Stephen King: Split beyond belief – so where next for the Bank and for mortgage rates?
What's gone wrong? Why can't the experts on the Monetary Policy Committee see eye to eye?
Monday 21 February 2011
In the red corner, we have Andrew Sentance, a man who fears Britain is on the brink of a major surge in inflation. In the blue corner, we have Adam Posen, a man who thinks today's inflation could easily become tomorrow's deflation. In the middle of the ring is Mervyn King, attempting to keep order and increasingly taking on the persona of someone whose only job in life is to herd cats.
The Monetary Policy Committee (MPC) of the Bank of England is beset by division like never before. The debate is intense and the stakes are, to say the least, high. If Dr Sentance is right and the MPC fails to raise interest rates, we're in danger of heading into a 1970s-style stagflation where, for any given level of economic activity, inflation will be a lot higher. The Bank's credibility would then be in tatters. If, instead, Dr Posen is right, and the MPC raises interest rates to ward off a non-existent medium-term inflationary threat, the UK economy could end up in a deep and long-lasting recession, echoing problems faced by the United States in the 1930s. Again, the Bank's credibility would be in tatters.
Indeed, a mistake now could sound the death knell for the entire inflation-targeting framework. Let's face it: of late, the framework hasn't been working very well. Even though inflation was mostly well-behaved in the run-up to the 2008-09 financial crisis, good inflationary behaviour back then wasn't enough to prevent the crisis from happening. And, following the deepest recession in living memory (at least for those who aren't nonagenarians), inflation has ended up much higher than the Bank of England and virtually everybody else expected. Was the painstaking establishment of anti-inflationary credibility in the early years of the Bank's independence all in vain?
What's gone wrong? And why can't the experts on the MPC see eye to eye?
Although some of the subsequent rise in inflation can now be explained away through the impact of increases in VAT (which won't happen every year) and higher commodity prices (which are notoriously unpredictable), it's still the case that inflation is higher than anyone on the MPC thought likely a couple of years ago, even adjusting for these "shocks". It's not just that the UK economy has been subject to adverse tax and import price increases. It's also the case that the impact on inflation of these shocks – the so-called "pass-through effect" – has been bigger than expected.
For Dr Sentance, this is all extremely worrying. Given that he's vacating his seat on the MPC in May, he has little time left to persuade his fellow Committee members of the wisdom of his views. Perhaps that's why he's become increasingly vocal, prepared to stick his neck out in much the same way that David Blanchflower did during his time on the Committee. Certainly Dr Sentance was particularly forthcoming shortly after the release of last week's Inflation Report. Only a day after Mervyn King had attempted to offer emollient tones to a sceptical press conference, Dr Sentance warned that interest rates would now have to rise faster than the markets were expecting if the Bank were to regain its credibility.
You can see his point. A standard interpretation of the inflation-targeting regime appears to suggest the Bank has got it completely wrong and that action is now required to put things right. As interest rates are currently so low, Dr Sentance's arguments seem entirely sensible.
They work, however, only so long as you believe that the UK's latest inflationary performance is a good guide to future inflationary performance. And this seems to me to be rather unlikely for the simple and rather obvious point that past inflationary performance – the good price behaviour pre-crisis – proved to be absolutely useless in offering any guide to current inflationary performance.
This, in turn, reveals an ambiguity within the inflation-targeting framework. According to the mandate – set by the government of the day – "The inflation target is 2 per cent at all times: that is the rate which the MPC is required to achieve and for which it is accountable". That seems straightforward enough. But the mandate then goes on to say that "the framework is based on the recognition that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output".
So the key issue is not whether inflation is too high. Rather, it's whether inflation will come back to target of its own accord. Will shocks and disturbances unwind without the need for some pre-emptive monetary tweaking that might, in turn, have damaging effects on output?
This issue can be divided into two parts. First, is there a danger that inflationary expectations are on the rise because headline inflation is higher than expected, leading to upward pressure on wages and a weaker exchange rate (which would, in turn, push import prices higher)? Second, if inflationary expectations remain well contained, will today's higher-than-expected inflation rate simply erode real spending power, revealing fault-lines in the economy which, in truth, are a bigger problem for activity than they are for inflation?
Dr Posen, an avid student of all things Japanese, knows very well that the Bank of Japan found itself in a similarly tricky situation at the beginning of the 1990s. Japan's bubble economy began to deflate in 1990 but inflation was irritatingly sticky, not just because the domestic economy was still subject to latent bubble pressures but also because, in August 1990, Iraq invaded Kuwait and oil prices went through the roof. In response, the Bank of Japan (BoJ) kept interest rates at a bitingly-high level, a policy that, at the time, received plaudits all over the world. For a while, the policy seemed to be entirely appropriate: Japanese inflation threatened to rise beyond 4 per cent but, thanks to BoJ governor Yasushi Mieno's tough brand of monetary medicine, it soon came back down again.
It wasn't long, though, before Mr Mieno went from hero to zero. Bringing inflation back down was the easy part. But inflation soon turned into deflation and Japan entered a period of economic stagnation it has yet to escape from. A focus on near-term inflationary concerns may have brought Mr Mieno some near-term respect but he later became known as the man responsible for Japan's subsequent deflationary disaster.
The lesson from Japan is, surely, that near-term inflationary disturbances do not always translate into persistent increases in inflation. Admittedly, the UK finds itself in a very different position to Japan: our bubble burst long ago and interest rates are now very low. But to argue that today's inflation will simply get worse tomorrow in the absence of significant interest-rate increases pushes to one side some of the subtleties of the UK economic dilemma: with weak money-supply growth, lower real wages, a draconian tightening of fiscal policy and a housing market that no longer appears to be quite so robust, the UK is already facing headwinds sufficient to bring inflation back down.
The choice is not between a small increase in interest rates today or an even bigger increase in interest rates tomorrow, the argument typically espoused by the monetary hawks. The issue is ultimately whether today's inflation says anything of substance about inflation tomorrow. I'm not convinced it does.
Stephen King is managing director of economics at HSBC
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