Hamish McRae: Why the Bank of England's guns are aimed at the wrong inflation target

The background to the increase in interest rates to 5 per cent that seems certain to come today is more interesting than the increase itself. For we are beginning to stress-test the whole basis on which interest rates are officially set: to hold inflation to within 0.5 per cent of a central 2 per cent measure.

The immediate issue is what effect the rise might have on the different segments of the economy: on consumption, on the housing market, on sterling and so on. The longer-term issue is whether trying to aim for any particular level of inflation, as calculated on the slightly odd European measure, is actually the right policy at all.

To explain this wider point, we are in a world where international prices of goods and traded services are held down by the entry onto the global labour market of hundreds of millions of low-waged Chinese and Indian workers. But we are also in a world where the new global rich flood to Britain to buy assets, thereby forcing up their price. The Bank of England's guns are calibrated to hit the former but arguably the latter form of inflation is more important in both social and economic terms. So the guns arguably are facing in the wrong direction. More of this in a moment, the narrow issue first.

We are getting higher interest rates because inflation is above the target range and threatens to remain there. But the mechanism whereby the two are linked is very uncertain.

One key link used to be the labour market. Lower interest rates boosted demand for goods and services, which boosted demand for labour, which bid up wages, which increased costs and hence prices. But now that labour can move freely in from Poland, or production can be offshored to China, that does not seem to matter much any more.

Another key link has been the housing market. Lower interest rates boost house prices, so people withdraw equity to maintain their spending, which enables suppliers to get away with price increases. But two-thirds of the world's largest economies have had housing booms without much increase in current prices. There are perfectly sound reasons for not wanting house prices to soar to unsustainable levels but while the link with consumption does hold true to some extent, the link with current prices is quite weak.

What we do know is that the housing market has rebounded this year. Though the annual rise in house prices is a long way down from the levels of three years ago, it is running around 8 per cent a year which is double the increase in average earnings. So every year housing becomes less affordable. Retail sales fell back last year, only just inching up in value terms through much of the year (red line, top graph) but have now recovered. A Barclays Capital forecast based on British Retail Consortium results (green line) suggests that the present rebound may be tapering off. Were the housing market to plateau then maybe growth in retail sales would come back further.

So, insofar as there is still some link between house prices and consumption, the thing to watch over the next few months will be whether the housing market does shade back. If it doesn't there will be higher rates in the spring.

That is a useful rule of thumb. But I don't think we should become mesmerised by the growth of retail sales. Remember these are presented here in value terms, not volume. So if prices in the shops are falling, people can still enjoy higher consumption even without the value figures rising: people can get higher living standards as a result of lower prices, not higher wages. That is what has been happening for much of the past decade as far as goods are concerned: inflation happens only in non-tradable services, including many public sector services.

You can take the argument further. Anyone worried about inflation in the UK ought to note that there has been huge inflation in healthcare costs. But because these are mostly paid out of general taxation they are not caught in the inflation figures. We have to pay them in some way or other and insofar as we do, that reduces the amount of money we have to spend on other services. There are many other examples where prices have gone up but are not reflected in the statistics: the price for local authority services and for education.

Now you could perhaps fix this by changing the way the inflation index is calculated - except that we are tied in to the European measure and no government is going to want to include the cost of providing public services in inflation. So it won't happen.

In any case why should it be assumed that prices ought to go up by some small incremental amount each year? Inflation targeting has been a useful tool in coping with the excessive inflation of the past, just as money supply targets were also a useful tool at one time. But the aim of monetary policy should surely be general economic stability, rather than focussing on any specific number, particularly a flawed one. And there are growing signs of an inherent instability in UK finances.

Have a look at the bottom graph. The blue line shows how our current account has remained in deficit of around 2 per cent of GDP for the past five years - it is heading towards 3 per cent at the moment but that does not seem to be a material shift, at least for the time being.

The big change is the ease with which it is being financed. There has been a sharp rise in foreign central banks buying sterling assets to go into their reserves (red line) and an even more remarkable surge in foreign companies buying UK companies (blue line). Through much of 2002/3 UK companies were net buyers of foreign ones. That has now reversed dramatically. Put these two together and you can see how the overall structural balance of payments, taking capital and current account together, has gone from a minus to a plus (green bars).

Citigroup, which assembled this data, notes that the net merger and acquisition inflow into the UK is now equivalent to 5.7 per cent of GDP, while foreign central bank purchases amount to a further 2-3 per cent of GDP. No wonder sterling remains strong.

What has all this go to do with interest rate policy? Well, directly not a huge amount. Having somewhat higher interest rates than the eurozone, though not the US, may encourage some central banks to increase their sterling assets. It will also support private sector inflows. So there has to be some concern that pushing rates up more might push the pound up too. But the indirect concerns are really more important.

You see, we are in a situation where domestic demand is supported by strong property prices. And we have sterling supported by a strong capital flow of funds. In the short-term that is fine. But we have become vulnerable, more vulnerable that the relatively steady growth of overall demand and the apparently low inflation rate would suggest. This increased vulnerability won't matter next week or next month or probably next year. But I don't think we should assume that the present stability will last forever.