What Mervyn King, governor of the Bank of England, called the Nice (“non-inflationary, consistently expansionary”) decade has vanished. In its place, we see what I would now call the Nasty (“nightmare of austere and stagflationary years”). Nasty times create nasty choices: should the monetary policy committee respond to the inflationary overshoot by tightening, despite economic fragility and fiscal austerity? Or should it continue to assume that the overshoot will end?
I remain convinced the latter is the better choice and so agree with yesterday’s decision to leave rates unchanged and not to follow the lead of the European Central Bank, which raised rates from one percent to 1.25 percent, the first increase in three years. But the choice is now a hard one, not least since the MPC’s forecasts have been wrong for so long. Credibility may be at stake.
Among the more enjoyable consequences of the shift to today’s monetary policy regime, in 1997, is the improvement in the debate. In addition to the inflation report and the minutes of the MPC, members of the committee produce illuminating speeches. Spencer Dale, the chief economist, who backed a quarter-point increase last month, gives a useful analysis of what has gone wrong in his “MPC in the dock”.
In February 2009, for example, the MPC suggested that the possibility that inflation would be above 3 percent in 2010 was less than one in 20 in each quarter. In fact, inflation was above 3 percent in every quarter. That does not look too good, does it?
Over the period since mid-1997, annual inflation on the consumer price index has averaged 1.9 percent. Unfortunately, this consists of two sub-periods: mid-1997 to mid-2005 when consumer price inflation averaged 1.3 percent; and the period since then when inflation has averaged 2.7 percent and remained almost consistently above target. The MPC did a better job of hitting 2 percent CPI inflation before that became its target, in 2004, than afterwards.
All this goes to show that we do not understand how the economy works. Nevertheless, as Mr. Dale also notes, it is at least quite easy to explain the overshoots in 2009 and 2010. In the former year, the surprise was the speed of the pass-through from the depreciation of sterling. In the latter year, the surprise was the surge in world commodity prices. In short, a series of shocks — sterling’s fall, higher commodity prices and the rise in VAT — can more than account for the recent failures. No reasonable people would have voted for higher rates at the depth of the crisis, even if they had known what was coming, to push domestically generated inflation lower, in order to offset such temporary factors.
Moreover, the past overshooting should be irrelevant to today: what matters are the prospects. On this Mr. Dale remarks, “inflation will probably rise further in the near term as recent commodity price increases pass through the supply chain. But, further out, inflation is likely to fall back as temporary impacts of the price level shocks wane and the slack in the economy continues to pull down on inflation.” This remains much the most plausible view. Remember that the prospective structural fiscal tightening has barely begun, while the economy seems to have been stagnating over the past two quarters. In the year to the third quarter of 2010, unit labor costs stagnated. Moreover, for those (now few) who care about such things, broad money is actually shrinking.
The MPC’s soon-to-depart hawk, Andrew Sentance, argues in a thought-provoking speech, that we do not understand how spare capacity works in a service-dominated economy. Yet this hardly means there is none. After all, in the last quarter of 2010, gross domestic product was 4.6 percent below its level in the first quarter of 2008, while unemployment was 8 percent.
The case for waiting and seeing remains strong. Against this, there are two objections. First, the rise in global commodity prices may not be a price-level adjustment, but a new trend. If so, the MPC should be trying to reduce domestically generated inflation permanently. Against this, I would argue that we do not yet know this — swings in prices are a feature of commodity markets. Moreover, even if we did know that there is some upward trend, trying to disentangle it from the noise is, alas, almost impossible.
Second, the lengthy failure to meet the target, combined with today’s extraordinarily easy monetary policy, risks severing inflation expectations from their anchor. That would be a disaster, as the world discovered in the 1970s. Alas, there is some evidence from both surveys and the bond markets that inflation expectations are rising. Wages, too, seem to be rising somewhat faster than before. None of this looks lethal yet. But great care is required.
I see no decisive case for the Bank to follow the ECB. But if inflation does not fall back soon and if inflation expectations deteriorate, tightening will, alas, have to occur. The economy will then go from nasty to nastier. It is a dire prospect. Let us pray it can still be avoided.