Hard-won credibility and stable inflation expectations should not be forgotten in the search for faster growth, cautions HSBC economist John Zhu
It all changed when sterling crashed out of the Exchange Rate Mechanism (ERM) in 1992. A major reason for joining the ERM in the first place was to borrow the German Bundesbank’s inflation-fighting credibility. Monetary policy was once again in tatters. What saved the UK was nothing less than a central banking revolution.
Hard-won credibility and stable inflation expectations should not be forgotten in the search for faster growth, cautions HSBC economist John Zhu
It all changed when sterling crashed out of the Exchange Rate Mechanism (ERM) in 1992. A major reason for joining the ERM in the first place was to borrow the German Bundesbank’s inflation-fighting credibility. Monetary policy was once again in tatters. What saved the UK was nothing less than a central banking revolution.
First came inflation targeting, then the announcement of the Bank of England’s (BoE) independence in May 1997. In the decade that followed up to 2007, inflation was both low and stable. However, central banks emerged from the 2007/08 financial crisis blamed for first sowing the seeds of, and then neglecting to stop the asset prices bubbles.
And subsequently, economists cannot seem to agree on the right balance between reducing government debt on one hand and trying to stimulate economic growth on the other hand.
Complete independence – really?
Ultimately, a central bank is never completely independent. It is accountable to an elected government. With the current government committed to cutting the budget deficit, it falls to monetary policy to boost demand. But looser policy is not riskless policy: eventually, cheaper money could simply fuel inflation with no real benefit. Indeed, the BoE has already acknowledged a worsening inflation/growth trade-off.
In its February inflation report, it forecasted sluggish growth but also the highest projected inflation rate two years ahead since the 2% CPI target was introduced in 2004. Despite admitting that inflation is unlikely to fall back to target in the near future, the Bank also declared that it is willing to ‘look through’ this above-target inflation in an unusual policy statement in February.
It echoes the sort of approach proposed by Mark Carney, currently head of the Central Bank of Canada, who takes over from Sir Mervyn King in July. Ever since his appointment, Carney has outlined a series of imaginative ways to reform the UK’s monetary framework.
He rowed back from the most radical ideas such as targeting nominal GDP, but has basically signalled that the BoE will continue to be ‘flexible’ in its approach to inflation-targeting, ie, it will tolerate prolonged deviations from target without changing policy, if changing policy comes at the expense of too much volatility in GDP growth.
Effectively, the Bank is now signalling it will care a bit more about growth, and a bit less about inflation than before. This risks a shift to permanently higher inflation expectations and damaging the Bank’s credibility for keeping inflation low and stable in the decade before the financial crisis.
Furthermore, there is the question of what exactly the BoE can do to boost growth. While more central bank money can always be created and pumped into the system through further purchases of government bonds, this approach may have a diminishing effect on real demand.
Finally, monetary policy may be ineffective if the economy cannot supply the goods and services needed to match any boost to demand. If the economy is actually operating at or near full capacity, then more money chasing the same amount of goods and services will only result in higher inflation.
I don’t think the UK is anywhere near full capacity, and the still-elevated unemployment rate suggests there is still some slack in the economy. But it is also possible that some of the growth pre-crisis was in fact unsustainable, and so despite a major fall in GDP, we may not be as far away from maximum potential growth as previously thought.
The contribution to growth from financial services pre-2007 certainly looks too large in hindsight, and is unlikely to be repeated anytime soon.
It seems though, that the pressure to act may mean the central bank will continue to try and find new ideas. Independent, inflation targeting, central banking consensus is in danger of being nothing more than a short-lived experiment.
John Zhu, UK economist, HSBC
