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December 13, 2012 7:19 pm
Like generals, central bankers always fight the last war. Today’s global policy elite is influenced above all by the fight against inflation, which was the predominant challenge of their formative years. Eddie George, a former Bank of England governor, is said to have begged senior politicians shortly before his death to never again loose the inflationary genie he had spent his life bottling. German economists, meanwhile, are obsessed by the (false) idea that the rise of Hitler was a consequence of hyperinflation unleashed by the Reichsbank in the early 1920s, rather than the deflation of the 1930s.
But the fight against inflation has been well and truly won. And in recent days there have even been signs – in Shinzo Abe’s flirtation with an inflation target in Japan, and the Federal Reserve commitment to keep interest rates near zero until unemployment falls to 6.5 per cent – that the global policy elite has begun to see inflation as the least painful instrument of debt erosion.
In the UK too there is a whiff of change in the air. Since the BoE was granted operational independence over monetary policy in 1998 it has operated under a mandate, set by parliament, to meet an inflation target of 2 per cent. Until now this target has been pursued by an ideologically orthodox governor.
An imminent change at the top, however, may provide the perfect occasion to shift the mandate in an American direction. The UK needs more inflation. It is good for the government (less fiscal consolidation would be needed to bring down the stock of debt). It is good for most companies and households (for whom debt exceeds savings and is more likely to be nominally denominated). By reducing real debt, it would make companies and households more creditworthy, making banks more likely to lend, and at lower rates. It should also reduce the value of sterling, boosting exports and reducing imports.
Given the political predicament of the coalition government – an outlook of seemingly endless austerity – a review of the BoE’s mandate is a political no-brainer. There is a variety of ways in which the mandate could be modified, including: expanding the inflation target band to say 2 to 4 per cent; introducing a Fed-style dual mandate, which includes a growth or unemployment objective alongside inflation; or an outright nominal gross domestic product target, in effect making growth part of the responsibility of the central bank.
Mark Carney, the incoming governor, will not be uncomfortable with such discussion, as a speech this week made clear. The Canadian central bank, which he currently leads, works to multiple objectives, including influencing “fluctuations in the general level of production, trade, prices and employment”, as well as promoting “the economic and financial welfare of Canada”. For George Osborne, the chancellor, the temptation to change the BoE’s mandate should be overwhelming. He can argue that he inherited present targets from a different party that governed in a different economic era. If he revises the mandate in an inflationary direction, the coalition will have a fighting chance of winning the next election. If they continue on the current path they will probably lose. Ed Balls, the shadow chancellor and a magpie for good ideas, would then be quick to put his own stamp on the mandate as soon as Labour returned to office.
So what is the catch? There are some who object to so-called “fiscal dominance” – the subordination of the central bank to the sovereign. This would be a legitimate concern if government actually meddled with central bank policy to a degree or with a regularity that destabilised markets. But refinement of central bank mandates, such as is being proposed in Japan and is mooted here for the UK, does not amount to such a degree of destabilisation.
A second objection is the Eddie George concern that an explicit change in mandate would unleash inflationary expectations which could not be controlled. For Britain, in particular, this recalls the nightmare of the 1970s – collective bargaining, incomes policies and unburied dead. But that was a different time: there was no central bank independence; monetary policy was manipulated by both parties to manage the electoral cycle; the labour force was inflexible and heavily unionised; and the economy was half-closed. Inflation could easily take root.
A final objection comes from critics of the fiat currency era, who fear “fiscal dominance” will unleash a race to the bottom of competitive currency devaluations, ending with gold as the only investment refuge.
But this argument is a caricature. Monetary policy tools are now sufficiently sophisticated and labour markets sufficiently flexible that it should be possible to manage a moderate level of inflation (low to mid-single digit) without the genie escaping the bottle. The real problem facing today’s central bankers is how to create much inflation at all.
The writer is chairman of hedge fund group Marshall Wace
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