While the Bank of England might not follow the Fed and change its inflation remit, we doubt this will stop it from significantly loosening policy and from keeping it loose for a very long time.
- While the Bank of England might not follow the Fed and change its inflation remit, we doubt this will stop it from significantly loosening policy and from keeping it loose for a very long time.
- The Fed announced last week that it will now seek “to achieve inflation that averages 2% over time”. As inflation has been below 2% for a while, this implies it now wants it to be above 2%. And the shift from focusing on “shortfalls” rather than “deviations” from full employment implies it will respond to a weak labour market, but not a strong one. Taken together, this suggests that US monetary policy will be kept looser for longer than might otherwise have been the case. (See here.)
- We doubt the Bank of England will shift towards an average inflation target soon for three reasons. First, the need is not as strong for the Bank as for the Fed. Inflation has been higher in the UK than in the US over the past two decades. The average rate of CPI inflation in the UK has been 2.2% since the switch to the CPI target rate in 2003, compared to 1.8% in the US. (See Chart 1.) What’s more, since 2018 inflation expectations have not drifted down as much in the UK as they have in the US. (See Chart 2.) And the 1% band around the 2% target gives the Bank more leeway than the Fed had to put up with higher inflation.
- Second, unlike the Fed, it is not in the Bank of England’s gift to amend its remit. That’s something only the Chancellor can do. Admittedly, with government debt headed further above 100% of GDP, it is hard to believe that the Chancellor wouldn’t want a combination of low interest rates and higher inflation. But any adjustment would certainly take time and wouldn’t be introduced until the Budget in late-2020 at the earliest or until after the conclusion of the Bank’s strategic review in 2021.
- Third, even then the Bank might not be keen. Both Bank Governor Andrew Bailey and Deputy Governor for Monetary Policy, Ben Broadbent, have pointed out that at a time when both government debt and central banks’ balance sheets are rising, it is important to underline the independence and the credibility of the central bank. That implies the Bank of England might be wary of any changes that could be seen to reduce either its independence or credibility, such as the government asking it to let inflation rise.
- Admittedly, it could be argued that the Bank’s latest pledge not to tighten policy until it is close to “achieving the 2% target sustainably” is a move towards tolerating higher inflation. (See here.) But the Bank has said that this is more about signalling to the markets that it won’t tighten policy until inflation actually rises, rather than signalling that it is willing to accept inflation above 2%. This demonstrates the Bank’s ability to achieve much the same results as the Fed (i.e. anchoring market interest rates) without the possibility of its independence or credibility being called into question. And we expect the Bank to continue to use forward guidance to do this. Here it could take a leaf out of the Fed’s book, by strengthening its guidance, perhaps by pledging not to tighten policy if the unemployment rate falls below the estimated equilibrium unemployment rate, unless that fall is accompanied by actual signs of inflation.
- Of course, if further down the line inflation remains muted, the Bank may resort to more drastic changes, including negative interest rates or changes to its inflation target. But other than strengthening its forward guidance in the next year or so, we are not expecting any big changes to the remit. Even so, if we are right in thinking that the Bank will eventually announce an extra £250bn of QE and keep interest rates at 0.10% or below for five years, the end result is likely to be much the same as in the US.
Chart 1: UK CPI & US PCE Inflation (%)
Chart 2: 5-year Break-even Inflation Rates (%)
Sources: Refinitiv, CE
Sources: Refintiv, CE
Ruth Gregory, Senior UK Economist, +44 (0)7747 466 451, firstname.lastname@example.org