- 13 Nov 07, 01:05 PM
Inflation is up to 2.1%. That may not seem a very big deal.
And as we have a symmetric inflation target of 2.0%, 2.1 is about as close to good news as you could imagine.
But in these fragile times for the financial sector, my own inflation preferences are decidedly asymmetric. At the moment, anything above target severely complicates the management of the economy over the next two or three years. Here's why.
In essence, the argument is that dealing with one problem is far harder than dealing with two. Just as doctors find it harder to give a heart by-pass to a patient with renal problems, a central bank finds it harder to deal with an economic slowdown and falling asset prices, while there's inflation lurking around in the system.
But this argument is particularly important at the moment, as most of the indications suggest the economy is at an interesting turning point. The Bank of England needs room for manoeuvre right now.
To understand exactly why, one needs to follow the chain of events that is likely to occur.
After several years of strong consumer spending underpinned by rising house prices and growing consumer debt, house prices will probably stagnate at best and consumers will probably start to retrench. The turning point has been a long time coming, but it seems to have arrived.
These things happen and do not, on their own, constitute a problem. If we buy more cars than we need in 2006, we buy fewer than we need in 2008. If house prices rise too much in 2006, they fall back to where they should be in 2008. Indeed, I would personally argue that one might see the current economic turn as good news rather than bad.
However, falling house prices and declining consumer spending do become a real problem if they leave the economy with too little spending to keep everybody employed. In that situation, the downward momentum can become self-reinforcing. The slowdown leads to job losses, which lead to further house price falls and further
slowdown, and more job losses.
This is where the central banks come to the rescue. They can prevent that downward spiral by cutting interest rates and stimulating spending.
They probably won't stimulate consumer spending as consumers won't borrow and spend more, whatever the level of interest rates, if they feel they have already borrowed enough.
So the role of the central bank in this situation is to stimulate exports by cutting interest rates and allowing the pound to fall to make exports more competitive.
That leaves the economy a perfectly good escape route from its obvious challenges. The central bank can ensure that at a difficult time the economy continues to grow, workers stay in work, consumers improve their finances and save more. All because exports rise.
But here's where inflation can get in the way.
If the pound falls, domestic prices tend to rise, which obviously adds upward pressure on inflation. If inflation is already above target, the central bank can't allow that to happen.
At a time when we need to extricate ourselves from a difficult situation, we may not have any way out. And we get back into the downward spiral of declining demand and rising unemployment.
The pre-existing inflation can end up being the equivalent of the locks holding the fire escape doors shut. In the end most macro-economic management issues come back to inflation. This is because you can convert many macroeconomic problems - like unemployment and falling house prices - into inflation problems if you want to by printing money to stimulate demand.
This means that as a simple rule, most problems are curable in the absence of inflation, and few problems are curable in the presence of it.
There are still grounds for debate on whether inflation is really a problem at all at the moment. Remove energy, and our rate is on target. And one of the economists I rate most highly, Graham Turner, thinks the Fed may be acting far too cautiously in cutting rates, fighting a non-existent battle against price rises. He was an astute observer of the Japanese economy over the 90s and knows a thing or two about asset price deflations in leveraged economies.
I'm personally agnostic. I just don't know whether inflation is back or not. I've written before about how the "China effect" which has kept our inflation low is surely a temporary one (although a very long temporary), and the current inflation news from China is discouraging.
Moreover, I certainly don't believe in excluding the fastest rising prices when assessing underlying inflationary pressure at home. 2.1 is 2.1 in my book.
But we'll see whether underlying inflation is at or above target over the next year, as the economy undoubtedly slows.
However, there is one general lesson to be drawn from recent experience: it is that flexibility around the symmetry of an inflation target might be helpful.
If things go as crazy as they have over the last few years, with asset prices booming and the economy and consumer spending strong, we would probably have done well to have erred on the side of keeping inflation below target. That would have ensured there is almost no risk of it being above target, so that when this crunch moment inevitably arrives we can stop the drama turning into a crisis.
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