Stephen King: Inflation watchdogs should beware a penalty of the Maradona effect

A central bank is likely to be successful because of the actions expected of it by the population

Similarly, a central bank is likely to be successful not so much because of its actions but, rather, because of the actions expected of it by the population at large and by financial markets in particular. If a central bank sticks credibly to its goal of price stability, and the market expects that commitment to be maintained, then actual changes in official interest rates may become few and far between. If signs of higher inflation emerge, market interest rates are likely to rise in anticipation of central bank action, thereby reducing the need for such action. Similarly, if there are sudden signs of economic weakness, market interest rates are likely to decline, thereby reducing the need for action from the central bank itself.

Of course, this argument works only so long as the central bank is seen to act in a predictable fashion. What happens, though, if the policymakers who decide on interest rates disagree with one another? How are markets supposed to interpret likely central bank actions if it turns out that the committee with the responsibility to set interest rates is divided? Put another way, what if Maradona's right leg wants to go in one direction, but his independently-minded left leg wants to head in an entirely different direction?

One response is simply to say that public disagreements are no bad thing. The structure of economies is constantly evolving, and disagreements between central bankers are simply a reflection of the puzzles that are associated with monetary policy decisions. On this interpretation, a divided committee unable to reach a unanimous decision about the direction in which interest rates should be heading sends a useful message to financial markets to keep, collectively, an open mind.

This is very much the approach used by the Bank of England. A quick look at the voting record of the Monetary Policy Committee (MPC) over the last three years shows plenty of occasions when the committee has been clearly divided. Earlier this year, there were no changes in interest rates, but a small minority on the committee favoured increases. By June, a small minority favoured cuts. In July, four out of the nine members favoured a rate cut and, in August, the rate cut finally occurred.

In 2003, there was a similar year of divisions. Interest rates were cut in both February and in July, although a vocal minority had been in favour of rate cuts throughout the first half of that year. By October, however, four out of the nine MPC members favoured a rate increase. That rate increase was duly delivered - not quite unanimously - on 6 November.

The MPC's approach has certainly been successful, to the extent that inflationary expectations have been very stable in recent years, but to my mind there's something still a little odd about the approach. Take another footballing analogy. Imagine two teams in their separate dressing rooms ahead of a big match. The first team - let's call them team A - have a big argument in the dressing room about tactics. To resolve the issue, they take a vote. They decide to go for the attacking option. Importantly, regardless of the dressing-room differences, they go onto the pitch absolutely united in their intentions. They are, if you like, a proper team, putting aside personal differences for the good of the team as a whole. They never reveal to the other team, nor to the public at large, that they had a prior disagreement.

The second team - let's call them Manchester United - also have a big tactical argument in the dressing room. They also take a vote but, rather than keeping their differences private, the results leak out, revealing a disunited team. Each team member is free to air his opinions on television, and one team member, Roy Keane, is particularly aggressive. The opposition lick their lips: here, they think, is a team who want to win, but have lost their way, with dressing room acrimony spilling over onto the pitch.

Apart from its obvious topicality, the relevance of my footballing analogy lies with the differing philosophies of the Bank of England and the Federal Reserve. The Federal Open Markets Committee (FOMC), under Alan Greenspan, offers a much more collegiate approach than the Bank of England. While I'm sure that the members of the FOMC do disagree from time to time, you'd be hard-pushed to find those disagreements clearly stated in the minutes of the policy meetings held in recent years. Since 2003, all but two FOMC meetings have finished with unanimous policy decisions. The only exceptions were in June 2003, when one member favoured a 0.5 per cent rate cut rather than the 0.25 per cent rate cut actually delivered, and in September of this year, when one member chose not to vote for a rate increase because of concerns about Hurricane Katrina.

The Bank of England believes that disagreement is a useful signalling device, an indication of the level of risk faced by financial markets in their assessment of the direction in which interest rates are likely to be heading. The Federal Reserve, in contrast, believes that collective responsibility is key: transparency for America's central bank lies with the clarity of the public message, not with the disagreements that arise on the way to issuing that message. At this stage, neither approach can be described as clearly superior to the other. And it's always possible that the Federal Reserve's approach will change with Ben Bernanke replacing Alan Greenspan in a few weeks' time. It seems to me, though, that the Federal Reserve's approach offers greater certainty about a central bank's intentions.

Either way, there is something ultimately a bit odd about central banks' persistent pursuit of transparency. It's a logical conundrum. If the central bank is entirely credible in what it does, inflationary expectations will never change. The public will always expect the central bank to adopt the necessary measures that will ensure that price stability is achieved at all times. But if this means that market rates always correctly anticipate likely future moves in official interest rates - reducing the need for official interest rates themselves to change - there will come a point when markets realise that the anticipated movements in official interest rates don't actually take place and that, as a result, the central bank appears not to be responding to perceived changes in inflationary risk. Likewise, if Maradona continued to run in a straight line against opposition defences, they would surely work out that he would be a little easier to tackle than his reputation suggested.

An esoteric argument, perhaps, but one that is currently relevant. The Federal Reserve has been raising short-term interest rates for quite a while now, yet long-term interest rates - which can be described as a weighted average of expectations about future levels of short-term interest rates - have hardly budged. If inflation expectations really are secure, and the expected level of future short-term interest rates hardly changes, the link between central bank monetary policy decisions and their ultimate impact on the economy becomes increasingly tenuous. Short rates will increasingly move in seemingly random fashion, unrelated to the subsequent performance of either growth or inflation. And that would mean that the pursuit of transparency would eventually become self-defeating. With the link between action and objective increasingly opaque, it will become increasingly difficult for central banks to explain why they ever bother to change interest rates.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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