Economic Review - Monetary policy up for review - Third Quarter 2004

Foreword

By John Connolly, Senior Partner & Chief Executive, Deloitte

This issue of our Review comes to you at a time when the world interest rate cycle has turned firmly upwards. The UK has been somewhat ahead of the game with interest rates already 1% higher than they were last summer. And Roger Bootle, our Economic Adviser, says that they are likely to go some way higher yet.

However, he does not think that higher interest rates are going to be a permanent fixture. Indeed, they are likely to prompt a major housing market adjustment next year, which will in turn cause interest rates to fall back by the end of 2005 and perhaps continue falling in 2006. He even holds out the prospect that lower interest rates could weaken the pound, thereby delivering relief to the internationally exposed parts of the economy.

So house prices are likely to be at the centre of interest rate decisions and indeed the whole policy debate. Yet, according to the present monetary policy regime, house prices should have only a peripheral influence on interest rates. In this Review, Roger Bootle asks whether the current monetary policy regime of inflation-targeting is appropriate in a world of sharp movements in asset prices. He believes that the MPC may be gradually shifting the interpretation of its remit to allow more weight to be given to asset prices. The regime which has set UK interest rates since 1997 may be good but it is not perfect. Indeed, he argues, it is due for a change.

Elsewhere, although the US economic recovery has shown astounding strength in the last couple of years, higher interest rates are likely to result in a slowdown in the rate of economic expansion. But robust growth in Asia, will just about offset this. Meanwhile, although the rate of growth will remain weak, the euro-zone should also manage to pick up, thereby ensuring that the global economic recovery remains firmly in place. Once again, I hope that this Review is of help to you with regard to both the immediate outlook and your strategic thinking.

• The general perception among economists and the markets alike is that the UK’s inflation-targeting monetary policy regime is the model that all other countries should follow. But is the current regime really so wonderful?

• The MPC has undoubtedly done a splendid job and has kept general inflation well under control over the last several years. But it is clear that asset prices, and in particular house prices, have not been under control.

• Indeed, once you accept the critical importance of the property market in influencing the performance of the economy, the current monetary regime in which the Monetary Policy Committee devotes enormous time and effort to considering whether CPI inflation will be 0.1% above or below the 2% target in two years’ time looks bizarre.

• Of course, it wouldn’t be viable for the central bank to have a target for asset prices. Yet that is not the same thing as giving asset prices a heavy weight in the interest rate decision. The key requirement is being prepared to let the immediate course of the consumer price inflation rate diverge somewhat from the target or desired path in order to pursue stability in a wider and longer term sense.

• We suspect that once the housing bubble has burst, mature reflection on this episode will lead people to conclude that once again the monetary regime needs to change. However, there need not be an end to the MPC and to inflation targeting altogether. Instead, all that is necessary would be an evolution to something better which explicitly takes asset prices into account and reduces the hang-up over the 2-year CPI inflation forecast horizon.

• The MPC has arguably already taken steps towards this. Although an improving growth outlook and mounting wage pressures will play a part in interest rates rising from their current level of 4.5% in the second half of this year, the MPC’s key motivation for higher interest rates is the continuing strength of the consumer sector and the housing market.

• Admittedly, the latest data have revealed signs of a slowdown in the housing market. But so far these have been very tentative signals and we expect that interest rates will still rise to 5.25% by the end of the year, or shortly afterwards.

• But we think that next year will prove to be the crunch year for the housing market. With annual house price inflation having turned negative by the middle of the year, together with low inflation and a high sterling exchange rate, we think that interest rates will fall to somewhere around 4.75% by the end of the year.

• Elsewhere, although the US economic recovery is likely to remain strong for the rest of this year, higher interest rates should prompt a more modest expansion next year. In contrast, the euro-zone economy is still failing to mount a significant recovery and lower interest rates later this year should not be ruled out altogether. But with growth in Asia likely to remain robust, mainly because of China’s strength, the global economic recovery will remain firmly in place.

Nearly everyone seems to think that the current regime governing UK monetary policy, that is to say, the setting of interest rates to hit an inflation target specified by the Chancellor, is a raging success. Indeed, it appears to be so successful that it seems remarkable that it has been with us for such a short time. It has already taken on an air of inevitability and invincibility.

But is the current regime really so wonderful? The MPC has done a splendid job and it is likely that as long as the UK remains outside the euro, it should and will continue to set interest rates. But the form of its target, and its interpretation, is another matter. They are not set in stone.

Churchill said of democracy, that it was the worst system of government ever invented – except for all the others. The current monetary policy regime is not even necessarily that good. It is certainly better than its recent predecessors but it is far from perfect, and far from immutable. Indeed, the time could be fast approaching when it could be set for a change.

The main factor which gives rise to concern about the current framework is asset prices. General inflation may have been well under control over the last several years but asset prices have not been. First there was the boom in equity prices, followed by their collapse. More recently, house prices have continued to rise at extraordinary rates. When you look at house prices rather than consumer prices, there is no evidence of the transition to a stable economy about which the Chancellor of the Exchequer has frequently boasted.

Shouldn’t asset prices enter significantly into the MPC’s decisionmaking process? House prices already do, although MPC members are keen to stress that they are not targeting house prices specifically and are interested in them only so far as they affect the prospective rate of general inflation.

If the MPC were to take more explicit notice of asset prices this would undoubtedly represent a major shift from the regime which has been in place now for many years. Still, as the following account shows, such shifts are nothing new in the history of monetary policy. Indeed, they are par for the course.

The MPC is so well-established that it seems that it has been there forever but in fact it has only been in place since 1997. Its predecessor, the so-called "Ken and Eddie show" only started in 1993. Before that there was a profusion of different monetary regimes which came and went with distressing regularity.

In the wider sweep of our monetary history, there have been two major themes which have alternated and intertwined: the relative importance of the exchange rate versus some sort of domestic monetary variable and the degree of discretion to be accorded to the monetary authorities. Current doubts about inflation targeting and concerns over asset prices represent a re-emergence of this second theme.

Throughout the 19th century, with a brief interruption during the Napoleonic Wars, right up to 1914, Britain was on the Gold Standard. This meant that although paper notes circulated freely, the pound was convertible into gold. Moreover, not only did this mean that the pound was fixed against gold, but for all those other countries which tied their currencies to gold, it was fixed against them also.

The monetary authorities exercised no discretion over exchange rate policy. They did have some discretion over interest rate policy but in practice their room for manoeuvre was severely limited.

In 1914 this system was suspended and the Bank of England now had discretion. Inflation took off before giving way to deflation. In 1925, the Chancellor of the Exchequer, Winston Churchill, famously took sterling back to the Gold Standard at the old parity. Things were apparently back to normal. And discretion was out again.

But the deflation necessary to accommodate the economy to the fixed exchange rate proved to be crippling to the British economy. In 1931 sterling came off gold and the pound depreciated. UK interest rates could now be set in pursuit of domestic objectives. They were cut to 2%. Indeed, with the exception of a brief period in 1939, they stayed at this level for 20 years. During this 20 year period, monetary policy was officially free to vary but in practice this flexibility was not used. Rather, the objective was to keep interest rates as low as possible, so as to minimise the cost of financing investment – and the cost of funding the huge government debt.

Moreover, although the Gold Standard had collapsed after Britain’s withdrawal, at the end of the war, the Bretton Woods conference established a hybrid version in which currencies, including sterling, were tied to the dollar, which was tied to gold. So flexibility on interest rates was severely circumscribed by the need to stick to the fixed exchange rate.

Furthermore, whatever flexibility still existed for "the authorities", this did not apply to the Bank of England, which had been nationalised in 1946. Accordingly, monetary policy, although advised on and implemented by the Bank, was in fact decided upon by the Chancellor.

Although the pound was twice devalued, this regime lasted until 1971 when the pound was floated – and duly sank. Discretion was back in. Under Chancellor Barber, the policy was now to try to break out of the cycle of low growth by making a dash for growth. Monetary policy was loose and rampant inflation ensued. 1976 was the nadir. The pound plunged and the UK was forced to borrow from the IMF.

Stability was again what the authorities now wanted to achieve. But how? Fixing the exchange rate was still not back in fashion so some domestic variable had to fulfil this function. Starting under the Labour government, the money supply was elevated to this role. When the Conservatives were elected in 1979, however, they took things several stages further. They believed that they had found the Holy Grail of monetary policy in fixing targets for the growth of a particular definition of the money supply known as Sterling M3. This would be the cornerstone of their economic policy. Discretion was now out. Indeed, this new regime was, if you like, the new Gold Standard – except that the exchange rate itself was left free to float. Supposedly this did not matter. The money supply would ensure stability.

But experience did not bear out this confidence. The government soon discovered that it could not control the money supply, which continued to barrel along at high rates – despite eye watering interest rates, which were raised in 1979 to 17%. Meanwhile, there was no sign of stability in the economy. The exchange rate rocketed and the economy plunged into recession. Unemployment soared. Nevertheless, inflation came down.

This experience convinced some Treasury officials and ministers that although there was nothing wrong with the theory, there was something wrong with the particular definition of the money supply. So they experimented with others – a narrow measure known as M0, wider measures known as M1 and M2, and still wider measures known as M3 and M4. This plethora of Ms prompted the barb that government policy was obsessed with motorways. Other more exotic sounding animals, known as PSL1 and PSL2 followed. None proved reliable and eventually the era of motorway madness was over.

An end was never formally declared as such. It was rather a case of less and less notice being taken of the various Ms and policy being conducted more on a seat of the pants basis. Or, to put it differently, discretion was back. But the new situation was deemed to be unsatisfactory. Monetary policy still needed a restraint and an anchor. The authorities could not be allowed complete discretion.

So the Chancellor, Nigel Lawson, returned to an exchange rate regime, by surreptitiously and informally pegging the exchange rate to the deutschemark. Although he was forced to abandon this policy, it returned in a formal version when the UK joined the ERM in 1990. Now monetary policy again had very little discretion. UK interest rates were as good as set in Frankfurt.

When this system burst apart on 16th September 1992, and the pound plunged, the authorities faced the age-old dilemma. How to keep freedom of action but also impart some stability to the monetary system. They established an inflation target, something which a few years earlier would have been met with derision, if not disbelief.

The Inflation Report was born, and soon afterwards the Bank of England was given greater discretion over the timing of interest rate decisions. This was the vital moment which led us on to the system which we now have.

So well has the current system performed that there is a widespread feeling that it is set to continue ad infinitum. In my experience, however, this is the normal state of affairs in all monetary regimes. People tend to believe that the current regime, whatever it is, is bound to sail on forever. They cannot believe that the things which obsess them will soon fade into insignificance. Yet this is the evidence of history. Who bothers now about the monthly figures for the growth of M0, M1, M2, M3, M4, or indeed the monthly trade figures? Yet in their time these figures had markets, and ministers, quaking in their boots. Why couldn’t the current obsession with the minutest variations in the inflation rate go the same way?

Indeed, this is surely all the more plausible when you consider that in the MPC’s procedures are sui generis. In America, for instance, the Fed has no explicit inflation target. Moreover, its objective is not only to control inflation but also to promote economic growth.

Given all that, what is it about the current UK monetary regime which cries out for change? Despite the regime’s success in achieving low and stable inflation, the area of obvious failure is asset prices. As the MPC has set out to keep the rate of increase of prices of finished goods and services at the designated level (first 2.5% on RPIX and more recently 2% on the CPI) so the price of the two most important assets has gone haywire. First it was shares – as part of the global bubble, originating in the US but spreading around the world. More recently it has been houses.

When you run a policy of emergency low short term interest rates – 3.5% in the UK and 1% in the US – you should expect, indeed, you hope for, some boost to aggregate demand. But in today’s global market conditions the signs that this policy may have gone too far may not come in the market for goods and services, not least because there is such unused supply potential in Asia. In essence there is what the economists might describe as a horizontal supply curve. China sets the price and at that price there is a seemingly infinite supply of goods. Where loose monetary policy may now be expected to have its effect, however, is on asset prices.

Now that is all very well, defenders of the status quo might say, but there is no need for macro policy to be directed towards the stabilisation of asset prices. It is consumer prices which matter. And in most cases that is a reasonable thing to say. But when you have a bubble of the size and scope of what occurred in the US in the late 1990s, or what is in progress in the UK housing market now, it does not wash. In the UK, houses are the most important asset for most individuals by far – and the price of property is probably the most important price in the whole economy.

Whether house prices are in the index which the government sets the MPC to target, and at the moment they are not, the price of property is a key driver of the whole economy. Indeed, it is impossible to imagine that the UK economy can be remotely stable when house prices are rising at 20% per annum. Either there will be an upsurge of inflation brought about by the increase in consumer wealth (and the cost of housing for those not yet on the ladder) or there will be a plunge into recession, now accompanied by serious deflation dangers, when the chickens come home to roost.

Once you accept the critical importance of the property market the current monetary regime looks bizarre. Each month the MPC devotes enormous time and effort to considering in the minutest detail whether the inflation outlook in two years’ time is likely to be 1.9%, 2%, or 2.1%. Fan charts are constructed, risk profiles manufactured and endless discussions are launched on this arcane subject. The irony is that no one can be sure what the inflation rate will be in two years’ time.

Moreover, to add insult to injury, whether it turns out to be 1.9%, 2.0% or 2.1% does not matter one jot. By contrast, anyone with any knowledge of the UK’s economic history knows that house price inflation sustained at 20% is bound to bring serious trouble.

In the past, looking at house prices in real terms, every previous sharp rise in house prices has been followed by a bust. Moreover, on every occasion this has been accompanied by a fall in real consumer spending.

For a variety of reasons, including lower loan to value ratios, and a lower level of housing transactions, as well as the unlikelihood of unemployment and nominal interest rates rising to anything like the extent they did in previous housing downturns, we believe that the impact of housing market weakness on the economy would not now be as severe as on previous occasions. Nevertheless it would still be substantial.

What to do? One way out is to include house prices in the consumer price index which the Bank is to target. To some extent that is what happened under the old target specified in terms of RPIX as it included an item for "housing depreciation" which was tied to average house prices.

But as a practical matter this must await a decision by the statisticians at Eurostat. In any case, this would be only a partial and an unsatisfactory solution. After all, what about equities? If there were to be another bubble in the stockmarket, many people would now accept that the central bank should try to do something about it, yet no one is suggesting that equity prices should be included in the consumer price index.

Moreover, the trouble runs deeper. The inflation targeting regime is a direct result of the period of high inflation in the 1970s and the extreme difficulty experienced in bringing inflation down again. As time goes on, the key problems of monetary policy, and the way the economy behaves, change. You cannot set monetary policy in aspic. You cannot lay down an approach which will endure for all time. The best central banking practice will change with changing circumstances. In essence, central banks need to be free to adapt to changing situations and different challenges.

This of course, runs completely counter to the modern urge to have central banks pinned down to precise targets, in relation to which their behaviour is fully predictable. This is understandable given the history of the western world over the last thirty years – but it does not make much sense today.

What is the point of tying interest rates precisely to the supposed most likely outturn of a variable which is likely to be so low that it is barely worth bothering about anyway? Talk about generals fighting the last war. In this way, the continuing obsession with inflation fighting long after the battle has been won, mirrors what happened with regard to the pursuit and maintenance of high growth and low unemployment in the 1970s. It was the single-minded pursuit of these objectives which allowed inflation to creep up and all but suborn the economic system in the west.

Now, over-concentration on the last problem – inflation – has encouraged central banks to pay insufficient attention to the new problem emerging before their eyes, namely asset price bubbles.

But given all this, what is a central bank to do? There is an extensive debate. Some argue that although bubbles can be so serious that directing monetary policy to preventing them may have some sense, it is impossible to know in advance what is a bubble and what is a normal market movement. Indeed, Chairman Greenspan has himself made this point. Better, he says, to wait until the bubble has burst and then to devote monetary policy to clearing up the mess and minimising the adverse effects on the economy. In the UK, the Bank of England’s chief economist, Charlie Bean, has argued something similar.

That is all very well, but one can readily see why Greenspan might want to argue this line, bearing in mind that he did not direct monetary policy against the equity bubble in the late 1990s and subsequently cut interest rates all the way to 1% in order to ward off the possible consequences.

There is also the question of whether directing interest rate policy towards bubbles can actually do any good. As some wag recently put it, if you have a time-bomb ticking away at the bottom of the garden, what use is it to go down there and start poking it about with a stick? Better to retreat to a safe distance and let the bomb go off! But stretching the metaphor somewhat, in practical terms the "bomb" is not a fixed danger: it is growing as the bubble inflates. Actually, it would be better for the "bomb" to be exploded earlier when its size, and the consequent damage, may be relatively small.

Moreover, the argument that bubbles are impossible to spot in advance is completely unconvincing – particularly coming from Greenspan. After all, he made the famous speech about irrational exuberance in 1996. This came very early in Wall Street’s ascent to ludicrous levels.

Moreover, it is not as though other economists and commentators did not correctly identify the bubble in the equity market. Notable among them was Robert Shiller, who wrote a book entitled "Irrational Exuberance". He argued that to assess shares, the correct methodology was to cyclically adjust earnings for the state of the economic cycle and to make comparisons over very long periods. As for clearing up after the bubble has burst, it depends upon how serious the aftermath is. In Japan the bubble of the late 1980s effectively undermined the performance of the economy for a decade and rendered monetary policy next to useless. As and when the housing bubble bursts in the UK, the consequences will be so serious that monetary policy will be dominated by them – perhaps for years to come.

But surely monetary policy alone cannot be expected to control asset prices. Surely that is asking too much. Indeed, it is. It wouldn’t be viable for the central bank to have a target for asset prices.

Yet that is not the same thing as giving asset prices a heavy weight in the interest rate decision. The key requirement is being prepared to let the immediate course of the consumer price inflation rate diverge somewhat from the target or desired path in order to pursue stability in a wider and longer term sense.

At some point it is possible that the MPC’s remit will be changed to make this clear. For instance, a phrase could be inserted explicitly allowing the MPC to let inflation diverge from the target for a period in order to achieve the target over the medium to long term. But in fact such a shift would not be necessary to facilitate a change of approach with regard to asset prices.

The MPC’s remit from the Chancellor is:

"a) to maintain price stability, and

b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment."

At the moment price stability is defined by the Chancellor as 2% inflation on the CPI. But there is nothing in the remit about the two year time horizon which figures so prominently in the Bank’s deliberations and policy pronouncements. That has been imposed by the Bank itself because that has tended to be the Bank’s forecasting time horizon and the period over which monetary policy is believed to have full impact.

But if the Bank were to move away from this two year hang-up, there would be no need to change the remit. So in current circumstances it would be putting interest rates up in order to cool the housing market but this would be presented, not as an objective in its own right, but rather as necessary to keeping inflation on track in the medium term – even if that meant undershooting the inflation target two years out.

And what are we to make of the second point of the MPC’s remit? It has been widely ignored by commentators, yet it is there for a reason and the evidence is that the MPC itself may be treating it more seriously. The wording is ambiguous but it implies that the Bank has some responsibility for the real economy. Given how damaging bubbles can be, preventing or minimising them can readily be construed as fitting in with this second objective.

The downside to the approach outlined here, of course, is that it would make monetary policy less predictable and would give the Bank more discretion in its conduct. According to the fashions of the last ten years that is a major weakness.

But it would not always have been viewed in this way. As we showed earlier on, central banking is an art and not a science, and the certainties of one epoch can readily be turned upside down in the next. We suspect that once the housing bubble has burst, mature reflection on this episode will lead people to conclude that once again the monetary regime needs to change. Hopefully, this time there will be no wholesale revolution: no end to the MPC and no complete rejection of inflation targeting altogether, but rather an evolution to something better which explicitly takes asset prices into account.

As events on the world stage have borne out all too well, contrary to the title of a well-known book of a few years ago, the fall of the Berlin Wall did not spell the end of history. Equally, the establishment of inflation targets and their pursuit by an independent MPC has not spelt the end of monetary history either. Close observers of the Bank of England may be in for an interesting few years.Continued

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