Fifteen years ago, the UK exited from the ERM in humiliation. At the time, the failure struck at the very core of the Bank of England’s counter-inflationary strategy. By targeting the pound to the German DM, the bank hoped that it could hold down inflation. However, the Bank couldn’t maintain the target.
In the days following the ERM exit, the Bank of England faced the difficult question of “what now?” It came up with a barely noticed idea. From now on, the bank announced, we will target inflation directly. No more intermediate targets for us, the Bank declared. The Bank would no longer look at money supply growth, interest rates, or exchange rates; only the end result would matter. Inflation, and only inflation, would be the only target that mattered.
At the time, the implications of this new inflation targeting regime were only dimly understood. Superficially, it seemed like a sound idea. Its simplicity and clarity was appreciated by politicians. In 1997, the inflation targeting regime was further enhanced when the Bank of England gained policy independence from the Treasury.
However, inflation targeting had a deep dark side that only became apparent much later. The chosen target wasn’t price inflation, it was consumer price inflation. The Bank of England chose to target a subset of inflation. Crucially, the Bank chose to ignore asset prices, housing costs and indirect taxes.
Inflation targeting also meant that the Bank no longer paid much attention to other indicators, which could guide monetary policy. The Bank, in effect, threw away, monetary economics as a guide for policy. It ignored the money supply, interest rate policy and exchange rates.
The Bank quickly realized that it needed some guide to underlying inflation developments. In order to distinguish between one-off price shocks, from generalized inflationary pressure, it created a new indicator – core inflation. This index is an even more restricted measure of price changes; it excluded energy and food prices. The Bank argued that these indicators were too volatile and therefore made it harder to understand inflation dynamics.
It is impossible to over-emphasize the absurdity of core inflation. No one consumes a basket of goods that excludes food and energy. It makes absolutely no sense trying to track the true underlying price changes by excluding information. Since both inflation and core inflation are contemporaneous measures, the latter adds no further information about the future developments of prices that isn’t already included in the former.
To add irony to absurdity, there are other proven and reliable measures that can predict rising inflationary pressure – for example, money supply measures, exchange rate changes and interest rate developments. However, the Bank had, for all practical purposes, dumped these indicators when it went for the new inflation targeting regime.
The volatility argument is also fraudulent. Food and energy prices may be more volatile, but seasonal adjustments can resolve most of these fluctuations. More suspiciously, the core inflation rate is persistently lower than the headline inflation. Thus, it would appear that core inflation has a strong persistent downward bias, lulling central banks into a false sense of security.
These statistical weaknesses and theoretical absurdities are but small inconveniences. In contrast, the exclusion of asset prices as a matter for policy has devastating economic consequences. In recent years, countries like China and India have been prepared to suppress domestic wages and maintain a highly depreciated exchange rate, in order to accelerate their economic development. The UK was flooded with cheap imports and the consumer price inflation fell. So far, so good; these generous but poor developing countries kept their own people’s real wages low in order to maintain high living standards in the UK.
The Bank of England saw lower prices, and congratulated itself on what a great job it had done holding back inflation. It began to relax monetary policy; the money supply increased, interest rates came down, and growth picked up.
However, the prices that targeting regime has excluded began to rise. The afore-mentioned developing countries do not produce food or energy, so all that extra money floating around, pushed the prices of these key commodities up. At this point, the core inflation measure was no longer a mere absurdity; it was a positive menace, misleading the Bank of England into a false sense of security. Lower real interest rates discouraged savings and encouraged the accumulation of debt. This additional debt was mostly used to finance consumption and in particular, higher mortgages.
The monetary-housing market nexus was particularly insidious. The supply of housing barely changed, despite rising prices. At the risk of simplification; people bought the same houses that they would have bought if the Bank of England had been sensible and kept credit growth under control. Unfortunately, people now bought these houses with much higher levels of personal debt and therefore, they were much more vulnerable to any adverse changes in interest rates. Instead of buying a house at three times income, people bought them at six times income.
So the Bank of England were faced with two conflicting developments; lower import prices, comprising mostly of finished mass produced consumer goods, and rapidly rising non-traded goods, coupled with an unprecedented housing market bubble.
Back in 2004, the Bank began to see increasing inflation risks, and belatedly increased interest rates. It had the desired effect, and slowed the housing bubble. Then their inflation targeting regime cruelly trapped the Bank of England. The CPI inflation rate and its crippled friend, core inflation, began to moderate. The Bank thought that the dangers of inflation had subsided and cut interest rates.
It was an almost criminally irresponsible act; it reignited the housing bubble and unleashed the greatest spurt of inflation seen in the UK in fifteen years. Within 18 months, the more reliable retail price index shot up to almost 5 percent. For the first time, the Bank could not prevent inflation from breeching the government’s inflation target. It was a humiliation for the Bank and a damning indictment of its inflation targeting regime.
Irony piles upon irony here. A casual examination of monetary growth data could have told the bank that it had a problem. Economies can not absorb 10 percent more money each year without higher prices.
So where does the bank go from here? Somewhat belatedly, the Bank of England woke up to the gathering inflationary dangers. Interest rates are now on the way up. Nevertheless, monetary growth has refused to calm down. This is largely due to the aftershock coming from the housing market. The housing bubble, and the fear of ever increasing house prices, continues to fuel demand for credit. So far, higher interest rate increases have not discouraged people from taking out ever higher loans. Sadly, this means that the Bank must keep on raising rates. If it does not, all this additional credit will find its way into the real economy and push up inflation.
The Bank is now fighting a difficult battle to regain control of monetary aggregates. To win this battle, the bank needs to aggressively raise rates, and this may well create a recession. Any economic downturn will leave the debt-sozzled private sector vulnerable. Private sector balance sheets need to recover, overall indebtedness needs to fall, which is just another way of saying that people need to save more. In this regard, higher interest rates will restore the incentive to save. However, the housing bubble will be a necessary victim in this adjustment.
In essence, the UK is looking at a repeat of the early 1990s. This begs the question could this mess have been avoided. The answer is yes. Ultimately, monetary economics is a very straightforward matter. If a central bank prints money, it gets inflation. It also gets abnormally and temporarily low real interest rates that discourages savings and creates asset bubbles.
What is the future for inflation targeting? In a word; bleak; the Bank of England are waking up to some painfully obvious realities. The Bank is learning excessive monetary growth does matter; core inflation is absurd; and asset markets should not be ignored. In other words, it is time to dump inflation targeting.