Imagine you are the chairman of a major multinational company and you set the chief executive of one of your key subsidiaries a very explicit target as an essential component of your overall business strategy. The key control lever is at their disposal, but they seem reluctant to use it and their record is unimpressive. They have missed the target every month this year and announced they are unlikely to hit it next year.
Although the CEO holds regular meetings with their management team to discuss the policy options, nothing changes, despite mutterings from some of the junior colleagues. The outcome of these sessions is a foregone conclusion. As chairman, you do, however, get regular letters from the chief executive explaining why they have not done what was required, but assuring you that doing nothing is the best option and that it will all come right in the end. How big a bonus should the CEO get?
This, in a nutshell, is the relationship between the chancellor of the exchequer (our chairman) and the governor of the Bank of England (the CEO). As head of the Monetary Policy Committee (MPC), Mervyn King is the guardian of the inflation target set by the chancellor, the principal anchor of economic policy since the humiliating ERM exit in 1992. Missing the key objective with such apparent impunity begs a number of important questions of the policymakers. Does the target itself matter anymore is an obvious one, as is whether price stability still underpins policy; plus doubts about the relevance of the monthly meetings of the MPC. What is the point of going through this charade 12 times a year when everyone knows ‘no change’ will be the decision?
Part of the answer, of course, is that doing nothing suits the chairman very well at the moment. While he is busy squeezing the overall organisation from another direction, fiscal policy, he welcomes the continuing support historically low interest rates are giving those customers overloaded with debt, while also offering others the incentive to spend by boosting their incomes. It is also helping total sales by keeping sterling competitive and encouraging exports to fill the hole left by weak domestic activity.
Demand could fall off the edge of a cliff again if the MPC responded solely to changes in the inflation index. King’s pragmatism, therefore, sits very comfortably with his bosses’ medium-term objectives.
With some justification, the CEO can point to external factors (recovery in the global economy), together with the impact of weaker sterling on the cost of imports, as the main drivers of inflation, rather than companies at home padding margins or workers taking excessive pay increases.
Despite three quarters of positive growth since the end of recession, there is still a significant spare capacity in the system, which means British companies have no real pricing power. They are having to absorb a significant proportion of their cost increases. Raising interest rates now increases the likelihood of the economy slipping into a double-dip recession. King may well be right that inflationary pressures will ease in the medium-term, so there is no need to address a problem now that will disappear in the coming months.
And we should keep the price increases in perspective – this is not hyperinflation. Back in the late 1970s, prices were rising by 20 percent or more a year and then we used to round up to the nearest five percent for convenience. Today, we are worrying about the first digit after the decimal point. If living in the short term with a little bit more inflation means a little bit more growth, it is a price worth paying, although a touch on the brakes will probably come during 2011.
Even if King has got it about right for now, there is still a debate to be had about what is the appropriate inflation target and should price stability still anchor economic policy.
Those issues will have to wait, but it is worth asking now whether or not the MPC should be given a sabbatical until next Easter.