The MPC’s inflation-targeting remit contains an ambiguity: it requires the Committee to achieve the target “at all times” while allowing for temporary departures due to “shocks and disturbances”. Judging from remarks in a speech last week, Bank of England Governor Mervyn King plans to exploit this ambiguity to underreact to this year’s inflation overshoot.
Extending arguments in his five explanatory letters of 2007-09, Governor King absolves the MPC of responsibility for higher inflation due to “temporary price level factors”, which he defines to include exchange rate depreciation, global commodity price rises and indirect tax hikes. Such effects, he suggests, can be ignored as long as there is a “large amount” of spare capacity and monetary growth is low.
The speech does not address the issue of why the disinflationary impact of the “output gap” has, to date, been much weaker than the Bank forecast. The assertion that low money supply growth ensures that inflation will return to target is also simplistic – an alternative view is that there is “excess” money despite slow supply expansion because the demand to hold money is falling in response to negative real interest rates and reviving risk appetite.
The phrase “temporary price level factors” is misleading: sterling depreciation, commodity price gains and excise duty increases, unless reversed, have a permanent impact on prices. Governor King means, of course, that the effect on inflation is temporary. Yet these factors will plausibly continue to exert upward pressure over the medium term.
Take sterling. The real effective exchange rate is currently 8% below its pre-crisis long-term average (calculated over 1970-2006). Suppose, reasonably, that it returns to this average in five year’s time. If the nominal exchange rate is stable, this implies UK manufacturing prices rising by 1.7% per annum more than in competitor countries. Such a differential would lift UK CPI inflation by about 0.5% pa relative to the overseas trend (based on the 31% weight of “non-energy industrial goods” in the CPI).
Commodity price gains in recent years have been largely driven by industrial expansion and rising food spending in emerging economies, trends that will persist. Fiscal adjustment, meanwhile, will necessitate further hikes in indirect taxes, with a rise in the standard rate of VAT to 20% widely expected during the next parliament.
In sum, the three factors could plausibly boost the CPI by about one percentage point per annum over the next five years. If the MPC were to exclude the effect when setting policy, this would imply a de facto raising of the inflation target from 2% to 3%.
How the MPC interprets its remit may be as important for the interest rate outlook this year as the evolution of inflation and output. In effect, Governor King is advocating downgrading the “at all times” requirement while shifting to a “core” inflation operational target (i.e. a Canadian-style approach). This warrants wider debate, both within and outside the MPC.