Central bank impotence

David Smith writes about monetary policy in his Sunday Times column today - and there are some terrific evaluation points of use to AS and A2 students. Robert Peston is presenting a radio 4 programme on this very topic on Monday 19th.

He argues that the rise in CPI and RPI inflation has been remarkably modest given the scale of the jump in food and energy prices. The UK inflation target does allow CPI inflation to deviate by more than 1% from the 2% target because of “external events and temporary difficulties” - but the Bank must write to the government to explain how it intends to bring inflation back into range.

The bulk of his article concerns the external factors that are reducing the powers of the Bank of England to manage the course of the economy going forward

(1) The disconnect between the official base rate and the LIBOR (London Interbank Offer Rate) - brought about by the credit crunch and the sharp decline in the willingness of banks to lend to each other - “In many cases official rate cuts have been meaningless for borrowers; the opposite has occurred for them. The Bank has also been powerless to prevent a sharp drop in credit availability at all rates, even if it had wanted to.”

(2) Global energy and commodity prices have inflicted a sharp cost-push inflationary shock on the UK economy - raising food and fuel prices and eating into real disposable incomes. This is the factor most likely to cause a slowdown and possible recession in the real economy as consumers look to rein in their discretionary spending and concentrate on paying for the basics. The BoE has little or no impact at all on the course of international commodity markets.

(3) Gyrations in the currency markets: The pound has depreciated by 14% on a trade weighted basis since the start of 2007 - this is mainly due to external factors - expectations of a recession in the UK property market; the ever-widening UK current account deficit; a fall in international confidence about the performance of the UK economy. A fall in sterling is a useful competitive boost for British manufacturers but it also raises import prices still further adding to the inflationary pressures in the economy.

An impotent central bank? Not really, it is just that the external environment facing the Bank has become much tougher in recent months. The true test of central bank independence is how it manages the economy in difficult times. Sadly the Bank’s freedom has also been undermined this week by the crass £2.7 billion tax introduced by a panicking Chancellor Alastair Darling.