Stephen King: Will our central banks make a Freudian slip over their illusory control of price stability?

As oil and other commodity prices rise, there's a sense that our inflationary destiny no longer lies with our central banks

Are we finally seeing The Future of an Illusion? Sigmund Freud's essay on the nature of religion focused, as you might expect, on religion's psychological importance. Freud – not the world's biggest believer – thought that, as science revealed truths which previously had been shrouded in religious mystery, people would eventually have to recognise their own irrelevance in a universe that was, in truth, devoid of spiritual life. Would they be able to cope? How would they be able to reconcile their inflated egos with the essential meaninglessness of life?

Freud defined an illusion in terms of wishes. We wish religions to be true because we cannot tolerate the consequences of their being false. We're afraid of death, we fear anarchy and we're terrified of loneliness. Religions claim to provide answers for all these worries. We wish, therefore, that religions are true. A world in which religious "truth" is destroyed is, therefore, too frightening to contemplate (unless, of course, you're Richard Dawkins).

Central bankers, too, depend on an illusion. They are, if you like, the high priests of money. Their success depends entirely on their ability to persuade the rest of us that, come rain or shine, they are able to deliver price stability. Our dislike of inflation means, in turn, that we wish the illusions the central bankers create to be true.

This is a beautiful self-fulfilling arrangement. Why, after all, would any of us demand an inflationary pay increase if the central bank is proved, time after time, to be right in its pursuit of price stability? The central bank, though, only gets it right because we don't demand those inflationary pay increases. This is a circle not of logic but, instead, of faith. In Freud's eyes, then, it's not much more than an illusion. Central banking, in this sense, thrives on the placebo effect.

This illusion, though, is in serious danger of crumbling, going the same way as the many religions which were unable to stay the course (few of us have the opportunity these days to pop down to the local mithraeum, and most of us don't typically choose to offer a prayer to Thor).

The threat is obvious. As oil and other commodity prices rise into the stratosphere, there is an increasing sense that our inflationary destiny no longer lies with our central banks. They, too, understand the problem. The Federal Reserve last week revised down its forecasts for US economic growth but, at the same time, revised up its forecasts for inflation. Meanwhile, the Bank of England continues to warn of difficult times ahead, with Mervyn King skippering a ship that's heading all too quickly towards the inflationary rocks.

The problem can be simply stated. The prices of the individual things we buy on a regular basis are not determined by our central banks. Indeed, central bankers would be horrified were they to be accused of trying to influence the price of, say, bread, spring onions or shoe polish. All they're interested in is the price level as a whole or, put another way, the value of money. The value of money is determined in relation to a hypothetical basket of goods and services which we call a price index. If, within this price index, some prices rise, it follows that other prices must fall to ensure that the price level as a whole doesn't stray too far from the path implied by the inflation target. That way, the value of money is preserved.

Within the price index, however, is a mixture of prices some of which are easier to influence through monetary policy than others. Moreover, even those which can be influenced are only affected with a lag. Like Steve Austin, the Six Million Dollar Man, central bank policy works only in slow motion.

It is for this reason that faith in our central bankers is being severely tested. To get monetary policy right, the central bank has to make guesses about the future path of the prices it can't influence, to work out the degree to which interest rates have to be tweaked to set the path of the prices it can influence. This is no easy task.

In the UK, food and energy prices make up around 17 per cent of the consumer price basket. As I argued in last week's column, higher food and energy prices in the UK owe a lot to the strength of demand – and overly loose monetary conditions – in China, India and other emerging markets.

Knowing, though, that food, energy and, for that matter, metals prices have now pushed inflation up to uncomfortably high rates simply tells us that the Bank of England left monetary policy too loose a year or two ago (or, alternatively, that it was happy to interpret its inflation remit generously). The prices it might have influenced to meet the inflation target were allowed to be too high in the light of the unexpected – and uncontrollable – surge in food and energy prices.

So where should interest rates be heading now? The answer, I'm afraid, depends in part on the assumptions made about food and energy prices. Central banks can take any one of three broad approaches. First, they can assume that what goes up must come down. In other words, the increase in food and energy prices this year will be followed by a decline next year. Second, they can assume there's a one-off structural increase in food and energy prices which will raise the inflation rate for two or three years but not beyond. Finally, they can take the much more pessimistic view that food and energy prices will rise over an indefinite period of time.

What happens if the central bank takes the first view only to discover that the third view – persistent price increases – proves correct? In this case, monetary policy is left too loose and inflation takes over. Alternatively, what happens if the central bank takes the third view when, in fact, the first view is correct? In these circumstances, monetary policy is left too tight, spelling bad news for, for example, the housing market.

All the evidence suggests central banks have, in fact, been too relaxed about food and energy prices. However, they're not the only ones. Financial markets have also got things persistently wrong. The charts show the levels of oil and copper prices since 2000 tracked against implied levels as determined by futures markets at the beginning of each year. The story is worryingly consistent. In virtually every year, oil and copper prices have ended up higher than markets expected at the beginning of the year.

Three conclusions stem from this. First, it's terribly difficult forecasting food, energy and metals prices. Markets get it wrong all the time. Second, these errors must corrode the ability of central banks to set monetary policy correctly. Third, as we begin to recognise these economic uncertainties, our faith in inflation targeting is likely to be sorely tested.

All of this raises a disturbing question: what future does the illusion of price stability really have? Our central banks are in danger of making a major Freudian slip.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

Start your day with The Independent, sign up for daily news emails
PROMOTED VIDEO
Arts and Entertainment
British musician Mark Ronson arrives for the UK premiere of the film 'Mortdecai'
music
Voices
Winston Churchill, then prime minister, outside No 10 in June 1943
voicesA C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
News
i100
Sport
footballBrighton vs Arsenal match report
Arts and Entertainment
Benedict Cumberbatch has spoken about the lack of opportunities for black British actors in the UK
film
News
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Tax Assistant

Negotiable: Recruitment Genius: A Tax Assistant is required to join a leading ...

Recruitment Genius: Outbound Sales Executive - OTE £25,000

£16000 - £25000 per annum: Recruitment Genius: This is an exciting opportunity...

Ashdown Group: Java Developer / J2EE Developer - Watford - £45,000 - £47,000

£45000 - £47000 per annum + bonus + benefits: Ashdown Group: Java Developer / ...

Ashdown Group: Marketing Product Manager - (Financial Services) - SW London

£35000 - £38000 per annum + Benefits: Ashdown Group: Marketing Manager - Marke...

Day In a Page

Iraq invasion 2003: The bloody warnings six wise men gave to Tony Blair as he prepared to launch poorly planned campaign

What the six wise men told Tony Blair

Months before the invasion of Iraq in 2003, experts sought to warn the PM about his plans. Here, four of them recall that day
25 years of The Independent on Sunday: The stories, the writers and the changes over the last quarter of a century

25 years of The Independent on Sunday

The stories, the writers and the changes over the last quarter of a century
Homeless Veterans appeal: 'Really caring is a dangerous emotion in this kind of work'

Homeless Veterans appeal

As head of The Soldiers' Charity, Martin Rutledge has to temper compassion with realism. He tells Chris Green how his Army career prepared him
Wu-Tang Clan and The Sexual Objects offer fans a chance to own the only copies of their latest albums

Smash hit go under the hammer

It's nice to pick up a new record once in a while, but the purchasers of two latest releases can go a step further - by buying the only copy
Geeks who rocked the world: Documentary looks back at origins of the computer-games industry

The geeks who rocked the world

A new documentary looks back at origins of the computer-games industry
Belle & Sebastian interview: Stuart Murdoch reveals how the band is taking a new direction

Belle & Sebastian is taking a new direction

Twenty years ago, Belle & Sebastian was a fey indie band from Glasgow. It still is – except today, as prime mover Stuart Murdoch admits, it has a global cult following, from Hollywood to South Korea
America: Land of the free, home of the political dynasty

America: Land of the free, home of the political dynasty

These days in the US things are pretty much stuck where they are, both in politics and society at large, says Rupert Cornwell
A graphic history of US civil rights – in comic book form

A graphic history of US civil rights – in comic book form

A veteran of the Fifties campaigns is inspiring a new generation of activists
Winston Churchill: the enigma of a British hero

Winston Churchill: the enigma of a British hero

A C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
Growing mussels: Precious freshwater shellfish are thriving in a unique green project

Growing mussels

Precious freshwater shellfish are thriving in a unique green project
Diana Krall: The jazz singer on being friends with Elton John, outer space and skiing in Dubai

Diana Krall interview

The jazz singer on being friends with Elton John, outer space and skiing in Dubai
Pinstriped for action: A glimpse of what the very rich man will be wearing this winter

Pinstriped for action

A glimpse of what the very rich man will be wearing this winter
Russell T Davies & Ben Cook: 'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'

Russell T Davies & Ben Cook: How we met

'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'
Bill Granger recipes: Our chef serves up his favourite Japanese dishes

Bill Granger's Japanese recipes

Stock up on mirin, soy and miso and you have the makings of everyday Japanese cuisine
Michael Calvin: How we need more Eric Cantonas to knock some sense into us

Michael Calvin's Last Word

How we need more Eric Cantonas to knock some sense into us