Stephen King: King has the intellectual muscle but he needs to flex it correctly

Inflation targeting is in danger of becoming yesterday's success story rather than today's solution
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Don't you think it's rather fortunate that Gordon Brown has different tastes to those of the Californian electorate? Who would you rather have as Governor of your economy? A learned, bespectacled professor of economics, a scholar of Cambridge and Harvard, someone who knows something about the economic issues of the day? Or a movie star with overdeveloped muscles who, when asked to comment on claims about groping, said: "It is true that I was on rowdy movie sets and I have done things that were not right which I thought then was playful"?

For those of you who read not only The Independent but are tempted to dip into Hello!from time to time, you might be sorely tempted to go for Arnie the Terminator as your Governor. For the rest of us, though, I suspect Mervyn King cuts a more reassuring - if not such a well-honed - figure. His background and experience suggest that he has a good chance of getting things right and, as a central bank governor, he certainly shouldn't succumb to playfulness.

This doesn't mean, though, that Mervyn King and his colleagues at the Bank of England will be spot-on all of the time. One of the difficulties for any central banker lies in knowing when to pull the interest rate trigger and for what purpose. Last week's Monetary Policy Committee meeting doubtless focused on precisely these issues. Markets increasingly believe - whether rightly or wrongly - that interest rates have bottomed and, in the words of Yazz and the Plastic Population, "the only way is up". Yet, even if this were true, the MPC has yet to pull the trigger. One of the key dilemmas for the MPC lies in the time horizon for its interest rate decisions. This issue is well documented in a paper entitled Inflation targeting: the UK experience, presented at the beginning of October by Charles Bean, the Bank's chief economist (you can find it at www.bankofengland.co.uk).

Mr Bean notes that asset price bubbles and associated build-ups of debt have the potential to destabilise the achievement of price stability over the medium term. He argues that, because of this, there may be occasions when the central bank should aim to tighten policy even if a near-term undershoot of the inflation target is then threatened. He admits, though, that the practical difficulties involved in knowing when, and when not, to act are immense and, in many ways, compromise the transparency that the Bank of England has strived so hard to achieve since independence was granted in 1997.

This argument, though, may be a second-order argument relative to a potentially more serious structural problem. Mr Bean argues that inflation targeting has led to a better economic performance for the UK since 1992 than anyone could reasonably have hoped for at the time. He's probably right: growth has come in better than expected, inflation has generally been lower and unemployment has collapsed. At least some of this can be explained by the adoption of inflation targets and central bank independence: the credibility gains associated with these moves helped deliver lower long-term interest rates, thereby reducing the cost of capital for millions of individual and corporate borrowers.

The problem now, though, is that the achievement of low and stable inflation may have become a little too easy. Inflation targeting may work very well in puncturing a bubble of inflationary expectations, but what happens when inflationary expectations fall in line with the central bank's target? Does this mean that we have reached a new economic nirvana, with the inflationary beast slain? Or does it simply mean that inflation itself has dropped down the league table of economic problems, to be replaced by other awkward challenges?

From a pure UK perspective, the case for nirvana may be relatively easy to argue: after all, the UK has avoided a serious economic downswing in recent years, despite all the shocks landing on our doorstep from other parts of the world. A quick look elsewhere, however, suggests that this conclusion might be overly complacent. Japan's price stability in the late 1980s didn't lead to economic nirvana. America's price stability in the late 1990s provided no real sign of approaching economic difficulties. More generally, as I argued in Bubble Trouble (1999), the vast majority of asset price bubbles that eventually end in tears are normally associated with well-behaved, or at least better than expected, inflation.

Put another way, inflation itself may have become a less-than-useful indicator of long-term economic health. Inflation targeting - at least in its current formulation - is in danger of becoming yesterday's success story rather than today's solution. It's certainly true that the UK has performed very well under the inflation targeting regime but inflation has been very well-behaved all over the world in recent years, irrespective of the chosen monetary policy regime. Despite all this, the world has shifted from one crisis to the next. There have been plenty of good times in between but my point is simply that the eradication of inflation has not led to a notable improvement in global economic stability, even if the UK itself has done rather well in recent years.

Of course, the Bank would argue that the inflation-targeting regime itself has insulated the UK from these global shocks and, therefore, should be regarded as an unqualified success. This, though, doesn't seem to be good enough. If I'm right to suggest that low inflation, in itself, is no guarantee of lasting economic success, it might be worth thinking about tell-tale signs that might suggest that all is not as it seems.

The obvious place to look at is the structure of demand. The Bank of England has consciously boosted domestic demand knowing full well that a failure to do so would have led to an inflationary undershoot, given the weakness of the global economy. That policy would have been fine had the global economy eventually recovered. Given recent better data in the US and Japan, and continuing very strong data in China, it might just be possible that a desirable UK "rebalancing" lies just around the corner. The problem, though, is the eurozone. The UK's latest trade data reveal that exports are still falling, despite the better global picture, and they are falling specifically against the eurozone, by far our biggest trading partner.

This story need not end in tears but, to the extent that the UK's trade position continues to deteriorate, it reveals that the economy is increasingly debt-dependent, irrespective of what is going on in the housing market. We are being encouraged to behave in a certain way even though this might not be fully consistent with developments in other parts of the world. Another way of putting this is that we are increasingly being dominated by global events, beyond the influence of our domestic central bank. Inflation is well-behaved in the UK because inflation is well-behaved globally. Growth is unbalanced in the UK because the UK inflation-targeting regime may be inconsistent with developments elsewhere in the world.

The inflation-targeting regime is all well and good but it cannot easily deal with the relationship between the UK and the rest of the world. Each move and counter-move on interest rates is taken with not much more than a guess about what is happening elsewhere. And each success - or failure - on inflation has to be seen in the context not just of the inflation-targeting regime itself but also through the influence of external forces. This "internationalist" approach might suggest that the inflation-targeting regime has not played the pivotal role in UK economic success. And it might also suggest that having an Austrian former Mr Universe in charge of an American state, offering its electorate a unique international perspective, may not be so daft after all.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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