Asset Allocator’s Soapbox: SLI's Douglas Roberts

Mervyn King, the Governor of the Bank of England, once famously said that he wanted to make monetary policy boring.

By that he meant that policy should be so predictable and transparent that any policy changes should come as no surprise to market participants. The key to this brave new boring world of monetary policy was the adoption of inflation targeting.

When the Bank was granted independence it was set a target level for consumer price inflation. Interest rates would then be set so that the target level was achieved within a reasonable time period (in practice 2 years). As a result, it was hoped that such a clear remit, and policy prescription, would anchor expectations, and corral wage and price rises into a range consistent with meeting that target.

The problem was that a quiescent inflation rate was no guarantee that monetary policy was being set at the most appropriate level for the economy as a whole. Goodhart’s law asserts that once an economic indicator is adopted for the purpose of guiding economic policy, then it will lose the information content that would qualify it to play such a role.

This is what seems to have happened with inflation targeting through the early years of the century. Indeed, inflation levels in the UK were reflecting that, if anything, policy was too tight. Other indicators, however, were signalling that policy was anything but tight. The economy was on a multi-year growth streak that would culminate in a period of strong above-trend expansion. The balance of payments was in hefty deficit and asset prices were surging.

A key consequence of using inflation as the sole driver of monetary policy was that policy was kept too loose for too long. Inflation was being kept low as a consequence of a significant addition to the global supply of goods and services.

These new suppliers, benefiting from low labour costs, brought a disinflationary down-draught to the global economy. But the maintenance of overly low interest rates continued to boost demand, underpin a balance of payments deficit and juice asset prices.

That was then – now the problem has been reversed. Consumer price inflation has consistently been exceeding its target for the best part of three years and, under the targeting scheme, interest rates should have been rising. But other indicators have been signalling that all is not well with the economy.

It has been operating well below trend, and that is expected to continue as the fiscal austerity squeeze takes effect. House prices are under pressure and equity prices are no higher than they were five years ago. Raising interest rates now might, or might not, control inflation – what it would certainly do is add to present downward pressures on growth.

The upshot is that monetary policy has been far from boring. Inflation targeting has neither delivered predictable policy nor a transparency of action. Part of the problem is that policy is couched in terms of where inflation is expected to be in two year’s time. However, a more appropriate gauge of inflationary pressures on the economy must include not only a measure of consumer price inflation, but also an appraisal of what’s happening to asset prices and the balance of payments.

The resulting broader basis on which to judge the appropriate policy stance may be less straightforward than the present system, and it would be less predictable and transparent. However, a key element in monetary policy is to cement future expectations. This can be achieved by delivering a stable environment for the economy as a whole, not just for consumer price inflation.