Mark Carney, the governor of the Bank of England, wrote to the chancellor last week to explain why inflation fell to 0.5% in December, significantly below the monetary policy committee’s target of 2%. As one of the nine policymakers on the monetary policy committee (MPC) at the bank, I had been voting for a rate rise since August but the news about December’s inflation led me to change my vote in January.
As the governor explained – and not surprisingly – the single biggest explanation of very low inflation is the decline in the price of oil. Since the inflation rate is measured by looking at the change in prices over 12 months, inflation is likely to stay very low until the sharp fall in oil prices lies more than a year in the past. In fact, because not all prices adjust as rapidly as does petrol, the impact is likely to linger for longer than this.
The falling price of petrol has meant many people have more money to spend on other things. Only oil producers and practitioners of the dismal science might try to find bad news in a change like this. But while lower petrol prices are good news for the UK as a whole, there is a risk that people become used to very low inflation.
They might start to assume that inflation is going to stay around zero or below instead of recovering to the MPC’s target. If very low expectations of inflation were to become entrenched there would be a risk that the economy would sink into a deflationary spiral. Wages and prices could fall, people might put off spending if they thought things would be cheaper in the future, and they would find that, even though interest rates were very low, their mortgage became a burden which was difficult to manage. This could lead to lower spending, prompting further deflation and weak economic growth.
This is something that the monetary policy committee is committed to prevent. It is sometimes suggested that central banks, the Bank of England among them, have run out of effective means of returning inflation to target. That is certainly not the case. My own work suggests that asset purchases have retained their effectiveness, both here and in the US. So I think further asset purchases are a viable option.
Alternatively, improvements in the health of the banking system mean that, should the need arise, we can now consider a further reduction in Bank rate from its current level of 0.5%; that was not sensible three years ago. Finally, explaining to households and businesses that interest rates are likely to remain low for even longer can offer a stimulus to spending on its own, although the effects of such an approach are particularly uncertain.
So why have we neither cut Bank rate nor made further asset purchases as the inflation rate has dropped? The answer is that, as things stand, the committee expects inflation to return to target in two years without further help, as the impact of cheap oil drops out of the inflation numbers and the current economic expansion continues. While there are risks that inflation will remain subdued, as I have described, there are also risks that it will rise more strongly than we have forecast. Unemployment has fallen very steeply and pay growth is picking up. The picture on pay I get from the businesses I visit throughout the country is very different from what I was hearing a year or so ago.
In the second half of last year it seemed to me that, while inflation was below its target, the outlook for pay was changing sufficiently rapidly to justify an immediate rate increase. That is not to say that people were already getting sharp pay increases. The interest rate needs to be set with reference to where things are expected to be 18 months to two years ahead, not where they are now. I was voting in the light of the situation that seemed likely to develop next year.
These risks of an increase in inflation sharper than we have forecast remain. As the price of oil fell, however, I became increasingly concerned about the offsetting downside risk that expectations of low inflation might become built in. The further the price of oil fell, and the lower the inflation rate sank, the bigger this risk became.
In January I decided it outweighed the upside risk and that a Bank rate increase was no longer appropriate. The risks are, however, finely balanced.
Our recent forecast showed inflation rising above target by mid-2017. We expect that, in order to manage this, Bank rate will rise gradually. In my own view, rates will also have to rise somewhat earlier than market participants currently expect.
Different members of the committee obviously have different opinions about the future and, while we all listen carefully to each other’s views, from time to time that leads to split votes, as indeed it should. We are, however, all agreed that the job given to us by parliament is to deliver inflation of 2%.
Anyone who is concerned about inflation picking up faster than expected, or a period of very low inflation, should not doubt that, while the timing cannot be precise, the committee has both the will and the means to bring inflation back to target.
Martin Weale is an independent member of the Bank of England’s MPC
