Sunday, April 22, 2012
Bank takes a battering as it gets it wrong again
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Once Sir Mervyn King, the Bank of England governor was master of all he surveyed, the King of Threadneedle Street, showered with new powers by the coalition government.

Now he has become the governor everybody loves to criticise. If there was a City TV show about him it would be called “Everybody Hates Mervyn”. The debate over his successor used to be couched in terms of who could possibly replace him. Now people are talking about the need for a new broom to sweep up after the mistakes of recent years.

You also have to feel a bit sorry for Adam Posen. The American member of the Bank’s monetary policy committee (MPC), and until now its most aggressive proponent of quantitative easing, was rash enough to say in an interview last year that if inflation did not drop to 1.5% or thereabouts this summer, he would not seek a second term.

I don’t know whether Posen was getting used to the London life and planning for a second term. But Paul Tucker, the Bank’s deputy governor, says inflation will not drop below 3% this summer. If that turns out to be the case Posen, in all conscience, cannot stay on. He now says the Bank has serious concerns about inflation. His term expires in August.

The Bank is getting it in the neck because some people have old scores to settle. Many of the criticisms of King, his downplaying of financial stability in the Bank before the crisis and the Bank’s initial slow and very unhelpful response to it, have been around for years. So has the fact that, unlike his predecessors, instead of rubbing shoulders with bankers, he has always rubbed them up the wrong way.

The renewed outbreak of criticism, however, has followed the latest inflation figures, together with the fact that a decision on the governor’s successor will have to be made in the next few months, even though his term does not expire until the middle of next year.

Consumer price inflation was 3.4% in February. Had the March figures, published last week, shown a fall to 3.3%, the reaction would have been that the pace of the fall was slow but nonetheless happening. An unchanged figure would have been disappointing but nobody would have got too excited.

The fact that inflation rose to 3.5%, however, and that the deputy governor described it as “bad news on the inflation front” and effectively tore up the Bank’s forecasts.

These were indeed bad figures. Two years ago the Bank predicted, not for the first time, that we would now be in a period of sub-2% inflation, which if true would have allowed Posen to stay on.

Even when that proved too optimistic, the Bank’s big story for this year was supposed to be a drop in inflation to 2.5% this summer, as a prelude to dropping below 2% before the end of the year. Anything is possible but most forecasters, and apparently now the Bank, think that is not going to happen. Whether King will see a rate of 2% or below before he steps down from the Bank in a year or so has become an interesting debate.

There are 12 broad components to the consumer prices index (CPI), ranging from food and non-alcoholic drinks through to clothing and footwear, transport and domestic bills. Only one of those 12, recereation and cuture, where prices are actually falling, has an inflation rate below 2%.

Since July 2005, when inflation rose above the 2% target, we have had 81 monthly readings. The overwhelming majority, 64, had inflation above target, with only 17 at or below it. Every monthly reading since December 2009 has been above target.

Since 2005, despite the worst recession in the post-war era, inflation has average one percentage point above target. There is a pattern here. What is it.
When King tackled the issue of the inflation overshoot in a speech in Newcastle in January last year, he set out a theme that has since become familiar.

Inflation was high because of factors outside the Bank’s control, including Vat hikes, the pass-through in import prices from sterling’s fall and global energy and commodity prices.

The first of these is no longer valid: inflation excluding the effects of indirect tax changes is 3.5%, the same as overall inflation. Give that sterling has been stronger in recent months, the second effect should have come to an end.

We are left with commodity and energy prices, and domestically-generated inflation. “Core” inflation, excluding food, energy, alcohol and tobacco is running at 2.5%.

This is all rather uncomfortable. The only time over the past few years when inflation fell decisively, if briefly, below target was when the global financial crisis hit commodity and energy prices hard. The Bank only hits its target, it would appear, when the world economy is in trouble.

Credit where it is due, and a lot of credit should go to Andrew Sentance, who left the MPC last year and is now with Price Waterhouse Coopers, for his perceptive analysis of this. Inflation would not come down to target but would be uncomfortably sticky, he said in an interview with me on leaving the Bank.

The Bank, he said repeatedly while on the MPC, gave too much weight to spare capacity at home - the output gap - and not enough to global inflationary pressures which, as we have seen, are no flash in the pan.

The majority on the MPC rejected Sentance’s call for a hike in Bank rate and, to be fair, raising rates against the backdrop of a weak economy may have been a step too far.

Not only did the MPC not raise rates, however, it then moved dramatically in the other direction, launching what turned out to be a further Ł125 billion of QE last autumn, against the backdrop of 5% inflation.

My argument against it at the time was that QE was a weapon to be used only in emergency conditions and when there was a real fear of deflation. MPC members countered by predicting that inflation was going to fall like a stone. So confident were they I thought surely this time they were right. Sadly not.

Some will say inflation a point or so above target is neither here nor there. But, at a time when total pay is increasing by 1.1% (1.6% even excluding bonuses), the fall in inflation was essential for the economy. Only by that means would the growth in real incomes needed to boost the 62% of GDP accounted for by consumer spending. We can only hope that inflation fall has been delayed, not cancelled.

As for the Bank, its reputation has taken another battering. There will be more letters from King to George Osborne explaining the inflation overshoot. And with each one, confidence in its ability to keep inflation on target will diminish.