Sunday, February 13, 2011

Looking through the inflation rate

I enjoyed reading these paragraphs in Philip Aldrick, and Emma Rowley piece on inflation, which appeared in the Telegraph:

For the past three years the (Bank of England) has got inflation consistently wrong. Just last year, it predicted the current quarter's inflation figure would be 1pc. When the ONS publishes a figure four times that level on Tuesday, it will only aggravate concerns.

The Governor and his cohorts have a formula for dealing with overshoots now. The Bank needs to "look through" inflation, King says. Shear off the one-off events, oil price spikes, poor harvests that lead to food price rises, the inflationary effect of the pound's devaluation and the VAT rise. Strip all that out and domestically generated inflation in the past four years has been "close to zero and obviously well below the target", King said in Newcastle last month.

"Looking through inflation" - as if we couldn't see it every time we enter a supermarket.

Aldrick and Rowley’s article hints at some deeper problems of monetary policy management. Over the last quarter of the 20th century, a consensus developed that price stability should be the primary focus of monetary policy.

In order to deliver low and stable inflation rates, a parallel consensus emerged. Central banks should be independent of political control and receive a unambiguous mandate for which they are then held accountable.

In order to make this mandate operational, Central banks needed a data-based standard. This meant choosing a single price index, which was compiled independently of the central bank. A third consensus developed. The Consumer Price Index was to be that benchmark, and it was to be produced by an independent national statistical office. (As an aside, I always thought that this was the wrong benchmark, because it excluded house prices. But let’s leave that objection at the cloakroom for fear that it might obscure my central argument. )

In summary, modern monetary policy had arrived that three points of agreement:
  • Monetary policy should be directed towards price stability:
  • Central banks should be independent:
  • The CPI should be the metric for measuring the central bank’s success in meeting its primary objective.

Unfortunately, the Bank of England failed to abide by this social contract. Instead of maintaining price stability, it has chased growth with paltry results and kept the banking sector afloat at the cost of higher inflation.

This race for growth has compromised its independence. Today, the monetary policy committee looks more like a gaggle of incompetent and unelected politicians rather than a group of competent, rational, data-driven bankers.

As for the transparency of the CPI benchmark, the Bank has tried to detract our attention from it by a litany of self serving excuses about global shocks, oil prices, VAT and whatever else seems convenient to put forward as an explanation for unacceptably high inflation.

It is all rather disappointing. There was a time when I though an independent central bank was the answer. Perhaps, this explains my anger what has come to pass as monetary policy. The consensus could have worked, if only the MPC had understood what it had signed up for - keeping inflation under control.

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