Central banking: An illusionary control over price stability?
In a way, Central bankers depend on an illusion. Their success depends entirely on their ability to persuade the public that, come rain or shine, they are able to deliver price stability. The general dislike of inflation by the public means, in turn,...
In a way, Central bankers depend on an illusion. Their success depends entirely on their ability to persuade the public that, come rain or shine, they are able to deliver price stability. The general dislike of inflation by the public means, in turn, that people wish the illusions the central bankers create to be true.
This is a beautiful self-fulfilling arrangement. Why would anyone demand an inflationary pay increase if the central bank is proved, time after time, to be right in its pursuit of price stability? The central bank, though, only gets it right because individuals do not demand those inflationary pay increases. This is a circle not of logic but, instead, of faith.
This illusion, though, is in serious danger of crumbling. The threat is obvious. As oil and other commodity prices rise into the stratosphere, there is an increasing sense that our inflationary destiny no longer lies with our central banks. They, too, understand the problem. The Federal Reserve recently revised down its forecasts for US economic growth but, at the same time, revised up its forecasts for inflation. Meanwhile, the Bank of England continues to warn of difficult times ahead.
The problem can be simply stated. The prices of the individual things people buy on a regular basis are not determined by the central banks. Indeed, central bankers would be horrified were they to be accused of trying to influence the price of, say, bread, spring onions or shoe polish. All they are interested in is the price level as a whole or, put another way, the value of money. The value of money is determined in relation to a hypothetical basket of goods and services which we call a price index.
If, within this price index, some prices rise, it follows that other prices must fall to ensure that the price level as a whole does not stray too far from the path implied by the inflation target. That way, the value of money is preserved.
Within the price index, however, is a mixture of prices some of which are easier to influence through monetary policy than others. Moreover, even those which can be influenced are only affected with a lag. In layman terms, central bank policy works only in slow motion.
It is for this reason that faith in our central bankers is being severely tested. To get monetary policy right, the central bank has to make guesses about the future path of the prices it cannot influence, to work out the degree to which interest rates have to be tweaked to set the path of the prices it can influence. This is no easy task.
In the UK, food and energy prices make up around 17 per cent of the consumer price basket. Higher food and energy prices in the UK owe a lot to the strength of demand - and overly loose monetary conditions - in China, India and other emerging markets.
However, knowing that food, energy and, for that matter, metals prices have now pushed inflation up to uncomfortably high rates simply tells us that the Bank of England left monetary policy too loose a year or two ago (or, alternatively, that it was happy to interpret its inflation remit generously). The prices it might have influenced to meet the inflation target were allowed to be too high in the light of the unexpected - and uncontrollable - surge in food and energy prices.
So where should interest rates be heading now? The answer depends in part on the assumptions made about food and energy prices. Central banks can take any one of three broad approaches. First, they can assume that what goes up must come down. In other words, the increase in food and energy prices this year will be followed by a decline next year. Secondly, they can assume there is a one-off structural increase in food and energy prices which will raise the inflation rate for two or three years but not beyond. Finally, they can take the much more pessimistic view that food and energy prices will rise over an indefinite period of time.
What happens if the central bank takes the first view only to discover that the third view - persistent price increases - proves correct? In this case, monetary policy is left too loose and inflation takes over. Alternatively, what happens if the central bank takes the third view when, in fact, the first view is correct? In these circumstances, monetary policy is left too tight, spelling bad news for, for example, the housing market.
All the evidence suggests central banks have, in fact, been too relaxed about food and energy prices. But, they are not the only ones. Financial markets have also got things persistently wrong. Looking at the levels of oil and copper prices since 2000 tracked against implied levels as determined by futures markets at the beginning of each year, we note that in virtually every year oil and copper prices have ended up higher than markets expected at the beginning of the year.
Three conclusions stem from this. First, it is terribly difficult forecasting food, energy and metals prices. Markets get it wrong all the time. Secondly, these errors must corrode the ability of central banks to set monetary policy correctly. Thirdly, as we begin to recognise these economic uncertainties, our faith in inflation targeting is likely to be sorely tested.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
This is a beautiful self-fulfilling arrangement. Why would anyone demand an inflationary pay increase if the central bank is proved, time after time, to be right in its pursuit of price stability? The central bank, though, only gets it right because individuals do not demand those inflationary pay increases. This is a circle not of logic but, instead, of faith.
This illusion, though, is in serious danger of crumbling. The threat is obvious. As oil and other commodity prices rise into the stratosphere, there is an increasing sense that our inflationary destiny no longer lies with our central banks. They, too, understand the problem. The Federal Reserve recently revised down its forecasts for US economic growth but, at the same time, revised up its forecasts for inflation. Meanwhile, the Bank of England continues to warn of difficult times ahead.
The problem can be simply stated. The prices of the individual things people buy on a regular basis are not determined by the central banks. Indeed, central bankers would be horrified were they to be accused of trying to influence the price of, say, bread, spring onions or shoe polish. All they are interested in is the price level as a whole or, put another way, the value of money. The value of money is determined in relation to a hypothetical basket of goods and services which we call a price index.
If, within this price index, some prices rise, it follows that other prices must fall to ensure that the price level as a whole does not stray too far from the path implied by the inflation target. That way, the value of money is preserved.
Within the price index, however, is a mixture of prices some of which are easier to influence through monetary policy than others. Moreover, even those which can be influenced are only affected with a lag. In layman terms, central bank policy works only in slow motion.
It is for this reason that faith in our central bankers is being severely tested. To get monetary policy right, the central bank has to make guesses about the future path of the prices it cannot influence, to work out the degree to which interest rates have to be tweaked to set the path of the prices it can influence. This is no easy task.
In the UK, food and energy prices make up around 17 per cent of the consumer price basket. Higher food and energy prices in the UK owe a lot to the strength of demand - and overly loose monetary conditions - in China, India and other emerging markets.
However, knowing that food, energy and, for that matter, metals prices have now pushed inflation up to uncomfortably high rates simply tells us that the Bank of England left monetary policy too loose a year or two ago (or, alternatively, that it was happy to interpret its inflation remit generously). The prices it might have influenced to meet the inflation target were allowed to be too high in the light of the unexpected - and uncontrollable - surge in food and energy prices.
So where should interest rates be heading now? The answer depends in part on the assumptions made about food and energy prices. Central banks can take any one of three broad approaches. First, they can assume that what goes up must come down. In other words, the increase in food and energy prices this year will be followed by a decline next year. Secondly, they can assume there is a one-off structural increase in food and energy prices which will raise the inflation rate for two or three years but not beyond. Finally, they can take the much more pessimistic view that food and energy prices will rise over an indefinite period of time.
What happens if the central bank takes the first view only to discover that the third view - persistent price increases - proves correct? In this case, monetary policy is left too loose and inflation takes over. Alternatively, what happens if the central bank takes the third view when, in fact, the first view is correct? In these circumstances, monetary policy is left too tight, spelling bad news for, for example, the housing market.
All the evidence suggests central banks have, in fact, been too relaxed about food and energy prices. But, they are not the only ones. Financial markets have also got things persistently wrong. Looking at the levels of oil and copper prices since 2000 tracked against implied levels as determined by futures markets at the beginning of each year, we note that in virtually every year oil and copper prices have ended up higher than markets expected at the beginning of the year.
Three conclusions stem from this. First, it is terribly difficult forecasting food, energy and metals prices. Markets get it wrong all the time. Secondly, these errors must corrode the ability of central banks to set monetary policy correctly. Thirdly, as we begin to recognise these economic uncertainties, our faith in inflation targeting is likely to be sorely tested.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.