Monday February 20, 2006
Guardian
While the Bank of England's quarterly inflation report press conferences are usually dominated by the comments of the governor, Mervyn King, there was, on last week's occasion, a particularly noteworthy statement from the Bank's executive director, Paul Tucker.The recent big rises in the prices of assets such as houses and shares, he said, did not "provide a comfortable backdrop to monetary policy". This one remark at a stroke helps explain the monetary policy committee's dilemma as it seeks to set the correct short-term interest rate for the British economy.
It points to the core issue facing central banks around the world today: what to do about asset price inflation, as opposed to consumer price inflation. It is, of course, the latter which most central banks are mandated to keep low. In the Bank of England's case, there is a government-set target of 2% for consumer price inflation. It is simple and well understood.
If you looked solely at consumer price inflation in Britain now, at 1.9%, and add in the awful retail sales figures of last Thursday, then, given the importance of consumer spending to the British economy, you could make a reasonable, if over-simplistic, case for interest rates to be cut immediately.
But Mr King made it clear that things were not as simple as that (they never are). He was concerned that share prices have risen by 10% just in the past three months and doubled in the past three years. He was also worried that house prices, which the MPC had succeeded brilliantly in taming, have started to move up again. That could well be related to the extremely low long-term interest rates prevailing in much of the world and especially in Britain.
Unlike the short-term repo rate, which is set by the Bank, longer-term rates are set by money markets, and the markets have driven rates down as investors have clamoured to buy government bonds for several reasons, which has the effect of pushing yields down. This may sound esoteric but it feeds through into fixed-rate mortgage rates, which have fallen sharply, thus helping support the housing market.
Bursting bubbles
On this issue Mr King differs from the former Federal Reserve chairman Alan Greenspan, who argued that asset price bubbles were difficult to spot and raising interest rates sharply to prevent them could have damaging wider effects on the economy as a whole. Better to let bubbles burst by themselves and cut interest rates if they threatened to bring the whole economy down, he thought.
But Mr King has never been so sure and has been keener to deal with the country's housing bubble of the past few years. The Bank raised interest rates from late 2003 to mid-2004 at least in part to rein in the housing market and possibly by more than was justified to tame consumer price inflation. Then Mr King's impeccably timed warning in June 2004 that house prices were in danger of falling stopped the housing market in its tracks. It did not cause it to burst but rather to deflate gently. House prices remain overvalued by most measures, however.
The Bank then cut interest rates last August, when it appeared that consumer spending had fallen off a cliff and overall economic growth was sluggish. But since then the picture has been far less clear, as economic growth has recovered to around its long-term trend and, as Mr King said last week, the housing market has picked up, as have shares and consumer spending. And rising gas prices, the Bank fears, could push up consumer price inflation this year.
Herein lies the answer to why last week's inflation report seemed more hawkish than many City pundits had expected and gave out a distinct signal that further rate cuts were off the cards. It seems that the last thing the governor wants to do is further boost a booming stock market by cutting interest rates and pushing house prices into a fresh boom when he has only just stifled the last one.
But this does make the presentation of monetary policy difficult. Indeed, the inflation report raised the Bank's profile for economic growth in the next year - meaning the Bank is now well above the average of independent forecasters and is predicting growth will be above its long-term trend over the next three years. It admitted that the risks to this forecast were on the downside. If that was the case, why not leave the forecast where it was before, when the risks to it were balanced? The reason seems to be that stronger growth is required to enable the Bank to forecast inflation remaining bang on its 2% target for the next three years. With the old growth forecast, and inflation falling back since November, the projection for inflation would probably have been below target in the coming years.
Wriggle room
So does all of this mean interest rates will remain on hold throughout this year? Not necessarily. Ultimately, if inflation and growth come in lower than the Bank has forecast, as many independent analysts believe, the committee will have to cut interest rates since its mandate to hit the 2% target is clear and unambiguous, even if the MPC can allow itself some wriggle room to "lean against the wind" as far as asset prices are concerned. This means it might raise rates a bit further or quicker, or hesitate in cutting them more than is justified by inflation alone in order to deal with an asset price bubble.
Minutes of the MPC's meeting this month, due out this Wednesday, are likely to show that at least one member voted to cut rates immediately. Steve Nickell and Kate Barker are concerned that the economy has spare capacity and that growth may not pick up as quickly as the inflation report projected.
The central projection also allows for consumer spending to carry on growing at its long-term average over the next year, for business investment to stage a modest recovery and for net trade (exports minus imports) to make a stronger contribution than in the past.
From the MPC's point of view, it was lucky that it presented the inflation report before January's awful retail sales figures emerged on Thursday.
While it is always important not to get too carried away by one month's data, it would have made it difficult for Mr King to be upbeat about consumer spending in the face of such woeful figures, which suggest that the increase in sales before Christmas may have represented the last gasp from the British consumer. It is quite likely that a much leaner period lies ahead as people struggle with rising gas and electricity bills, higher council taxes and the mountain of personal debt built up in recent years. It is perfectly possible to paint a gloomy picture - based on weak retail sales, a 10% fall in car sales over the past year and rising unemployment - that consumer spending, which accounts for two-thirds of the economy, could be in for a really slow few months or even years, especially as income growth has been weak.
The MPC has for some time been hoping for a strong pick-up in business investment and net exports to take up the slack from the slower growth of consumption and the housing market, thus giving a more balanced economy. But it admitted last week that business investment was likely to continue to grow slowly for a variety of reasons, such as companies filling holes in their pension funds (caused by the same falling long-term bond yields that have lowered fixed-rate mortgage rates) or being reluctant to invest, given the costs of higher energy prices, for example.
If the economy fails to perform as the Bank expects, interest rates will come down, with the effect of boosting the domestic economy again. But, as Mr King's predecessor, Eddie George, used to say, unbalanced growth is better than no growth at all.
Clinton 1998 wagging finger: "I did not have sex with that woman!"
Bush 2005 wagging finger: "I did nothing illegal!"
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