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Adviser  >  News  >  June 2008  >  Economic Commentary from RLAM’s In-house Economist

Economic Commentary from RLAM’s In-house Economist

Ian Kernohan considers topical issues including the impact of changing the UK inflation target, the prospect of recession in the US and the future direction of UK interest rates.

Changing the inflation target would create more problems than it solves

In a reversal of conditions prevailing in the first half of the decade, globalisation has turned from a disinflationary to an inflationary force. The subsequent squeeze on living standards poses political problems on both sides of the Atlantic. There has been some speculation about changing the UK’s inflation target to enable rates to be lowered, thus easing the economic pain.

Having spent most of the post-war period trying to find an economic policy framework that delivered low inflation and stable growth, inflation targeting was introduced in 1992, with the Bank of England given operational independence in 1997. The aim was to remove the pursuit of low inflation from the influence of the political cycle. The system is not perfect in the sense that it can eliminate fluctuations in the economy. However, compared with what went before, it has been successful. At the heart of the system is the idea of inflation expectations: if we believe the Bank of England when it says it will aim to keep CPI at an average of 2% over the long term, then this will influence our economic decisions and that in itself will help to keep inflation down.

Raising the target now, at the first sign of difficulty, would more likely result in higher, not lower interest rates. There would be a large shock to inflation expectations as individuals and firms lost faith in the ability of the Bank to keep inflation low. Political interference would have returned to the day to day operation of UK monetary policy. Once credibility is lost, it is very difficult to restore and raising the inflation target is a sure-fire way to create a recession, since one would become necessary to put the inflation genie back in the bottle.

The existing regime does provide some flexibility: inflation does not have to be held at 2% each month.  Instead, if faced with an overshoot on the target, the aim is to bring inflation down over a period of time. This is what the MPC is trying to do, but it will require domestically generated inflation to be severely squeezed to offset imported inflation. In turn, this will require a major economic slowdown, which could create tensions between the government and the Bank.

Comparisons have been made between the current situation and the 1970s, though inflation remains much lower now that it was then, as does the level of industrial unrest. The oil shock of 1973 fed very rapidly into inflation because it was allowed to. Wages rose because workers did not believe that inflation would fall back and had the power to push for greater compensation. The presence of an independent central bank committed to a low inflation mandate and changes in the structure of the labour market are two key differences between then and now. If we can stick to the current inflation target, the short term pain of the next 12 months as inflation is squeezed lower will be more than offset by long term gain.

US Recession still more likely than not

With markets pricing in only a very shallow downturn or no US recession at all, a gap has opened up between our view of the world and the consensus: we’re still very firmly in the US recession camp and see the deterioration in the labour market as a key indicator.  As far as the unemployment rate goes, if it looks like a recession, it probably is a recession and the jump in unemployment tells us that this is something worse than just a mid cycle pause.

Next move in UK rates is down

By the end of 2008, the MPC will be setting interest rates with a view to the outlook for inflation in mid 2010. With interest rates on hold for the time being and the availability of credit to households and companies constrained, monetary conditions remain tight. This will provoke a substantial slowdown in the economy lasting well into next year and it is this slowdown which will determine the prospects for inflation in 2010. Expect rates to be cut again before the end of the year.