Conflicting Messages

28/01/2011 at 10:48 am

It is not often that the UK economy makes national headlines, but this week’s GDP data saw that it did. Last quarter’s contraction of -0.5% took everyone by surprise – including, it seems, the Office for National Statistics, which stated that this preliminary release would be “more liable to revision than usual”.

Even taking this number at face value, however, the comments made the same evening by Bank of England governor Mervyn King were just as worrying. Not the fact that he reckons standards of living are to fall faster than at any time since the 1920s (something that has been clear for some time), but the mixed messages he gave on the way the Bank is apparently interpreting its mandate.

As stated on the Bank’s website, this is as follows:

The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.

Those subsidiary aims might come as news to many who see the UK’s central bank as a straightforward inflation targeter. But the speech he gave on Tuesday demonstrated that Mr King has not forgotten them. Indeed, what is worrying is that he might no longer even view them as subsidiary. For while he averred that inflation was the biggest “threat” faced by the MPC (as opposed to the “choppy” economic recovery), he also had the following to say:

“If the MPC had raised the Bank Rate significantly, inflation might well have started to fall back this year, but only because the recovery would have been slower, unemployment higher and average earnings rising even more slowly than now,” he said.

Hmm. On the face of it, that looks like an explicit admission that the Bank is prioritising growth and employment over price stability.

And again:

Mr King said he was unable to offer any imminent hope [to savers] of a rise in interest rates in coming months because of the poor economic outlook.

What about the inflationary outlook?

When it comes to real wages, it is the UK’s unusually high inflation (relative to its developed-economy peers) that sticks out. Nominal wages are growing at a similar, rather sluggish, pace elsewhere too. A central bank with a focused inflationary mandate would be seeking to contribute to living standards only by reducing inflation – not by chancing higher prices as a risk worth taking to secure a higher rate of nominal wage growth.

Let’s take an example. During the difficult first years of the euro, some European politicians worried that the ECB was setting rates too high in the context of a world economy that was slowing in the wake of the dotcom / tech bust. The ECB responded by observing that growth in real wages, assisted by its acting to contain inflation, would ultimately boost confidence and secure economic growth.

That’s how a central bank with a genuine inflation target looks at its support function to the wider economy.

As for the Bank of England, there is no better summary than that given by another member of the MPC, Andrew Sentance, in a speech he gave a day before that of his boss:

“The lack of a substantive policy response to persistent above-target inflation… enhances the risk of a loss of credibility in the inflation target itself and a loss of belief in the commitment of the MPC to achieving it.”

Following Mr King’s speech, the lack of such a commitment does not seem like a matter of belief. Perhaps his Bank’s gamble with UK prices will pay off, but it should worry us that he is taking it at all.


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