Stephen Lewis: MPC is ensuring that Mr King won't achieve his 'boring' ambition

The reported rise in June CPI conjured a vision of Mr King waking up in a cold sweat
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The Independent Online

In his best-known aphorism, Mr Mervyn King said it was his ambition to make monetary policy "boring". By this he meant that a central bank's actions were likely to be most effective if they conformed to a widely understood policy framework.

Then, even if inflation happened to deviate from the official target, the confidence of financial market participants, consumers and businessmen in the central bank's resolve to bring it back in line would remain unshaken.

By the standards of the Monetary Policy Committee (MPC), the decision it took on 3 August to raise the Bank rate from 4.5 per cent to 4.75 per cent was far from "boring". Not only was the timing of the move unexpected, but the grounds for the MPC's action appeared unrelated to committee members' previous policy discussions.

Mr King mounted a robust defence of the MPC's position when presenting the Bank of England's

Inflation Report last week. He accepted that the rate rise had not been what many people thought the most likely outcome of the MPC meeting. But, he argued, the idea that it had been a complete bolt from the blue did not fit with the facts, the data or what financial markets had expected.

The financial markets had certainly been discounting higher short-term interest rates, though not much before the end of this year. The reason why they expected the MPC to delay was that data published prior to the committee's August meeting seemed to give no grounds to justify a move within the MPC's decision-making framework.

To be sure, there were factors that might lead a prudent central bank to tighten credit. House prices appeared to be on the rise again. Bank lending to financial institutions was ballooning, possibly feeding speculative activity in capital and commodities markets.

However, the MPC had not previously emphasised these factors in its economic analyses. Members had preferred to foster the impression that, however asset prices behaved, they would keep their eyes fixed on the consumer price target.

The governor tried to argue that the MPC's decision had been a surprise because it happened to be one of those occasions when there had been a lot of news between meetings. Thereby, he tacitly conceded the MPC's August decision could not have been guessed on the basis of its July deliberations. The fresh news, according to him, was twofold. There was information on output and what that meant for the likely future path of inflation, and there was news on inflation itself.

In fact, the "news" on output had been available to the MPC at its July meeting. The committee was then aware of the revisions to the 2003 and 2004 GDP data that Mr King was to claim made all the difference to the committee's estimates of spare capacity in the economy. It is worth recalling what the MPC had to say about the annual Blue Book GDP revisions in the minutes of its July meeting. It said they had not been large by past standards. Minor adjustments in the figures had raised the level of GDP at market prices in the first quarter of 2006 by 0.7 per cent.

Despite this, the MPC mused that there "remained a risk that the erosion of spare capacity in the economy would be slower than envisaged in the May Inflation Report".

By its August meeting, the MPC was worrying that the margin of spare capacity within businesses was "limited". Why was there this apparent shift in view? It hardly reflected what was happening in the labour market. The August Inflation Report reached this conclusion: "Taking the survey and official data together, the MPC judges that there is little sign yet of tighter conditions in the labour market, despite the recovery in demand growth".

In fact, according to the latest figures available, the jobless total - on the ILO basis - had risen by 89,000 during the quarter leading up to the Bank's August forecasting round. That was hardly consistent with the view that capacity constraints were emerging.

Why then was the MPC suddenly so anxious about dwindling spare capacity? The committee said it was impressed by survey evidence. The Inflation Report noted that surveys pointed to an easing in capacity pressures through much of 2005. More recently, however, capacity use seemed to have picked up.

Still, the survey readings from the British Chambers of Commerce and the Bank's own agents were close to their averages since 1998. "That suggests that the margin of spare capacity within businesses is likely to be limited," the Bank concluded. This is so, but only in the banal sense that capacity can never be supposed to be limitless. The truth is that survey estimates of private-sector capacity utilisation have this year been consistently below their levels in 2004, when the MPC saw fit to cut interest rates.

The argument the MPC advanced regarding capacity constraints is flimsy, to say the least. Perhaps, then, the Bank's other concern - the inflation news - was paramount in driving the MPC to tighten credit.

The reported 2.5 per cent year-on-year rise in June CPI was a shocker. It conjured a vision of the Bank governor waking up one night in a cold sweat as the realisation dawned that he might soon be obliged to write a letter to the Chancellor explaining an inflation overshoot.

Yet Mervyn King is made of sterner stuff. He has long recognised that he would probably have to write a letter one day. The sharp rise in energy costs gives the Bank a reasonable excuse for failing to meet the target.

Admittedly, the MPC has come up in recent weeks with the strange view that changes in domestically generated prices should always offset movements in energy costs. In other words, we should expect the second-round effects of energy price rises to be negative. This view is so bizarre that it can be seen only as part of the Bank's special pleading in favour of a rate increase.

In any case, Charles Bean has since said it is not the current inflation rate that matters but inflation two or more years down the line. The MPC may worry about rising inflation causing expectations to slip anchor. But household surveys suggest inflation expectations have fallen recently, as the MPC acknowledged in its August minutes.

A new element in policy thinking, highlighted in those minutes, is the growth in broad money supply and lending. There has been especially rapid expansion in recent months in the liquidity of financial institutions. In the year to June, this sector's M4 deposits rose by 31.5 per cent while its borrowing from M4 lenders increased by 29.6 per cent. This expansion in liquidity contributed significantly to the reported 13.7 per cent surge in overall M4 money supply over the period.

The MPC's August minutes noted that the financial institutions' behaviour could "put upward pressure on asset prices, increasing household wealth and potentially pushing up nominal spending". It is a long time since the Bank worried about the money supply, but the numbers are so extreme now that they can no longer be ignored.

Central bankers from Seoul to Frankfurt are worrying about excess liquidity. The Bank of England seems to be joining them in their concern. The problem for the MPC is to change its policy framework to incorporate monetary influences without forfeiting the clarity of the message it sends about its policy actions. The consternation that greeted this month's rate increase shows the MPC has yet to find the solution.

Stephen Lewis is the chief economist at Insinger de Beaufort