Friday, August 22, 2008

Three into one doesn't go

There is one metaphor that the MPC have repeatedly used over the last year. They have characterized their monetary policy decisions as finding a "balancing act", trading off growth with price stability.

Over the last two weeks, economic data has knocked the MPC to the floor; the economy has ground to a halt while inflation has taken off. Furthermore, the numbers are only going to get worse. Growth will almost certainly slip into negative territory during the third quarter, while inflation is projected to rise to five percent by the autumn.

So what has gone wrong? Simply put, the MPC have lost their focus. Prior to the credit crunch, they had somewhat timidly raised interest rates and were beginning to bear down on inflation. During the first two quarters of 2007, inflation was slowly heading downwards.

Then along came Northern Rock. The MPC, along with other central banks, started to pursue mixed objectives. Simultaneously, the BoE, the Fed and to a lesser extent, the ECB, tried to protect banks from insolvency, maintain growth, while trying to keep inflation under control.

However, central banks have only one policy instrument; short term interest rates. Three into one doesn't go. With their multiple objectives, the MPC now seem confused. If you need proof of this confusion, just take a look at recent MPC minutes, where votes are now typically split three ways. The upshot of all this confusion is rapidly declining anti-inflationary credibility. How can inflation fall when the MPC aren't prepared to raise interest rates?

Unfortunately, there is a widely held and deeply damaging view that the MPC doesn't need to do anything to contain inflation. It just has to wait until the credit crunch and declining GDP growth does the job for them. The chart above comprehensively demolishes that argument. The UK has now recorded four consecutive quarters of declining growth, coupled with four quarters of rising inflation. It will shortly add a fifth quarter.

Why won't declining growth do the trick? First, we need to understand that inflation is fundamentally due to rising monetary growth, which is currently growing at double digit rates. Second, we need to understand why the money supply keeps on rising, despite the credit crunch.

So far, the credit crunch has not produced the massive monetary contraction that some feared. Certainly, it has killed off mortgage applications, and it has wasted the housing bubble. However, the MPC policy of lower interest rates has kept other forms of credit growing strongly. For example, take a look at non-financial corporate borrowing. It is powering along at double digit rates.

Part of the recent double digit monetary growth might also be due to weak banks shoring up their feeble lending books by continued credit growth. There is no direct evidence of this, but the recent UK capital issuance data looks very suspicious, with huge intra-financial sector activity.

So the MPCs multi-objective muddle has led to a fairly comprensive series of defeats on all fronts. Growth has died, inflation has taken off, and UK banks are still struggling. It would have been far better if the MPC had picked one objective - price stability - and ensured that it succeeded. It would have easily achieved this goal;all the MPC had to do was raise rates.


  1. Dear Alice,

    Please post the following links:

    House buyers are demanding 20% discounts on homes as market continues to sink

    By Simon Duke
    Last updated at 6:51 PM on 21st August 2008


    Britain: Economy hit by inflation and threat of recession
    By Jean Shaoul
    22 August 2008


  2. Falling house prices will not leave their mark on the inflation figures, as they are not measured there.

    The "credit crunch" will not leave its mark on wide money supply growth until credit actually contracts. Not just "not growing much", but an actual contraction. Only three ways that's going to happen. People go bust, banks go bust, or people pay off their debts - that's not going to happen if they lose their jobs.

    A recession is not going to lower prices, if the GBP doesn't keep its value. That's not going to happen unless the BoE raises interest rates.

    In short, there's a whole shed-load of stuff that isn't happening...

  3. Why so much private corp. lending?

  4. Check this out on inflation!.html?

  5. This is the real conundrum, and either the Fed or the ECB is going to be proved right. Not both. Mind you, they could both be wrong!

    I think William Buiter has said the thing to watch out for is credit contraction - and it's not here yet.

  6. Wasn't one of the reasons for creating the FSA to make it easier for the BoE to concentrate on its core function?

    Doesn't seem to have worked.

    For a long time I believed that BoE independence meant we'd never have to worry about inflation ever again. Now, I'm starting to believe that the return-to-the-gold-standard crowd might have been right all along.