Stephen King: Bank of England grapples for truth in 'monetary murkiness'

The times they are a-changin' and the old monetary frameworks are looking creaky
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Monetary policy decisions are typically reached within some kind of framework. Whatever its nature, the framework must offer more than a simple description of the ultimate monetary policy objective. Having an inflation target, money supply target or exchange rate target is all very well, but the policy-maker needs some idea of how to influence events in ways that will increase the chances of hitting the target. Only with a framework is monetary action likely to lead to monetary success.

The typical central banker's framework includes a number of tried and tested economic relationships. The central banker should have an idea of how much productive potential an economy has. He or she should also have a view about how quickly that productive potential is growing from one year to the next. The central banker will want to know how distant the economy is from productive potential at any point in time. If, relative to available supply, demand is too low, the central banker will expect to see declining inflationary pressures and, at the limit, a world of falling prices. If, though, demand is too high relative to available supply, accelerating inflation is likely to be the main concern.

These things are neatly captured in the concept of the output gap, the distance between actual and potential output. The output gap, in turn, stems from earlier concepts such as the natural rate of unemployment. Whatever the concept, though, it's only likely to be useful if the central banker has an idea of whether the distance between actual and potential output is getting bigger or smaller over time and the extent to which policy should change to help the economy reach its potential.

In reality, these are tricky calibrations. The latest set of minutes from the Bank of England's Monetary Policy Committee - summarising the meeting held on 4 and 5 October - is full of references to actual and potential output but, in each case, the impression given is of a Committee grappling for the truth, not a Committee in command of the truth.

If there's a conclusion from the minutes, it's that the economy may be operating above potential. "Some members [thought] ... there were signs that above trend growth had continued ... and there were risks of real wage resistance and/or a rise in inflation expectations ... Other members placed considerable weight on these arguments ... but thought there was no pressing need to raise rates this month."

These comments have persuaded markets that the Bank will raise rates in November. Yet it strikes me that the Committee is frustrated with its inability to couch its decisions within a reliable framework. The times they are a-changin', and the old monetary frameworks are looking creaky.

Let me offer a few examples of "monetary murkiness". Money supply growth has been buoyant in recent months. Offering almost 14 per cent growth in August, money supply is expanding at a rate that would make even the most laid-back central banker feel distinctly squeamish. Historically, a monetary expansion at this pace would mean higher inflation but, as the Bank of England notes, the acceleration in money supply growth is mystifying, partly reflecting balance sheet adjustments within the private sector that may have little impact on future demand. Hedge funds, pension funds, insurance companies and private equity vehicles may be awash with cash but it's not obvious that this will be converted into demand-boosting investments within the UK.

Then there are supply issues - or, at least, this is how the Bank treats factors that, in truth, are affected by both supply and demand. The labour market is especially puzzling. The Labour Force Survey measure of unemployment has been drifting higher for a while but the range of explanations for this varies hugely.

The rise in unemployment might represent a shortage of demand, in which case the output gap might be a bit bigger and, thus, inflationary risks somewhat smaller. It might, instead, reflect a rise in structural unemployment, perhaps because workers have demanded wage increases in compensation for higher energy prices, in which case the output gap would be smaller than before, pointing to higher inflationary risks. Or, alternatively, it might suggest an increase in labour supply associated with higher rates of immigration and the return to work of the over-55s - once again implying a bigger output gap and, hence, more spare capacity.

The Bank needs confirmatory evidence to decide which of these explanations is the more likely but, so far, is having trouble finding any. Wage pressures have been muted given the rise in the headline rate of retail prices inflation (a traditional yardstick for pay settlements), suggesting that much of the rise in unemployment is a result either of a loss of demand or an improvement in supply potential, but the Bank clearly worries that higher headline inflation in the months ahead could trigger a wage response that would overturn this conclusion.

Meanwhile, the Bank's "agents" have been asking firms about their price-setting behaviour (named this way, the Bank's regional staff sound as though they're wearing dark glasses and trench coats, ready to drop a cyanide pill into the gin-and-tonics of those daring to raise prices too far). According to the Bank, "around 50 per cent of firms reporting that they had experienced margin erosion in the recent past [largely because of higher energy prices] planned to respond by raising prices".

I wonder, though, whether these really are the best-laid plans of mice and businessmen. The intention to raise prices must always be there. However, businesses no longer operate in the safe, cosy and price-fixing environment of domestic oligopolies but, instead, face a world of intense competition, where price increases all too often have to be reversed as new entrants make their presence felt.

The Monetary Policy Committee minutes reveal a world that is changing. The traditional frameworks for monetary policy decisions are being given a good shaking. Energy costs may rise, but wages may not respond. Attempts to demand pay increases may lead to higher immigration.

Rising unemployment provides ambiguous signals, suggesting that the concept of "spare capacity" has lost some of its meaning (to the extent that the UK can draw on resources shipped in from elsewhere in the world, the measurement of capacity itself has become tricky). Companies may be thinking of raising prices but, to use a sporting metaphor close to Mervyn King's heart, Aston Villa are doubtless thinking of winning the Premiership one day. In both cases, though, thoughts alone may not be enough.

Another way of putting this is to suggest that we are living through the globalisation of both framework and outcome. Rapid money supply growth may eventually point to higher inflation but it might, instead, point to the purchase of foreign assets by British institutions that will have no direct effect on UK demand. Inflationary outcomes, meanwhile, may depend as much on events beyond these shores as they do on the careful stewardship of domestic monetary policy. Expressed slightly differently, UK inflation may have been a lot more stable in recent years but the Bank may be rather unsure of its own contribution to this new-found stability.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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