Thursday, 10 April 2008
Making choices when there is nothing to choose
Today’s interest rate announcement from the MPC was an extraordinary piece of contorted logic. Inflation is rising, but the UK still needs an interest rate cut to save the banks. In reality, the MPC will get more inflation, and the banks still need saving.
Here are a few quick observations from me on today's MPC statement.
CPI inflation rose to 2.5% in February. The Committee expects inflation to rise further this year, reflecting the continuing impact of higher energy and food prices, as well as the recent depreciation of sterling on import costs. Such pressures are already evident in producer input costs and pricing intentions.
Under normal circumstances, this opening paragraph should be leading towards an announcement of an interest rate increase. Just consider for a moment what the MPC said. Inflation is rising, it is expected to rise further. Key components of the index (food and energy) are rising particularly quickly. The exchange rate is falling, leading higher import prices. To cap it all, producer prices, a leading indicator of future inflationary pressures, is also flashing red. The case is watertight, where is the 0.5 percent hike?
Even if commodity prices remain at their current high levels, inflation should fall back.
The MPC made this statement without any supporting evidence, and which is flatly contradicted by the previous paragraph. It only shows that the MPC can successfully hold two conflicting positions without generating any internal anxiety.
But to ensure that inflation meets the 2% target in the medium term, the Committee needs to balance two risks. On the upside, above-target inflation this year could raise inflation expectations so that, in the absence of some margin of spare capacity, inflation would remain above the target. On the downside, the disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target.
Lets get one thing straight; higher inflation is a risk; the banking crisis is a reality. The former needs higher interest rates; the latter issue is a distributional question about who will pay for the losses now sitting on bank balance sheets.
The MPC should focus on the inflationary risks, since that is the mandate the government gave it back in 1997.
However, there is a problem with this mandate and its associated inflation target. The Bank of England does not take it seriously and has not been able to meet it for about two years. Today’s statement provides further evidence of an increasing unwillingness on the part of the MPC to take tough decisions to fight inflation. Instead of targeting inflation, the MPC believes that it is now torn between two conflicting objectives, price stability and protecting the banking system.
It is highly doubtful that a 0.25 percent can do much to help the banking sector. However, the cut can do enormous damage to price stability. The Bank of England’s own inflation expectations survey confirms that people now anticipate higher inflation. The downside inflation risks are high and growing. It is the exchange rate where the real danger is lurking. Lower rates will put downward pressure on sterling, and this will push prices up regardless of capacity utilization.
As far as an inflation strategy goes, the vague promise of a credit crunch induced slowdown is the best that the BoE can do right now. However, it is hard to see how an unemployed estate agent in Harrow will put much downward pressure on the price of bread, a gallon of oil or an ipod from China.
In the Committee’s judgment, the balance of these risks to the inflation outlook in the medium term justifies a cut in Bank Rate this month. Credit conditions have tightened and the availability of credit appears to be worsening. While the recent depreciation in sterling will support net exports, the prospects for output growth abroad have deteriorated. In the United Kingdom, business surveys suggest that growth has begun to moderate and that a margin of spare capacity will emerge during this year. This should help to keep domestic inflationary pressures in check in the medium term.
The MPC would do well to have a deeper look at the UK long term experience with inflation. As the 1970s and 1980s will show, high inflation rates can happily co-exist with high levels of unemployment and low capacity utilization. This is called stagflation. The combination of a depreciating exchange rate and a credit crunch provide the ideal conditions for such a miserable state of affairs.
The credit crunch will, in the fullness of time, create a lot of unemployment, primarily in financial services. It has already busted the housing bubble and it may lead to lower consumption growth. However, a depreciating exchange rate will nicely complement the already strong upward price pressures coming from fuel and food.
Like a cook making a broth, the MPC thinks it can chose the right combination of inflation, unemployment and financial sector bailout to make everything taste just right. It is likely to end up with very bitter stew of a recession, a systemic banking failure and deeply entrenched inflationary cycle. These things are not mutually exclusive, whatever the MPC might think.
Against that background, the Committee judged that a reduction in Bank Rate of 0.25 percentage points to 5.0% was necessary to meet the 2% target for CPI inflation in the medium term.
This statement is pure nonsense. There is no way that a cut in interest rates helps the MPC get to its 2 percent target. It is already above the target, it has admitted that inflation will move further away from the target. The best that they can hope for is that the interest rate cut is completely ineffective in terms of raising aggregate demand and therefore puts no additional pressure on prices.
The prose of this statement may superficially appear calm, but listen to it a little closer and you can hear the MPC having a screaming fit. The MPC is in a deep economic crisis, and like all such crises, the MPC is confronted with limited options and a mountain of problems. So, in the absence of anything better, it chose to cut rates.
Unfortunately, lower rates won't help much. It will not reduce inflation, and it will not save the housing market. As for the credit crunch, it won't even help the banks that much. Interest rate spreads might increase, but bank balance sheets are full of rotten mortgages collateralized on overpriced real estate.
So the Bank of England might have looked like it was doing something to relieve the credit crunch today. However, it was giving an impression of making a policy choice in an environment of policy impotence.