Stephen King: Is it time to thumb our noses at the rules?

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The Independent Online

We often make decisions on the basis of "rules of thumb". There simply isn't the time to carry out a thorough analysis of the choices on offer. Some of our rules are based on previous experience. Loyalty to a particular brand of motor car might be based on the reliability of the models we've owned in the past.

Other rules of thumb may be imposed from outside. We're told that recreational drugs, for example, are very bad for us and we avoid them without necessarily having had any experience of their effects.

These rules can suddenly change. If you own a car that keeps breaking down, you might begin to question your loyalty to the brand that had served you so well in the past. If your friends are all taking drugs, you might be tempted to take some yourself. Of course, you may regret your change-of-heart later on and, as a result, choose to reinstate your earlier rule. But that simply shows that our attitude towards rules of thumb can be rather fickle.

This fickleness is a potential problem for policymakers. It's explored in a working paper published by the Bank of England last week. Engagingly entitled "The danger of inflating expectations of macroeconomic stability: heuristic switching in an overlapping generations monetary model", the paper is of more than academic interest: one of its four authors is Mervyn King, the Bank of England's Governor. (The others are Alex Brazier, Richard Harrison and Tony Yates).

The authors are specifically interested in why growth and inflation have been more stable in recent years compared with, for example, the 1970s and 1980s. Many academics have argued that policymakers have simply been lucky because, in recent times, there have been fewer nasty external shocks.

I find this hard to believe. There have been plenty of shocks: those that spring to mind include the Asian crisis in 1997, the Russian crisis and collapse of Long-Term Capital Management in 1998, the global stock market crash in 2000 and, of course, the terrorist atrocities in 2001. The surprise has been the remarkable resilience of economic performance in the light of these shocks.

One reason for this resilience may be that objectives for monetary and fiscal policy are much more clearly defined today than they were in the past. Put another way, expectations about future economic developments don't depend quite so much on current economic developments.

Back in the 1970s, when oil prices went up, people pushed for wage and price increases. These days, when oil prices go up, people don't. Perhaps that's because we all understand the central bank's inflation-targeting mandate and know that the only reward for excessive wage and price increases will be horribly-high interest rates (in the 1970s, after the break-up of the Bretton Woods exchange rate system, there weren't any obvious monetary rules).

The authors develop a "very simple model" (16 equations of varying complexity with useful summaries for the layman such as "complete stabilisation of consumption and employment is optimal because of the curvature of agents' utility (a feature preserved by our quadratic approximation)") which allows them to investigate future inflationary behaviour on the basis of two alternative rules of thumb or "heuristics" used by members of the public.

The first rule says that inflation tomorrow is assumed to be the same as inflation yesterday. The second says that inflation tomorrow will be equal to the central bank's inflation target. Not surprisingly, the first rule leads to an unstable inflation performance: yesterday's higher inflation, perhaps the result of an oil price shock, raises people's expectations of inflation tomorrow.

The second rule, though, is much more satisfactory: yesterday's higher inflation need not have any effect on inflation expectations so long as people believe that the central bank will be able to deliver on its promise of price stability.

The problem, of course, is that policymakers cannot guarantee that the public will necessarily use the second rather than the first rule. Still, it's better to have the second rule available as an option: without it, price stability would be more difficult to achieve. The authors are, therefore, able to conclude that "inflation in an economy with an inflation target tends to be more stable than in an economy without a target".

Their work also suggests that a central bank should respond to changes in inflation expectations because these are the best way of gauging whether people are shifting from a desirable rule of thumb to one which threatens a period of sustained economic instability.

Arguably, central banks around the world have been raising interest rates over the last few quarters precisely because the public may be thinking about shifting from one rule of thumb - the central bank always hits its target - to another rule of thumb - the central bank can't be trusted to hit its target.

Constantly rising oil prices have threatened the ability of central banks to deliver on their price promises. The left-hand chart, for example, shows that inflation in the eurozone has been persistently above the European Central Bank's inflation target in recent years.

Gauging the public's perceptions about inflation is no easy task. The bottom chart shows that, on Ben Bernanke's favoured "core" definition of price stability, which excludes food and energy prices, US inflation has been reasonably well-behaved, for the most part staying within Bernanke's "comfort zone".

But what if the US public prefers to focus on headline inflation, which has been extremely badly-behaved in recent months? The Bank of England's answer is to focus on how inflation expectations are changing but, unfortunately, there is no single handy measure of inflation expectations: as a result, we may never know that rules of thumb have changed until it's too late.

I think the Bank would be happy to admit this. Indeed, the working paper's authors state that "there are periods like 'Great Stabilities' in which inflation is very stable but these are interspersed with periods of greater volatility".

This observation, though, reveals the paper's limitations. The focus on inflation targeting ignores the other nominal frameworks that have been used to help achieve price stability. These alternatives include money supply growth, nominal GDP targeting and exchange rate targeting.

From the late-1970s through to the mid-1980s, monetary targeting was seen in the UK to be the best way of securing economic stability. In the late-1980s through to sterling's ejection from the ERM in 1992, exchange rate targeting was apparently the best mechanism.

For a while, these approaches seemed to offer rules of thumb that might have been useful for an otherwise-sceptical public. Each approach, though, eventually ended in failure. Of course, it's not clear that these approaches were undermined simply by changes in the rules of thumb used by the public.

However, there's a good chance that promises of stability led to increases in risk-taking that, in turn, undermined the ability of policymakers actually to deliver stability over a sustained period of time.

Two questions stem from this. First, do periods of stability contain within them the seeds of their own destruction, perhaps reflecting society's wanton desire to be exposed to excessive risk from time to time? Second, when periods of stability draw to a close, do we ever subsequently return to the policy frameworks in operation during those periods of stability?

If the answer to the first question is "yes" - and the Bank admits that this is a possibility - and the answer to the second question, based on past experience, is "no", then perhaps inflation targeting will eventually end up on the policy scrap heap. Somehow, I doubt that the Bank of England will be writing a paper on this subject any time soon.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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