The MPC must keep the target in its sights

Gavyn Davies on the signs that the bank's committee is forgetting its inflation objective
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The Independent Online
IT IS proving every bit as difficult as may have been expected to remove the setting of monetary policy from the political arena in the UK. Although decisions on base rates are now taken by the technicians on the Monetary Policy Committee (MPC), the Chancellor is still being held fully accountable by the political process for the out-turns of these decisions, and every detail of the mechanism is subject to increasingly intense scrutiny. This is entirely appropriate in a vibrant democracy. The idea UK base rates could be set in the environment of secrecy and obfuscation which has usually surrounded the activities of the Bundesbank, and which now looks likely to be exported to the European Central Bank, is quite frankly absurd. The open model of the US Federal Reserve is much more suited to British needs.

To judge from recent sessions at the Treasury Select Committee, there is still some genuine doubt about who sets the inflation target, and how it should be interpreted. This really should not be the case. When Gordon Brown established the new mechanism last May, he made it clear that the Government would set the inflation target in the Budget each year, and that the responsibility of the MPC would be to "deliver price stability (as defined in the Government's inflation objective)". He then added that "without prejudice to this objective" the MPC should "support the Government's economic policy, including its objectives for growth and employment".

This last sentence has caused some confusion, since some have argued it leaves room for the MPC to consider objectives other than inflation. However, the phrase "without prejudice to" the Government's inflation target surely makes it clear the MPC is not free to give primacy to these other matters if this threatens the inflation objective. And, in the 1998 Budget, the promised definition of the inflation target is very clear: "The inflation target is 2.5 per cent at all times; that is the rate which the MPC is required to achieve and for which it is accountable." There is no mention of growth, employment or, indeed, anything else.

These points are relevant for several reasons. First, if the MPC hits the inflation objective, but simultaneously the economy falls into recession, it will not be reasonable to blame them. Second, the MPC should really remain overwhelmingly focused on inflation, and not become too mesmerised by the behaviour of sterling, or by the path for output and jobs. In recent sets of MPC minutes, there have been disturbing signs that the committee is beginning to take its eye off the ball, and is considering such matters as the smoothing of GDP growth between 1998 and 1999, and the possible damage to the MPC's "credibility" if base rates were to rise and then fall again over a short period of time. These arguments, which have been used by the doves to justify leaving base rates at current levels, seem to be straying some way off limits. Third, if the primacy of the inflation target is accepted, this has some important connotations for the role of the Bank's inflation forecast in the committee's deliberations.

It has always been accepted that monetary policy works primarily over a two-year time horizon when it comes to influencing inflation. This means that if inflation looks set to miss the target over the next 12-18 months owing to past policy errors, there is not necessarily any presumption that base rates should be raised today to bring prices back on track. Unintended deviations from the inflation target are therefore inevitable, and are part and parcel of the new regime. However, intentional deviations from the inflation target over a two-year time horizon are a very different matter, and it is hard to see how these can be justified by the MPC. The upshot is that if the MPC - the committee as a whole, not the Bank's economics department - is forecasting that inflation will exceed the 2.5 per cent target is two years' time, there must surely be a very strong presumption that base rates should rise fairly soon.

This seems to be the case at present, since the latest "Inflation Report" contains the MPC's modal (or most likely) forecast for inflation in two years' time, and this is higher than the 2.5 per cent target. The inflation forecast is intended to incorporate all of the leading information on prices which is available to the committee, including monetary data, wages, sterling, gross domestic product (GDP) growth and the like. Indeed, it is precisely because the forecast takes account of all these factors that it is a superior guide to policy than any one such factor - such as monetary growth - taken in isolation. Perhaps some on the MPC might feel that this gives too much power to the Bank's number crunchers who crank out the first version of the forecast, but was this not intended to be a technical exercise in which monetary policy technicians have the most say?

At present, the gap between the inflation forecast and the inflation target in two years' time is not very large, so the implied internal contradiction in the MPC's behaviour is not too worrying. However, if the inflation forecast were to rise significantly above 2.5 per cent, while base rates were not increased because of a desire to "smooth" output, then that would constitute prima facie evidence that the MPC was exceeding its mandate. Under the present system, any such juggling between output and inflation objectives should clearly be left in the hands of the Chancellor, who should change the inflation objective if he wants to smooth the path for output or employment.

Enough about the nitty gritty of operating the present arrangements. In the longer term, a more profound problem is arising, not just in the UK, but throughout the developed world. This concerns the role of asset price inflation in the setting of monetary policy. As the graph shows, the rate of increase in UK asset prices (house prices plus share prices) is now running at 15 per cent per annum, over five times the rate of increase in the prices of goods and services, as measured by the RPI.

Should monetary policy be concerned about this? The obvious answer is that monetary policy should be tightened only if it is thought that the rise in asset prices will threaten the RPI inflation objective in two years' time. But this may not be sufficient. Volatility in asset prices might do great damage to the rest of the economy, even if there is no threat to the RPI objective. After all, many of the most damaging monetary policy mistakes in the past decade - Japan during the "bubble economy", the UK in the late-1980s, Asia in the mid-1990s, etc - have been much more intimately connected with the behaviour of asset prices than with the behaviour of retail prices. And these asset price mistakes have done more harm to the stability of output and employment than any similar mistakes connected to the prices of goods and services.

Central bankers around the world are very aware of this, but few of them have been willing to take responsibility for asset price volatility, even when their constitutional mandates would permit them to do so. The next great debate on monetary policy should concern this topic.

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