Mark Carney’s comments on monetary policy at Davos, though not specifically about the UK, opened a wide gap between his thinking and that of outgoing governor Sir Mervyn King). The latter expressed doubts last week about the ability of monetary policy to boost the economy further, given his concerns about the UK supply side, and his related worries about the 2 per cent inflation target.
At Davos, Mark Carney showed very little sympathy for any of this, arguing that there is plenty of scope for monetary policy to boost the developed economies further, and specifically saying that it might be appropriate to allow inflation to run above 2 per cent for a time in order to achieve this. It would be very surprising if Mr Carney were willing to make such remarks unless he believesthey apply to the UK.
The gist of Mr Carney’s remarks would place him somewhere between Ben Bernanke and Janet Yellen in the current Fed spectrum, which means he is at the dovish end of global central bank thinking. In view of the fact that the UK’s recent track record on hitting its inflation target has been very poor, the arrival of an aggressively dovish new governor certainly carries some risks.
Recent events in the UK have had some parallels with those in Japan, where the resignation of Governor Shirakawa has given the government a chance to replace him with a more dovish successor, more likely to deliver a monetary stance that will help to achieve sustainability on fiscal debt. The UK has certainly not gone as far as Japan in the direction of fiscal dominance, but this is another step that emphasises the extent of the change occurring in global monetary policy at present.
In the US, for example, the leading candidate to succeed Ben Bernanke as Fed chairman early next year is vice-chair Janet Yellen, who is one of the few Fed officials clearly more dovish than her boss. A very large global bet is being placed on the belief that easier monetary policy will boost real activity and not inflation, which of course is exactly the opposite of what was believed for several decades. The amount of spare capacity left in the system probably justifies this, but there are risks, especially in a UK context.
Mr Carney made two key points. First, he said that the most important objective of monetary policy at present is to ensure the economy achieves “escape velocity”. Although he did not define this term, it presumably means that the economy must achieve self sustaining real growth and a continuing decline in unemployment. This seems close to the Fed’s commitment to maintain its current rate of balance sheet expansion until there has been a marked improvement in the labour market.
Second, Mr Carney said it might be acceptable for inflation to exceed the government’s 2 per cent target for a fairly lengthy period, especially in the context of fiscal consolidation. Again, this is similar to the Fed’s current approach, which would allow inflation to rise to 2.5 per cent without this triggering any tightening in policy. But it is not clear how this approach can be made compatible with the Bank of England’s current mandate, which has always been interpreted by the MPC as requiring a return to a 2 per cent inflation target over roughly a two-year horizon.
The official remit was set in the Bank of England Act in 1998, which stated that:
The objective shall be: (a) to maintain price stability; and (b) subject to that, to support the economic policy of HM government, including its objectives for growth and employment.
The Bank explains that it interprets this as follows:
The MPC’s aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy.
Mr Carney seems to think that he can just about square his remarks yesterday with this “flexible inflation target” mandate, but in spirit his remarks are more in keeping with a nominal GDP target, or a twin inflation/employment mandate of the Fed variety. If policy is to shift in this direction, which means placing a greater weight on unemployment within a Taylor rule framework, then many members of the MPC might prefer the government to reduce confusion by changing the official mandate.
Last week, Sir Mervyn suggested that the government could announce in each budget the time period over which the Bank would be expected to bring inflation back to target, assuming it had overshot. But governments do not normally like to get the blame for high inflation, so it is unlikely that this would appeal to the Treasury.
Without a change in the mandate, there is some doubt about whether the majority of the current MPC would support Mark Carney’s approach. The nine-person committee has recently been split into three roughly equal camps, and only the most dovish third appears to accord with the Carney stance. A change in the official mandate might be needed to bring the majority into line with the new governor, assuming that all the existing members would be willing to work under the new framework.
So if the Bank is doing nothing more than moving into line with the dovish end of the Fed spectrum, is there anything for the markets to worry about? The problem is that the UK, on many estimates, has far less spare capacity than the US, and has a much less impressive record in hitting its 2 per cent inflation objective in recent years. As a result, UK inflation forecasts have been drifting upwards, and the consensus projections for 2013-14 do not assume that the target will be hit. This is in contrast with all other major economies, where inflation targets are expected to be hit, or missed on the low side, even though monetary policy is aggressively easy.
Mervyn King is suffering the fate of many lame ducks, and his critics are now inclined to ignore his perfectly sensible concerns about the future effectiveness of monetary policy and possible inflation risks in a UK, if not a global, context. I have some sympathy for him, and not only because his beloved Aston Villa have been knocked out of two cup competitions within a week.