Stephen King: Why we'll have to take the Bank more on trust

'The Bank is potentially on a collision course with the UK government'
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The Independent Online

The more transparent things are, the less we have to rely on trust. The more we trust, the less transparent things need to be. Which one's better? Most religions aren't exactly transparent, yet many people have no problem with their faith, perhaps the ultimate form of trust. But most employers would think twice about hiring someone on trust alone, preferring to look at exam results, previous experience, references and performance at interview: for most recruiters, the more transparent, the better.

When it comes to economics, trust and transparency are important issues, particularly in the realm of monetary policy. On one side of the Atlantic, we have a central bank that is very transparent indeed. We know what the Bank of England is thinking but, more importantly, we also think we know why it is thinking what it is thinking. The Bank of England has been given an inflation target, apparently needs to aim at that inflation target at all times, and tells us that interest rate changes occur only in order to ensure that the target is met.

On the other side of the Atlantic, we have a central bank that prefers to emphasise the role of trust. The Federal Reserve - at least in the form of Alan Greenspan - thinks that an inflation target is not the solution to monetary policy problems. Instead, the Fed has a rather vague commitment to lasting economic health, in a "mom and apple pie" kind of way. The Federal Reserve Act requires the Fed to achieve a combination of price stability, high employment and moderate long-term interest rates - admirable aims in themselves but not always easy to achieve simultaneously. And because of this, we have to take the Fed's behaviour on trust.

Why draw a distinction between the approaches of these two esteemed institutions? For the simple reason that both central banks are engaged in an internal debate about monetary tightening. The Bank of England has already raised interest rates, and is likely to push them up a fair bit further through the remainder of this year. The Federal Reserve has, so far, kept its powder dry but, in a series of speeches and comments last week from Alan Greenspan and assorted other Fed governors, the Fed has made it absolutely clear that monetary tightening is most definitely on the policy agenda. The issues for them are not so much "if" rates go up but "when" and "by how much".

So, is it better to conduct this debate on the basis of trust, or is it better to have an entirely transparent approach? In my view, trust will win the day. This puts the Bank of England in a difficult position - potentially on a collision course with the UK government - but I suspect that, as the year progresses, we will all be forced to take the Bank's decisions increasingly on trust rather than on the basis of transparency.

The reasons for trust rather than transparency were spelt out by Alan Greenspan in a speech - "Monetary policy under uncertainty" - last year. He wasn't talking about inflation targeting alone: instead, he was referring to the general philosophy of simple "rules-based" monetary regimes, of which the Bank of England's inflation targeting approach is but one example. Among other things, he said: "Rules by their nature are simple, and when significant and shifting uncertainties exist in the economic environment, they cannot substitute for risk-management paradigms, which are far better suited to policymaking. Were we to introduce an interest rate rule, how would we judge the meaning of a rule that posits a rate far above or below the current rate? Should policy makers adjust the current rate to that suggested by the rule? Should we conclude that this deviation is normal variance and disregard the signal? Or should we assume that the parameters of the rule are mis-specified and adjust them to fit the current rate?" (Jackson Hole, Wyoming, 29 August 2003)

In other words, Dr Greenspan is saying "trust me, I'm a central banker". When he talks about risk management, he's referring to the risks, or shocks, that come in all directions to upset the economic apple cart. Dr Greenspan is arguing that there are occasions when it might be appropriate to change interest rates even though it is near impossible to explain why the changes are taking place in the context of an inflation target.

Greenspan's world is a world of uncertainty where the policy challenges are constantly evolving, often in unexpected directions. To constrain policy towards an inflation objective alone might provide transparency, but it might eventually undermine the credibility of the central bank itself. Take the Long Term Capital Management (LTCM) affair in 1998. At the time the Federal Reserve chose to reduce interest rates because it recognised that the collapse of LTCM could rip apart the fabric of the US financial system. Of course, had the system collapsed, there might have been an impact on inflation, but that was not the Fed's justification for the rate changes: irrespective of the outlook for inflation, the objective was to avoid financial meltdown.

The Bank of England's dilemma is easy to state, but less easy to deal with. The latest inflation figures show that the rate is down to 1.1 per cent, well below the 2 per cent target and within a whisker of the lower end of the bands that surround the target (see chart). Were the rate to fall further - to less than 1 per cent - the Bank of England would then be obliged to write a letter to the Chancellor explaining, in one sense, what had gone wrong.

Actually, this is a little unfair: the Chancellor has made it clear that "the thresholds [1 percentage point on either side of the central rate] do not define a target range. Their function is to define the points at which I shall expect an explanatory letter from you because the actual inflation rate is appreciably away from its target" (Chancellor's remit to the Monetary Policy Committee, 10 December 2003).

I think it would be a very good thing for inflation to fall below 1 per cent, because it would force into the open a discussion about trust and transparency. It would be simple to argue, were inflation to drop below 1 per cent, that the Bank of England had failed, but that, surely, would be the wrong interpretation. Using the Greenspan approach, it would be much easier to argue that the current risks facing the UK economy are the continued strength of house prices, the persistent rise in consumer debt and the possibility of unpleasant consequences associated with these changes further down the road.

At this stage, it is near enough impossible to quantify these unpleasant consequences, and certainly it is difficult to measure their impact on inflation, but surely the key point is that failure to act now may make life a lot more difficult both for the Bank and the Government at a later date.

The danger with this approach is that it waves goodbye to the pseudo-scientific pushbutton view of economics that is so beloved of economists who spend more time looking at their econometric equations than they do focusing on real world issues. In other words, it provides a less transparent, more trusting, approach to monetary policy. Yet, this may be no bad thing. Pushbutton economics is - and always was - an illusion, a comfort blanket used by those who do not want to face up to the inherent uncertainties central bankers have to face in the real world. A Bank of England forced to write a letter would have the opportunity to spell out in a lot more detail how it inevitably has to cope with the myriad shocks and uncertainties that are a natural part of economic life. And the Bank should not be afraid to do so: after all, it would have the support of the world's most eminent central banker.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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