Stephen King: House prices force velvet revolution at Bank

The Bank will plan for inflation to drift outside its bands
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The Independent Online

Revolutions can be noisy affairs, violent affairs and, on a few occasions, remarkably quiet. Central bankers are known for their inherent conservatism, so if there is a revolution taking place in the corridors of the world's major monetary institutions, we are not likely to hear a great deal about it.

Revolutions can be noisy affairs, violent affairs and, on a few occasions, remarkably quiet. Central bankers are known for their inherent conservatism, so if there is a revolution taking place in the corridors of the world's major monetary institutions, we are not likely to hear a great deal about it.

Yet revolution there is. In the vanguard lies the Bank of England. This, though, is no ordinary revolution. It is a revolution of ideas, an attempt to redefine the central bank's role in our lives. And it is coming about because central banks are becoming increasingly doubtful about the use of simple, rules-based approaches to economic policy.

Specifically, I am thinking about inflation targets. Financial market participants like to believe that inflation targets are "the answer" to all macroeconomic problems, the best framework for getting the level of interest rates right.

Their belief comes from three simple observations. First, inflation is the main macroeconomic problem: solve inflation and everything else should swiftly fall into place. Second, an explicit inflation target is a declaration of intent which ensures that inflationary expectations within the economy-at-large fall into line. Third, an inflation target makes policy transparent, thereby reducing confusion about the central bank's intentions and leaving financial markets less exposed to undesirable monetary "shocks".

The Bank of England believes most of this, but it appears to be worried about one part of these observations. Although it doubtless views inflation as the main macroeconomic problem, it is increasingly having trouble with the idea that sorting out inflation sorts out everything else. And, because of this, it becomes more difficult to regard the inflation-targeting policy framework in the comfortable, purist sense that financial market participants want to believe in.

If this is the case, the Bank will increasingly have to tell the markets that, no matter how transparent it wants to be, transparency will have to be based on a more eclectic series of indicators than inflation itself.

Of course, the language used by the Bank still pays lip service to the inflation target in its purist form. As Mervyn King said in a Financial Times interview last week, "Having had inflation stay within one percentage point of the target now every month for more than 10 years, there will come a time when some shock to the economy... comes along and pushes inflation just one side or another of this one percentage point band on either side of our central target." In other words, circumstances beyond the Bank's control could cause inflation to stray from target. The Bank, though, would still act to get back to the target sooner rather than later.

I would go further than this, though. It seems to me that the Bank will eventually encourage inflation to drift outside its bands from time to time - even plan for inflation to drift outside its bands - not because of some external shock, but rather because that is the price that has to be paid to deliver sustainable macroeconomic balance over the medium-term. Let me explain. Inflation targeting does not offer the solution to macroeconomic problems that market participants hope for. Booms and busts have been features of the economic landscape for centuries, whether or not inflation itself has been a problem. Low and stable inflation may well be a necessary condition of lasting prosperity but in no way is it sufficient.

It is simply impossible to hit an inflation target each and every year. More precisely, attempts to hit an inflation target in any one year can make it more difficult to hit the very same target in other years.

To see why, think about Japan's experience in the late 1980s. Throughout that period, Japanese inflation came in below the rates that are now the mandated "norm" for the majority of central banks.

In that sense, the Bank of Japan was being over-zealous, leaving monetary conditions too tight. This, though, seems a perverse conclusion. The accompanying bubble in asset prices - both equities and real estate - suggests monetary policy was too loose. And when the asset price bubble eventually burst, deflation became a major headache for Japan's central bank. In hindsight, it would have been better for the Bank of Japan to have delivered a near-term inflationary undershoot. Monetary policy would have been tighter, the asset bubble therefore smaller and the ultimate risk of deflation - when the bubble eventually burst - lower.

I have used the Japanese example because it resonates with some of the problems now facing the Bank of England. Up until now, the Bank has given the impression that it thinks about inflation on a "two-year ahead" basis, partly because that is how it presents the risks to its central inflation projection within the quarterly Inflation Report. However, the governor's comments in the FT last week - in the context of renewed house price strength - suggest that the Bank wants to move away from this mechanical approach. In Mr King's words, "If we saw, for example, that we really were running the risk of a big deviation of inflation from target further ahead, then we could take that into account and would do so."

In other words, the Bank increasingly wants to take a more judgemental approach to policy-making. It is not difficult to see why. If the experience of recent years has taught us anything, it is that attempts to hit inflation targets on a fairly rigid timescale tend to create new sets of problems. The Bank shifted interest rates down to much lower levels in the 2001-2003 period partly because of a fear of meltdown associated with rapidly falling stock prices.

Near-term, the policy worked: inflation has continued to behave itself. However, had the Bank known the degree to which house prices would pick up, it might have had second thoughts about the extent of any monetary stimulus.

My point is simple: although the Bank's actions may have increased the chances of hitting the inflation target in the short-term, the gains in house prices and the build-up of leverage may have lowered the chances of hitting the inflation target in later years.

Of course, making inflation forecasts beyond a time horizon of six months or so is always fraught with danger. Economists simply aren't able to pull these kinds of forecasts off with any degree of accuracy. In that sense, it might be argued that policy-makers should only focus on the short-term. That, though, is a mistake. We might not know the precise shape of inflation over coming years, but we do have a pretty good idea of where the risks lie.

The Bank's revolution lies in making a much more graphic assessment of the broader risks facing the UK economy. The Monetary Policy Committee will never know for certain where, precisely, inflation is heading. Inflation will, from time to time, stray beyond the 1 per cent bands that surround the central target. But by being more open about the broader macroeconomic risks the Bank will be able to set a course that focuses more on medium-term stability of inflationary expectations than on short-term accuracy of inflationary achievement. By doing so, it can talk about the impact of asset prices much more openly. And if that discussion forces the Bank to send a letter to the Chancellor from time to time explaining why inflation has strayed too far from target, that, in my view, is no bad thing.

Stephen King is managing director of economics at HSBC