I consider three policy scenarios. In the first scenario (the green line), the central bank can credibly commit to its future policy settings. I do not regard this as attainable in practice over anything other than very short time horizons, as central bankers generally cannot tie the hands of their successors. But it does provide a useful benchmark against which to judge alternative policies. The nominal interest rate is cut straight to its zero lower bound and remains there for over six years, far longer than is necessary to bring output back to potential and enough to generate subsequent overheating and excess inflation. But it is precisely that expectation of temporarily higher future inflation that reduces expected future real interest rates and boosts demand today. In the second scenario (the red line), the central bank cannot commit in this way; the best it can do is simply to set policy on a quarter by quarter basis. Interest rates are again cut to their zero lower bound but now the monetary stimulus is withdrawn earlier, after about four years, and there is no overheating phase. The consequence is that expected real interest rates are higher than under the first scenario, demand is weaker and the output gap larger. From a welfare perspective, the first scenario offers a better outcome, because – at least in the model – the overheating period is a price worth paying to generate higher activity and less deflation in the near term.
So the central bank’s mandate needs to permit a temporary undershooting of its inflation target if it thereby reduces the risk of a subsequent painful bust. The past few months have, however, seen questions asked of our inflation-targeting framework for other reasons. According to some, the framework has constrained the ability of monetary policy to support the recovery; an objective giving higher priority to growth or employment might have produced a better outcome. A particular, and increasingly popular, variant of this involves combining growth and inflation into a single target for nominal income. The first thing to be said is that the MPC’s mandate already incorporates a growth and employment objective. While our primary objective is to maintain price stability, subject to that we are also expected to support the Government’s policies for growth and employment. The Chancellor’s annual remit letter puts flesh on those bones, by specifying not only the 2% target for CPI inflation but also the Government’s desire for high and stable growth and employment. And the letter goes on to note “that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances (and that) attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output.” If we had tried to offset the impact on consumer prices of, say, sharp movements in import prices, then we would need to engineer countervailing movements in domestically generated costs, in particular pay.