So much for the UK managing inflation expectations.
That’s from the excellent fixed income team at Deutsche, who note that despite the Bank of England having done quite well in terms of keeping actual inflation close to its 2 per cent target since 1997, there’s one area that has become much more volatile in recent years: inflation expectations.
Meanwhile, the Bank’s mandate has come under increasing criticism. The financial crisis has, in some pundits’ eyes, highlighted the fact that inflation-targeting is too narrow a focus for a central bank. Nevertheless, the Bank seems pretty preoccupied with its inflation target while it engages in quantitative easing.
What’s the solution?
According to Deutsche, the BoE has a few options to expand its remit beyond simple inflation-targeting. For instance, it could formally extend the horizon of its inflation targeting — that would give the Bank more flexibility to account for business cycles. Alternatively it could seek to regulate things like asset values and leverage ratios — that would probably be (very) politically contentious but at least it would stop asset bubbles from forming, DB says.
Or, it could simply increase its inflation target – something that would get straight to the point – but is likely to roil markets .
Here’s DB analyst Mohit Kumar, with his preferences:
In the near term, the BoE faces the onerous task of averting the Japanese style deflation scenario, while at the same time ensuring that a build up of inflationary forces is kept at bay. Given the bias to avoid the deflation trap, monetary policy is likely to be accommodative in the near term. Over the medium term, once the economy is back on track, having the additional mandate to take better account of asset bubbles would imply a structurally more restrictive policy than we have seen over the past decade.
A new policy framework is likely to be evolving in nature with the BoE and the regulatory bodies adapting the policy framework to market conditions. It will add a degree of discretion which may not be quantifiable and hence would tend to increase the volatility of economic variables, particularly inflation expectations.
. . .
Extending the inflation target would have an adverse impact on the balance sheet of the ALM players as it leads to a rise in liabilities. This alternative has the maximum probability of disrupting the market which would be an undesirable outcome in an environment of fragile economic recovery.
In our view, a combination of macro-prudential policies to avoid build up of leverage in the economy, a more robust regulatory and supervisory regime for the financial sector and focusing the monetary policy over a longer horizon would help put future growth on a sound footing. However, it is imperative that any changes to the monetary framework are communicated in a transparent manner to avoid a disruption to the market forces.
UK CPI is due on Tuesday at 9:30 am local time.
Expectations, for what they’re worth, are for a 1.4 per cent year-on-year increase.
Related links:
It is never too early to fear inflation - FT
Central banks must target more than just inflation – FT
There is no easy way out for central banks – FT