy management. That is not to say, of course, that the monetary authorities do not need to apply discipline. I would not be keen to absolve any central bank from a responsibility to manage an economy effectively. It’s isn’t apparent that this is defined solely in terms of arbitrary inflation targets, particularly when the official inflation data is bogus.