Stephen King: Inflation can no longer be policy makers' only guiding light

Despite their claims for transparency, central bankers are increasingly operating in an impenetrable fog

"Oh, what to do?" Central bankers never have it easy. Raise rates, lower rates or leave rates unchanged? Every few weeks, each central banker has to address this quandary. And each central banker has to reach a conclusion based not just on the available evidence, but also on the interpretation of that evidence.

Take a look at the US economy. The governors of the Federal Reserve have to sit down together every month-and-a-half and reach a conclusion about the appropriate direction for monetary policy. Their latest thoughts? Some of them will doubtless focus on the recent strength of economic activity. US GDP growth was exceptionally strong in the third quarter of 2003, appears to have remained reasonably buoyant in the fourth quarter, and has been accompanied by persistently upbeat business surveys - reason enough, perhaps, to shove interest rates up sooner rather than later.

Others will focus on the labour market. The weekly initial jobless claims have been declining for quite a while now, and could point to a renewed appetite for hiring. The problem, though, is an absence of decent jobs growth in the most widely watched barometer of the US labour market, the monthly non-farm payrolls release. The latest month revealed an increase of just 1,000, a pathetic gain compared with past economic recoveries that have had no difficulty in generating jobs growth of 300,000 or 400,000 a month. With this kind of insignificant improvement, perhaps it might be better to leave interest rates unchanged.

Still others might take a look at the inflation rate. They might say that, with the jobs market weak, and with intense global competition obliterating pricing power, there is a risk that inflation will fall too far, that it will undershoot desirable levels. As a result, real, inflation-adjusted, debt in an already heavily leveraged economy will be too high, undermining the sustainability of economic recovery. For them, the answer might be to cut interest rates; if not now, then later in the year.

Do these governors see different lumps of information? Are some of them privy only to growth numbers, whereas others are supplied only with information on the labour market, or on inflation? Can this explain why their views diverge to such a great degree? No, of course not. They all have the same information. Their understanding of this information, and how it should be processed, however, differs hugely.

And this is the problem. Central banks increasingly like to argue that they offer transparency, that their intentions and actions are always clear and intelligible to the financial markets. Surprises can be kept to a minimum, because all issues are always out in the open. All very well, but what happens when central bankers have a debate about the "right" economic model. If they disagree, transparency quickly, and in contradictory fashion, becomes very murky indeed.

I suspect that murkiness is here to stay for quite a while. The global economy is going through one of those phases where the old "rule book" is being ripped apart. No longer do the tried and tested barometers of economic activity work in reliable ways.

Let me give a few examples. For many central banks, inflation is the only thing to worry about. If inflation is low - and is likely to stay low - central bankers have got things about right. How can they tell that inflation will remain low? There are lots of possible ways, but one of the more obvious is to take a look at long-term bond yields, which supposedly will rise if inflationary expectations pick up.

But what happens if someone is buying these bonds who cares not one jot about the inflationary outlook? At this point, let me introduce the Asian central banks. They have been buying US assets - mostly US government bonds - not because they think the US is free of inflation but because they have no desire to see their currencies appreciating against the dollar. To prevent currency appreciation, they have to sell their own currencies and buy US assets, primarily bonds. In other words, the demand for bonds is potentially independent of the outlook for US inflation: and that means that bond yields must contain less helpful information for the Fed than before.

Then there's the issue of commodity prices. They've been rising quite strongly in dollar terms over the past couple of years - up around 40 per cent, enough to get any central banker into a cold sweat. Is this a sign of inflation? In the good old days - or bad old days, depending on your point of view - it most definitely was. Recently, though, it's been countries like China that have been driving up commodity prices, associated with strong economic expansion. But the strength of China's expansion is closely related to China's ability to gain a higher share of world trade as a result of low labour costs and, hence, lower selling prices. So it becomes a lot more difficult to argue that inflation is about to pick up. I would suggest the opposite: that China is more likely to push global inflation lower than higher.

How about currencies? Once upon a time, we used to think that a falling currency was a sure route to higher inflation. Indeed, the desire for exchange rate targets came directly from the view that a stable currency implied a stable inflation rate, so long as the currency was anchored against the right "lynchpin". This view, however, is no longer very useful. Countless currency declines over the past 15 years or so have had only a marginal impact on inflation, starting with sterling's exit from the exchange rate mechanism of the European Monetary System and ending, bang up to date, with the dollar's decline over the past two years.

And finally, for good measure, there's inflation itself. This is one of my favourite little bugbears. Do central bankers who preside over a "well-behaved" inflation rate sleep easily at night? They certainly hope to and, indeed, are obliged to, in countries where there is a formal inflation target. But inflation is a bit like a naughty child at a party: persuading the child to behave might be a success, but it can only be a qualified success if the other children then start to misbehave.

And that's precisely the problem. Central bankers are beginning to realise that inflation is not the only naughty child. Why else would the Bank of England have raised rates at the end of 2003? Inflation, after all, is very well behaved in the UK, particularly with respect to the new inflation target. The Bank of England is, instead, fretting about other things, most obviously house prices and the persistent strength of consumer spending. And why are the Federal Reserve's intentions seen to be increasingly confused? Because it is not sure what to do in a world that seems to generate price stability come rain or shine.

This week's charts show that, in recent years, US economic growth has persistently surprised on the upside whereas US inflation has not - yet stronger growth normally gives rise to higher inflation. In other words, economists - and, for that matter, central bankers - do not fully understand the relationship between growth and inflation. If the traditional indicators of inflation are no longer accurate, and if inflation itself is persistently well-behaved when growth is stronger than expected, it's hardly surprising that, despite all their claims for transparency, central banks are increasingly operating in an impenetrable fog.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com