The Hindu Business Line : Asset prices thrive on liquidity

One of the first things that Mr Gordon Brown, Britain's Chancellor of the Exchequer, did, after Labour came to power, was to make the BoE autonomous and responsible for ensuring inflation did not exceed target. It has worked well for ten long years.

But, for the first time since 1997, when the bank became independent, i.e., was given full freedom to decide on monetary policy and interest rates, inflation climbed well above the bank's target of two per cent, to over three per cent.

The string attached to the BoE's monetary independence was accountability if inflation went over the benchmark. The Bank's MoU with the Government requires the Governor to write to the Chancellor of the Exchequer explaining the inflation breach and the measures being taken to bring it back to the acceptable level.

The bank's policy is actually run by the Monetary Policy Committee (MPC), comprising the bank's Governor and Deputy Governors and outside experts. The intellectual quality of the MPC's debates is extremely high. It looks not just at inflation but a wide spectrum and cross - section of data on the pace of economic activity, the pound's behaviour in forex markets, credit growth and pay and wage settlements. In fact, Mr King's letter to Mr Brown cited the (obscene?) bonuses in London's financial district - the City - as a proximate reason for the recent increase in inflation.

Mr King is under attack on another front. He is being blamed for a lax attitude to the boom in property prices. Here he is (or at least was) in the good company of Mr Alan Greenspan, the former Chairman of the US Federal Reserve, who did nothing about it and was not afraid to say so.

Mr King's answer is also in the same vein - it is not the bank's job to control asset prices.

But what creates asset bubbles in the first place? A widely-held view is that it is ample liquidity and low borrowing costs in financial markets. So keep an eye on credit in addition to inflation (as the European Central Bank does).

Not that BoE is unaware of this. In a recent study, it finds liquidity thriving globally, thanks to narrow bid-offer spreads in currencies and bonds and low risk premiums in low and unrated (`junk') bonds.

Mr King's critics say that when the asset bubble bursts - as it must some day - the bank will be forced to cut interest rates, endangering its inflation target.

It is a dilemma faced by all central banks in the world - what to do about asset prices? At this point, the best one can hope for is that, when the time comes, they will be able to engineer a non-disruptive adjustment, with skilful management of liquidity and interest rates.

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