Stephen King: Mystique now lies at the heart of Bank's interest rate policy

The Bank of England is reverting to the age-old approach adopted by central banks the world over
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A quarter of a point on base rates. Nothing to get too excited about, perhaps. But it still requires some explanation. This week, the Bank of England will provide its own spin with the publication of its latest Inflation Report. I know in advance what the report likely to say. So do the rest of you. The rise in base rates has given the game away. The Bank will say - indeed, will be obliged to say - that, without the rise in interest rates, there would be a danger of inflation exceeding the Government's new target. In case you've forgotten, the new target - based on the so-called harmonised inflation measure - stands at an annual rate of 2 per cent.

Is this really credible? Should we really believe the Bank sees higher inflation as a genuine risk? Because, if it does, the Bank envisages a totally different world from the one that has existed for the past seven years, during both good times and bad. Over this period, as my left-hand chart shows, inflation on the harmonised measure - the one that now matters - has remained stubbornly below target, sometimes considerably so. In other words, despite the rate of economic growth, the pace of house price inflation (see right hand chart) and varying levels of unemployment, inflation itself has not once threatened to become a serious problem.

Which begs the obvious question. Why, over these seven years, has the Bank nevertheless chosen - on plenty of occasions - to raise interest rates? The straightforward answer is that, over seven years, the Bank had a different inflation target, the so-called RPI-X. On this measure, inflation has more frequently threatened to be too high relative to target and, hence, the Bank has sometimes chosen to take remedial action in the form of higher interest rates.

In a speech last month, the Bank of England's Governor, Mervyn King (no relation) argued that the shift from one inflation target to another really didn't make a lot of difference. He likened the change to a shift in the measurement of temperature. You can measure temperature in Centigrade or in Fahrenheit. The numbers will obviously differ, but the temperature will nevertheless remain the same. Similarly, you can measure inflation using either RPI-X or the harmonised measure - now known as the consumer price index (CPI) - and the numbers again may differ, but inflationary pressures remain exactly the same and, therefore, the policy challenge is no different.

True, up to a point. But Mr King is forgetting - or, more likely, sidestepping - a key objection. It may well be that inflationary pressures remain the same, but the desirable level of inflationary pressures - as determined by the Government - may, nevertheless, have changed. The inflation target is a bit like the temperature you set on the thermostat of your central heating system. Change from Centigrade to Fahrenheit and there should be no alteration to the ambient temperature, if you make the appropriate arithmetic adjustment. However, get this adjustment wrong, and you may end up with a very different temperature indeed.

Although, therefore, there are all sorts of technical reasons for occasional differences in the measurement of inflation using RPI-X or CPI, the fact of the matter is that, for an extended period of time, CPI inflation has been persistently below the new, CPI-based, inflation target. This was rarer with the old RPI-X target. And if inflation persists in being below the new target in the future, there are only so many conclusions that we can reasonably reach.

First, it may simply be the case that the Bank's models of future inflation persistently overstate the likely inflationary risk associated with any given growth rate. This would be nothing new - consensus forecasts seem persistently to overestimate the risk of inflation. This "error" could certainly explain why the Bank might choose to raise interest rates even if, in the event, inflation remained relatively low. However, by now, it would be reasonable to think that any bias in the inflation forecasts had been removed. Moreover, given the behaviour of the new target compared with the old one, the Bank is already fully aware of the additional risk of undershooting the new, CPI-based, target.

Second, even the removal of the bias might still leave the inflationary outlook very uncertain and, as a result, could still lead to a lack of confidence about the impact of interest rate changes on the final inflation outcome. The Bank of England's Inflation Report typically contains two charts on the inflationary outlook, one based on the current level of base rates and the other dependent on the path for future interest rates as discounted within financial markets. As I have noted in this column before, the Bank's inflation projections under these two - often quite different - scenarios are virtually the same, suggesting a lack of confidence in the precise effect of changes in interest rates on future inflation. On this basis, changes in interest rates could be based on a hunch about future inflationary risk, but not much more than that.

Third, and most likely in my view, the Bank itself no longer feels quite so comfortable with a formal inflation targeting approach that can still, nevertheless, give rise to imbalances within the economy. Moreover, Bank discomfort may have increased in response to the Government's new inflation-targeting regime. The Bank has raised interest rates but such decisions are becoming increasingly difficult to justify on the basis of the inflation target alone, given the persistence of inflationary undershoots.

Instead, the Bank is reverting to the age-old approach adopted by central banks the world over. The Bank claims to have a clear set of targets but, at the end of the day, will succeed not by sticking to those targets, but rather by adopting a "mystical" approach to policy-making. Perhaps the best example of this mystical approach was the Bundesbank during its heyday in the 1980s. Back then, everyone knew the Bundesbank's policies were based on targets for the money supply. These targets would be set on an annual basis and adhered to rigidly.

Or at least that's the image, the mystique, that the Bundesbank managed to create. In reality, the Bundesbank managed to hit its money supply target only half the time. The rest of the time, it was busily overshooting or undershooting, without ever threatening the credibility of its underlying image with the German public. Of course, this meant the transparency of policy was not always that great. But that didn't matter so much when the institution itself was so highly revered both within Germany itself and elsewhere in the world, so much so that virtually all other European countries gave up the right to make their own decisions and anchored their policies instead to the mystical wisdom of the Bundesbank through the Exchange Rate Mechanism.

I really don't think there's anything too wrong with this approach. It is right that the Bank of England should fret about house prices, about consumer debt and about imbalances within the economy. It is right that interest rates should adjust to deal with these issues, even if there is no obvious threat to inflation. But it means that, under the current institutional arrangements, we should put more faith in the Bank's actions than its words. It is compelled to justify movements in interest rates on the basis of the outlook for inflation, as the Bundesbank was compelled to justify its decisions on the back of money supply developments. At the end of the day, though, it is a central bank's ability to create mystique that may ultimately determine its success. The transparency of the Inflation Report is no more than a diversion from the mystical elements that are now creeping into the Monetary Policy Committee's decisions.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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