The Bank of England should consider replacing its inflation-targeting regime with one focusing on nominal gross-domestic-product growth, U.S. economist Scott Sumner said.
Targeting nominal GDP growth, which is not adjusted for inflation, would clarify the bank’s mandate and lessen its reliance on unreliable price indicators, Sumner, an economics professor at Bentley University in Waltham, Massachusetts, said in a report published today by the Adam Smith Institute. It would also moderate the severity of financial bubbles and crises.
Pioneered by the Reserve Bank of New Zealand two decades ago and now followed by more than 20 central banks globally, inflation targets aim to control expectations of future price pressures and give clarity about the path of interest rates. Sumner said such regimes are flawed because they rely on consumer-price indicators that are affected by factors not requiring a monetary-policy response such as sales taxes and exchange rates.
Inflation is “measured inaccurately and doesn’t discriminate between demand versus supply shocks,” Sumner said in a telephone interview. “Inflation often changes with a lag and sometimes when you go into recession, it doesn’t change very easily, but nominal GDP growth falls very, very quickly, so it’ll give you a more timely signal stimulus is needed.”
The U.K. central bank should target annual nominal GDP growth of about 4 percent to 5 percent, Sumner said. This would also lead to a better coordination of monetary and fiscal policy, he said. The Office for Budget Responsibility, the British government’s fiscal watchdog, last month cut its forecast for 2011 economic growth to 1.7 percent from 2.1 percent.
The U.K. government shouldn’t be in a position where it is “reluctant to cut the budget deficit because of fear of the effect on the recovery,” Sumner said. “With nominal GDP targeting, you have the assurance that any slowdown in nominal GDP due to budget tightening can be offset by monetary policy.”
U.K. inflation accelerated to 4.4 percent in February, more than twice the central bank’s 2 percent target. That has pushed three of the bank’s nine-member Monetary Policy Committee to vote to raise the benchmark interest rate even before the full impact of the government’s fiscal squeeze is felt.
Bank of England policy makers are “in a little bit of a bind where they would really like to carry forward with a little bit more stimulus, but they’re getting pressured by the high inflation numbers to tighten,” Sumner said. “There really is a danger that if they tighten at the same time as the fiscal policy tightens, you could have a double dip.”
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