Is the Bank telling us interest rates have very little effect on inflation?

By only hinting at its broader concerns, the Bank is in danger of making its message less transparent
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Understandably, the Bank of England likes to give the impression that it is in control. After all, who wants a central bank that does not know what it is doing, or where it is going? The Bank of England knows where it has to get to - it has a government-defined inflation target - and wants us to think it has a good and reliable satellite navigation system that will provide the best way of getting there.

The Bank likes also to give the impression of transparency, that it plans not to spring too many surprises on the financial markets. That is one of the reasons why it publishes its quarterly Inflation Report. It's a good way of setting out the key issues and explaining how these are likely to affect current Monetary Policy Committee thinking.

Last week, the Bank produced its latest, November 2003, Inflation Report. Glancing through it, I can't help but think that there are a few peculiar inconsistencies contained within. In the summary, the Bank says "unemployment is low and there are indications that the labour market may be starting to tighten". Nothing wrong with any of this, until you wade your way through to page 21 of the report, when the Bank says "the low level of unemployment may overstate the degree of tightness in the labour market". Later on, the Bank says that "unemployment may provide a misleading indication of labour availability" and, in referring to structural changes in the labour market, concludes that "such changes could have lowered not only actual unemployment or inactivity, but also the level consistent with a given degree of wage pressure".

These comments aren't completely inconsistent but it requires quite a degree of verbal dexterity to turn them into a sensibly consistent message, a degree of dexterity seemingly at odds with the desire for transparency. Perhaps we should put all of this down to a lack of editorial control, but the problems don't really end there. The report suggests also that the Bank is having trouble in coming to terms with the relationship between short-term interest rates and inflation over the medium term.

In the Report, the Bank shows so-called "fan charts" for inflation. These charts are supposed to show a "central view" for inflation together with a variety of less and less likely inflation outcomes on either side of the central view. The Report provides two of these charts. The left-hand chart assumes that short-term interest rates remain at current levels over the next two years. The right-hand chart shows inflation based not on current interest rates but rather on interest rates over the next couple of years as currently expected by financial markets.

If I can be a bit more precise, the left-hand chart is based on interest rates at 3.75 per cent for ever more. The right-hand chart is based on interest rates going up to 4.8 per cent by the end of 2004 and to 5.2 per cent by the end of 2005. At this stage, you would be entitled to be a little puzzled. Try as you might to see the difference between the two charts, there is, in truth, very little. You might need your magnifying glass or, preferably, your microscope and all of your forensic skills to tease out the distinguishing features. The Bank seems to be saying that, with rapidly rising interest rates, inflation can be lowered only by a less-than-impressive 0.1 per cent.

Just 0.1 per cent? What is the Bank trying to say? Is it saying that it doesn't know where inflation is heading, in which case it isn't willing to indicate a difference between two worlds, one of which has stable interest rates and one of which has rising interest rates? Or is it saying that the lags between changes in monetary policy and their impact on inflation take absolutely ages to feed through, suggesting that the supposedly transparent links between policy changes and inflation aren't really there? Or is it just saying that interest rates just don't have much of an impact on inflation, either because interest rates themselves have lost their power over the economy or because important changes in the economy no longer reveal themselves through inflation?

The Bank isn't likely to give us an answer to these questions but, if forced, I suspect it would attribute everything to long and variable lags. In my view, though, inflation itself may no longer be such a useful indicator of economic performance. Inflation didn't pick up in Japan in the late 1980s yet Japan had an enormous economic boom. Inflation hardly budged in the US in the late 1990s yet the US went through a period of excessive economic expansion. And, today, inflation in the UK hasn't really moved around very much yet still we fret about house prices and household debt levels.

A while ago, I took a look at the relationship between domestic costs, domestic inflation and global inflation for a number of different countries over a number of different decades. I was intrigued to discover that, whereas in the 1960s, 1970s and 1980s, there was a very close correlation between domestic costs and domestic prices, that correlation became a lot weaker in the 1990s. The correlation between prices and global prices, however, was very high in the 1990s.

Why might this be? One possible reason is that the combined impact of globalisation and information technology has changed the competitive pricing environment facing many industries. No longer is the "cost plus mark-up" model of inflation relevant. Instead, maybe companies simply have to take prices as given and try their best to control costs - maybe a process not easily picked up in the Bank's econometric equations but one that I suspect would strike a familiar chord with many businesses up and down the country.

If this is true, the Bank - and, indeed, the Government - is faced with a rather tricky conundrum. The Bank's success in fighting inflation is to be commended but it may well be that fighting inflation itself has just become a lot easier as global market structures have evolved over the past 10 years. On that basis, judging the overall success of Britain's macroeconomic policy on the basis of inflation alone may be rather misleading. That, in turn, may mean that the Inflation Report is not such a useful document after all. Sure, we don't want to see a return to a world of high and unstable inflation rates, but attempting to gauge the likely success or failure of our economy on inflation seems a little odd.

And that, I suspect, is why it has been so difficult to iron out the inconsistencies within the Inflation Report. The Bank is obliged to hit an inflation target and is judged on that basis alone, yet it is well aware that there are many other tough macroeconomic issues out there that any sensible economist should be worrying about, inflation target or no inflation target. By only hinting at its broader concerns, the Bank is in danger of making its message less transparent. But if it is able to express its concerns more freely about the broader health of the economy, we might then begin to believe that it should move interest rates up and down for reasons unconnected with inflation alone.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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