By Anfdrew Clare, financial economiist Legal & General Investment Management Since operational i...
By Anfdrew Clare, financial economiist Legal & General Investment Management
Since operational independence, the Bank of England's inflation target has never been outside 1.5% to 3.5%, despite the south east Asian financial crisis, the Russian debt crisis, the demise of the New Economy, the foot and mouth crisis and Gulf War II. All were events that might in the past have caused those of a weaker constitution to make significant monetary policy errors.
However, some have argued that the Monetary Policy Committee (MPC) has been almost too successful. The MPC has managed to control average inflation by performing a delicate balancing act. The weakness of the manufacturing and production side of the UK's economy has been offset by the consumer side. In fact, one could argue that the MPC have targeted the imbalance in the UK economy. Goods price inflation is determined far more by factors outside the UK and the control of the MPC, such as the global prices of raw materials and labour. Service sector inflation, however, is the part of total inflation that is more heavily influenced by domestic developments and, accordingly, domestic interest rates.
The low interest rate environment of the past two years has led to high levels of service sector inflation, but this has been offset by lower goods price inflation. In effect, the MPC's remit has forced it to target the imbalance.
But although the MPC's actions have been at least partially responsible for this phenomenon, it is difficult to blame the committee for this side-effect, as it has only one interest rate but is faced with two economies. The answer to the problem probably lies elsewhere, but nevertheless the practice of inflation targeting may well have exacerbated the problem over the past two years.
Without the Inflation Report and post-MPC meeting press conference, one might be forgiven for concluding that the MPC was no longer targeting inflation but instead aiming for something else, perhaps growth. But the MPC has explained it believes the rise in inflation is a result of temporary factors such as oil prices and house price inflation, that will moderate in the near term. In its view, responding to this current rise in inflation by increasing interest rates now would be a mistake.
The MPC could, of course, be wrong about the temporary nature of this rise in inflation, in which case its hard-earned credibility will be tarnished and its rate-cutting decision in February will be viewed with hindsight as a policy error.
But the point about transparency and the target itself is not that it ensures a perfect policy response every time. Instead, the point of the framework is that it anchors inflation expectations. Inflation may turn out to be higher than the Bank expects over the next year. But should this happen, we can remain confident that the necessary action will be taken to bring inflation back into line.
So mistakes can be accommodated in a well designed monetary policy framework because it gives the monetary authority every incentive to take the necessary corrective action. Having said this, there are limits. Any monetary authority that makes mistake after mistake, despite their good intentions, soon loses credibility. Japan's Central Bank is a case in point.
BoE has successfully kept to inflation targets.
Track record shows that mistakes are rectified.
Temporary factors said to be cause of inflation.
Decision to cut rates may be seen as an error.
Manufacturing side has been weak.
BoE has relied on the economy's imbalance
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