The latest speech by the Bank of England’s chief economist Huw Pill contained an admission he probably did not quite mean to make. Speaking at an economic conference in North Macedonia on Tuesday, he warned: ‘Dealing with uncertainty is central to taking monetary policy decisions – perhaps now more than ever.’ This raises one key issue: if monetary policy is being set under conditions of ‘radical uncertainty’ and if the Bank accepts there are limits to what it can do about the inflationary effects of energy shocks, then why is it still clinging to a framework built around CPI inflation?
The trouble is not that the Bank lacks flexibility or good intentions. It is that it has the wrong nominal anchor. The CPI inflation target of 2 per cent appeared reasonable when it was first set in the more tranquil, inflation-targeting era of the early 2000s. Today, it appears more like a trap in a world of energy shocks, shipping disruptions, tariffs and geopolitical turmoil. It forces the Bank to engage in the same pointless debate: should it tighten into a supply shock to protect its inflation-fighting credentials or ‘look through’ higher prices and run the risk of appearing complacent?
At this month’s meeting, the Bank’s Monetary Policy Committee (MPC) unanimously voted to hold rates at 3.75 per cent – a surprise move that left many macro hedge funds nursing significant losses – while acknowledging subdued domestic growth and renewed upside risks from energy prices. Bank staff continued to estimate that underlying quarterly GDP growth in the first quarter would be around just 0.1 to 0.2 per cent. The Bank also repeated the obvious truth that monetary policy cannot influence global energy prices – only the way the economy adjusts to them.
That is precisely the problem. Britain is once again facing a weakening domestic economy while an external price shock pushes inflation higher. This is classic stagflation and exactly the moment when inflation-targeting becomes least helpful and most dangerous.
Pill notes there are limits to what the MPC can do about the short-run effects of oil and gas price hikes, and that policymakers must instead focus on second-round effects. He is right. The Bank cannot control the original shock, yet it is obliged to act because its mandate puts the focus on a random inflation target from more than two decades ago.
All this is happening as the external environment becomes more unstable by the month. Markets have lurched on the back of Donald Trump’s erratic remarks about Iran, with oil, bonds and rate expectations moving sharply within hours. No central bank can construct a coherent short-term policy response when a single Truth Social post can ricochet through global markets before Threadneedle Street has finished its morning coffee.
The trouble is not that the Bank lacks flexibility or good intentions. It is that it has the wrong nominal anchor
The Bank of England cannot reopen the Strait of Hormuz nor can it reverse the supply disruption caused by conflict in one of the world’s key energy chokepoints. Andrew Bailey acknowledged as much this week, saying the resolution of such shocks depends on events at source. That is not a failure of central banking. It is simply a recognition of what central banks have the power to do.
The real question is whether policy should continue to be designed around a single variable – which is itself highly vulnerable to the effects of war, tariffs, blockades and political panic. Or should it instead be organised around something more stable and more relevant to the wider economy?
That is the case for nominal GDP targeting.
If Britain’s trend real growth rate is around 2 per cent, and inflation averages another 2 per cent, then the obvious nominal anchor is a 4 per cent path for nominal GDP. That framework is far better suited to an era of energy shocks, trade wars and geopolitical disorder. The task of monetary policy is not to fine-tune away every external jolt to the price level but to stop such shocks from knocking the whole economy off course.
Would that mean a bit more short-term inflation volatility? Yes, somewhat. However, that is exactly the point. Whether the Bank likes it or not, some price adjustments will unavoidably occur when Britain is hit by an oil, tariff or geopolitical shocks. The choice is not between volatility and no volatility; it is between keeping overall nominal spending on a stable path or tightening policy into an increasingly unrealistic target.
The familiar swipe at nominal GDP targeting is that these datasets are revised. Well, yes – so are plenty of the numbers central banks already use. The real issue is not statistical perfection. It is whether the policy framework fits economic reality. And, on that count, nominal GDP targeting has a far stronger claim than the creaking inflation-first consensus.
Monetary policy cannot prevent external shocks from hitting Britain. What it can do is keep nominal demand on a stable course. That is the task central banks are actually capable of performing.
Jon Moynihan, writing recently in The Critic, described the endorsement of my case for nominal GDP targeting as ‘eccentric’. Perhaps. But in an age of radical uncertainty, clinging to an inadequate framework is no longer good enough. If the Bank of England is serious about contrarian thinking, it should be willing to revisit inflation targeting itself. Nominal GDP targeting would be the obvious place to start.
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