Catherine Mann of the Bank of England says inflation will stay above 2%. But what if the problem isn't inflation but is the target itself?
The 2% rule was invented in the 1990s to please markets, not to help people.
In this video, I explain why our obsession with hitting that number is crushing wages, stalling investment, and protecting the rich at the expense of everyone else.
It's time for an inflation policy that serves people, jobs, and the planet, and not financial markets.
This is the audio version:
This is the transcript:
Catherine Mann, who is one of the members of the Bank of England's Monetary Policy Committee that sets the Bank of England's base rate in this country, with the aim of controlling inflation, has said recently that inflation will stay above 2% for some time to come.
Now, I don't agree with everything that Catherine Mann says on a great many issues, but I have a suspicion that she's right on this one. Where she's wrong is with her answer. She says that means that we have to keep monetary policy tight, which is code for keeping interest rates high. But what if the problem isn't the fact that the economy is simply running with an inflation rate of around 4% at present, but that the problem is instead with having a target of 2%? Suppose we're just trying to crush the economy to achieve something that is itself pointless. That's what I want to talk about in this video.
The 2% inflation target is not scientifically determined. It was based on politics. It was invented in the 1990s by the Central Bank of New Zealand, and nobody knows why it picked that number. It was simply plucked out of thin air in the height of the hype of the neoliberal era, to reassure markets that central bankers were in control of the destinies of the fortunes of the wealthy by keeping inflation low.
They were given power. That is, central bankers were given power by elected governments to achieve that goal of keeping inflation low. In most countries in the world where we have independent central banks, there is no other goal that is set for them. Everything is supposedly decided within our economies for the single purpose of keeping inflation low, and nothing else matters.
But the truth is, there is absolutely no empirical evidence to show that a 2% inflation rate optimises either growth or jobs. It's just become a ritual target which central bankers want to prove they can hit, and they try to prove it more for the sake of, well, trying to suggest their own virility is intact than anything else, as far as I can see. You could say it's about trying to prove the credibility of finance, but whatever it is, that credibility has come at a massive social cost.
We've faced pandemics, wars, climate shocks, and supply fragility since that 2% target was set. The world has, in other words, changed phenomenally since the mid-1990s, and yet the inflation target remains the same.
And that ignores the fact that, in many senses, inflation is the price of adaptation to deal with the shocks that I've just described. More than that, it's a measure of the resilience in the system. Low inflation does imply we have reached a point of relative stability, but controlled and moderate inflation is simply an indication that we are going through a process of change and nothing more or less than that. So long as the inflation doesn't go out of control, and there's no reason why it should if we stand back and understand the reasons why the inflation is created, which is normally precisely because we have pandemics, wars, climate shocks, and supply fragility, none of which are influenced by the rate of interest in any particular country, then we will adapt to the situation that is developing and go back to the mean, which is a very low inflation rate.
More than 500 years of history in the UK, or rather, I should say in England, because the UK hasn't got that long a history, has proved that this is the case. Whenever there's been a shock of the sort I've described, usually a war in the case of England, but the others as well now, then there might be an inflation hike, but very soon after, there's a fall, and the trend is always to return to normal without ever having had central bank's involvement in the process of achieving that outcome by changing interest rates. Change in the value of money is not, then, an indication of a policy failure; it's simply the reality of adaptation inside the economy.
So is it the case that we're using the wrong tool, the wrong weapon to try to tackle inflation? Are interest rates just a blunt and aggressive instrument for this purpose, which achieves no real outcome?
After all, upping interest rates hurts mortgage holders and renters, but rewards banks.
It discourages productive investment.
It discourages the activity that is necessary to manage climate change.
And there is absolutely no indication at all that it solves inflation caused by external shocks like COVID.
So what is really going on? Is Catherine Mann actually simply saying that she doesn't like the higher wage demands that are the current result of higher inflation expectations? Is what we are really seeing: a war on labour? Are we really seeing the bank's paranoia about labour power being revealed? And is monetary discipline really something no more than social control hidden behind the disguise of inflation control?
After all, the bank has admitted that we do have modest growth and a softening labour market. In fact, that's inevitable because if you increase interest rates above the rate of inflation, and they have now managed to do that for a period of time, then the consequence is going to be that there will be a tightening within the economy. High rates of interest, after all, crush spending and stall investment, and that's exactly what the Bank of England has done. The fact that we have an economy that is not functioning well is the consequence of an economy crushed by the Bank of England's policy to take inflation out of it, which is actually exacerbating inflation expectations.
They're choosing stagnation, and that's the problem. A 2% inflation target might keep markets happy and workers disciplined, but in practice, all it is doing is protecting financial assets from mild devaluation when we all know that stock markets are overvalued, houses are almost certainly overvalued, and esoteric supposed savings vehicles like Bitcoin are off the scale with regard to the price being paid for them. And whilst those asset prices are being protected, jobs are being sacrificed, innovation is being lost, and fair outcomes within society are being foregone.
So what if we changed the question?
What if we didn't ask how to force inflation to be 2%, but instead said, " What level of inflation supports full employment and a green transition, and what level of inflation protects those on low incomes from real hardship?" We would then get targets that would fit the world we live in, and not the one that no longer exists. Wouldn't that be a better choice?
We would get fiscal policy in that case that encouraged investment and infrastructure development, and fair taxation as a means to control real inflation through, for example, changing the rate of VAT, rather than getting inflation management through interest rate changes, which appear to have no beneficial impact at all, either on inflation or anything else. We would end up with a situation where we would actually get proactive management of the economy for the greater good.
But instead, by choosing just one economic goal, instead of many, we end up with economic policy that is balanced against price stability, full employment, and our biosphere and climate.
A single number can never define success. If inflation stays above 2%, it doesn't mean the economy is broken. That's my core message.
It simply means that the inflation target is no longer working, and that is my second core message.
Inflation targets should serve people. That's my third core message and not the other way round.
We need other targets, in other words, and that's my fourth core message.
We do need to care about people, employment, investment and our planet, and they're much more important than protecting the value of financial assets. That's what we need as economic policy, and we're not getting it.
Catherine Mann does not understand the job that she's been given by the Bank of England, and nor does anybody else on that committee either come to that at this point in time. And as a consequence, we are in deep trouble. But we don't need, and this is fundamentally important, we don't need an inflation target of 2%, which drives all economic policy, because that is incredibly harmful.
Taking further action
If you want to write a letter to your MP on the issues raised in this blog post, there is a ChatGPT prompt to assist you in doing so, with full instructions, here.
One word of warning, though: please ensure you have the correct MP. ChatGPT can get it wrong.
Comments
When commenting, please take note of this blog's comment policy, which is available here. Contravening this policy will result in comments being deleted before or after initial publication at the editor's sole discretion and without explanation being required or offered.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
There are links to this blog's glossary in the above post that explain technical terms used in it. Follow them for more explanations.
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
Buy me a coffee!
The Bank of England explain that they have a 2% inflation target set by the government.
Researchers have given us some context around the US-called “natural rate of interest” (also called r*), and the models used to calculate it. They 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
But actually, there is still no rational explanation for 2%, and I am not alone in thinking so. Krugman agrees, for example.
May be the banks like getting the 2% and in fact would like more. Not that banks ever consider the consequences.
I am not sure I follow your logic.
This argument of yours needs to be repeated over and over again.
The inflation figure is arbitrary. But if you want growth, you have to pump money into the economy and risk inflation. And so, we appear to go nowhere.
What this always indicated to me was a lack of creativity and discrimination over the most useful deployment of money. Money produced is not all the same – base money is not credit issuance. Discriminating on that issue might be able to create differential interest rates based on social utility. What we have instead is Lord of the Rings like ‘one interest rate to bind them all’ – a strangle hold on fiscal policy that plays to private banking sector/city of London.
This lack of discrimination and the blindness to how tax helps curb inflation due to an anti-tax theology does us no favours at all.
I was thinking about the 4 million people your wrote about yesterday that have to borrow just to keep their heads above water. I also know there are about 17 million people in the UK living in mortgaged houses. Goodness knows how many have car loans or other consumer credit that exceeds their ‘current assets’. Maybe (unsurprisingly) half the UK population are ‘net debtors’, and the other half net lenders…
In the short term inflation of course hits the poorest hardest – but in the long term, if they remain net debtors, inflation will reduce the real value of their debts. They gain. It’s the lenders, the UK financial sector and the wealthy individuals that own it, that are the real long-term losers from higher inflation and lower interest rates – and that can be compensated for their inflation losses with higher interest rates.
The question is, of course, whether Reeves, Mann, etc, really don’t understand – or is it simply another case of the UK economy being run for the benefit of the City, for the haves rather than the have-nots ?
Agreed.
If inflation is higher, then the Bank of England will need to create more money. With inflation of 2% the government needs to create 2% of GDP, £50 billiion, in new money to compensate and maintain the real value of money in the economy. If inflation is 4%, which may be appropriate, then the government would need to create £100 billion. In fact, since inflation is actually nearly 4%, the BoE should create that money anyway irrespective of the inflation target.
On top of this the BoE needs to create more money to support growth. That might be another £50 billiion.
That’s a lot of money, which is not currently being created. It’s probably a significant reason for our economic problems.
Perhaps one of the reasons for a higher rate of inflation is, not only to allow more flexibility for the economy to adjust to shocks, but also to allow the government to create more money and increase spending. Or perhaps those are just two sides of the same coin.
You get it
Thank you for that. Nice and clear.
One question: when do we reach the point where inflation is out of control? Is it 10%, 20%? or is it variable depending on the situation?
It is only out of control when it will not reverse because of the natural course of events. It almost invariably does.
Understood. Thanks for the clarification.
The UK government is unlikely to alter the fiction “it’s the BoE’s job to control inflation”. Why? Because it absolves the UK government from “blame” if this pushes interest rates up.
The 2% gaol like everything else in neoliberalism is a big iron rod to beat the more and more suffering 90% of the UK population.
Economists are fantasists, following self imposed theories and rules that bear no relation to real world experience.
For example when are they going to wake up to increasing public sector salaries in the UK does not impact on inflation for the simple fact that at the moment 99% of UK public services are not charged for at the point of service to the public.
With the UK economy currently flat lining keeping interest rates high and imposing more government funding cuts is most certainly not going to encourage growth.
To increase interest rates when world oil prices shot up after the Russian invasion of Ukraine, and when supply chain prices rose in the wake of the pandemic seemed just as absurd as medieval blood letting.
Even as they were doing it I think the BoE did acknowledge the interest rate rise would have little effect on those prices, so they were sort of doing it as a flag waving exercise – to signal that they were aware inflation had shot up, but they didn’t warn about the damage it would do to people and the economy..
At least the US Federal Reserve has to target ‘ maximum employment, stable prices, and moderate long-term interest rates’, which seems more nuanced , would allow the BoE to consider lower interest rates now that employment is obviously being damaged by the high rates.
It might seem a bit cavalier – to say ‘inflation always comes down again’ after a spike. It can wreck peoples living standards in the short term – lower income people – so action could be needed to protect them.
It might be cavalier – it’s also true and the only thing to do in 99.5% of cases. Sorry.
There’s an interesting article by Larry Elliott in this morning’s Guardian online. I do not always agree with him but on this one he seems spot on.
I might ask him to discuss it here.
I strongly suspect the answer to why 2% is similar to why the EU has a 3% deficit rule, the EU actually got it from France and the reason they had the rule was that in 1981 Mitterrand had asked three civil servants to come up with a rule he could sell to ministers. One of the three explained the choice of a 3% rule as
“In a hurry, lacking ideas, but reckoning that a reference to the GDP ensures to be taken seriously, especially by those people who have studied a bit of economics but not too much, we build the elementary ratio deficit on GDP, a round object, a nice chimera (using the word etymologically),”
In a TV interview I heard one of them say (from memory so paraphrased slightly)
“we needed a good number and the holy trinity is three so that’s a good number”
The French rule became the EU rule because in 1990 another French bureaucrat, Jean-Claude Trichet, was leading a working group on the Maastricht Treaty and German negotiators insisted on including a rule for rigorous budgets, so Trichet proposed the French rule.
Since then various mainstream economists have written reams trying to give it a robust economic justification but the truth is it was just ‘pick a number’
Much to agree with
Why 2%? is an important question that ought to be asked more often, and it is good that it is raised in the Guardian today as well as here. In fact it ought to be asked in Parliament every time there is a Budget or Financial Statement, and adjusted if there isn’t a good justification.
It is absurd that it is the only target for the Bank of England. There should be something equivalent of the wider remit Andrew Broadbent describes above for the Federal Reserve. I see some rationale in interest rate decisions being delegated to non-politicians because otherwise partisan electoral considerations take priority over economic needs, but the Bank is hamstrung by having a single tool at its disposal.
On the basis that someone sometime must have had some sort of imprecise logic for choosing this target I suspect it was a number high enough that a drift towards deflation could be headed off, but at the same time low enough to be manageable (in the short term) through adjusting discretionary expenditure of both businesses and households. Much larger and there is a risk that businesses make anticipatory price rises, and employees make anticipatory pay claims. Both those could mean inflation becoming self-perpetuating which the government isn’t going to see as desirable.