Stephen King: The only certain thing about inflation is there is no certainty

On Thursday, the Bank of England's Monetary Policy Committee (MPC) decides on whether or not the UK economy needs a further tightening of the interest rate screw. At least some of the evidence that's accumulated in recent weeks suggests that inaction might be more of a surprise than action: the housing market is rebounding rather robustly, the economy is expanding rapidly, inflation is above target and money supply growth is, to say the least, a touch exuberant.

Nevertheless, not all members of the MPC think that rates should be going up. Last week, Professor David Blanchflower, one of the MPC's newer recruits, argued in Wales that the labour market had softened and emphasised that "at present, I see no evidence of any second-round wage effects from the recent oil price increases". Perhaps, then, there is a case for waiting until November, around the time of the Bank of England's next Inflation Report. As Professor Blanchflower noted, "we are as a Committee unanimous in agreement that there is greater than usual uncertainty over the outlook for inflation ..."

Why are our monetary masters now so puzzled? One possibility is that, as membership of the MPC has changed, the MPC's confidence in judging the outlook for the economy has waned. In Professor Blanchflower's case, though, this seems unlikely: his views are not so different from those of Steve Nickell, his predecessor on the committee.

A more plausible explanation lies with the yardsticks by which monetary success and failure can be judged. Sometimes, these yardsticks provide good and consistent readings. On other occasions, they're less helpful.

Part of the problem lies with interpretations of the inflation target. Faced with external shocks, to what degree should inflation be allowed to deviate from target and at what point should central bankers start to worry about the second-round effects that Professor Blanchflower suggests are simply not there?

Over the last 10 years, we've had two major external price shocks, both of which relate to aspects of globalisation. The first, in the late 1990s, was associated with the import of remarkably cheap goods from China and elsewhere in the emerging world. Structurally, this shock reflected increasing access to low-cost labour markets. Cyclically, it reflected deflationary effects stemming from the Asian crisis in 1997 and 1998. The second, more recent, shock has been associated with the remarkable success of emerging markets. Their rapid - and for the most part, sustainable - rates of economic expansion have led to significantly higher world prices for oil, gas and other raw materials.

The first of these shocks lowered inflation. The second has helped to lift inflation. But to what degree should central bankers respond to these deviations from the underlying inflation target? Arguably, they needn't respond at all: the price declines of the late-1990s left us all feeling better off so rate cuts designed to prevent inflation from falling would have been a case of gilding the lily. Similarly, the price rises of recent times have left us all feeling a bit worse off, so why raise interest rates and double up the misery?

The answer lies with uncertainty. Inflation may have headed up recently because of one-off energy price effects that may not translate into higher wages. But perhaps inflation has risen for other reasons too. Maybe monetary conditions are too loose. If so, holding back on rate hikes in the hope that credibility will never be damaged might prove to be a mistake. It might, instead, be wise to raise interest rates a bit, buy some credibility, and accept there'll be a small price to pay in the form of a temporary loss of output.

An even better approach, though, would be to find a way to reduce the level of uncertainty. If you're not quite sure why inflation has picked up, perhaps you should look at other data in the hope of getting a "second opinion".

This is exactly what the Bank of England seems to be up to. Suddenly money supply has become interesting. Like leggings and Bob Dylan, monetarist thinking is, remarkably, back in vogue. When interest rates were last raised at the beginning of August, among the justifications cited by the Bank of England was "rapid growth of broad money and credit".

The top chart shows what's happened to M4 growth in recent years. This is the most closely-watched measure of so-called "broad money". It captures not just notes and coins in circulation and sight deposits at banks but a whole range of other things, including money balances held by so-called "other financial corporations". This rather amorphous category includes deposits held by pension funds, insurance companies, private equity companies and hedge funds.

Basically, M4 growth has gone through the roof. Those of a monetarist persuasion - and a few of them wrote in to the Financial Times last week demanding action - are likely to be feeling a touch uneasy. Their world view is simple: an acceleration in money supply is likely, eventually, to mean higher inflation.

There is, though, a tricky problem. As the chart shows, the acceleration in money supply growth is entirely the result of the increase in money balances held by the so-called "other financial corporations". The Bank doesn't really know why their demand for money has increased so much.

One possibility is that the money will eventually be used to buy equities or housing - which, by driving asset prices up, will simply encourage more bank lending and, eventually, higher inflation. Another possibility, though, is that there simply aren't enough investment opportunities around. As a result, these other financial institutions are happy to hold more cash than they've done in the past, leaving inflation untouched.

In any case, money supply growth has varied quite a lot from country to country - accelerating in the UK over the last five years but slowing down in the US - yet asset prices across different countries have tended to move in similar directions. The link between money supply growth and, say, stock market performance is, therefore, a little tenuous. And even if asset prices were to pick up, inflation may still not be a problem.

To see why, it's worth thinking about the trade-off between unemployment and inflation. In the 1970s, economists began to recognise that attempts to bring unemployment down below a so-called "natural rate" would lead to ever-accelerating inflation.

Put another way, excessively loose monetary policy might raise output temporarily but would raise inflation permanently. Over the last 10 years, though, this argument has been turned on its head: the UK unemployment rate has varied hugely from year to year but inflation has hardly budged (lower chart).

Perhaps this can be seen as a victory for central bank credibility. Maybe it reflects the impact of globalisation on the wage-bargaining process. Either way, it reveals yet another puzzle about the relationship between interest rates, financial markets, the real economy and, ultimately, inflation.

Using money supply as an additional input in the interest rate-setting process is sensible enough. Pretending, though, that money supply provides a definitive guide to inflationary risks is a step too far: let's not forget that money supply targeting was abandoned in the mid-1980s because it basically didn't work. Professor Blanchflower is right to argue that we live in uncertain times, but there's no point in believing that somewhere out there lies a silver bullet, ready to take that uncertainty away.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com