David Prosser: Time to raise the inflation target?

Outlook In these challenging times for the pound, sterling bulls need all the help they can get: hence the alacrity with which the minutes of the most recent Bank of England Monetary Policy Committee meeting, which chronicled some members' concerns about the inflationary effects of the falling value of our currency, were seized upon yesterday.

Still, how worried about inflation should we all be? The MPC has no choice but to think hard about rising prices right now because it has an inflation target of 2 per cent to hit and CPI is currently running at 3.5 per cent. For the rest of us, however, it may be time to think again about whether a bit more inflation might just be a good thing.

For both Labour and the Conservatives, the Bank of England's 2 per cent inflation target has become sacrosanct – one of the cornerstones on which both parties now rest the credibility of their economic policy. The target certainly couldn't be changed lightly – people tend to lose faith in your promises if you change tack at the first sign of trouble – but there are some good reasons to think about doing so.

The most tempting of these is that a higher inflation rate would shrink the real value of all that horrible debt sitting in the public accounts more quickly – a 4 per cent rate, say, would effectively slice a third off the value of our debt within a decade without a minister having to unveil a single unpleasant spending cut or tax rise.

The more respectable case for an inflation target increase is the one currently being put by Oliver Blanchard, chief economist at the International Monetary Fund, and some very widely respected economists – not least Nobel laureate Paul Krugman.

The IMF argues that by setting an inflation target as low as 2 per cent, the monetary authorities don't have sufficient room to cut interest rates when a crisis such as the last one comes along.

An inflation target of 2 per cent means, generally speaking, a nominal interest rate of 4 to 5 per cent. As we saw when the Bank of England began slashing rates in response to the financial crisis, from that level you quickly get down to 0 per cent and run out of monetary weaponry (the Bank then had to begin its unprecedented quantitative easing programme). An inflation target of 4 per cent, say, and thus nominal rates of 7 per cent, gives a little more room for manoeuvre.

The wider argument is that, in any case, while setting an inflation target for the Bank seemed to produce a period of economic stability for the UK (and other countries where a similar policy was adopted), that has now proved to be an illusion. You don't, after all, hear the Prime Minister waxing lyrical about having abolished Britain's cycle of boom and bust quite so often these days.

There are both political and economic difficulties in tinkering with the inflation target and it's certainly difficult to imagine our eurozone neighbours considering doing the same, which is another reason to give us pause for thought. The idea, however, is certainly worth a debate once the election period – when anything with the slightest whiff of controversy can't possibly be mentioned – is done with.

Would the dreaded bond market hold us to account for back-sliding on repaying our debts should we go for a 4 per cent target? It's possible, though higher inflation should also mean higher returns for bond investors, which might soften their attitude. And the IMF appears to believe that 4 per cent for the UK – which, after all, is far from high by all historical standards – would not scare the horses.

The Bank of England, for the record, is not convinced, with deputy governor Charlie Bean urging caution earlier this week.

Even so, it is possible to argue that not only was the inflation target not the reason the UK enjoyed 10 years of stability, it was actually a significant contributing factor to the crisis that shattered the good times. The plentiful supply of cheap credit turned out to be the bubble we should have been most concerned about in the first years of the new century, not the level of price inflation.