A visitor from Mars who arrived in the UK three weeks ago and read only what
the economics commentators are saying would be forgiven for believing that
inflation was out of control and that interest rates needed to rise by a
very significant amount to restore stability. The timing of this recent
“inflation panic” is unfortunate, as it might partially obscure the fact
that, during the past ten years, the existence of the Bank of England’s
Monetary Policy Committee (MPC) has coincided with encouraging economic
performance.
The average level and volatility of inflation has been very significantly
lower than the 1950-97 period and this has been accompanied by a remarkable
reduction in the volatility of the GDP growth rate.
Of course, the improvement in macroeconomic performance has occurred for a
variety of reasons, including common global factors and pure luck. However,
it is plausible that the MPC has contributed to the improvement by helping
to bring inflation expectations down — indeed, the announcement of the new
regime ten years ago was associated with a significant decline in measures
of inflation expectations.
With inflation expectations anchored, shocks to the economy such as we have
seen over the past decade from oil and other commodity prices lead to a much
more muted reaction from other prices and wages than was true in the past.
If, in early 1999, one had asserted that the oil price would rise about
sevenfold by the summer of 2006 but that inflation would deviate outside the
“letter-writing” band (of above 3 per cent, or below 1 per cent) on only one
occasion, the vast majority of the economics fraternity would have regarded
one as certifiable. Back then, most economists believed that letters would
be triggered quite frequently (more than once a year).
It is my understanding that the letter-writing arrangement was an expression
of the accountability of the MPC and was also designed to give the
Chancellor an opportunity to tell the MPC if he disagreed with the time that
it would take to return inflation to its target level. In practice, the
triggering of the first open letter in ten years has been widely interpreted
as a sign of failure and has led to some commentators arguing for a
half-point rise in rates at the next meeting (something that the MPC has
never done) and to some economists arguing that interest rates might have to
rise from the current 5.25 per cent to as high as 7.5 per cent!
This overreaction to the letter is most unfortunate. Most economists who
forecast inflation for a living expect a combination of the likely decline
in domestic energy price inflation and the reversal of some other temporary
factors to lead to a significant fall in inflation this year. Encouragingly,
so far, wage growth has not responded to the rise in headline inflation by
as much as had been feared. Yet there is a risk that the hysterical reaction
of some parts of the media and the writing of the letter might generate an
unfounded rise in inflation expectations, which could force the MPC to react.
Many inflation-targeting countries do without the letter-writing feature of
the arrangements and therefore even rather larger deviations from the centre
of the inflation target band than we have experienced do not seem to have
elicited any significant concern in the media about inflation rising out of
control. For example, in Australia, where in recent years inflation had
risen at times to 4 per cent, expectations remained relatively
well-anchored. I wonder if the time has come to review whether we need to
dispense with the letter-writing feature of our regime.
Some of the economists clamouring for much higher interest rates are doing so
on the basis that money supply growth is high and has been rising in recent
years. They argue that hitherto the MPC has placed insufficient emphasis on
money supply growth in formulating policy. I regard this criticism as
unfair. The chart here shows M4 money supply growth versus inflation (RPIX)
over the 1992-2007 period. Casual inspection fails to suggest any reliable,
stable relationship — an impression confirmed by most careful empirical
studies. I do not intend to imply that one should ignore the growth of money
supply — but to set much higher interest rates just because money supply is
growing at double-digit rates seems rather difficult to justify.
In some ways, it is ironic that the MPC is being attacked for being
insufficiently vigilant about inflation. If anything, one could argue that
the MPC has had a tendency to be too pessimistic about beneficial structural
changes in labour and product markets. For example, in the 1997 to 2002
period, the MPC’s two-year ahead forecast was around 0.5 per cent above the
actual out-turn, with a failure to allow for a fall in the level of
unemployment consistent with stable inflation being an important
contributory factor. It may well be that the MPC has, in recent years,
continued to underestimate the beneficial effects of improvements in the
labour market, as its forecasts for wage growth have tended to be higher
than actual out-turns.
Similarly, the MPC has used a convention to project exchange rates (based on
the theory of uncovered interest parity) that is well-known to be a biased
predictor. As a result, the average out-turn for the effective exchange rate
has been around 3 per cent above the MPC’s two-year ahead projection. Given
the important role of the exchange-rate assumption in the Bank’s inflation
forecast, this has had the tendency of imparting an upward bias to the
inflation forecast.
In thinking about the MPC’s legacy after ten years, one cannot ignore the
likelihood that we have a housing market that is significantly “overvalued”.
If, at some point, an inflation shock forced the Bank to raise interest
rates significantly, there is considerable potential for a significant fall
in house prices and consumption, with the Bank possibly unable to do much in
the way of preventing a recession. This is unfortunate, and I wonder whether
central banks should react to asset price misalignments.
Specifically, the MPC as a whole could have announced that a perceived
overvaluation in the housing market might lead interest rates to be somewhat
higher than could be justified by the two-year ahead inflation forecast.
Such a course of action may well have led house-price growth to be more
muted in recent years.
This would be wholly consistent with the existing remit. It is important to
recognise that some of the major monetary policy errors over the past
century — such as Japan’s “lost decade” in the 1990s and the Great
Depression — have occurred when central banks have taken their eye off the
asset price misalignment ball.
Looking ahead, in any case, it is likely that the next ten years will be more
volatile then the unusually benign period we have just experienced. While
the anchoring of expectations provided by the MPC should help, allowing
house prices to have become overvalued could, under certain circumstances,
make it a rather tricky ride.
Sushil Wadhwani, a former external MPC member (1999-2002) and former
director at Goldman Sachs, runs Wadhwani Asset Management. He is a member of
The Times MPC
