Caught between inflation and growth
The Governor of the Bank of England recently told the House of Commons Treasury Select Committee that "a change in the prices of food and energy relative to other prices cannot by itself produce sustained inflation unless we allow other prices and...
The Governor of the Bank of England recently told the House of Commons Treasury Select Committee that "a change in the prices of food and energy relative to other prices cannot by itself produce sustained inflation unless we allow other prices and wages to rise at a faster rate".
What was the Governor referring to? One possibility is that the Bank of England simply does not accept that food and energy prices can continuously rise. In other words, the Bank of England believes 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.
However, forecasting the future level of food and energy prices has become quite daunting. 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 traders thought oil prices today would be around $72 per barrel. Today they are in the $130 per barrel range.
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, particularly the emerging world. Their interest rates are low, their inflation rates are rising and their economies are overheating.
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 is 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 is not true at the moment.
Moreover, loose emerging market monetary conditions do not 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 being 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. What the Bank of England 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.
While this is theoretically true, turning theory into reality is no easy task. UK house prices are falling. The financial system is under stress. 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.
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. The bank is asking everyone in the country to accept inflation as an unfortunate fact of life. But what happens 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? What if the public does not 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.
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. Data and figures are correct as at when article was sent for publication.
What was the Governor referring to? One possibility is that the Bank of England simply does not accept that food and energy prices can continuously rise. In other words, the Bank of England believes 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.
However, forecasting the future level of food and energy prices has become quite daunting. 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 traders thought oil prices today would be around $72 per barrel. Today they are in the $130 per barrel range.
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, particularly the emerging world. Their interest rates are low, their inflation rates are rising and their economies are overheating.
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 is 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 is not true at the moment.
Moreover, loose emerging market monetary conditions do not 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 being 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. What the Bank of England 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.
While this is theoretically true, turning theory into reality is no easy task. UK house prices are falling. The financial system is under stress. 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.
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. The bank is asking everyone in the country to accept inflation as an unfortunate fact of life. But what happens 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? What if the public does not 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.
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. Data and figures are correct as at when article was sent for publication.