The Week
The Week, 20/02/09
Bull's eye
The perception that Gordon Brown has a monopoly on great economic ideas has been enhanced by suggestions that the Federal Reserve Bank has effectively set an inflation target for the US, just as its counterpart over here aims to keep UK inflation within a set range.
Lo and behold, the target appears to be 2%, the very level set by Brown as Chancellor for the Bank of England’s monetary policy committee.
For various reasons, I treat this idea of a US target rate for inflation with some scepticism. For a start, it is not an official target, merely a long term estimate. It does not contain a band either side to form a ceiling and floor as we have here.
Secondly, the Fed has had much greater flexibility than our own MPC. The Fed was able to reduce US interest rates more promptly as the credit crisis unfolded because keeping the economy going was as important as controlling inflation. Over here the inflation rate is the be all and end all of interest rate decisions.
I cannot see this flexibility being dropped. Some time in the future the idea of an inflation target will be quietly forgotten by the Fed or it will point out that it never set a target in the first place and it was all media assumptions.
According to the minutes of the most recent Fed meeting, the idea of an inflation estimate is to help to manage public expectations rather than to set a formal target. I know that central bankers like to work with nods and winks but a forecast, which can be moved up and down, is not the same as a target.
In any case, this target is long term, which allows a lot of leeway. Long term economic forecasting is an inexact science, as we all should have realised by now.
Speculation over a US target rate should not distract us from the rather dire figures contained in the Fed’s minutes. The US economy is now expected to contract by 1.3% this year compared with a prediction in October of only 0.2%. The Fed also sees US unemployment rising sharply to 8.8%.
There is nothing to suggest yet that the global economy is on the right path, let alone out of the woods. Minutes from the MPC meeting reinforce the view that no-one knows whether action taken or to be taken will work.
The Bank of England now says that further interest rate cuts are unlikely to have much impact – this despite the vote of one committee member for a larger cut than the half point we got earlier this month.
I have argued in this column that interest rates have been reduced far enough and that the impact on the exchange rate and on the level of savings is offsetting what little benefit we are getting from the spasmodic falls in borrowing rates.
The tiny fall in the inflation rate in January is particularly disappointing and calls further into question the decision of the Bank of England to reduce interest rates earlier this month.
The drop in inflation from 4.1% to 3.1% in December was regarded as small considering the sharp fall in oil prices but we were able to console ourselves with the thought that January would see the inflation rate plunge back below 3%, the top of the target rate.
I took it that the Monetary Policy Committee, which has preliminary inflation figures available when it sets interest rates earlier each month, had seen good news on the inflation front when it decided to go ahead with its half point reduction in base rate to 0.5% a couple of weeks ago but it is clear that this was wishful thinking.
I had things back to front. The Bank went ahead with another dramatic gesture because the inflation news was bad. In the event, inflation eased from 3.1% to 3%. So while the Governor of the Bank of England will not have to write any more explanatory letters setting out the reasons from breaching the 3% ceiling, there is little other comfort.
If inflation cannot fall heavily when the price of crude, which affects everything down the line, is collapsing, what hope is there now that oil has stabilised? Economists had generally been hoping for an inflation figure of about 2.7% this month, which in my view would have been a quite modest reduction.
No doubt the fall in the pound, which has been greeted with acclaim in some quarters, is responsible. Only this week Charlie Bean, Deputy Governor at the Bank, claimed that the 25% fall in the value of sterling over the past year was necessary to ensure recovery in the UK.
Devaluation is very much a short term measure and its benefits are dubious. Because the price of imported raw materials and parts go up, manufacturers have to pass on the higher costs in higher prices so the competitive gain is rapidly dissipated. The workforce pushes for higher wages to cope with increased prices. Then you are back to square one but with a debased currency.
The Bank’s minutes do not, however, rule out further interest rate cuts. They merely argue that other measures are required as well. I believe that another half point will be sliced off in March and that will be the end of the line.
Bonus issue
Thanks to all email recipients who sent me their views on bank bonuses. Most took the line that the bonus culture needs stamping out but there is a contrary and cogent view that the bonuses are necessary to keep the best people and to reward those who did well.
I reproduce, in the interests of balance and with his permission, a response I received from Afam Edozie:
"Banks are multi-departmental entities. Some departments have done very well and one or two departments have done very poorly (threatening the whole).
Why should a bond salesman who has exceeded targeted bond sales or a recovery specialist who has achieved targets in the repossession and successful disposure of collateral from non-performing borrowers not get their bonus, particularly when there is a contractual obligation?
And why on earth should a top salesperson or recovery specialist hang around a bank that is not paying his bonus?
I am a shareholder and an employer. We made a loss in 2008. I paid top performers a generous bonus, whilst poor performers (including myself) got nothing.
We work in a merit based economy. Indeed this has been the source of our strength for 500 years. I shudder as I see Hemscott, The Economist, The Wall Street Journal and other bastions of capitalism carrying the flag of socialisation."
Rodney Hobson
Author, Shares Made Simple and Small Companies, Big Profits