When the Bank of England's Monetary Policy Committee met last week, the backdrop was one of Christmas gloom. As soon as it decided to cut interest rates, the headlines told of Christmas cheer, for retailers and retail junkies alike.
Now, I'm not a natural Scrooge-like figure. But I suspect the festive joy will be short-lived. And to understand why, it is necessary to consider how the economic landscape has shifted from the golden conditions prevailing over much of the past decade, to the challenging climate of today and the tough times that lie ahead.
The past decade was a truly remarkable period. The integration of emerging countries into the global economy lowered the prices of the goods we import. Increasing flexibility of the UK labour force pushed down on not only unemployment, but also the level of unemployment consistent with stable inflation. And the inception of the Monetary Policy Committee brought another benefit to the UK economy, as expectations of future inflation fell and hopes of greater stability increased. The period is summed up by Mervyn King, the Governor of the Bank of England, as "nice" a non-inflationary consistently expansionary decade.
Times have changed. In particular, the external environment has turned rather nasty. As housing market woes in the US have infected global financial markets, credit conditions have begun to tighten. That has put a signif-icant dampener on growth pros-pects here and in many other advanced economies.
The slowing in growth has, however, been accompanied by rising cost pressures. Cheap goods may still wind their way from China and India across to these shores. But as the emerging economies have grown rapidly, so has their demand for oil, food and other commodities. That has resulted not only in higher petrol prices at the pump and higher gas and electricity prices in the home, but also a surge in the costs facing producers of a wide range of goods.
This isn't "nice". Even as the economy slows possibly quite sharply firms are intending to raise prices more aggressively than at any time in the past decade. It might not be stag-flation, but it's a pretty uncomfortable economic environment nonetheless.
What does this mean for the future? Well, in large part, pros-pects for the UK economy are going to depend on the Monetary Policy Committee. During the past decade, as the prices of many imported goods fell, the committee kept interest rates low to ensure robust growth and more rapid rises in the prices of other items. It succeeded: overall inflation stayed close to target.
The committee played a skilful hand, but it was also a popular hand. The current economic environment requires something very different. The MPC, and indeed the rest of us, will have to accept a period of slower growth in the coming year or two well below the rates of growth that we've seen over the past decade in order to hit the inflation target further ahead. This isn't just choosing between growth and inflation, however. It's also a choice between today and tomorrow: short-term pain for long-term gain. And that creates a problem.
The problem, in the jargon, is one of time inconsistency. The classic example is hostage-taking. A government might announce that it will in no circumstances negotiate with terrorists. That could, in principle, deter terrorists from taking hostages. But terrorists know that, in the heat of a hostage crisis, the government would struggle to explain its policy of inaction to the voting masses. It would have every incentive to renege on its commitment. The same applies to interest rate decisions. A government may be aware of the benefits of a low inflation environment. It could be fully conscious of the ephemeral nature of any trade-off between growth and inflation. But when it tells voters that it won't sacrifice low inflation at the altar of rapid unsustainable growth, the public is likely to be sceptical. If push came to shove, would the government really pass up the opportunity to slash rates in the run-up to an election and engineer a vote-winning boom?
The solution to the time inconsistency problem is for policymakers to credibly commit to limit their own discretion. So, in the case of monetary policy, the UK government handed over interest rate decisions to the MPC and gave it a specific inflation target. That's not the end of the story, however.
A concern with the current interest-rate-setting framework is that government involvement has far from disappeared. The Bank of England is only operationally independent. The Chancellor sets the Bank's objectives and can change them as he did four years ago, when he changed the inflation target to something a little looser. The hand of government is also felt in the make-up of the Monetary Policy Committee. Directly or indirectly, it appoints seven of the nine MPC members. And reappointments of those members including the Governor depend on the government too.
Now, the MPC has made it clear that it will withstand political pressure and take tough decisions. Indeed, one MPC member, Tim Besley, recently noted that he didn't join the committee "to make friends". But the problem is one of perceptions. People may think that there are incentives for MPC members to renege on their commitment to the inflation target. And, although impressed by the MPC's success during the benign conditions of the past decade, they may not be convinced that the committee will be able to retain its focus on inflation when to do so necessitates a period of unusually sluggish growth.
This would make the MPC's job much harder. Workers would expect inflation to be high in the future and battle hard for higher wages. Firms would assume rises in their competitors' prices and raise their own prices too. Growth is going to have to slow whatever people expect. But the less credible the monetary framework, the greater the slowdown that the MPC will have to oversee to meet the inflation target.
The reality is that full credibility has not been achieved. The MPC may have won a battle with inflation, but the war is certainly not won. Indeed, as prospects for growth have deteriorated, inflation expectations have actually been drifting up. So enjoy last week's cut in interest rates and the further cuts that are likely to follow. But no amount of festive cheer can hide the message the economy is slowing and tough times lie ahead.
Karen Ward is UK economist at HSBCReuse content