Stephen King: Bias in the Bank's inflation strategy risks losing public backing it needs
Outlook: A credit-constrained economy won't be able to generate high inflation for ever, yetthe split between growth and inflation has deteriorated rapidly
Monday 07 February 2011
"The anchoring of inflation expectations has been central to the stability enjoyed by the UK economy over the past decade. . .Inflation expectations have been anchored because the MPC has responded to events that have pushed the outlook for inflation away from target and households, businesses and financial markets have understood and anticipated our responses." – Mervyn King, Governor of the Bank of England, "The MPC Ten Years On", May 2007
"Even if we had known a year ago that 2010 would bring further increases in food, energy and other import prices, as well as a rise in VAT, it would not have been sensible to pretend that a tightening of monetary policy to offset those upward pressures on CPI inflation was consistent with aiming to keep inflation at the target in the medium term." – Mervyn King, speech at the Civic Centre, Newcastle, January 2011
Contained within these two quotes from the Governor of the Bank of England is the key question which members of the Bank's Monetary Policy Committee now have to grapple with. At what point does a deviation of inflation from the underlying target – for whatever initial reason – threaten the medium-term outlook for inflation and inflation expectations?
After all, inflation is a long way away from where the Bank expected it to be two years ago. Back then, the Bank thought there was a very high probability, based on market expectations for the future level of interest rates, that inflation would by now be below 1.5 per cent. Yet, as Mr King suggested in his Newcastle speech, there's every chance that inflation in the coming months will be between 4 and 5 per cent. As errors go, that's a pretty big one, particularly given that the pace of economic growth has been a lot more sluggish than the Bank projected at the beginning of 2009.
Mr King expects inflation to come back down again over the medium term. Signs of a pick-up in inflationary expectations have, to date, been relatively modest and – as Mr King rightly points out – the pace of monetary expansion has been remarkably limp, suggesting that a credit- constrained economy won't be able to generate high inflation for ever. Yet there can be no doubt that the split between growth and inflation has deteriorated rapidly in recent months. Ultimately, money supply growth says more about pace of increase in the value of GDP. The split between volume and price might either improve or, as we've seen recently, deteriorate.
In his 2007 speech, Mr King referred to the anchoring of inflation expectations. "Faced with changes in their costs stemming from, for example, changes in import or energy prices, businesses... can pass these cost changes forward to prices or backwards to money wages. With inflation expectations well-anchored to the target, companies have restricted the pass-through of costs to prices. The necessary adjustment of real take-home pay has taken place more through fluctuations in money wages than prices."
But are money wages still quite so flexible? The pass-through from import prices into consumer prices has risen significantly in recent years. Because wages haven't picked up correspondingly, the rise in consumer prices has made workers genuinely worse off. As Mr King noted in Newcastle: "As a result, in 2011 real wages are likely to be no higher than they were in 2005. One has to go back to the 1920s to find a time when real wages fell over a period of six years." (The decade in which the General Strike took place – you have been warned). Mr King regards this adjustment as "the inevitable price to pay for the financial crisis", noting that "Monetary policy can [only] affect the inflation rate at which these adjustments take place".
This seemingly innocuous reference to inflation is, however, a very important statement. If the public begins to recognise that the Bank can "choose" which inflation rate to select in allowing an adjustment to living standards to take place, might this then lead to uncertainty over the commitment to a particular inflation target? And if there is uncertainty, might this increase the difficulties faced by the MPC in ultimately bringing inflation back to heel?
The Bank is in danger of offering an asymmetric bias in its approach towards inflation. The recent big increases in global commodity prices, alongside the lagged effects of sterling's huge decline in 2008, have raised goods inflation in the UK to a rate unprecedented since the Bank of England was granted independence in 1997. The Bank is effectively saying that these gains have to be absorbed in a temporary higher-than-target inflation rate because the output costs of driving inflation back down again in the near-term would simply be too great.
Yet, when the Bank was confronted with the same situation in reverse in the first few years of the last decade – a period when goods prices were falling in response to a worldwide decline in the price of manufactured goods – it was far less willing to embrace a significant undershoot of inflation. While inflation was typically lower than target in the early years of Bank independence, the degree of undershoot was far less than the more recent degree of overshoot. Put another way, the Bank was happier to accept the growth benefits of a favourable external price shock than to accept the more recent growth costs of an unfavourable external cost shock.
The Bank's defence is to argue that it would have done nothing different two years ago had it known that inflation would subsequently have ended up so high. Up to a point, it's a perfectly reasonable argument. After all, would anyone have argued two years ago, at the height of the financial crisis, that the UK needed a big increase in interest rates to prevent inflation from rising? This, after all, was a time when most economists – myself included – thought the bigger risk to the UK economy was deflation, not inflation.
The problem, however, doesn't go away quite so easily. If the Bank is willing to accept large inflationary overshoots when global commodity prices are rising and VAT is going up, but willing to accept only small inflationary undershoots when faced with a more favourable set of circumstances, might the public begin to believe that the Bank is, on average, willing to tolerate an inflation rate higher than its 2 per cent target? If so, what then happens to inflation expectations for a given rate of economic growth? Mr King said in 2007 that inflationary expectations were well-anchored and that, because they were, the UK economy had enjoyed an exceptional period of stability. Today, the Bank has to confront an altogether more challenging environment. Yet, if inflationary expectations are cast adrift, at least part of the blame will lie with the MPC's performance in its early years when it was prepared to accept only small inflationary undershoots even though much of its initial success owed a great deal to global disinflationary trends which were beyond its control.
Stephen King is managing director of economics at HSBC
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