Monday, January 17, 2011

Difficult Choices for Monetary Policy

The Bank of England face difficult choices this year. On the one hand, they have the task of keeping inflation within the government's target of CPI 2% +/- 1. On this count they are currently failing as temporary factors push inflation above the government's target. Also, the problem with these temporary factors, is that they seem to have been around for quite a long time and no longer seem so 'temporary'.

The Prime Minister is conscious of hurting savers (often pensioners) by having interest rates low and inflation remaining stubbornly high. Some economists also fear that the prolonged period of above target inflation will lead to a more permanent inflationary pressures. For example, rising costs of living could lead to higher wages and wage push inflation.

On the other hand, there are those who argue that the high inflation really is temporary. Strip away taxes, food and energy prices and underlying inflation is on target (see: Which inflation target should we use) Currently there is no evidence of run away wage inflation, in fact the opposite: many workers are receiving wage freezes or low wage growth.

The economy is still weak with low employment growth, pessimistic outlook and the threat of stubbornly low growth. Maintaining high growth is essential for reducing unemployment and reducing the cyclical aspect of the budget deficit. Given the tightening of fiscal policy (higher taxes and lower government spending), it makes sense to adopt loose monetary policy to offset the tightening effect. Therefore there is a strong case for keeping interest rates at zero, despite the impact of inflation.

Whatever decision the MPC take, some group will be unhappy. If rates go up, it will bad news for homeowners struggling to meet mortgage payments. It could derail the recovery and keep unemployment high. However, if they fail to act and raise rates, many will criticise the 'neglect' shown to targeting inflation. There is a danger they will lose their reputation for keeping inflation low.

The MPC will probably try, as much as possible, to keep both arguments in mind. They will talk tough on inflation and highlight the temporary factors in inflation. Yet, if inflation remains stubborn and they feel growth is strong enough, then they will raise rates sooner than might have been expected.

The next published statistics for inflation and economic growth, will be scrutinised even more closely than usual. However, when passing judgement on the relative merits of increasing rates. It should be borne in mind:
  1. Inflation is not the only economic target. In current climate, growth and unemployment are equally, if not more, important.
  2. Different Inflation Rates. It is essential to consider underlying inflationary trends and not just the headline rate.
With these two factors it becomes easier to have the courage to resist knee jerk reactions to inflation. But, it will still need courage.

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