As the UK's financial system stumbled towards the abyss last week, there was a near universal demand for the Bank of England to dramatically cut interest rates. Politicians and journalists alike advised the BoE to forget about inflation and focus on the health of the banks. The MPC bowed to this pressure, surrendered its independent status and cut interest rates by 50 basis points.
Unfortunately, inflation hasn't forgotten about us. It keeps on rising remorselessly, and in September, it reached 5.2 percent: the highest level for 16 years. As for the inflation target, it is now a distant memory. No one seriously thinks that the Bank of England will come within a mile of the 2 percent target for years.
The sad fact is that monetary policy is now a complete mess. Policy rates are in real terms negative. Furthermore, the relationship between the Bank of England's base rate and the wider economy has broken down. Earlier interest-rate cuts had absolutely no effect on commercial bank lending, while the latest cuts are unlikely to elicit much of a response. Going forward, the newly nationalised banks have government mandated credit growth targets. It is hard to see where the MPC fits into this new regime
The policy contradictions run deeper than that. On the one hand, the Bank of England hope that a slowdown in growth, coupled with lower commodity prices will bring inflation down. Growth has been slowing for over a year, but inflation hasn't paid much attention. While it is true that commodity prices are starting to drop, the rapidly depreciating pound has added to inflationary pressure through higher import prices.
While the Bank of England is counting on slower growth to put a cap on inflation, the government is doing everything in its power to keep credit growth strong. If the government succeeds, then the prospects for inflation are really grim. If the government fails, then the recession is inevitable, and those bank balance sheet that everyone is so desperate to shore up, could become really nasty, particularly if the housing market really begins to slide and mortgage default rates rise further. In policy terms, it all adds up to a hopeless mess.
If only the Bank of England had acted more decisively back in 2005 when inflation first began to pick up. It should have increased interest rates, and punctured the housing bubble when it was still containable, Banks would have been in better shape, inflation would have been lower, and house prices would have been more sustainable. The MPC missed the opportunity then, and chose to allow inflation to creep beyond the 2 percent target level. Rather than take some difficult decisions, it turned a blind eye to the increasing inflationary pressures. Three years later, the entire monetary policy framework is in tatters.
Here we come to the heart of the matter. A central bank that thinks it can forget about inflation is quickly reminded that rapid monetary growth and negative real interest rates always leads to higher prices.
While it is true that the banking crisis has recently constrained monetary policy, the Bank of England now has some difficult questions before it. When does it re-establish control over monetary policy and begin a serious attempt to bring inflation down? Does it take a chance and wait until a recession does the job for it? Or will it idly standby as the government tries to pump up credit in its newly nationalized banks in a shortsighted strategy to maintain its own electoral popularity?