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The power of expectations Samuel Brittan Financial Times 22/06/07 The Bank of England’s structure for taking interest rate decisions is different to that of other central banks. Not only is the decision taken by a committee, but each member is individually and publicly responsible for his vote. In the European Central Bank votes are (rightly in view of the international structure) not published at all; and the US Federal Reserve has a tradition of trying to ensure the chairman is not outvoted. The British system would look like a nursery tale if the governor were never outvoted, which Mervyn King has been twice; but it would equally lose credibility if it happened too often. The minutes of June’s meeting of the monetary policy committee revealed that a sizeable minority of members – four out of nine – voted for a rise in the bank rate; and that minority included Mr King. The odds are thus in favour of a rise in July. What would be unforgivable would be if the MPC used the pretext of the Bank inflation forecast due in August as an excuse to procrastinate further. Such forecasts are – just – worth having, but as a way of summarising present information and not as crystal ball. There is still a basic divide between those who view inflation as simply a series of price changes – one thing after another – and those who see common financial forces at work. This does not only mean a particular monetary aggregate, which can be very misleading on its own, but in conjunction with increases in the availability of credit and the readiness of businessmen and consumers to take it up – what Mr King called in a speech to the employers’ body, the Welsh CBI, “a supply shock” in the money-creating process. The earlier stages of this international monetary easing were on the whole benign as they so often are. Above all they facilitated a worldwide decline in real long-term interest rates when otherwise the gigantic saving surpluses of China and the oil producers might have precipitated a Keynesian world recession. Instead, as the governor pointed out, world gross domestic product growth over the past three years has, despite the slowdown in the US, averaged more than 5 per cent a year, the fastest such period since the late 1960s. The UK has experienced stable annualised growth of about 3 per cent a year in the past 18 months – the longest such run since 1997. But there are accumulating indications that this demand growth is becoming too much of a good thing. Hence the tightening mood in so many central banks and the fading of prospects for an early Fed cut. The rise to 3.1 per cent in the British inflation rate in March – which precipitated the governor’s long-foreshadowed statutory letter of explanation to the chancellor – was clearly a blip. But further out there are fresh inflationary threats. Indicators of capacity pressures, pricing intentions and inflation expectations remain in central bank-speak “elevated”, or in English too high. Moreover, inward migration has not proved sufficient to offset rapidly rising domestic and overseas demand, although, I would add, that is clearly “a good thing” at least from a central banker’s point of view. As the governor remarked: “A position in which growth is above its long-run average and businesses are already operating with pressures on capacity is unlikely to be without inflationary risks.” Bankers, unlike columnists, are allowed double negatives. The factor on which Mr King homed in was the rise in inflationary expectations. The Bank’s Inflation Report unfortunately no longer includes a chart of such expectations, based on the difference between conventional and index-linked gilt-edged yields. The main reason seems to be the complication that indexed gilts are indexed to the old fashioned retail price index while the government’s inflation target is based on the so-called consumer price index, now 1.8 percentage points less. But enough information is provided for outsiders to work this out; and it shows expected inflation over 10 years rising from about 2.8 per cent last summer to 3.4 per cent now. This is in conformity with charts that are published in the last Quarterly Bulletin stretching back over a longer period. A similar picture is provided by a more down-to-earth opinion poll survey in the same bulletin. Indeed inflation expectations provide the clue to what might bridge the gap between the various factions on the MPC. Suppose that you hate monetarism and are dying to get back to 1970s-type demand management. After everything that has happened, by far your best chance is a state of low and stable inflation expectations, which makes the case for the occasional demand stimulus easier to put forward. This will also apply if you are in neither of these camps but just an Anglo-Saxon pragmatist interested “in what works”. Indeed if you are interested in what will happen rather than what should, watch every indication you can find of such expectations. That would make an improvement on the so-called Taylor rule much loved by analysts, based on the two unknowables of the “capacity gap” and the trend growth of output. At least you can have a shot at estimating what people think prices are likely to do.
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