Tom Spencer is an associate of Young Voices and the main organizer of London New Liberals.
It is impossible to predict what the Bank of England will do next. Despite strong signs that it would tighten at the last meeting, the Monetary Policy Committee (MPC) opted to keep rates. Such deceptions create uncertainty and chaos in the financial market. The Treasury should change the bank’s mandate by asking it to target gross domestic product (GDP) to provide certainty and thus stability to the economy.
There are rules that govern the bank’s actions. For example, its mandate states that it is necessary to maintain price stability and help meet the government’s economic policy objectives, that is, strong, sustainable and balanced growth. While maintaining price stability and economic growth sounds simple, it’s a controversial job. For example, we are seeing an increase in inflation right now, but growth is still lower than expected before the pandemic. It is unclear, under the current mandate, how the bank should respond to such a turbulent period.
The recent actions of the MPC symbolize these problems very well. Before the meeting, members like Huw Pill endorsed limits to quantitative easing and warned of the risk of inflation exceeding five percent. This signaled one thing: that they were going to tighten monetary policy. As a result, investors bought sterling, hoping to take advantage of the higher return on savings as the value of the pound rose. So when the bank surprised them by keeping rates and buying, it caused the value of pounds to plunge by more than one percent.
Instability like this is extremely detrimental to investor expectations and consumer confidence. According to Nobel Prize-winning economist James Buchanan, the ability to predict the value of a currency allows greater economic coordination lending itself to better economic results. Buchanan’s theoretical observation is consistent with more recent empirical analyzes. For example, a 2014 article in the Journal of Control and Economic Dynamics found that the eras of rule-based central banking are associated with higher levels of economic performance.
The best idea of how to achieve this rule-based system is one popularized by the American economist Scott sumner. He argues that instead of the bank having discretion to do what it wants based on its idea of what stable prices and strong growth mean, it should have a simple goal: to ensure that GDP increases by a certain percentage annually.
The main benefit of this is that it is a much more accurate measure of the business cycle. When we are in danger of overheating, GDP will rise, causing the bank to moderate the market by raising rates; In the meantime, if the economy needs stimulus, the bank will provide it. Under the current regime we simply do not have this level of protection. Currently, if growth is low and inflation is high, we always have uncertainty and debate about whether we care more about growth or jobs.
Targeting GDP would solve the need for such discussions and provide more certainty for all, leading to better long-term results. According to an article in The Quarterly Review of Economics and Finance, This mandate could reduce volatility by up to 25% relative to the current approach.
This will be particularly important in times of economic crisis. Before the great recession monetary policy was quite strict despite a massive drop in GDP, due to inflation fears. This led to a drop in asset prices that caused highly leveraged companies like Lehman Brothers to bankrupt. It wasn’t until this failure that the real economy took a hit, resulting in a financial crisis that turned into a Great Recession. If the Federal Reserve had stepped in by loosening the money supply earlier, we probably wouldn’t have seen the global crisis that we saw.
Even if the recession hits, then targeting GDP is in a better position to help resist it. In 2011, when the Great Recession peaked, an oil crisis, similar to the one we are seeing now, resulted in temporarily higher inflation levels globally. Despite GDP indicating no risk of overheating, the bank responded by raising interest rates. Naturally, world oil prices fell again and the overheating did not occur anywhere. But the nations that accepted the temporarily higher prices continued to recover from the crisis, while The eurozone plunged into a debt crisis.
The current uncertainty generated by confusing signals and actions from the bank is hurting both consumers and businesses. It’s no wonder consumer confidence is at its lowest since January, when we simply can’t make long-term spending plans without knowing how expensive our debts will be in the near future. Targeting GDP would eliminate this uncertainty and provide more stability during turbulent periods. If the government wants to protect our macroeconomic future in the long term, then it is best to do so by changing the mandate to a regime of GDP targets.