Sunday, October 14, 2012
Low inflation concealed dangers below
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

It is 20 years since, in the aftermath of the ERM (exchange rate mechanism) Black Wednesday debacle, the then Tory chancellor, Norman Lamont, announced that the government was adopting an inflation target.

A young, or at least a younger, Mervyn King was, as the Bank of England’s chief economist, tasked with producing a quarterly inflation report. This enhanced role for the Bank paved the way for independence in 1997.

Had either the chancellor or the Bank’s chief economist said in 1992 inflation would average just 0.1 percentage points above the official target over the next two decades they would have been ridiculed.

But that, as an older Sir Mervyn King, now on his last lap as Bank governor, reminded us last week, was what happened. Consumer price inflation has averaged 2.1%, compared with a 2% target. Britain’s traditional Achilles heel - inflation averaged 12% in the 1970s and 6% in the 1980s - may not have been cured but for 20 years it has been strapped up.

Before getting on to whether this has been such a good thing, I should point out for the sake of purists that there was a different inflation target for more than half of the period in question. The original target, the retail prices index excluding mortgage interest payments (RPIX) was set at 2.5% and lasted well into the 2000s. The change does not, however, change the big picture of close-to-target inflation.

So should we doff our hats to Lamont and garland the Bank for its achievement? We should certainly give some credit where it is due but we should also not ignore the shortcomings. King, to be fair, took some of these on the chin in a 20th anniversary speech at the London School of Economics.

The first is that inflation has been too high over the past three years, indeed the past seven years, at the very time we needed it to be low to support consumer spending. The record for two-thirds of the 20 years was good, helped by favourable international factors, but the final third has been poor. In only 14 out of the past 84 months has inflation been at or below target.

King’s defence was that the low-inflation credibility built up earlier prevented recent inflation from being much higher. So, he said: “Since 2007 the UK has been able to absorb the largest depreciation of sterling since the Second World War, as well as very large rises in oil and commodity prices, with an increase in inflation to an average of only 3.2% over the past five years and without dislodging long-term inflation expectations.”

Fair enough, though the Bank was not merely an disinterested spectator in sterling’s fall. Quantitative easing, on the Bank’s own estimates, has boosted inflation and there has been a lot of it. The Bank was hit by unhelpful factors but also tolerated higher inflation, believing the alternative would have been much worse.

The bigger question is whether the inflation target breeds dangerous behaviour: one kind of stability promoting instability, volatility and excessive risk-taking elsewhere.

That may now be one for King’s successor, though it is also relevant to the incumbent’s record. Applications to succeed him closed last week and having Tu in your name (Paul Tucker or Adair Turner) looks to be an advantage.

King suggested there was nothing exceptionally frothy about Britain’s 2.9% growth rate in the run-up to the crisis - the International Monetary Fund (IMF) now disagrees - though admits it was unbalanced growth.

Monetary policy in Britain was not exceptionally loose in comparison with other economies. Interest rates were higher than elsewhere (and King reminds us he would have liked them even higher) and pre-crisis the pound was strong.

So what went wrong? Significantly higher interest rates - breaking Britain’s unbroken period of growth from the early 1990s to 2008 - could have changed behaviour. This is the argument that a couple of small recessions along the way could have prevented the big one.

Maybe, however, even if the Bank had deliberately aimed off the inflation target in that period and inflicted more pain on the economy, we would still have had the big one.

As King put it: “Leverage and the growth of credit may be relatively insensitive to interest rates, especially once a self-reinforcing cycle of optimism and credit expansion is underway. And this financial crisis was a global one: the UK alone could not have stopped it happening.”

So has inflation targeting done more harm than good? No, but given Britain’s high-inflation history, policymakers were guilty of giving too much prominence to it, and took their eyes off other dangers. It was a bit like the captain of the Titanic looking only at the calm waters on one side of the liner, missing the iceberg on the other.

That problem, we have to hope, has been corrected. If we ever get to a situation again where the banks are increasing their leverage too aggressively and credit is exploding, interest rates would rise whatever the inflation rate and “macroprudential” tools such as putting a cap on bank leverage would be employed. The Bank’s right hand - its monetary policy committee (MPC) - would co-ordinate things properly with its left-hand, the new financial policy committee.

Even that will not make Britain immune from the dangers. It was odd that in an era of globalisation it seemed for a time that nine members of the MPC had Britain’s economy under the tightest control; precision-guided policy.

It was an illusion then and it is an illusion now. The best monetary and macroprudential policy in the world wlll not prevent the economy being exposed to problems elsewhere, whether in the eurozone, America or other parts of the world.

Britain has been blown about and the gusts continue. The downside of inflation targeting was that it gave the impression that central banks had everything under control.

It will be a long time before we think that again, Tucker, Turner, or whoever else exceeds King, will not have gone into their job interviews preaching a doctrine of infallibility. All they can try to do is reduce the risks.