Why the Bank of England’s has now effectively set a 5% inflation target

Mark CarneyMark Carney, today announced a new regime at the Bank of England. He is going to keep their ultra-loose monetary policy until it is ‘knocked out’ by inflation projections going up. Instead of having to keep to a 2% inflation target every month, the target has now effectively moved to 2.5%. However of greater importance is what that new 2.5% target is set on.

It is based on the Bank’s own projections of what inflation is going to be like in two years (or thereabouts). The official logic behind this being that inflation shocks such oil price rises can distort the short term figures. But there is a big problem with using Monetary Policy Committee’s own estimate for future inflation. They are rubbish at it and mysteriously their future two projections often seem to be around 2% i.e. their old target.

Moreover Carney almost admitted to it in the press conference today when he let slip in another question that: “if you look at the inflation report, for what its worth..”  The chart below from book (chapter 11), shows exactly how inaccurate those projections have been.

11-2Data source: Bank of England February inflation reports
As you can see from the graph, the Bank of England projections are always lower than the final outcome – to the tune of about 1-2% (and more recently following QE).

Therefore by adopting the new knocked out rule, the Bank of England is now going to ignore inflation of not just 2.5% but more like 4% (by the time you add in the fact their projections always under-estimate it). Moreover that is CPI inflation.

The old RPI inflation, which in my view more accurately reflects our true inflation rate, can be 1% higher than CPI due to formula effects. Therefore this new target is effectively a 5% inflation target for the Bank.

If inflation averages that level, what implications does this have for savers? Mark Carney is expecting this policy will remain in place for least 3 years. Over that time, if average savings rates remain around 1%, the cumulative loss of wealth to UK savers would be over 13% (after tax) i.e. a loss of one seventh of the purchasing power of their money.

Of concern to me the complete lack of empathy that Mark Carney showed to the effects of his policy. In the press conference afterwards, he was challenged by Jeremy Warner of the Telegraph over the impact of this low interest rate policy. Nowhere in his answer did he show any acknowledgement that it might be a problem for savers.

So why has the Bank changed its policy? They have done so because they were specifically asked to do so by George Osborne. The government has a massive debt problem and the only solution to that is do what we’ve done before in this situation – inflate it away. As Lenin is reputed to have said:

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and.. impoverishes many.”

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