Stephen King: Central bankers need to learn new tricks

With complete credibility, the central banks really don't have to do very much at all

Have you ever wondered what central bankers do in their policy meetings? I've been thinking about this over the past few days and I think I've finally worked it out. They play five-a-side football.

I don't have much evidence to support this claim, but there's little point in them doing anything else. The European Central Bank (ECB) has paved the way: it has now kept interest rates unchanged for 16 consecutive months. Given that the ECB meets every two weeks, it's difficult to imagine what the members of the governing council can be talking about all the time. So, why not push the tables and chairs to one side and demonstrate a bit of sporting prowess instead? "Yours, Jean-Claude!" "Pass it to me, Otmar!"

Of course, the Bank of England has been a bit busier than the ECB over the past few years. Interest rates fell by 2.5 per cent between February 2000 and July 2003 and they've risen by 1.25 per cent since then. But these changes are still very modest compared with previous UK interest rate cycles. And there have been plenty of meetings - last week's, for example - where nothing much has happened. So, the members of the Bank's Monetary Policy Committee have still had time to improve their ball control.

Perhaps it's stretching the imagination a little too far to believe that the Federal Reserve's monetary decision makers have been spending their time practising keepy-uppy. After all, they've been a lot more active on the interest rate front than the European Central Bank and the Bank of England. And when they have had the odd spare moment, the Federal Open Markets Committee is more likely to have opted for a quick game of baseball.

Nevertheless, financial markets seem to think that the Fed isn't going to raise rates too far. If Fed funds, the Fed's target interest rate, peak at about 3 per cent next year, as financial markets currently seem to believe, this latest period of US monetary tightening will have proved to have been remarkably subdued.

What is going on? The ECB's enthusiasm for rate increases, which seemed to be on the rise earlier this year, now seems to be fading. Having gone up only a modest amount, financial markets are beginning to wonder whether UK base rates are at, or close to, their peak. And although the Fed has been happy to push up interest rates at every opportunity since monetary tightening began in mid-year, financial markets don't seem to think that they're going up much further.

The obvious answer is the absence of inflation. Although fears of inflation began to resurface earlier this year, the reality is that inflationary pressures have failed to build in any serious way. Even with oil prices heading through $50 a barrel, the ability or willingness of companies to pass on these higher costs in the form of higher selling prices has been remarkably limited.

One way to prove this is to compare the current consensus forecasts for inflation with those that prevailed at the end of 2003, when oil prices were still less than $30 per barrel. The latest forecasts have moved up a bit, but only in line with the rise in actual inflation (see table above). There seems to be no expectation of any significant further follow-through despite oil prices being at nearly double the level expected at the end of last year. This is surprising, because most econometric models suggest that the impact on inflation of higher oil prices should be a lot bigger: the IMF's calculations, for example, suggest that inflation in the US should have gone up by about 3-4 per cent this year and by a further 2-3 per cent in 2005.

Yet the latest inflationary data suggests, if anything, that price pressures are moderating. In August, for example, US core consumer price inflation was back down to 1.0 per cent on a three-month annualised basis, after a peak of 3.3 per cent recorded earlier in the year. Why might this be?

One possibility is the competitive nature of global markets. Cost increases simply cannot be passed on. Another possibility is that, in a post-bubble world, excess capacity continues to limit companies' abilities to raise price. Then there are the supply-side benefits stemming from technology and the gradual integration of China and India into the global economy.

But I want to go a bit further than this. Imagine a world where central banks are entirely credible, a world where they are always assumed to be able to hit their inflation objectives, year in, year out. What would that world look like? Presumably, it would be a world in which price stability reigned supreme. As long as central banks had the willingness, the ability and the mandate to control inflation, why would anyone ever think that anything other than price stability would be a normal state of affairs?

Are central banks the equivalent of Pavlov, with the economy the equivalent of his dogs? You will recall that, in his famous experiment, Pavlov's dogs were conditioned to associate a certain sound with the arrival of food. Eventually, they would salivate merely when they heard the sound, regardless of whether any food was on offer.

Similarly, have we got to the point where central bankers merely have to gather in a room and lock the door for the rest of us to think that they are craftily planning their next counter-inflationary move? Is that the equivalent of Pavlov's signal to the dogs? Does it mean that we will never expect inflation to return? And is this expectation alone good enough to ensure that inflation remains well-behaved, even when there's a large external shock in the form of dramatically higher oil prices?

If this is all true, it's not so surprising that central bankers have time to play five-a-side football. With complete credibility, they really don't have to do very much at all. As long as we associate their meetings with the desire to maintain price stability, and so long as price stability is, indeed, maintained, a central banker's life is a very happy one indeed.

There is, though, a major problem with this argument. Inflation targeting is all very well but controlling inflation is but one aspect of the challenges facing policymakers. If we are led to believe that inflation is the only problem that policymakers face, and we learn that inflation is completely under control, does that mean that we start to take too many risks? This, surely is the lesson that we have all, repeatedly, failed to learn over the past 20 years. Japan's bubble, the Asian crisis, the collapse in US equity prices and the rapid gains in house prices in recent years: are these not all signs of the excessive risks that we now take because we believe that, in a world of price stability, nothing can go wrong?

Central banks may still be facing problems. They might be good at five-a-side, but what happens if someone changes the game? Up until the 1960s, inflation really wasn't a problem at all, yet macroeconomic policy was still fairly tricky. Eventually, I suspect that central banks - and governments - will have to rethink their economic mandates and be faced with the difficulty of teaching old dogs new tricks.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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