I’m sure the Bank of England would have preferred to have more to celebrate the 25th anniversary of its independence earlier this month. The central bank‘s monetary policy committee has one objective, to which everything else is subordinate: to keep headline consumer inflation at 2%. But it’s been a year since the rate of inflation has been this low and since then the story has been one of ruthless and dramatic rise. Consumer price inflation is now 9%. The bank expects it to cap at 10%. Perhaps, although overall wages rose 7% in the first quarter, adding to inflationary pressures.
BOE governor proves inflation targeting is a bad idea
This week, BOE Governor Andrew Bailey and a few of his colleagues were called before the House of Commons Treasury Select Committee to explain the failure to rein in inflation. “It’s not our fault,” was the gist of the response. Bailey claimed – wrongly – that 80% of price increases were beyond the control of the MPC. Dramatic supply shocks driving up the costs of energy and traded goods could not have been predicted, and there was little the bank could do about it anyway. Nor could the MPC have realized that the UK labor market was as tight as it turned out to be. Anyone who claims otherwise does so in hindsight.
Really? Many credible voices have declared that inflation is about to rise. Mervyn King, who led the BOE from 2003 to 2013 and is another Bloomberg Opinion contributor, was quick to say central banks made a mistake by printing too much money.
But behind this monetary madness lie fundamental problems with what central banks are trying to achieve. Like his colleagues at central banks around the world, Bailey complains that the BOE cannot and should not do anything about unpredictable and adverse supply shocks. I would have more sympathy for this argument if it did not display both a breathtaking inconsistency and an unwillingness to state the obvious: targeting headline inflation is stupid.
Bailey is correct that central banks have little control over one of the main drivers of the sharp swings in headline inflation in developed countries in recent years, namely the rapid changes in the price of traded goods and energy. This is around a third of inflation in the UK. From shortly after the end of the global financial crisis until mid-2020, world prices of traded goods fell fairly steadily due to lower export prices from Asia in general and from China in particular. particular. This is why inflation in the UK was close to zero in 2015.
Domestic inflation – the part over which central banks have much more control – was flat. From 2014 to 2019, for example, prices for services in the UK drifted between 2% and 3%, slightly less than the range of around 3% to 5% of the previous two decades. Services prices in the United States and the Eurozone were also stable, although somewhat higher and lower, respectively.
To be the least bit consistent with their current argument, you might have expected central banks to have looked at this benign imported inflation. They did not do it. The BOE held the base rate at 0.5% from the global financial crisis until 2016, when it lowered it to 0.25%. In 2020, it cut the rate to zero and, like all other major central banks, accelerated quantitative easing enormously. Simply put, the BOE and other central banks spent many years before the current inflationary surge trying to push up headline inflation to counter the effects of a huge and entirely beneficial positive supply shock on which they also had no control over and shouldn’t have reacted to. Of course, their reactions to the Covid-19 pandemic were driven by a demand shock. Nevertheless, their arsenal was so bare precisely because central banks had targeted headline inflation.
This monetary policy strategy has been far from free, while helping to stimulate the current inflationary surge. On the one hand, the central banks have built a whole experimental monetary structure from which they have great difficulty in extricating themselves. Supertankers cannot change direction instantly. On the other hand, this policy pushed asset prices to levels at which investors were virtually guaranteed to lose money, especially as inflation rates climbed. This is what has happened in recent months.
If central banks had targeted only domestic inflation – an index of non-traded goods and services, for example – interest rates would at least have been much higher in the developed world and I doubt they would have done anything as the same amount of QE.
Eliminating the targets completely would be even better, as all of them have their flaws. Central banks should be given a much broader and vaguer mandate to protect the internal and external value of their currencies. They should also rely less on economists and more on people with much more experience in financial markets. And they should let go of the idea that their actions should be predictable and transparent, as both encourage leverage and risk taking. None of this would have solved the current problems, but we would have started somewhere better. More other writers at Bloomberg Opinion:
• Central banks cannot fight stagflation alone: Marcus Ashworth
• The Bank of England take away. Sunak should give: Mark Gilbert
• The UK and the EU now have two common enemies: Raphael and Ashworth
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Richard Cookson was Head of Research and Fund Manager at Rubicon Fund Management. Previously, he was Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.
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