Tuesday, April 5, 2011

The Alternative Letter

We've recently covered monetary policy, and the current UK framework where the Bank of England has been granted independence from political interference to use tools of monetary policy (interest rates and QE amongst others) to achieve an inflation target. We noted in lectures that for a long time now, the Bank has missed the target and we have inflation over 4% (target 2%).

In Money Week there's a mock alternative response from the Chancellor; if inflation misses the target, the governor of the Bank writes a letter to the Chancellor, and the next day the Chancellor responds. The Chancellor usually refrains from being critical, and hence this has drawn criticism: Why shouldn't the Chancellor start holding the Governor to account?

The letter is of course highly sarcastic and tongue in cheek, but it is written for a reason and helps us think a little more about monetary policy and the current framework. It is essentially true that the Bank has no regulator: Nobody is really keeping check on whether the Bank hits the target or not. Osborne can't really do it, as the letter kind of hints at with its final riposte: Maybe we should find someone else to do the job if you can't Mervyn (paraphrasing). If Osborne wrote a letter like this, it would be a very clear indication that the Bank's independence was no longer. If the Bank did subsequently raise rates, regardless of why it did so, it would be easily interpreted as having done so under political pressure. And if political pressure starts once again to dictate what happens with interest rates, then we're right back to square one, where we were before 1997 and the political business cycle.

The letter also makes some other important points:

  • Why are forecasts so bad?
  • How do we know inflation is caused by the weak exchange rate and not negative real interest rates and QE?

On the first, the stock answer is that the economy is a complicated beast. But the letter kind of hints at that when it criticises the reliance on the output gap in a rather Austrian-type criticism: How can we really know about this incredibly complicated and generally theoretical entity called the macroeconomy? Of course, just because something is complicated is no reason to give up on it, particularly when policy needs to be made (I'm not going into any arguments over free banking and the like).

On the second, the 30% fall in the trade-weighted exchange rate noted in lectures means that the goods we import (which is quite a few) are more expensive, and since these often take up a large portion of our basket, then it is quite reasonable to assert the high inflation is due to that - along with the VAT rise, since that also makes the goods we buy more expensive. Remember, inflation is just the change in the Consumer Price Index (CPI), year-on-year, for a given month, and the CPI is calculated over a "basket of goods" which is supposed to be representative of what the average person buys.

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