Stephen King: Our dull low-inflation world still needs the art of nimble economic policy making

One of the Bank's biggest difficulties lies in knowing, precisely, what's going on at any moment in time. The Bank clearly distrusts the data it receives from the Office for National Statistics (ONS), not so much because the ONS is error-prone but, rather, because the ONS simply doesn't have enough information available to make a reliable and accurate quick-fire assessment of the economy's performance from one quarter to the next.

For an economy like the UK's, heavily dependent on services, it's not enough to be able to count the number of widgets churned out from one month to the next: information on services, though, comes through only in dribs and drabs. As a result, initial estimates of GDP are best regarded as the first snapshots taken from the camera on a mobile phone rather than the 8 megapixel images that might come from a truly professional camera - at best, therefore, a foggy representation of the truth.

On top of that, the imagery the Bank requires is multi-dimensional whereas the ONS's first estimates are merely two-dimensional. The budding policymaking cameraman has to incorporate more shots from different angles to get a better picture of what is really going on. And those new images take time to put together. One implication of this is that the Bank is likely to make mistakes of interpretation from time to time: it sets policy on the basis of what appears to be happening rather than on the basis of what actually is happening. It's a bit like seeing a wedding day snapshot and concluding that bride and groom are now living happily ever after, perhaps with a baby on the way: only later on do you discover that the groom ran off with the best man before the vows were taken.

Central bankers have to rely on a hypothesis, an approximation of reality that can continuously be tested over a period of time. Currently, for example, the Bank is concerned about the impact of higher oil prices. It knows what oil prices have done up until now, it knows what futures markets are thinking oil prices will do in the future and it also knows that futures markets have been wrong. But even if the Bank had perfect foresight, it would still have a problem: it has to provide a hypothesis of how, exactly, higher oil prices feed through to the broader economy.

An obvious difficulty lies in assessing precisely why oil prices are higher. On one interpretation, higher oil prices stem from supply-side shocks, the kind of thing that happened after the 1973 Yom Kippur war. On another interpretation, they're the result of stronger than expected demand, the result of faster global economic growth. Currently, the second of these interpretations looks to be the better bet. Then there's the question of who, in the world, is delivering strong demand. It's certainly not the usual G7 suspects: Britain's European trading partners are still very weak, despite some slightly better business surveys in recent months. The US consumer is playing a role, but the biggest increases in demand for commodities are coming from countries like China. And while they may be contributing to higher global energy and other raw materials prices, they're also putting downward pressure on global wage levels. Because of that, the inflationary implications of higher energy prices may differ from previous oil shocks.

Meanwhile, there's a broader issue about expectations and credibility. To what extent does the policy framework and a commitment to a certain set of economic conditions influence the ways in which we react to external shocks like, for example, higher oil prices? In the 1960s and 1970s, the overwhelming consensus was one in favour of full employment: governments liked to advertise the fact that, whatever happened, they had the tools to maintain full employment at all times. As it turned out, they were wrong, not because their commitment wavered but, rather, because companies and workers discovered how to exploit that commitment.

Higher oil prices made people worse off. If, as a worker, you didn't like that conclusion, you could demand, through your union, a significant pay increase. There may have been no productivity justification but what did you care? Higher wages should have threatened higher unemployment but, so long as you had the government guarantee, you didn't have to worry too much. It was only when inflation began to rise that the full employment commitment no longer appeared tenable. Put another way, the goal of full employment was undermined by the way that society, collectively, took advantage of the supposed guarantee.

The good news today is that a repeat of the inflationary 1970s and 1980s seems highly unlikely. This is not just a story about globalisation, about mobile capital and new sources of cheap labour. It's also a story about the credibility of policy frameworks in general and central banks in particular.

Mervyn King has famously argued that the ambition of central bankers is to be boring. To a degree, he has succeeded (although he may want to play down the cricketing metaphors if the Ashes series maintains its current level of excitement). I would, however, go a little further. If a central bank really is successful in maintaining low inflation, it's because society expects it to maintain low inflation. Once that point is reached, the central bank's job actually becomes rather easy. In last week's press conference, all sorts of references were made to difficulties of interpretation, of problems with data and so on yet, despite all these headaches, the truth is that the Bank has been remarkably successful at meeting its inflation objective. It might make mistakes, but these mistakes are unlikely to show up initially in a significant deviation of inflation from its target. After all, if society as a whole believes that inflation will remain at 2 per cent over the medium term, why would anyone demand an inflation-busting wage increase?

The truth is that the inflationary consequences of policy mistakes these days are a lot smaller than they were in, say, Paul Volcker's day, when the Fed had to stamp out cancerous inflationary expectations endemic in the US - and world - economy. We now have the same beliefs about inflation that, once upon a time, we had about unemployment - we believe our policy makers can achieve the right outcome year in, year out. That, in itself, is a victory of sorts. However, like the achievement of full employment, success with low inflation may simply lead to economic problems in other areas: asset prices and debt levels are obvious sources of concern. By making the world a safer place, our policy makers may eventually entice us to take risks that, eventually, lead to renewed economic instability. And this means that although inflation may be dead, the art of nimble policymaking needs to be kept very much alive.

Stephen King is managing director of economics at HSBC

stephenking@hsbcib.com

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