Thursday, June 15, 2006

Mervyn King and the Maradona Theory of Interest Rates

Mervyn King gave a very interesting speech last May to the Cass Business School, City University, where he said the following:

"The great Argentine footballer, Diego Maradona, is not usually asociated with the Theory of Monetary policy. But his performance against England in June 1986 is... a perfect illustration of my point..... His second goal was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran in virtually a straight line. How can you beat five players by running in a straight line? The answer is that English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.

Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years, the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals."

The bank has of course held interest rates at 4.5% since last August, despite the market thinking first that a rate cut was on the way, and now a rate rise. On Monday 12th June, we saw another Maradona like management of expectations from King when he warned that the prices of imported goods into the UK were starting to rise. On Tuesday we saw an unusual intervention from Gordon Brown echoing King's comments, when he said that the authorities would be "resolute" in fighting inflationary pressures that were emerging across the world.

Global interest rates are rising due to inflationary pressures emerging in the USA and China. But will rates rise here? Real interest rates (the base rate less headline CPI) in Britain are the highest in the developed world with the exception of Australia and New Zealand. The £ is strong, which should help contain "imported inflation", unemployment has crept up to 5.3% from it's 40-year low last year, so labour supply is not tight, and above all, the Treasury is embarking on tightening fiscal policy, which should slow the contribution of the public sector to the economy. I think the bank will want to keep rates will be on hold all year, and the statements from the governor and the chancellor are designed to talk the consuming public to rein in their spending so that inflationary pressures are contained without the need for a rate rise.

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