The hawk and the dove give their verdict

Andrew Sentance
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Confusing Bank policy is failing to contain persistently high inflation

MONETARY policy in the UK is becoming increasingly confusing. When the Bank of England assumed responsibility for setting interest rates in 1997, it was given a clear objective – keeping inflation on target at a low target level (retail price index, excluding mortgage interest payments (RPIX) at 2.5 per cent, and then consumer price index (CPI) at 2 per cent). And until the financial crisis, the Monetary Policy Committee (MPC) succeeded in doing this.

Since 2008, however, inflation has been persistently high – hitting 5 per cent twice and averaging close to 3.5 per cent. At no point has any action been taken by the MPC to bring inflation back to the target. Instead, the MPC has risked adding to inflationary pressures by injecting more money into the economy through quantitative easing in 2011 and 2012.

In its inflation report last week, the MPC acknowledged that the combined impact of these policies and other factors meant it was unlikely that inflation would come back to the 2 per cent target in the next two years. Indeed, inflation is likely to rise above 3 per cent in the short-term.

But despite all this, we learned from the MPC minutes released yesterday that three of its members – including the outgoing governor Sir Mervyn King – wanted to inject more quantitative easing, even though the response of the economy to the same medicine in late 2011 and last year was very disappointing.

Fortunately, the majority of the Committee resisted this pressure. But the foreign exchange markets took a clear signal from the minority vote, and sterling fell below $1.53 against the US dollar and €1.15 against the euro – its lowest value against both currencies for over a year. Sterling is getting little support from the statements of ministers and Bank officials. And with the current combination of disappointing growth and high inflation, it seems likely to sink further in the weeks and months ahead.

Yet a weaker pound can only make the outlook for inflation worse, as it will push up the value of imported goods. And because this in turn squeezes consumers, it is also likely to hit economic growth. As we saw in the aftermath of the big fall in the pound five years ago, the boost to UK exports of weaker sterling doesn’t offset the consumer squeeze from higher import prices.

In addition, the split vote on the MPC sends out a very confusing signal about the Committee’s commitment to low inflation. Coupled with all the discussion of “flexible inflation targets” and perhaps a shift away from inflation targets altogether, many people may conclude that the Bank is giving up on its commitment to price stability and low inflation.

All this is sadly reminiscent of the late 1960s and 1970s – the belief that a falling pound will help the UK economy and rising inflation will prove temporary and can be contained. It didn’t work then and it is not working now.

Andrew Sentance is senior economic adviser to PwC and a former member of the Bank of England’s Monetary Policy Committee.