Britain must not cut loose its anchor

By Martin Wolf

Tougher times loom ahead for the UK. That is the lesson of the latest inflation report from the Bank of England. Interest rates may stay where they are for the next two years, even though the Bank of England’s monetary policy committee expects there to be a sharp decline in growth. So be it. The country must bear it.

Abroad, the UK confronts soaring commodity prices, a fragile global financial system and weakening economies, particularly the US. At home it suffers from a demoralised and mistake-prone government, a weak fiscal position, a damaged banking system, the beginnings of what may well be a substantial fall in house prices and a tumbling exchange rate. To all this must be added a big jump in consumer prices, which rose by 0.8 per cent in April alone.

Yet it is essential to keep a sense of proportion. The economy has expanded by 57 per cent over 63 successive quarters, without even a quarter of decline. One cannot expect such halcyon days to last forever. It would be ridiculous to panic.

Yet panic there will be: both the MPC and the policy regime are likely to come under severe attack. Some argue that the committee is too optimistic about the economy. Others argue that it is too constrained by the inflation target. Peter Spencer of the Ernst & Young Item Club has suggested that the chancellor of the exchequer should take a risk with inflation or even change the target, to focus on domestically generated prices.

To the concern that the MPC is unduly optimistic, the simple answer is that, if true, it is at least free to respond to events. But it will retain such freedom if and only if the credibility of its regime is maintained.

Imagine that the chancellor raised the inflation target in response to the inflationary shocks. He would then be saying that the government would consider raising its target whenever meeting it looked awkward. This would destroy the credibility of any target-based regime.

Investors in sterling bonds and, indeed, in sterling itself would conclude that the UK was going back to its bad old ways at the first sight of serious difficulty. Interest rates on longer-term bonds would rise, because of higher expected inflation and a bigger inflation-risk premium. The result would be a severe brake on economic activity. Any attempt by the MPC to offset this effect by lowering short-term interest rates would risk further worsening credibility.

In short, an announced rise in the target for inflation would almost certainly lower, not raise, activity in the economy, beyond the short run. Nor would a tacit decision by members of the MPC to ignore the target be any better. A rogue MPC would also destroy the credibility of the regime, with equally dire consequences.

A more subtle alternative would be to change the target, to focus only on some index of domestic costs. Yet this change, too, would be problematic, not least because it would also undermine the credibility of any target.

First, such an index would fail to measure the inflation people perceive. It would be impossible to explain that the monetary authorities had no interest in what was happening to the prices of energy or food, for example.

Second, the proposed shift would be asymmetrical. For a long time, the UK enjoyed disinflationary external shocks via a strong exchange rate and falling world prices of commodities and labour-intensive manufactures. Nobody then suggested the target should strip out these gains. Instead, the MPC was encouraged to let the economy expand further. If the target were altered, now that the reverse is happening, the conclusion would be that shocks can only raise inflation. The consequences for expectations must be evident.

Third, it is hard to separate domestic from foreign costs in either measurement or policy. In particular, the main aim of any central bank is to prevent shifts in the latter from becoming embedded in the former. This cannot be done by ignoring foreign costs, even if they are not in the target. The caveat is that policy should not respond to such shocks too brutally, since that would make output unstable. The Bank does not do that, however. Indeed, the inflation report expects inflation to hit its target only two years hence. If so, the Bank would have allowed inflation to exceed its target for almost all of the period between mid-2005 and late 2009, in response to a succession of external shocks. That looks too loose rather than too tight.

The lesson of the 1970s was simple: letting inflation rip, to avoid pain in the short run, greatly increased pain in the long run. The UK must not repeat that error. Today, the combination of a devaluation with tight monetary policy gives it the best chance of escaping from its predicament. It enjoys this option because it decided, rightly, not to join the eurozone. But the country must have the will to make that option work. There is no sane alternative.