Neither was everyone surprised by CPI inflation rising to 5% or even more (the current predictions of Citi and now Mervyn King for later this year). I’d predicted that as early as February 2009, and was, again, far from the only one.
I obviously feel vindicated, also, in having argued since June that we needed to be going more QE to offset the coming double dip and to smooth the start of the fiscal consolidation. The Bank of England should have commenced as soon as the Emergency Budget set out the government’s intentions in respect of fiscal consolidation. If it felt the plans might lack credibility, then it could perhaps excuse waiting until after the detailed spending cuts programme was set out in late October, and hence commence QE in November (though that was already getting late). If the economic data continues to look very weak up to the February meeting, there must be a chance that there will be more votes for recommencing QE then.
Maybe, however, we are now getting late for doing additional QE. That was most needed earlier, at a stage when it could keep broad money growing through the back end of 2010 (which it has not been doing, adequately) and provide the economy with a sense of support and confidence. Unless the data show considerable further weakening, or the GDP growth figures in April for the first three months of 2011 show a worsening of the GDP contraction (say, a contraction closer to 1.0% than 0.5%), then I’m likely to have switched away from doing more QE. They’ve simply missed the boat, I think.
If the data do show such continued weakness, is there anything George Osborne could do at the Budget? I always argued against the VAT rise (I wanted to raise income tax instead, and to do it in a phased way, back-loading the tax rises), but it’s too late to do anything about that now. However, the Coalition is committed to raising income tax thresholds (as per the Liberal Democrat’s manifesto pledge), and Osborne has some discretion over how rapidly to do that. If the GDP contraction appeared to be accelerating, instead of being the blip I expect (perhaps as a consequence of further problems in the Eurozone, or a blow-out in China ), the speed with which income tax thresholds are to be raised could be accelerated.
The government can show some flexibility on tax cuts, to give the economy the sense of support, the sense that policy-makers still have some options left. Where there must be no flexibility — unless in the direction of acting more and acting faster — is on spending cuts. The spending cuts announced are just barely adequate and if anything too slow, rather than too quick (though of course being "adequate" is about the best anything ever gets in politics). If the government were to be seen as backing down one inch on spending cuts, in a weakening economy, it could be disastrous. There could be an immediate negative response from bonds markets of gilts yields rising as confidence was lost, but a greater danger would be that spending would not be reduced, and when the next recession comes in 2013/14 (which it will) we would still have a large structural deficit — leading to a serious gilts crisis. The Balls plan would invite disaster.
What else? A key problem with the economy since 2007 has been the collapse of the inflation target. For the period 1997-2007, the UK’s inflation target was understood by all concerned as being that the Bank was required, over the medium term, to deliver a rate of CPI inflation of 2% (until 2003 it was RPIX inflation of 2.5%), and that in the short-term it was permitting only to deviate from its long-term target by 1%. That gave it a tolerance band, around the target, within which it could manipulate interest rate to achieve other goals, such as supporting growth in the economy. But it was not supposed to permit CPI inflation, at any time, to go above 3% or below 1%. If it did so, it had to explain to the Chancellor why it had happened, in an open letter, and the understanding was that if the reason could not be demonstrated as some force majeure beyond the Bank of England’s control, then the Monetary Policy Committee would be admonished by the Chancellor for its failure to meet its target, and further action might follow.
This regime worked extremely well in the UK, by and large. Inflation did not go outside the permitted threshold from the time of its introduction in 1992 until 2007 — Britain was alone, amongst the international inflation-targeters, in never having had a policy miss. This very high credibility to the regime allowed the Bank of England great license to offset macroeconomic shocks, holding interest rates much lower for much longer following the 2000 and 2001 macroeconomic shocks (dot-com and 9/11 respectively), without inflation rising, than would have been feasible under previous monetary policy regimes.
I have written previously about the structural flaws in inflation targeting in this respect, and how it was always liable to generate asset price cycles if very credible. But the key issue now is the collapse in credibility from 2007 onwards. When, in early 2007, the inflation target was first missed, the members of the Monetary Policy Committee (perhaps naturally) were reluctant to accept their failure, and instead argued that there had never been any tolerance band of 1% around the centrepoint of the target. Instead, the target was just 2% and there was no upper or lower limit beyond which policy was not supposed to allow inflation to go in the short term. All that the requirement to write a letter meant was that a letter had to be written, not that there had been any particular policy failure at that point. At the time I argued vigorously that that should not be accepted, and that it was important that the MPC be admonished for its failure. This was not done.
In early 2008, it became clear that inflation was going to go very considerably above 3% in 2008. I urged that, this being so, unless Alistair Darling and Gordon Brown were willing to see a recession created by the interest rate rises that would be needed to keep inflation to target, the inflation target should be raised. A few months later it had become clear than CPI inflation would go well above 4% (in fact it reached 5% in the end) and I again urged that the target would lose credibility if it were not changed.
This year we face a similar problem. CPI inflation has been above 3% now for as long as anyone can remember. Since that first policy miss in 2007, about which I complained vigorously and was told not to be hysterical, meeting the inflation target has become virtually irrelevant as a determinant of monetary policy. When was the last time a Monetary Policy Committee decision has been felt to be affected by whether inflation would reach 2% in the medium term, without exceeding 3% or going below 1% in the short term? Throughout 2008, with inflation racing to 5%, the inflation target was totally ignored. Since late 2008, avoiding deflationary slump has been the overwhelming objective. Over the past nine months, with letter after letter written to the Chancellor about why inflation is too high, even the most hawkish of “inflation nutter” commentators has argued only that interest rates should be raised a quarter or a half point to declare willing on the part of the MPC in respect of inflation — no-one serious thinks interest rates should actually be raised enough to bring inflation down below 3%. The inflation target, which reigned supreme in credibility internationally from 1992-2007, has, since that first miss in early 2007, totally collapsed.
We need to restore credibility to the target. The very essence of an inflation target — the one thing it has going for it over a price-path (price-level) target is that it is set every year; we don’t have to target the same inflation rate each year, but instead have flexibility to respond to events by raising or lowering it. This year, inflation is forecast by the Bank of England to return to 2% in 2012, but exceed 4% (perhaps even 5%) in the short term. Well, perhaps we think that reaching 5% is okay this year, and that the Bank shouldn’t do anything to try to prevent that provided that inflation will indeed return to 2% next year, but that going any higher than that would be a real problem and inflation had better be getting back to 2% next year otherwise there will have to be very vigorous interest rate rises. Given where we start now, I would think that’s about right.
So, if that’s what we think, that’s what George Osborne should specify in the inflation target when he sets it at the Budget. If 5% is okay in the short term, but we want 2% next year, then he should say that the target is to achieve 2% next year, with a tolerance limit this year of inflation going no higher than 5% (and no lower than 1%, say, on the downside). And it should be specified clearly in Osborne’s letter setting out the target that if inflation does exceed 5% (or perhaps some lower number), Osborne will be disappointed, want a jolly good explanation of why, and be inclined to admonish the MPC and, if necessary, take further action.
At present, what is expected is that Osborne will set an inflation target of 2%, the MPC will make no effort whatever to meet that, Mervyn King will write many letters explaining why it would be a bad idea to try to meet the inflation target, and that will all seem okay. That is the very opposite of a credible monetary policy regime — it is one with so little credibility that no-one complains if policy makes no at temp t to meet its own stated objectives.
We are liable to have a material inflation episode in 2012, once the recovery really gets going decisively. It will be much less painful — involve much less recession — if monetary policy has some credibility when it becomes necessary to get inflation down. At present, monetary policy in the UK has zero credibility. We need to use the time left to try to restore some credibility. Credibility will not be restored by setting targets no-one has any intention of meeting or enforcing.
Overall then, from here, these are the key things:
– Do not move one inch on spending cuts, unless in the direction of doing more and doing them faster.
– Don't over-react to a little snow, but if the data continue to look weak, consider raising income tax thresholds a bit more than you otherwise would in the Budget.
– Try to restore credibility to the inflation target by saying that this year's target is 2%, going no higher than 5% and no lower than 1% in the short run, and that the target will be expected to be met and if not action from the Chancellor will follow.
– For the MPC, if weakness really continues consider more QE, but we are probably too late for that and, in any event, after staying low until probably September, interest rates will need to rise very rapidly thereafter (they should be thinking in terms of 1.5% by December 2011, 5% by May 2012, then (hopefully, if the economy can stand it) 8% by end-2012. The lower interest rates can rise in 2012, the more unhealthy that means the consumer will be, and greater the portion of inflation control that will have to be delivered by the 2013/14 recession rather than positive interest rates in 2012.