Bank down but not out in the inflation fight
Monday 10 February 1997
The Bank's basic argument is that there is an unacceptable risk of inflation exceeding the target in 12-24 month's time unless action is taken now. The continuing tension between the two sides was demonstrated again last Wednesday, when Kenneth Clarke probably turned down a request from Eddie George, Governor of the Bank of England, for a half-point rate base rise, and in effect scotched any prospect of any increase in rates before the election.
This decision, like others before it, has been met with general approval from many commentators, despite the fact that the monetary control mechanism invented in 1992 was clearly intended to prevent any hint of political manipulation of interest rate decisions in the run-up to a general election.
Even if the Chancellor's judgement proves "right" on this occasion - and that will depend mainly on the highly uncertain behaviour of the exchange rate in the months ahead - there is a case for saying that the control mechanism has already failed, since a politician standing for election has been able quite calmly to over-rule the advice of an impartial central banker in the run-up to polling day.
Whatever the detriments of the German system of monetary control, and there are many, it is hard to imagine this happening to the Bundesbank.
No doubt this is why the financial markets still demand a risk premium on UK bond yields compared to those elsewhere in Europe, and will probably continue to do so for as long as the operational decisions on monetary control ultimately lie in the hands of the Chancellor, whoever he may be. It is also why, in our present political environment, it can be a thankless task to be a British central banker.
The Bank of England has been required by the Treasury to base its policy advice on the objective of permanently hitting an inflation target of "2.5 per cent or less" (note that the 1-4 per cent inflation range, which previously co-existed with this central objective, was quietly buried last year).
Only for a few brief months since 1992 has this target actually been achieved, yet Mr George is habitually described as an "inflation nutter" for having intermittently argued during this period that policy should have been modestly tighter than it actually was. The implication, of course, is that the dominant consensus in the UK believes that we should not actually try to hit the inflation target that Mr George has been given.
Even though our inflation rate is the highest in the European Union, save for a few stragglers like Greece and Portugal, our body politic is therefore content with an inflation rate above 3 per cent at this stage of the economic cycle. The question is whether it should be. Is an acceptance of 3 per cent inflation really so bad, even though it implies that the price level will double every 24 years?
Obviously, compared to the time we were grappling with inflation rates in the region of 20-30 per cent, this is a luxurious problem to have. We are now talking about fine margins, where it is possible to put up a coherent case for the Chancellor's pragmatic approach.
For one thing, the official price figures are probably overstating the actual rate of inflation to some degree. In the United States, where there is a strong desire to cut the cost of the annual social security upratings in line with recorded inflation, a commission was recently set up under Michael Boskin to examine this problem. He reported that the actual inflation rate was probably about 1 per cent per annum less than it appeared in the consumer price index.
Statisticians were missing the fact that some goods, such as home computers, are rising in quality far faster than before, and they were also missing the tendency of consumers to shift towards cheaper goods through time. The same problems undoubtedly exist in the UK, though there are reasons for thinking that the systematic overstatement of inflation in the RPI may be less than in America, at perhaps 0.5 per cent per annum.
A further point to note is that recent studies have failed to demonstrate that inflation rates at under 5 per cent a year are damaging for economic growth.
Admittedly, empirical work has consistently shown that inflation rates above 8-10 per cent per annum are correlated with reduced economic growth, and several estimates suggest that every 1 per cent on the inflation rate at such levels reduces the gross domestic product growth rate by 0.02-0.08 of a percentage point. But inflation rates of 5 per cent or less are not shown to impact growth either way.
In fact, there have been suggestions that very low inflation rates can impair the functioning of the labour market, because it is harder for companies to change relative real wages when nominal wage increases in the economy are in the narrow range of say 0-3 per cent. A controversial Brookings paper last year (by George Akerlof, William Dickens and George Perry) argued that the difference between operating with a zero inflation target, rather than a 3 per cent inflation target, would eventually be to increase the structural unemployment rate by a full percentage point, simply because relative real wages would adjust less easily to the demand for labour.
Given all this, on what grounds can the Bank's case for higher base rates be supported, when inflation is hovering at only 3 per cent?
The case is subtle, and is based not solely on the most likely projection for inflation, but on the risk/return trade-off for po- licy mistakes in this area. There are two types of asymmetry that could be significant.
First, in the case of a country like the UK, where the credibility of the monetary authorities is still quite poor, the inflation expectations of the private sector could rise quite markedly if the actual rate of in- flation is allowed to exceed the target for even a short while. Once these expectations have been permitted to rise, it might take a deep recession to get them back down again.
Second, IMF authors Guy Debelle and Douglas Laxton have recently shown that the response of inflation to changes in economic activity is in itself asymmetric. The adverse effects on inflation of an overheated economy are considerably greater than the beneficial effects on inflation of a recession.
The implication of this result is that it is absolutely crucial to avoid excessive booms, since the cost of bringing inflation back under control will be so large. As they conclude: "In order to avoid the necessity of large recessions to rein in inflationary forces and re-establish credibility in low inflation, it may be optimal for policy-makers to provide a buffer zone to guard against the possibility of serious over-heating."
These asymmetries provide some justification for tightening monetary policy today. But no one should envy the policy-makers who have to explain this complex and unproven reasoning to a sceptical electorate.
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