Trade-offs are unavoidable, and no inflation target is fiscally neutral any longer.
For much of the decade before the Covid pandemic, Britain’s inflation problem was its absence. Prices rose too slowly. Policymakers fretted about deflation, secular stagnation and the limits of monetary policy. Interest rates hovered near zero. Quantitative easing was deployed not to restrain demand, but to stimulate it—often with disappointing results, unless you happened to own property or financial assets. Hitting the Bank of England’s 2% inflation target looked less like a ceiling than a distant aspiration.
That world has gone.
Consumer price inflation rose to 3.4% in December, its first increase in five months, driven not just by base effects but by higher tobacco duties, airfares and stubbornly high food prices. More worryingly for the Bank, annual average public sector pay growth is now running at 7.9% compared to 3.6% in the private sector.
Britain now finds itself in an awkward position. Inflation remains above target and appears structurally harder to bring down, even as other macroeconomic indicators and surveys suggest policy should be eased. At the same time, the structure of the public finances means that both higher inflation and higher interest rates are fiscally painful. This combination was not anticipated when inflation targeting was conceived in the early 1990s. It should prompt a more pressing concern: whether a 3% target now better reflects Britain’s economic reality.
Walter Bagehot once observed, not entirely approvingly, that since Britain had acquired a central bank, it should at least learn how to live with it. He was sceptical about having a central bank, but realistic about the institution once created. The same logic applies today. Britain has an inflation target. For many, the question is no longer whether inflation targeting is the right monetary regime (I have strong doubts), but whether the target itself remains appropriate—for this economy, with this debt burden and in a world where other central banks are grappling with similar dilemmas.
In practice, the Bank of England is boxed in. Keeping policy restrictive for too long risks tipping an already fragile economy into recession. Easing too soon, or too much, could entrench inflation above target. That dilemma has been sharpened by this week’s labour market data, which showed company payrolls falling by 135,000 compared with a year earlier—further evidence that momentum in the jobs market is weakening. Looming over every decision is a fiscal backdrop that did not exist when inflation targeting became orthodoxy. Public sector net debt has risen from 28% of GDP in 2000–01 to roughly 96% of GDP today, its highest level since the early 1960s. Britain’s debt pile now exceeds £2.9 trillion, while debt-interest spending is forecast to rise from £114 billion in 2025–26 to £140 billion by 2030–31.
More important than the headline debt figure is its composition. Roughly a quarter of the gilt market is index-linked, meaning both coupons and principal rise with inflation. In 2025–26, planned index-linked gilt issuance will account for 10.3% of total gilt issuance. In this world, higher interest rates raise debt-servicing costs; higher inflation does too. The idea that monetary policy can be pursued without significant fiscal consequences belongs to a different era.
This is not classic fiscal dominance. Neither the Prime Minister nor the Chancellor is instructing the Bank to keep rates low, or threatening litigation against Andrew Bailey. But the range of politically and fiscally tolerable outcomes has narrowed materially. Monetary policy now operates within constraints far tighter than they were in the past. In short, fiscal policy, not monetary policy, is increasingly responsible for the future path of inflation.
The uncomfortable truth is that no inflation target is fiscally neutral any longer. A rigid commitment to 2% risks prolonged tight policy, weaker nominal growth and repeated damage to the tax base. A higher target would mechanically increase payments on index-linked debt. The trade-offs are unavoidable.
The Bank of England, for its part, has been adamant that the 2% inflation target is not open to revision. Senior figures, including the Governor, have repeatedly stressed that the target is set by government and that the Bank’s task is to deliver it, not to debate it.
Yet Britain does not operate in a vacuum. Inflation targets function within a global monetary ecosystem. If the Federal Reserve—or other major central banks—begin to accept higher inflation in practice, the consequences will be felt through exchange rates, capital flows and imported price pressures. It is hardly surprising that similar questions are now being asked in the United States about whether inflation closer to 3% reflects deeper structural forces rather than a passing policy failure. Taken together, that international shift makes it increasingly difficult to argue that a higher target is illegitimate, even if the precise case for change must be made carefully.
Which brings the issue back to politics. What does the current Government want to prioritise, and what trade-offs is it prepared to accept? How should it balance inflation control against growth, financial stability against dynamism and risk taking, fiscal discipline against economic resilience? These are political choices. They cannot be delegated indefinitely to a central bank operating under the primacy of a single macro-variable mandate.
Britain’s institutional framework was built for a world of lower debt, lighter regulation and greater policy space. That world no longer exists. Debt is higher. Inflation is stickier. Geopolitical risks are rising. The state is larger, more interventionist, and still inefficient. Monetary and fiscal policy can no longer afford to pull in opposite directions.
History suggests that monetary regimes change only when reality forces the issue. Across advanced economies, the policy conversation has begun to shift: the dominant fear is no longer runaway inflation, but weak growth, softening labour markets and a prolonged loss of economic momentum. Against that backdrop, it is not radical to ask whether the 2% target still fits—or whether policy is quietly adjusting to a 3% world.