Stephen King: We must keep our heads, even if others lose theirs

The inflation-targeting framework in the UK has seemingly been hugely successful over the years. Arguably, though, it's never really been tested in difficult times. Under current circumstances, with inflation rising and house prices falling, will the framework really be able to cope?

For those of the hair shirt persuasion, the answer is simple. The framework has to be adhered to rigidly. Too much wavering and the whole edifice might come tumbling down. In that event, the costs would be too awful to contemplate. Monetary credibility would be thrown out of the window. The UK would become a monetary "pariah state". International investors would guarantee a collapse in sterling. Inflation would head into the stratosphere. And, in response, interest rates would have to rise to levels not seen in a generation. It makes sense, then, to raise interest rates now to avoid the need for much bigger increases later on.

All of this might sound spookily familiar to those who have memories (not fond, presumably) of sterling's abrupt exit from the European exchange rate mechanism (ERM) in 1992. The Conservative government of the day did everything in its powers to persuade people that sterling would not be allowed to budge.

On 9 July 1992, for example, Norman Lamont, the Chancellor of the Exchequer at the time, said in the House of Commons "the idea that we can help this country's economy by depreciating the exchange rate is pure illusion, pure fool's gold". Stephen Dorrell, the Financial Secretary, added for good measure "the logic of our determination to maintain our position within the ERM is our wish to match our standards of monetary control and discipline...to the highest standards in Europe...

Membership of the ERM provided an exchange rate target which, only by proxy, was likely to deliver price stability domestically. Now we aim for price stability directly. Within the ERM, we'd effectively handed over our monetary reins to the Bundesbank, which had to cope with the inflationary consequences, unique to Germany, of reunification. The Bank of England, by contrast, has the mandate and the ability to act solely in British interests.

There are, however, some obvious similarities. Housing is one. House prices were falling ahead of the ERM crisis, as they are currently. Then, as now, the housing market was a symptom of a deep domestic economic malaise.

Global shocks are another similarity. Back then, the shock was Germany's reunification, forcing the UK to live with interest rates which, for domestic purposes, were inappropriately high. Today, the shock comes from commodity prices which, in turn, relate to excessive demand pressures within the emerging world. These gains make most of us worse off yet, through the near-term impact on inflation, reduce the room for the Bank of England to cut interest rates. Then there's the fear factor. Now, as then, policymakers are terrified about the wilderness which might accompany a collapse in the monetary framework. As it turned out, Britain's exit from the ERM was an economic blessing, paving the way for a sustained period of good growth with low inflation. Indeed, the current monetary framework rose like a phoenix from the ashes of the ERM. The predicted inflationary woes never transpired, interest rates came down and, before long, sterling had returned to pre-crisis levels against the Deutschmark. The only real losers were the Tories, whose reputation for economic competence suffered a severe mauling.

If there's an obvious lesson from the ERM crisis, it's the impossibility of defending strict monetary credibility in the light of growing economic, political and social incredulity. Markets can quickly spot the chink in the armour of credibility and take advantage. It is, if you like, a Catch-22 situation: the short-term costs of sticking to the credible path become so high that the credible path no longer remains credible ...ask George Soros.

So how should policymakers deal with this apparent contradiction? The answer, surely, is to approach the framework with considerable flexibility. That means, in particular, recognising that the framework must be implemented always with the medium term in mind. In other words, the Bank of England must not get waylaid by short-term deviations of inflation from the "one true path".

Admittedly, this is no easy task. Imagine, though, that the Bank focuses entirely on the deterioration in the short-term inflation outlook while ignoring the collapse in house prices – and the recession that might follow. While this might be consistent with an ultra-strict interpretation of the inflation mandate, it's also likely to be the route to ruin. Would the country be willing to sing along to John Major's mantra that "if it isn't hurting, it isn't working"?

I suspect the answer is "no", either because there'd be political resistance or because there'd be a vicious market reaction (a collapse in sterling which, by adding to inflation pressures, would force an ultra-orthodox inflation-hating Bank of England to raise interest rates still further, thus perpetuating a vicious circle).

In other words, an overly-robust defence of the framework would probably leave us with no framework at all. Far better, then, to set the framework in a flexible fashion such that it won't be damaged or swept away by political or market resistance. After all, relative to the ERM, that's exactly what the Bank of England's mandate allows. Mervyn King, the Governor, may have to write the occasional letter to explain why inflation is more than 1 per cent away from the 2 per cent target, but better that than to throw the economy into recession and to discover, later on, that inflation wasn't much of a problem after all.

It's a crying shame, then, that the Bank of England didn't adopt the same approach in the late-1990s when the UK was importing deflationary pressures from the rest of the world. Then, there was a strong case for welcoming "good deflation", whereby we all became richer through falling global manufactured goods prices.

Plenty of letters could have been written explaining why inflation was, for a while, undershooting the medium-term objective. The Bank, though, chose not to do so, arguably leaving interest rates too low and, as a consequence, house prices too high. Letter-writing must be symmetric. Perhaps, in his forthcoming letter to the Chancellor, the Governor should explain not why monetary policy is too loose now, but rather why monetary policy was left too loose back then.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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