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Letter to the Chancellor

14 October 2015

Jonathan Marriott, Chief Investment Officer

Dear Chancellor,

In 1998, the Bank of England became independent of the government, and the Monetary Policy Committee (MPC) was given a target for 2% Consumer Price Inflation (CPI). The Governor of the Bank of England is obliged to write a letter to the Chancellor if inflation moves more than 1% above or below this target. The theory was that 2% inflation was consistent with trend growth. It avoided excess inflation and was set to avoid the dangers of deflation.

Today's Governor, Mark Carney, has had to write several letters to you explaining why inflation has been below target in recent months. With CPI close to zero, he will be writing again shortly. In his most recent letter, he comments that inflation is depressed due to falling oil prices and this effect will be diminished in the New Year as the falls of the previous year begin to drop out of the annual numbers.

However, core inflation is also below the 2% target. This is due to a number of factors including the strength of Sterling against the Euro and Yen which have been pushed down by actions from their respective central bank policies. Technology in the form of the Internet is making overseas production and price comparison much easier. In a global market UK inflation is influenced by many things that bear little relationship to the UK economy.

A questionable target

With inflation subject to so many external effects, it is a questionable target for any central bank but particularly for the UK. The Economist recently suggested a nominal GDP target would be more appropriate. However any specific target may tie them to inappropriate action. To change the target now could call into question the credibility of the Bank of England. However, a less specific target of setting rates to maintain economic stability could in the long run, be a better direction to give the MPC. Your colleagues at The US Federal Reserve have inflation, employment and financial stability targets which allow greater flexibility in making decisions.

A steep rise in the oil price could re-introduce high inflation and reduce growth as we saw in the 1970's. If this was the case, would high interest rates be justified? Setting a specific target can make it difficult to do the right thing.

Mark Carney has tried to give forward guidance on rates. He said the MPC would be in a position to raise rates if unemployment falls below 7%. It is now well below that and rates have not risen yet.

A measure or a target?

Goodhart's law states that "when a measure becomes a target it ceases to be a good measure". Charles Goodhart was a Bank of England adviser in the 1970's; perhaps this wisdom should be remembered.

Yours sincerely,

Jonathan Marriott, Chief Investment Officer