Mark Carney's big idea

In the words of Milton Friedman, the Nobel prize-winning economist, those who control the money supply within an economy must ensure two things: “a reasonably stable economy in the short run and a reasonably stable price level in the long run.” Since the financial crisis, the Bank of England has faced charges that it failed on both counts. Inflation has overshot the Bank’s 2 per cent target for 71 of the last 78 months. But these worries are overstated: recent inflation spikes are largely the product of oil price shocks and the rise in VAT, neither of which should concern the Bank.

By contrast, the outlook for growth is every bit as bad as the headlines suggest. The UK economy is still 3.6 per cent below its 2008 peak and unemployment is more than 50 per cent above the pre-crisis level. The UK economy is performing far below potential, much like a factory running below capacity. If the Chancellor is analogous to the factory's owner—concerned about the growth strategy—the Bank of England is the manager responsible for keeping the place operating near capacity.

So far, the Bank has dropped rates to near zero and implemented a large programme of quantitative easing, whereby cash is pumped into the economy to encourage spending. The goal was to encourage households to increase their spending, and it has probably helped avert a far deeper recession. However, flat growth and persistent unemployment show this to be insufficient. Recognising the problem, George Osborne has brought the former Governor of the Bank of Canada, Mark Carney, in to spearhead the next phase of "active monetary policy."

Carney's novel idea is to use "forward guidance," whereby the Bank would tie its hands and commit to allowing inflation to temporarily rise above target. Additional inflation would lift the prospects of wage growth, reduce the value of debts, and make it more expensive to hoard cash. That nudges people to spend slightly more today, which starts a cycle of growth that becomes self-reinforcing.

The difficulty with forward guidance is that the Bank is required to keep inflation stable in the long run. So it finds itself in the awkward position of keeping to an inflation target in the long run, while simultaneously promoting inflation to generate growth in the short run. If people guess that it will not allow inflation to rise then their behaviour will not change. That is part of the reason why quantitative easing has not had more success: most people think that the Bank will not intentionally allow it to push inflation over target.

For forward guidance to work the Bank must announce a new, supplementary rule to guide its actions. The rule must be consistent with both higher inflation today to create growth, and the inflation target in future. One possibility is a commitment to keep nominal GDP growing at 5 per cent each year. Nominal GDP includes inflation, so when growth is low, the rule allows more inflation to stimulate spending and, when growth is high, it restricts inflation to dampen the economy. It may not be a panacea but it could just kick-start the recovery that the UK so desperately needs.

James Zuccollo is senior economist at the Reform think tank. Its latest report, "Kick-starting Growth," is available here