In the medium term, the role of inflation as the anchor of UK economic policy could also come under increased scrutiny. Since the UK's ignominious exit from the Exchange Rate Mechanism in September 1992, inflation has been key to understanding official economic policy. The simple mantra that low and stable inflation leads to low and stable interest rates, and hence to stable and competitive exchange rates, has been followed by successive chancellors. This, it was thought, would produce the stable economic environment that the private sector wants and would engender the confidence that encourages the business community to take a longer-term view.
A break from ‘the Norm'
Since Norman Lamont's stint at the Treasury, governments have had an inflation target. Originally, managing inflation and interest rates was the chancellor's job, advised by a panel of ‘wise men', but that responsibility now resides with the independent MPC. And for a long period, the policy seemed to serve to country well.
During the recession, the MPC appears to have suspended the normal rules. The official target, to keep consumer price inflation within a range of 1%-3%, has been missed 10 times in the past three years. But the MPC's medium-term view (it was more concerned with the risk of deflation, IE falling prices) of inflation allowed it to cut rates. So, unusually, we have experienced a prolonged period when inflation has been higher than the official UK Bank Rate (or base rate).
These negative real interest rates have been a spur to recovery and, as activity starts to expand again, inflationary pressures will pick up and the authorities have to consider whether the old way of managing things is still the best way.
In any case, inflation will jump sharply in the next couple of months because the cut in VAT has been reversed, energy costs are higher than 12 months ago, and weaker sterling has pushed up the prices of imports. But this rise, almost certainly above the 3% target range, will be temporary and so the MPC is likely to keep rates on hold. Tightening policy too soon could stifle the nascent recovery before it gains momentum. Even if the rate of CPI inflation finishes comfortably within the target range this year, there are important policy issues that should be considered.
In 2003, the then chancellor, Gordon Brown, changed the inflation target from the Retail Prices Index (RPIX, excluding mortgage interest payments) to the Consumer Prices Index (CPI). Although similar, the CPI excludes a housing cost component which was included in RPIX, and so produced a lower inflation figure and lower interest rates. These contributed to the build-up of an asset price bubble, including the boom in house prices, the subsequent bursting of which caused so many problems.
Looking ahead, should the MPC still be targeting a measure of inflation which takes no account of asset prices? These issues are related to how inflation should be measured and the appropriate target rate for policymakers.
It is not very 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, but there is little evidence yet that this is on the political agenda.
Dennis Turner is chief economist at HSBC
With inflation expected to rise sharply, how should the MPC reverse the trend?
As the UK emerges from recession, it was no surprise that the Monetary Policy Committee (MPC) again sat on its hands at the first meeting of 2010. The Bank of England's interest rate seems likely to stay at 0.5% for several months and any changes to the programme of quantitative easing tend to be linked to the publication dates of the quarterly Inflation Report. The next is due in February, at which time the 200bn programme will be completed. The heavy dose of fiscal and monetary medicine prescribed over the past 15 months is finally taking effect.
