As the new year opened, the main political parties began
staking out their positions for the forthcoming general election. This has to be
held by 3 June, though 6 May seems a more likely date. It promises to be a long
and probably heated campaign with the economy featuring at the centre of what
passes for debate these days. Claim and counter-claim will be made about taxes,
jobs, house prices, living standards and so on, but little or no attention will
be paid to the one indicator that has been the anchor of economic policy for the
past 18 years.
Since the UK’s ignominious exit from the exchange rate mechanism in September
1992, the key to understanding policy has been inflation. A simple mantra has
guided the authorities: low and stable inflation will lead to low and stable
interest rates and, almost by definition, to a stable and competitive currency.
This cocktail will produce the stable economic environment the private sector
wants above all else from government. This stability will breed the confidence
that encourages the business community to take a longer-term view, boosting
investment, jobs, living standards, profits and tax revenues.
From Norman Lamont’s time at HM Treasury, governments have had an inflation
target, which has been redefined a little over time. Originally, it was the
Chancellor’s job, advised by a panel of ‘wise men’, but responsibility for
achieving it now resides with the Bank of England’s Monetary Policy Committee
(MPC). And for a long period the policy seemed to serve the country well. For
the first time since 1945, the UK had 16 years of inflation at 3% or less, which
delivered historically low interest rates even before the recession. As a
result, GDP rose for 63 consecutive quarters, from 1992 to 2008, the longest
period of sustained growth since records began in 1870.
Of course, nothing lasts forever. It all unravelled, as the households and
government embarked on several years of above-trend spending, funded to a
significant extent by borrowing stimulated by lower interest rates. As the UK
now emerges from the longest and deepest post-1945 downturn, the question that
needs to be addressed is whether we should go back to the old policy anchor of
The MPC itself suspended the normal rules during the recession. The official
target is to keep the Consumer Price Index (CPI) within 1% to 3% in the medium
term, while Bank Rate used to try and increase or decrease activity – and hence,
inflation. On ten occasions in the past three years the CPI has been outside
this range, above 3% each time, but the MPC’s medium-term view allowed it to cut
rates. And so, unusually, we have been experiencing a prolonged period when
inflation has been higher than Bank Rate, known technically as negative real
As activity recovers, inflation will pick up and the authorities have to
consider whether the old way of managing things is still the best way. In the
next couple of months, the CPI will jump, because the VAT cut was restored in
January, energy costs are higher than 12 months ago and weaker sterling has
pushed up the prices of imports. But this rise is likely to be temporary, so the
MPC will keep rates where they are.
In the medium-term, however, there are serious issues to consider. The
government likes to talk about ‘a co-ordinated global slowdown’ but this does
not acknowledge its own contribution to the borrowing and spending that led to
the recession. In 2003, then-Chancellor Gordon Brown changed the inflation
target from the old Retail Prices Index (RPI) to CPI. Although similar, the CPI
excludes a housing cost component which the RPI included. Given the price
pressures in the housing market at the time, the CPI produced a lower measure of
inflation and, therefore, lower interest rates.
Was it reasonable to ask the MPC to target a measure of inflation that
excluded asset prices, when the bursting of that asset price bubble caused so
many subsequent problems?
Also, from the mid 1990s, the UK benefited enormously from importing cheaply,
particularly from China. Domestically-generated inflation in services often ran
ahead of the target but we managed to stay on track and enjoy low interest rates
by importing cheap goods. However, if the exchange rate stays ‘weak’, or if
China becomes more expensive, how realistic is the old target?
This may seem like a debate for the anoraks, but it does matter for everyone.
Dare we risk another asset price bubble building without giving the policymakers
any effective tools to keep it in check? And, if imported inflation rises, we
may need higher interest rates than previously (with consequences for growth and
jobs) to achieve the same inflation target.
These issues are related to how inflation should be measured and the
appropriate target rate for policymakers. It is not particularly exciting, but
as Mervyn King said a while ago, the NICE (Non-Inflationary Consistently
Expanding) decade is over. A new set of circumstances requires new policy
guidelines. There is little evidence yet, though, that this is on the political
Dennis Turner is chief economist at HSBC
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