I just posted this video on YouTube and elsewhere.
As I note, a 3% inflation target would work just as well as a 2% one - so why are we going to pay a massive price for getting to 2% inflation?
The transcript is as follows:
The UK's inflation target is 2%, but 3 per cent would do just as well. Let me explain.
The Office for National Statistics has just come up with new data that says that the inflation rate in March 2024 was 3.2%.
Markets have reacted really adversely. They expected it to be lower than that. And they're now saying, as a result, that interest rates must remain higher than we would otherwise want as a consequence of this month's aberration, that inflation fell, but not by as much as they wanted.
The fact is that. they are fixated with there being an inflation rate of 2%. But nobody on earth, and I literally mean that - nobody on earth - knows why the inflation rate that we target was chosen to be 2%. It was created one day, decades ago on the back of an envelope as a convenient target, which it was thought central bankers should aim for, although nobody has ever found out why it was picked.
My point is a very simple one. If they'd picked 3%, first of all, we'd be there.
And secondly, we'd be just as well off as we are.
Actually, heading for 2 percent is going to make us much worse off than we are now.
The reason why is that to get to a 2 per cent inflation target, the Bank of England will keep interest rates high for a long time. So we will have a risk of a recession. We will have a risk of higher unemployment. We will have a risk of lower investment. We will have a risk of less government spending. All of those things are going to make us all worse off. Worse off, all for the sake of meeting a 2 per cent inflation target that nobody can explain why we have.
My suggestion is very simple. Two per cent is not a good inflation target. In fact, it might be a very bad inflation target, because it means that some things will actually be deflating. For example, goods - that's literally physical products - are right now. So instead, fixing at a 3 per cent rate would create a more balanced, more stable and stronger economy.
So why are we continuing with 2%? I don't know. Nobody does. Nobody can explain it. But we're all suffering for it. And that makes no sense at all.
Thanks for reading this post.
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We need positive real interest rates, to encourage investment.
Saving does not fund investment. Banks do not ledn customer desposits. Pension funds almost never fund new investment in any way.
Lending funds investment and you are asking for it to be more expensive. Tell me how you think that will help?
Why would people lend if their investment was going to lose money in real terms?
It makes no sense. Your suggestion would inevitably make the country poorer.
They have done it throughout history
Every mortgage since ww2 has been like that
You explain
Thank you and well said, Richard.
When I wrote my masters on central bank independence in 1994 – 5, I looked at New Zealand, which had the 2% target imposed by Roger Douglas and Don Brash. I could not find the rationale for settling on that target.
A dozen plus years later, working on bank capital requirements, a retired Bank of England official, supervisory stream, told me that the Basel I accords were finger in the air exercises and central bank inflation targets were probably the same.
My colleagues who have researched this got the same answers
Thank you, Richard.
The Bank of England explain that they have a 2% inflation target set by the government, but give us no indication why.
But now researchers have given us some context around the US-called “natural rate of interest” (also called r*), and the models used to calculate it. The conclude that it is “surrounded by very high uncertainty, making it a blurry guidepost for monetary policy”. They note:
“The concept of the natural rate of interest traces back at least to Wicksell (1898), who described it as the rate of interest that would equate saving and investment and be consistent with stable prices. In this vein, the natural rate is generally defined as the level of the short-term real interest rate that would prevail in the absence of business cycle fluctuations, with output at potential, saving equating investment and stable inflation (Borio (2021)).”
Sources
Inflation and the 2% target @ Bank of England
https://www.bankofengland.co.uk/monetary-policy/inflation
BIS Quarterly Review, March 2024 17
Quo vadis, r*? The natural rate of interest after the pandemic, BIS Quarterly Review | 04 March 2024
https://www.bis.org/publ/qtrpdf/r_qt2403b.htm
Wicksell, K (1898): Geldzins und Güterpreise. Eine Untersuchung über die den Tauschwert des Geldes bestimmenden Ursachen, Jena, Gustav Fischer (English translation: Interest and prices: a study of the causes regulating the value of money, Macmillan, 1936.
Borio, C (2021): “Navigating by r*: safe or hazardous?”, BIS Working Papers, no 982.
https://www.bis.org/publ/work982.htm
The real answer is they picked a number
It’s a shame they picked a rational number when an irrational number would be more appropriate. Pi or e might be more appropriate?
🙂
I seem to recall that Keynes introduced the term and used a nominal figure of 5% as the ‘Natural rate of interest” in some of his 1936 writings.
He was definitely in favour of long term steadiness in interest rates at a moderate level to provide certainty for savers and stability for small businesses.
Whether that is a ‘natural rate’ or not is highly debatable.
I don’t think the 5% was actually a recommendation, but it was used in discussing how inflation rates related to savings, aggregate demand and then unemployment levels.
Better information has seriously reduced any natural rate of interest since then as information reduces risk
Do inflation is 1% higher but investors won’t expect any change to the return on their investments?
No wonder you aren’t advising anyone about investments!
Q.Why do values of fixed income assets go down when inflation goes up?
A. Because investors demand higher interest rates to compensate
This is very basic stuff.
I remember the first p60 with £1 million of income on it. The client was really not very pleasant and was decidedly money pinching. He did not last.
Despite the labelling of the Bank of England as “independent” it isn’t anything of the sort. It merely has delegated authority from the government to set interest rates. It does so in the context of a specific remit from the government.
While there may not be a way of rationally coming up with an “ideal” inflation figure, I do see that the delegation wouldn’t work without a target being provided. But I see no reason why the target has to say constant for 25 years; when inflation rates rose in 2021-22 due to external factors outside the government’s or the Bank’s control the government could have instructed the Bank to aim for a set of interim targets, like 5% for 2023, 3% for 2024. Better a “soft landing” than the overshoot likely from keeping money too tight for too long.
I like a moving target….
The CPI level in April 2023 was 130.4, the level in March this year was 133; that’s a 2.6 point increase over those 12 months, which equals 2 percent. (2.6 is a bit less than 2 % of 130.4). Why does the ONS sum the monthly percent changes to get to 3.2%? I must be missing something fundamental here?
I don,t know and have not got time to check the data right now
Sorry…
The “just so” story is that a small but positive and stable rate of inflation is a “good thing”. Stable is good because people can plan for the future with some certainty. (Good luck holding that tiger by its tail.). Rapid fluctuations are bad for everyone. Inflation that is too high is also bad for everyone as cost and sale prices keep changing and wages fall behind. Inflation that is negative – that is deflation – is said to encourage saving rather than spending in the expectation that prices are will fall. So there is a “just right” number somewhere in the middle. This is a similar hand waving argument that is given by proponents of the Laffer curve. I don’t know how much theoretical work might support an inflation target of 2% over 1.5% or 3%.
Like very much of the accepted wisdom of mainstream economics, it is an article of faith with little foundation in reality.