Hamish McRae: A new dilemma for central bankers: Price of goods is falling, but assets keep on rising

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It looks as though August will be the wicked month.

At some stage this year the US Fed, the European Central Bank and the Bank of England will make their first upward move in interest rates. The move could come earlier, in May or June, but the balance of probability seems to have slipped backwards to the late summer. The balance of probability, too, is that the first move will come from the Fed, but that is harder to call. Eurozone inflation will continue to worry the ECB, particularly if the German metal workers' settlement is high, and the Bank will properly need to curb asset inflation here if house prices continue their double-digit parade.

This leads to a broader issue that will preoccupy the central banks: the social consequences of the different movements in the various types of inflation and how monetary policy should seek to mediate between these. This is an even tougher question than the one with which monetary policy has had to wrestle for the past generation: how do you bring inflation down to socially and economically acceptable levels? That battle has more or less been won. The second has now begun.

The UK gives a very clear picture of the dilemma. We have soaring house prices, as you can see from the top left graph. For most families that is their largest single asset, larger in most cases than the implied value of their pension fund, and very much larger than their other financial assets.

The reason for this climb is partly the rise in real earnings that has taken place in the past few years. But it is also the extent to which falling interest rates has reduced the cost of servicing debt and so encouraged people to take on larger debts at little or no additional cost to their monthly outgoings.

And there lies a key part of the paradox. The more successful central banks are at curbing inflation in goods and services the greater the extent to which they can cut interest rates. But the more they cut interest rates the more they add to inflation in house prices. The reward for success on one front actually makes for failure on the other.

Now look at the different measures of inflation. Core inflation at a producer level – the prices at which companies have to sell their goods – has in effect disappeared (top right). In some areas prices are plunging.

We all know about the declines that have been taking place in computers, the result you would expect from very rapid technological advance. But price destruction is happening in other areas: consider a very Old Economy set of products, clothing and footwear. Prices there are now falling relentlessly year after year, and as you can see from the bottom left graph, are now running down 5.6 per cent year on year.

That is pretty terrifying if you are in that sort of business, for you have to run very hard to stay in the same place. But from a consumer point of view it is wonderful: clothes become ever cheaper. By contrast services have become ever more expensive.

Higher charges from telecom companies desperate to claw back a bit more revenue have helped push services inflation up to 4.6 per cent a year, the highest since 1993.

So there are two switches taking place: between the price of assets and the price of goods and services; and between the price of many goods and many services.

These have the most profound and indeed disturbing social consequences. To take the second set first, people working in the footwear industry are finding their wages compressed and their jobs going. Meanwhile those in the most successful service industries (I suppose finance is the obvious example) are finding their earnings rising and ever greater demand for their skills. OK, this particular year financial services are having a tough time but on a 10-year view their relative advance is huge.

Such disparities also have regional effects – for example between town and country, between London and the South and most of the rest of England, and between the east and the west of Scotland.

So what should central banks do about this? I suspect there is nothing they could or should do. Changes in relative prices are a necessary and essential mechanism for getting resources out of one corner of the economy and into another. There is of course a strong case for trying to alleviate the social costs created by this need to shift resources, but that is different from trying to stop the shift taking place.

Yet central banks get criticised for this economic process. The Bank is attacked for setting the interest rates that it feels are appropriate for the whole economy by parts of the economy who would like lower rates, in particular manufacturing. There is an asymmetry here: I do not recall any calls from service sector industries saying that interest rates are too low because they are experiencing overly high inflation in the prices at which they can sell their services.

On the other hand central banks are rarely criticised for the divergence between asset inflation and current inflation, even though this has arguably even more serious social affects.

Strip away the guff and a house price boom benefits the rich and the old (or at least the middle-aged) at the expense of the poor and the young. It benefits the parts of the country that are already the most successful at the expense of those that are struggling. And it benefits the people who are sophisticated with money at the expense of those who are not.

It is, in short, a social disaster. It is distributing the rewards and penalties of the economic world in as arbitrary a way as the surge in inflation did in the 1970s and 1980s. Yet central banks do not have asset prices as part of their remit: the Bank here has a target for current inflation but no guideline for the acceptable limits of asset inflation. At the Fed, Alan Greenspan has rejected the idea that monetary policy should do other than focus on current inflation.

Worst of all, because articulate people tend to benefit from asset inflation while the less articulate suffer, there is no lobby against a housing boom. Rather the reverse. Higher interest rates hit manufacturing: squeal, squeal. Lower rates create a housing boom: purr, purr.

So when the inevitable happens in August or thereabouts and rates here, in America and in Europe start to nudge up, note the hostile comments. And please set those against the social costs of an excessive housing boom.