Thursday, August 03, 2006

Bank of England is right on target

I am a big fan of inflation targeting. I think a soft target, the sort that Ben Bernanke publicly advocated prior to becoming Fed chair, is the logical extension of the Fed's current philosophy of transparency. Inflation targeting would cement the inflation-fighting credibility that the Fed earned during the 1980's and 1990's, and likely lead to less volatile markets.

The Bank of England, one of the world's most prominent inflation targeters, hiked their benchmark rate by 0.25% to 4.75%. The ECB followed by also raising rates by 0.25% to 3.00%.

U.S. investors should take more than a passing interest in these moves, even if they hold no foreign investments. First of all, the BoE hike was unexpected, as Mervyn King & co. appeared to have completed a tightening cycle back in late 2004, and their most recent move had been a rate cut last August. Secondly, if Bernanke eventually succeeds in moving the U.S. central bank towards the British model, these sorts of "tweaking" moves should become more common.

Inflation targeting is based on the rational expectations hypothesis, which states that actual inflation next year will be similar to expected inflation this year. If you want to keep inflation low, first keep future expectations low.

So, in order for an inflation target to work, the public has to believe the central bank will do whatever it takes to keep inflation at the target. This means that if inflation drifts just a little high, then the central bank must tighten monetary policy. If they don't, then the public will start to form expectations that differ from the target, thus defeating its purpose.

If the U.S. eventually adopts an inflation target, look for more volatility of short-term rates, because it will be more difficult to tell whether the next move will be a hike or a cut. But also look for more stability in long-term rates, because investors will have faith that the Fed will prevent long-run inflation (or deflation) from developing. Stable long-term rates will mean cheaper funding for corporations and mortgage loans, and should be quite a boon to the economy.

1 comment:

Jay said...

Good post. However the rational expectations hypothesis assums that consumers actually have the power to drive inflation, if they expect it. I can hardly see how cause & effect would play here; more likely, inflation rears its head based on global and national market conditions, which drive the fed, which then drive consumer's behavior. So indirectly, the fed pushes consumers to spend less by making it costly.

This also assumes that long-term rate stability is the goal, and a flat curve is harmful. Forgive me, but the curve has been flat for quite some time, and I fail to see the devastingly harmful effects. Rather, I see a booming economy that is being bludgeoned into recession by excessive rate increases.

I think the old adage stands, fear of inflation is far worse than inflation itself.