Is ditching inflation control the next best thing to the gold standard?

Are central banks due a revamp? As we look to safeguard our economy for the future, Joey Simnett investigates whether targeting growth, rather than inflation would mean central banks made better decisions

The Bank of England (BofE) has always been the subject of heavy scrutiny for the way they handle our money, something that has only increased following the financial crisis. Most people’s understanding of the BofE’s role as the country’s central bank is that is does three things:

• Decides how much money to print
• Decides interest rates
• Talks about how and why it makes these decisions

But could there now be a new model of operation for how the BofE works? A concept known as ‘NGDP (Nominal Gross Domestic Product) targeting’ has been suggested by various economists as a new way for central banks to better help the economy.

The governor of the Bank of England, Mark Carney

The current way monetary policy is conducted is known as inflation targeting. This was adopted by the BofE in 1992 following the UK’s disastrous exit from the European Exchange Rate Mechanism. In 1998 the then Chancellor, Gordon Brown, made the bank ‘independent’ of government and since then inflation targeting has been led by the bank’s Monetary Policy Committee (MPC).

Inflation targeting involves the MPC setting the ‘bank rate’: the charge for lending to private banks. This effectively translates to the nation’s ‘official interest rate’, which is adjusted depending on the economic forecast. If inflation goes above 2%, interest rates are increased, and vice versa. The theory is that the monetary levers will keep the economy at a consistent inflation level, delivering macroeconomic stability.

Central banks, not central players

The goal of taming inflation became a national economic priority in the 1980s as the economic mainstream moved away from Keynesian consensus of politico-economic discretion and toward a more free-market approach such as that exposed by economists such as Milton Friedman and Fredrich Hayek.

The idea was that monetary policy should no longer initiate ‘easy money’ for political purposes at the expense of long-term economic health. Instead it should be a neutral, supporting mechanism in times of crises. Money should prevent demand collapses, while the markets should engage in the long-term economic planning. In short, central banks should aim to ‘set the rules of the game’ but not be the game’s main players.

Money printing should be neutral

However, whilst this framework has served the economy well for many years, a recent criticism is that the BofE’s inflation mandate has seen it run contrary to this vision by increasing the discretionary scope of their monetary tools and engaging in arbitrary behaviour to stick to their ‘targets’. Some would say this was demonstrated by the erratic and clumsy jump to asset purchasing (QE) which effectively led to money printing. Critics also highlight the lack of transparency over when QE would finish, and concerns over government pressure to stick to their mandate, even if it would mean using monetary policy inappropriately to respond to economic shocks.

Tinkering too much?

The use of such discretion in central banking is not a problem to be taken lightly: George Selgin, director of the Centre for Monetary and Financial Alternatives at The Cato Institute, notes that sceptics of monetary planning of all stripes are not ‘particularly impressed with “blackboard economics” demonstrations that an ideal, discretionary central bank regime can fine-tune monetary policy to avoid economic cycles while maintaining stable prices”.

They understand that a fiat money issuing central bank can make the money supply do practically anything, he says. ‘[But] while this includes “just the right thing”, in practice, discretion-wielding central banks often do things that are quite wrong.’ Selgin points to a banking history littered with notorious illustrations of hyperinflation due to excessive money-printing: ‘One needn’t harken back to Weimar or further. It will suffice to know what happened not long ago in Zimbabwe, or what is happening now in Venezuela.’ Whilst a modern-day central banker in the UK would be appalled at such reckless regimes, bad policy can set central banks on a similarly irresponsible course.

So what’s the antidote?

Advocates of NGDP targeting suggest instead that central banks simply streamline the process by laying out the tools in advance and adjust inflation to achieve a growth goal. If the NDGP target is 4%, and GDP growth is 2%, inflation should be 2% because: 2% growth + 2% inflation = 4% nominal growth. Following the financial crash central banks would have been able to say, as per expectations, that they were printing money to achieve a nominal growth figure, eliminating monetary policy opacity. In essence printing money via a growth formula, rather than a liquidity concept.

Could NGDP targeting help the Federal Reserve?

Sam Dumitriu, head of research at the Adam Smith Institute, describes how NGDP targeting can strip away the adventurous tendencies of central banks: ‘[Whilst] inflation targeting isn’t [inherently] discretionary, following the rules strictly will likely lead to real-world problems. For instance, tightening interest rates in response to a short-run demand shock makes sense, but tightening interest rates in response to a supply shock makes less sense. The BofE can’t control supply and it weakens the ability of markets to adjust to the shock.’

‘In reality, the BofE knows this and tries to look through supply shocks while responding to demand shocks. The problem is that it forces the Bank to distinguish between supply and demand shocks creating room for discretion. [By comparison] this process is automatic under nominal GDP targeting.’ For instance, an adverse supply shock would raise prices, which would contract spending. Under inflation targeting, monetary policy would be used to tighten interest rates to reduce prices whilst also contracting demand, when the appropriate policy would be to avoid a money supply contraction and allow the market to adjust.

One of NGDP targeting’s most prominent advocates, economist Scott Sumner, argues that it would ‘depoliticise monetary policy, and eliminates the need for fiscal stimulus and bailouts of politically connected firms during recessions. Across the pond it would also make the Federal Reserve, the central bank of the US, more accountable and is broadly consistent with the dual mandate of price stability and full employment.

Sumner goes on to say that currently the way the Federal Reserve works is ‘ill-defined and allows each side of the political divide to argue whether money is too easy or too tight. NGDP targeting would provide more transparency about whether policy was overshooting or falling short, as a single, easily monitored variable would be the policy target.’

Reflected in gold?

The distaste for ‘arbitrary’ central bank behaviour by NGDP advocates is echoed by those in favour of the gold standard – indeed they find themselves in a similar camp but with technically different prescriptions. Selgin, as someone with experience in both schools of thought, outlines the distinction: ‘There are two sorts of systematic “rules” that might be employed to manage paper money without simply having a committee make regular ad-hoc decisions concerning its future course. There are “quantity” rules such as NGDP targeting, which suggest money growth based on a basic number or a formula based on economic variables. And there are ‘convertibility’ rules such as the gold standard, which says “let anyone convert a unit of central-bank money at any time into a unit of some good,” meaning central banks’ ability to create money is limited by its holdings of the good in question.’

Is NGDP targeting reminiscent of the gold standard?

A gold standard advocate may be incredibly sceptical of NGDP targeting, pointing out that it’s simply another form of monetary planning, in addition to permitting monetary expansion in times of crises. Selgin suggests there is an inherent suspicion around hypothetical alternatives, and that it comes from the perceived grassroots nature of the gold standard and ‘convertibility rules’ in general: ‘It’s something the public itself has control over: by exercising the option to convert money into gold, they “police” the rule, instead of trusting in some more complicated, and perhaps less reliable, control mechanism.’

Selgin credits the classical gold standard for being ‘the best monetary system the world has ever seen’, owing to it combining long-term stability and predictability of purchasing power within fixed exchange rates. In his view, the First World War put paid to the gold standard and an NGDP rule would be the best hope for those who believe in a return to a rule-of-law based approach for monetary policy in the modern era.

Any sort of ‘rules-based’ system would still be an improvement compared to a discretionary system, fiat or not, says Selgin. ‘[Nominal GDP] is making inroads, at least as a step toward reducing the role of unlimited bureaucratic discretion in monetary policy. In that regard it does share a common characteristic with the gold standard, in that either a strictly-enforced NGDP rule, or a gold standard, serve to replace to some extent the “rule of men” with the “rule of law” as a basis for monetary policy.’