Does the Bank of England Need to Revise Its 2% Inflation Target?

The Bank of England has only hit its inflation target 30% of the time. Thus, it might be worth exploring a more flexible approach.

Dream Proves Elusive for Bank of England

Our analysis of Bank of England (BoE) data has found that Britain's central bank has only managed to keep inflation at the 2% (more specifically, between 1% and 2%) target c.30% of the time since it gained independence in 1997.

Over the past 27 years, the Bank of England has allowed inflation to run above and below target most of the time. Of course, some of these instances were down to factors outside their control, such as the Global Financial Crisis (GFC), but it also begs the question of whether it should adopt a more flexible inflation target as a result.

The Great British Rate Off

While 1-2% is widely seen as the ideal range in order to maintain price stability, sticking to such a textbook figure may be a fool's game given how susceptible the UK's economic growth has been to geopolitical affairs. After all, there have been several instances where inflation was allowed to run above target in order to spur economic growth, with the Bank even lowering rates in several instances.

Such examples include the 14 months between November 2002 and December 2003, where the Retail Price Index (RPI) ran above the BoE's then 2.5% target. In fact, the Monetary Policy Committee (MPC) opted to even reduce the base rate from 4.0% to 3.5% through the course of this mini inflationary cycle due to fears of potential deflation from the Dot Com bubble bursting a couple of years prior.

This strategy was used again during the 2008/09 GFC, when interest rates plummeted from 5.75% to 0.5% while above-trend inflation ran its course from October 2007 to May 2009, as GDP growth was negative for great swaths of this period.

Not only that, the MPC also let inflation run above its 2% target for 4 straight years between December 2009 to November 2013, leaving interest rates at virtually zero — 0.5% in order to support the economic recovery after the GFC. It's also important to keep in mind that services inflation ran as high as 4.9% during this period — still some distance, although not egregiously far from today's figure of 5.7% either.

In addition to that, headline inflation ran above target for almost 2 years from February 2017 to December 2018, with policy makers taking 9 months to increase the base rate from 0.25% to 0.75% as they were unsure about the economic impact of Brexit. This goes to show how susceptible the UK's inflation basket is to geopolitical factors, like energy prices and trading agreements.

Target Practice Makes Poor Economics

As such, this begs the question of whether Threadneedle Street should ditch its 2% inflation target. Would it be better to revise it to adopt a more flexible target that takes economic growth into account instead, as a flexible target could prove beneficial in several ways. For one, underlying weak demand due to an ageing population may require higher inflation to instigate stronger demand within an economy.

But perhaps what's most important is that the headline 2% figure may also mask significant variations across different sectors — and today's circumstances are a good example — we're currently seeing goods deflation being offset by stubborn services inflation, suggesting a single target might be too simplistic for modern economic conditions.

Moreover, with food and energy prices comprising a substantial portion of the CPI basket, the headline rate can paint a misleading picture of cost pressures facing households. This is particularly the case when volatile food and energy prices drive inflation lower while core prices remain elevated. Hence, a working-class family might find little comfort in learning that falling food and energy prices have brought headline inflation back to target.

Our Takeaway

Focus on sector-specific inflation/deflation patterns to gauge demand trends and the potential impact on company revenues. Consider cross-sector factors like energy costs for overall business performance as well.