The UK is celebrating a near three-year low in consumer price inflation, but we think the Bank of England (BOE) should be more worried about the role that money and credit play in the inflation process.
Consumer Price Index figures for August show that inflation, at 2.2%, has fallen to its lowest level for nearly three years. This comes just days after BOE Governor Sir Mervyn King said, in a speech marking 20 years of inflation targeting, that “low and stable inflation is a prerequisite for economic success”. In his view, inflation targeting and central-bank independence have played key roles in bringing price stability to the UK.
But here’s a more sobering statistic: between 1970 and 2007, the UK money supply rose by an average 11.5% a year, roughly three times the 3.7% rate at which it grew between 1870 and 1970. In other words, the stock of money has risen considerably more in the last generation than it did in the preceding three.
Moreover, until the credit crunch intervened, this explosive growth continued even after the Bank was made independent in 1997. The only problem is that it did not show up in the consumer-price index, which has risen by just 2.1% per annum since 1997, broadly in line with the current definition of “price stability”. In our view, though, the consumer-price index is far too narrow a measure to capture the true decline in the value of money. To see why, consider what has happened to house prices.
According to the Nationwide Building Society, the price of the average house in the UK has risen from £59,000 in June 1997 to more like £164,000 now. This may reflect some rise in the intrinsic value of housing, but it is totally implausible to suggest that the increase has been close to 200%. Using houses as a benchmark, the value of money in the UK has depreciated substantially since 1997.
By making inflation targeting more flexible and adding bank regulation to its toolbox, the Bank of England hopes to avoid a repetition of the recent boom-bust cycle, of which house prices are just one manifestation. In our view, this is a second-best solution which focuses on symptoms rather than causes. We would argue that inflation in its primary form is shown by the expansion in money and credit. The subsequent increase in prices—consumer, commodity or asset—is simply the way in which that inflation manifests itself.
We are puzzled by the Bank’s reluctance to recognize the crucial role that money and credit play in the inflation process, or to see how explosive monetary growth can create a breeding ground for misperceptions and mispricing. At the beginning of last week’s speech, Governor King asked: “should monetary policy go beyond targeting price stability and also target financial stability?” Our rejoinder would be: why shouldn’t monetary policy target monetary stability directly? Perhaps that would help the Bank deliver price stability without jeopardizing financial stability.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.