Monetary policy at the crossroads - time for asset prices to play a larger role?


20-07-2004

In the latest issue of the Deloitte Economic Review, our Economic Adviser, Roger Bootle, takes a look at the UK's current monetary policy regime of inflation-targeting and asks whether more emphasis should be placed on asset prices.

His main points are:



  • Despite the general perception among economists and the markets alike that the UK's inflation-targeting monetary policy regime is the model that all other countries should follow, it is not the perfect regime. Indeed, just as with all the other monetary policy regimes that have gone before it, after a honeymoon period the flaws are clear for all to see.



  • Undoubtedly, the inflation-targeting regime has helped the Monetary Policy Committee to keep general inflation well under control over the last several years. But it is clear that asset prices, and in particular house prices, have not been under control.



  • Defenders of the status quo might say that there is no need for macro policy to be directed towards the stabilisation of asset prices, as it is consumer prices which matter. But in the UK, houses are the most important asset for most individuals by far - and the price of property is probably the most important price in the whole economy. Indeed, with house prices currently rising at an annual rate of over 20%, it is very hard to argue that inflation-targeting has brought widespread economic stability.



  • Indeed, once you accept the critical importance of the property market in influencing the performance of the economy, the current monetary regime in which the Monetary Policy Committee devotes enormous time and effort to considering whether CPI inflation will be 0.1% above or below the 2% target in two years' time looks bizarre.



  • Of course, it wouldn't be viable for the central bank to have a target for asset prices. Yet that is not the same thing as giving asset prices a heavy weight in the interest rate decision. The key requirement is being prepared to let the immediate course of the consumer price inflation rate diverge somewhat from the target or desired path in order to pursue stability in a wider and longer term sense.



  • We suspect that once the housing bubble has burst, mature reflection on this episode will lead people to conclude that once again the monetary regime needs to change. However, there need not be an end to the MPC and to inflation-targeting altogether. Instead, all that is necessary would be an evolution to something better which explicitly takes asset prices into account and reduces the hang-up over the two-year CPI inflation forecast horizon.



  • The MPC has arguably already taken steps towards this. Although an improving growth outlook and mounting wage pressures will play a part in interest rates rising from their current level of 4.5% in the second half of this year, the MPC's key motivation for higher interest rates is the continuing strength of the housing market.



  • Admittedly, the latest data have revealed signs of a slowdown in the housing market. But so far these have been very tentative signals and we expect that interest rates will still rise to 5.25% by the end of the year, or shortly afterwards.



  • But we think that next year will prove to be the crunch year for the housing market. With annual house price inflation having turned negative by the middle of the year, together with low inflation and a high sterling exchange rate, we think that interest rates will fall, to somewhere around 4.75% by the end of the year.



  • Elsewhere, although the US economic recovery is likely to remain strong for the rest of this year, higher interest rates should prompt a more modest expansion next year. In contrast, the euro-zone economy is still failing to mount a significant recovery and lower interest rates later this year should not be ruled out altogether. But with growth in Asia likely to remain robust, the global economic recovery will remain firmly in place.







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