Defending price stability

One of the remarkable features of the past few years has been the dramatic reduction in inflation rates around the world. Although there are a few exceptions, for the vast majority of countries, price stability is now a reality.

When inflation shows signs of misbehaving, it becomes worrisome. Just over a month ago, Mervyn King, the Governor of the Bank of England was obliged to write a letter to the Chancellor explaining why consumer price inflation had risen above three per cent. While that letter brought with it a lot of comments that there were inflationary problems, it must not be forgotten that just a few years ago a 3.1 per cent inflation rate would have been hailed as a remarkable success.

What is certain is that price stability is highly sought as inflation is seen as an unwelcome and unpleasant economic distortion. Inflation arbitrarily redistributes income and wealth. Inflation's habitual volatility corrupts the price mechanism. Goods, labour and capital markets are unable to perform efficiently. Resources are badly allocated and societies end up that much poorer as a result. Therefore, in the context of post-war history, the past few years have been truly amazing. As inflation has come down, global economic growth has accelerated. With the majority of countries committed to price stability, exchange rate volatility has also declined. This, in turn, has facilitated much higher cross-border flows of goods, services, capital and labour.

People used to think low inflation could be achieved only through much higher unemployment. However, there is a better understanding that the achievement of price stability is the most obvious route to lower unemployment. Remove inflationary distortions and the price mechanism works better.

Having fought so hard to achieve price stability, policymakers are not in the mood to allow this most precious of prizes to slip through their fingers. Yet there is a heightened sense of nervousness. The US Federal Reserve is still not sure inflationary pressures are under control.

The Bank of England recently signalled in its inflation report the need for higher interest rates. China, meanwhile, worries the current rapid pace of economic expansion might, eventually, lead to a resurgence of inflationary pressures.

The odd thing about this unease is the absence of a common international framework to assess whether inflation might be returning. For such an important issue, the lack of any agreement on the appropriate monetary structure is disconcerting. One possibility is that the American monetary framework, for example, works well for the US economy while the British framework is tailored to fit the UK.

There may be some truth in this but it is not a wholly satisfactory answer. The decline in inflation in recent years has been a global phenomenon, an experience shared by many countries irrespective of their specific monetary frameworks. By the same logic, it is possible inflation might eventually rise on a global basis, regardless of the specific frameworks adopted in individual countries.

Can we tell if inflation is about to make a return? The economic models typically used by central banks are not really helpful. For the most part, they are cyclical models that tell you whether demand is a bit too strong or a bit too weak relative to available supply. However, they have nothing very much to say about the possibility that inflation is about to rise on a structural, multi-year basis, as it did in the 1970s. Indeed, many of these models assume policymakers are both credible and know, in advance, how to move along a credible policy path.

This approach cannot be right. What is needed, instead, is an approach that tells you when, perhaps, these cyclical models are in danger of breaking down.

In this area, central banks cannot agree. Most central bankers accept it makes sense to monitor inflationary expectations but, by the time expectations rise, it is often too late. What is needed is a measure that tells the central banker there may be trouble ahead. One such indicator might be money supply.

The European Central Bank has always thought this way. The Bank of England is beginning to think again about money supply. The US Federal Reserve, however, is totally dismissive. Since foreign holdings of US dollars are so high, and because money can be created and destroyed within the banking system without any help from the Federal Reserve's policymakers, it follows that traditional measures of money supply say nothing of significance about current or future inflation.

Central bankers need a warning light. The ECB and Bank of England think they have found one, in the form of money supply growth. For both, this warning light is flashing red. In contrast, the US Federal Reserve does not have a warning light it believes it can rely upon.

The irony is money supply growth in the UK and the eurozone may increasingly be influenced by monetary and economic decisions reached elsewhere in the world. Inflows into London, Frankfurt and Paris partly reflect interest rate levels in Japan, foreign exchange reserves in China, Russia and the Middle East and, indeed, the monetary stance in the US. Those inflows, in turn, lift asset prices and encourage additional domestic bank lending, which in turn, triggers the flashing warning light. In response, the Bank of England and the ECB will probably do only what they know best: move interest rates up more.

• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.