Stephen King: A surprise from the Bank. What next, the comfy chair?

The public's perception of inflation might be higher than the Bank would like to see
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The Independent Online

"Our chief weapon is surprise ... surprise and fear ... fear and surprise .... Our two weapons are fear and surprise ... and ruthless efficiency. Our three weapons are fear, surprise, and ruthless efficiency ... and an almost fanatical devotion to the Pope."

When it comes to the Bank of England, perhaps not all of this is true. I don't know anything about the range of religious proclivities within the Monetary Policy Committee (MPC). If there is a fanatical devotion, it's either to the control of inflation or, instead, to keeping Gordon Brown happy - both secular aims, even if inflation targeting is sometimes pursued with a degree of religious fervour. Moreover, when it comes to instruments of torture, the MPC has only one - interest rates - whereas the Monty Python (MPFC) team had the rack (in their case, a draining rack), soft cushions and, famously, the comfy chair.

Still, last week the Bank of England did manage, through ruthless efficiency, to create both surprise and fear via an unexpected increase in interest rates. No one expects the Spanish Inquisition, and no one, these days, expects any surprises from the Bank of England. Indeed, Mervyn King, the Bank's Governor, once said: "Our ambition at the Bank of England is to be boring. Our belief is that boring is best."

Well, Mr King, you've certainly failed in that particular aim. Although central bankers these days like to pretend they offer "transparency" - that markets and citizens should never really be surprised by what the central bank actually does - the Bank of England's Monetary Policy Committee is structured in such a way that surprises will almost inevitably happen from time to time. Put another way, we should view the Bank of England's surprising actions without any element of surprise.

You may think that the use of an oxymoron to guide us through the waxing and waning of UK monetary policy might seem a little odd. All I'm suggesting, however, is that an element of surprise is an inevitable feature of the way in which decisions on UK interest rates are reached. I'd add that, for either the Federal Reserve or the European Central Bank, surprises are generally less likely.

To see why, consider two features of the Monetary Policy Committee's structure. First, membership changes quite regularly. Changing membership implies a changing mix of opinions on the Committee: the new incumbent may regard existing data rather differently from the previous incumbent. Second, it's strictly one person, one vote. This removes any possibility of what might be described as "collective cabinet responsibility". The Governor may have a particular view about the path along which monetary policy should be progressing, but he can easily be overruled by other committee members (indeed, Mervyn King was outvoted in August 2005, when the MPC chose to lower interest rates).

The US experience is rather different. Within the Federal Reserve's Open Markets Committee, there is the occasional lone voice of dissent. For the most part, though, all members vote in the same way meeting after meeting. For the Federal Reserve, their regular meetings are, in many ways, a rubber-stamping exercise. These days, informed observers in financial markets know well ahead of each meeting what conclusions the Federal Reserve is likely to reach. The same is increasingly true of the European Central Bank under Jean-Claude Trichet. Whenever M. Trichet warns of the need to be "strongly vigilant", investors can be fairly confident that an interest rate hike is lurking just around the corner.

There was a time when the MPC's own voting patterns were supposed to provide a clue to future actions. At the December meeting, though, all nine members voted in favour of leaving interest rates well alone.

But times change and, perhaps, facts change. Accompanying last week's interest rate increase was a statement warning of the dangers of money and credit growth and also of a shortage of spare capacity. While there was also an admission that sterling was now stronger and oil prices lower - factors that might, eventually, reduce inflation - "the risks to inflation now appear more to the upside."

You can take this statement one of two ways. Remarkably enough, you'll have the answer tomorrow morning. That's when the UK inflation data for December are published. There's a chance that consumer price inflation will nudge up to 3.1 per cent, well above the 2 per cent target set for the Bank of England by Gordon Brown. Any deviation of over 1 per cent from target requires the writing of a letter by the Governor to the Chancellor of the Exchequer explaining why inflation is quite so high.

Members of the MPC knew the December inflation data last week, so there's a chance that the rate increase was a sensible prophylactic, enabling the Governor to emphasise to the Chancellor and to the nation at large that steps are already being taken to bring inflation back under control. Failure to have raised rates would have made the Bank, on this scenario, look a touch complacent.

The alternative scenario is, oddly enough, a little more worrying. Imagine that tomorrow's data shows an inflation rate not high enough to require the Governor's literary skills. That would suggest a deeper-seated worry within the MPC. Perhaps the members are becoming alarmed about the possibility of "second round" effects stemming from earlier oil prices increases. Even though oil prices have recently softened, there may still be legitimate concerns about rising wages, higher house prices and those uncomfortably strong money numbers.

Moreover, the public's perceptions of inflation might be a little higher than the Bank of England would ideally like to see. One reason for this is the growing divergence between the consumer price measure of inflation and the traditional retail price measures, either including or excluding mortgage interest payments. All three measures have been on a rising trend, but there's no doubt that the retail measures rose earlier and by greater amounts. If pay increases are negotiated with respect to these traditional measures, the danger is obvious: higher pay feeds into higher consumer price inflation over the next year or so, requiring even more interest rate increases.

While possible, is this a realistic scenario? The difficulty lies with developments over the next few months. The oil price declines will place some downward pressure on headline inflation rates. Gas and electricity prices, recently rather elevated, will come down, again securing lower inflation rates. Indeed, for these reasons, members of the MPC remain confident that the medium-term outlook for inflation is encouraging.

So, perhaps the MPC has fallen back on an old Bundesbank ruse. Faced with the risk of inflationary wage demands, the Bundesbank always chose to fire an anti-inflation interest rate shot across the bows. By warning of the need for further rate increases in the light of inflationary wage settlements, wage demands typically moderated and everyone behaved themselves. The Bank of England will be hoping for the same result. If, though, wages do rise rather too quickly, Mervyn King may have to resort to the comfy chair.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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