30 September 2022

The case for a rolling inflation target

By Andrew Hunt

With both sterling and the Bank of England’s reputation taking a battering as inflation runs out of control, a quick and simple fix is badly needed.

Fortunately, there is one. The Treasury should simply change the Bank’s 2% inflation target from a static target to a rolling one. That means periods of excess inflation (or deflation) would need to be offset by a subsequent period of below target inflation (and vice versa). Thus ensuring the long-term compound average matches the mandated target.

In other words, central bankers who lose control of prices do not get let off the hook at the public’s expense. They have to offset their past mistakes in future. Just as a teenager who has to clean his own room is unlikely to mess it up in the first place, this sort of accountability would encourage more diligent policymaking and long-term thinking.

It would also be popular. Unsurprisingly, voters all over the world do not like inflation. It undermines their trust in the entire capitalist system. Inflation disproportionately hurts the poorest and least numerate members of society. It allows large corporations and government to effectively ‘cheat’ via stealth taxes, fiscal drag or conjuring tricks with diverging inflation measures. The explosion in demand for crypto-currencies and gold is a direct reaction to governments not giving people the monetary security they want.  A fair and transparent approach to monetary policy is essential to the good health of a market economy.

There are two further advantages to a rolling target. Firstly, it enables central banks to maintain credibility, even when inflation or deflation deviates from its target. That sort of strict credibility is invaluable in controlling price expectations, which are often the driver of inflationary spirals. In fact, when it comes to expectations, a rolling target within a credible central bank is anti-fragile and self-correcting: the greater the deviation gets to one side, the greater the expectations for the offsetting deviation that lies ahead. 

This would make the bank’s current calls for wage restraint more reasonable. With inflation likely to stay high, workers are quite justified in their demands to keep up with the cost of living. However, if employers and staff believed that an offsetting period of modest deflation lay ahead, they could accept more modest pay rises (or a one-off bonus) to tide them over until prices came down again. That would reduce inflationary pressures and industrial action.    

The current system is also commercially unsound. No employee would accept a job where their salary fluctuated anywhere between about zero and £18,000 a month, with the only assurance being that now and again, it might hopefully be about £2000. Equally, no one would subscribe to a newspaper where the cover price could be 50p one month and £20 a few months later! Price volatility may be inevitable, but we should at least be able to know what the average will be. A rolling target would allow businesses, investors and the public to plan for the long term. This is, indeed, an explicit mandate of the Bank. However, the current system comes nowhere close to achieving this. 

Crucially, having more certainty around long-term average inflation would make planning much easier for pension funds and other bond investors. It is this uncertainty that has led to chaos in the bond markets, with the bank having to step in with yet more emergency QE – an action that damages credibility, weakens the currency and creates even more inflation. If investors knew that long-term average inflation would be 2%, they would be perfectly willing to buy 10 and 30-year gilts at 4%. That would steady the market and save the bank from any more counter-productive QE. And it would make the byzantine system of pension accounting simpler. 

The Prime Minister has said she is willing to revisit the Bank of England’s mandate. Making this small tweak immediately would go a long way to restoring credibility in sterling, the Bank of England and her Government.

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Andrew Hunt is a writer, investor and policy blogger.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.