Bank of England is targeting growth not inflation

Thanks to my colleague Namrata for pointing this.

Bank of Engalnd lowered its benchmark rates from 5.25% to 5.00% in its meeting yesterday. Its press release is pretty interesting:

Even if commodity prices remain at their current high levels, inflation should fall back.

Really? Inflation will fall back despite rising prices. How will this happen?

But to ensure that inflation meets the 2% target in the medium term, the Committee needs to balance two risks. On the upside, above-target inflation this year could raise inflation expectations so that, in the absence of some margin of spare capacity, inflation would remain above the target. On the downside, the disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target.

So, despite rising inflation and inflation expectations, BoE expects that financial markets would lead to slowdown. This would lower demand and aggregate price levels.

But as it is well known by now, this inflation is supply led inflation and is a result of years of ignoring the food security risks. Hence, by lowering its interest rate, it is at best trying to ensure that demand does not drop. So, in other words, it is targeting growth rates and not inflation.

Taylor’s rule suggests Central Banks target both prices and growth levels. So, we had multiple target central banks. But an inflation targetting central bank was formed on the presumption that inflation is the biggest enemy of growth. So, if we manage inflation we can manage growth as well.

This was working as long as both growth and inflation were moving in same direction. Now, in these times when inflation is rising  but growth falling,  you would expect a inflation targetting central bank to look at inflation. Isnt it? But BoE is targetting growth instead. (Bank of Canada, another IT Central Bank is also similar in its approach)

Obviously no questions would be asked as it is trying to protect jobs etc. But at the end of the day, it is not sticking to its mandate.

I would suggest Rajan report to look into this matter and be in tune with this reality. By simply suggesting RBI to adopt inflation targeting (IT) is not going to work. If IT Central Banks have been good at managing inflation it was only in good times. In times such as these it is leaning towards growth . So, it is not as perfect as it is made to look out to be.

True, New Zealand and Australia (and other IT Central Banks) have still not cut rates but they don’t have downward growth pressures as of date (though IMF has projected lower Australia growth rate) . So, it will be interesting to see how they react. Like it has been said at numerous places, this IT Central Bank experience has been too short for it to be considered as an outright success. We need to evaluate the evidence properly.