Stephen King: What if the Bank has lost its magic?

Monday, 30 June 2008


Mervyn King, Governor of the Bank of England, told the House of Commons Treasury Select Committee last Thursday that "a change in the prices of food and energy relative to other prices can't by itself produce sustained inflation unless we allow other prices and wages to rise at a faster rate".


Is he right? Arithmetically, the answer is no. Imagine a world where all prices and wages are rising at 2 per cent per year, in line with the Bank of England's inflation target (for those who care about such things, this imaginary world has no productivity growth). Then, all of a sudden, food and energy prices begin to rise rapidly, showing sustained annual gains of, say, 20 per cent per year. Under these circumstances, if other prices and wages carry on rising at 2 per cent, overall inflation will now be higher than 2 per cent. Only if all other prices and wages rise by less than 2 per cent will there be a chance that inflation as a whole will match the Bank of England's target.

What, then, was Mr King really saying? One possibility is that the Bank of England simply doesn't accept that food and energy prices can continuously rise. In other words, Mr King and his colleagues believe the world is seeing only a one-off adjustment in food and energy prices. Once the adjustment is over, and in the absence of any "second-round effects" on other prices and wages, inflation will eventually come back to target.

All well and good. However, like the rest of us, the Bank's confidence in its ability to foresee the future level of food and energy prices must surely have been rocked in recent years. Central banks typically use the futures market as the best guide of where, for example, oil prices will be over the next year or so, but the futures market has proved a hopeless predictor of oil prices in recent times. A year ago, supposedly clairvoyant traders thought oil prices today would be around $72 per barrel. As I was writing this article, oil prices were, in fact, heading through $140 per barrel. This, then, must be the mother of all one-off adjustments.

Another possibility is that the Bank believes that the reasons behind the increases in food and energy prices will ultimately cause problems not for the UK but, instead, for other parts of the world. In later remarks to the committee, Mr King rightly pointed his finger at the emerging markets. Their interest rates are low, their inflation rates are rising, their economies are overheating, and their resulting excessive demand for commodities is leaving the rest of us with a higher bill for food and energy.

If, though, inflation is too high in the emerging world, sterling should be rising in value against emerging market currencies. After all, the ultimate sanction for inflationary incompetence is a sharp currency decline.

Yet this is not happening. It's sterling, not the emerging market currencies, which is under downward pressure. Rather than insulating the UK from foreign price pressures, sterling's weakness is magnifying those pressures. So while it might be true in the very long run that higher inflation elsewhere in the world will leave sterling stronger, it's not true at the moment. Sterling's previous love affair with the all-conquering euro is over, and now we find ourselves in the bargain sub-prime basement alongside the US dollar.

Moreover, loose emerging market monetary conditions don't fully explain the strength of commodity prices. Raw materials prices are rising not just because emerging market interest rates are too low but also because emerging markets are, economically, catching up with the West. That, inevitably, means much greater demand for commodities over the long term, which, other things equal, will make Western households worse off. Failure to identify the magnitude of this trend will lead to errors in forecasts of inflation, which, in turn, will undermine confidence in a central bank's ability to hit its inflation target.

This, in turn, gets to the crux of the matter. He may be arithmetically wrong, but what Mr King is really saying is that big price increases in things like food and energy do not, in themselves, indicate the return of inflation. Inflation is ultimately a monetary phenomenon associated with a sustained rise in the general price level, or, put another way, a sustained decline in the value of money. For a country with an independent central bank and with a fully flexible currency, there is no reason, in theory, why the value of money cannot be preserved. That, after all, is what an inflation target implies.

However, while this is theoretically true, turning theory into reality is no easy task. UK house prices are falling. The financial system is on its knees. Mortgage rates are rising, and the supply of housing loans is in decline. The economy is slowing. All these factors point to lower future inflation. Oil prices, though, are surging. The exchange rate is falling. Unions are going on strike, demanding higher wages. Inflationary expectations have risen. Maybe, then, inflation will be higher. What, then, should happen to interest rates?

The challenge facing the Monetary Policy Committee is simply put, but fiendishly difficult to resolve. The evidence currently points to both slower growth and higher inflation. Cutting interest rates to preserve growth threatens higher inflation expectations and, hence, might damage the Bank of England's anti-inflation credibility. Raising interest rates to kill off inflation threatens recession, and might eventually undermine the country's political commitment to central bank independence.

The problem can be seen in the chart. It shows not the inflation rate (which measures the percentage change in the price level from one year to the next), but instead the price level itself. I've linked together the experience under the old RPI-X inflation regime (which lasted from 1997 to 2003) with the new CPI inflation regime.

On average, the Bank has been very successful in keeping the price level close to the path implied by the inflation target. Now, though, success is proving harder to come by. If the Governor's warnings prove to be correct – and I think they will – inflation is going to end up well above 4 per cent later in the year. For the first time since the Bank of England gained its independence in 1997, prices will end up a lot higher than implied by the long-term path. No wonder inflation has suddenly become a hot topic.

The Bank is asking everyone in the country to accept this as an unfortunate fact of life. What happens, though, if people begin to believe the Bank has lost its magic? What happens if people begin to think that the Bank is unable to control inflation, and that the 2 per cent target is no more than a charade, an elaborate confidence trick? What if the public don't share the Bank's view that inflation will come back to target over the next couple of years? Perhaps people will begin to demand inflationary pay increases.

In those circumstances, the Bank would have no choice but to administer some bitter monetary pills to remind everyone that, ultimately, inflation is indeed a monetary phenomenon. You can already sense the Governor's hands reaching for the medicine cabinet.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com