Tunnel visionaries miss targets

Inflation targets are de rigueur. Like a fashion accessory, they have been adopted by governments to demonstrate their commitment to price stability. Britain, Finland, Spain, Sweden, Canada, Australia, New Zealand, Israel and Brazil all have one, and it is tempting to conclude they alone are responsible for the slow pace of price increases in recent years. But history is strewn with examples of policy rules which have failed to live up to their billing.

While Britain's experiment with an inflation target has helped anchor price expectations after sterling's forced exit from the exchange rate mechanism in 1992, success in keeping price pressures at bay may also be due to structural forces such as technological change, more flexible labour markets and excessive global supply over which monetary policy has little control.

It may be a heresy in the self-congratulatory mood among policymakers, but the coexistence of inflation targets and low inflation may be no more than coincidental. It is worth asking whether central banks - such as the Bank of England, which holds its monthly meeting on Wednesday and Thursday - are right to continue inflation targeting as a strategy to avoid economic instability.

Some economists believe it might be better to focus on asset prices - which, when they boom and bust, have a huge capacity to wreak havoc on an economy.

It is true excessive asset price rises eventually spill over into the general rate of price increases and are therefore already monitored among a range of factors as a lead indicator of inflation.

But asset price bubbles are notoriously difficult to spot in advance. It is quite possible for one to arise during a prolonged period of subdued inflation, well beyond the normal two-year horizon on which central banks tend to base their inflation forecasts and monetary policy decisions.

The temptation is to wait for firm evidence of a rise in general inflation before putting up interest rates. But by that time consumers and businesses have already geared up to the hilt, and are very vulnerable to a market correction. Like big game hunters waiting to see the whites of a prey's eyes before they pull the trigger, central bankers can take a mauling.

Take Japan, for instance, still living with the consequences of the asset price bubble in the late 1980s. There, the central bank wrongly concentrated on inflation while land, property and stock prices soared. "Interest rates followed inflation and eventually burst the asset price bubble, but by then the damage was done," says Keith Wade, chief economist of merchant bank Schroders.

There are more contemporary illustrations of the phenomenon. Alan Greenspan, chairman of the United States Federal Reserve, has repeatedly warned to no effect about "irrational exuberance" in the stock market. But it is only now - eight years into an upswing when tentative signs of inflation are emerging - that he has begun to take some of the heat out of the economy by raising interest rates.

The danger is that he has left it too late and that subsequent increases in borrowing costs will trigger a Wall Street collapse once the markets accept the economy cannot grow indefinitely. Clearly, if equities fell sharply consumer spending would weaken substantially, given the record amount of wealth tied up in the stock market, threatening to send the US into recession. The sole consolation is that the drop in equity prices would have to be huge to wipe out all past gains.

Ireland is another country in which booming asset prices - in this case housing - have coexisted with low or stable inflation for some time. But, having surrendered control of monetary policy to Frankfurt, Dublin's central bank is powerless to act - apart from warning mortgage lenders not to be too free with their money. Its concern is that borrowers are overextended, leaving household finances exposed to a severe bout of negative equity if sentiment takes a turn for the worse.

If an asset price problem arises during the next few years in the UK, it will al most certainly be in housing, a traditional source of instability. Signs of an improving market abound, with prices rising at an annualised rate of 17.4% in the past three months, according to the Halifax index.

There is no need - just yet - to be unduly concerned. Goldman Sachs's David Walton pointed out in a recent note that house prices in real terms are still 25% below the 1989 peak, and remain low in relation to earnings. Housing turnover is 25% below the average recorded between 1986 and 1989.

But there is plenty of scope for the market to heat up, given high level of consumer confidence, rapid growth in real take-home pay and low interest rates. Moreover, there is potential for a sharp increases in "equity withdrawal" - that is, borrowing against the rising value of a property.

In themselves rising house prices have little impact on consumption at the macroeconomic level. "The housing market is largely a zero-sum game - for each seller there must be a buyer," says Mr Walton. "Home owners can realise their gains from higher house prices if they trade down. However, for each person trading down there must be another trading up. The gainers are matched by losers. Thus, the aggregate effects on consumption of a change in prices are likely to be quite small."

However, once home owners start releasing equity from their properties, as they are doing now, the scope for faster consumption and inflation can be quite considerable.

Mr Walton says equity withdrawal was £2.8bn in the first quarter of 1999, up from £0.6bn a year ago, which may account for the entire 1.4% real rise in consumer spending in the first quarter.

"If equity withdrawal increased to those of late 1980s and all the money released went on consumption, spending would receive a boost of around 5%. This would represent a very significant stimulus to economic activity," he said.

That is the worst-case scenario, and probably some way off. Although the bias of the housing market recovery may be clear its magnitude is not. The economy has only just begun growing again and unemployment may rise a little in coming months, taking some of the wind out of the housing market's sails. Wall Street could crash, with repercussions around the world.

Assuming no mishaps, however, house price inflation will be one of the key indicators over the next year or so. Inflation is heading downwards, further below the government's 2.5% target - at least in the short term - thanks to the delayed impact of the strength of the pound. Underlying improvements in the economy's performance mean it could stay there.

But subdued inflation will not necessarily be an excuse for lack of action from the MPC. The bigger picture may require a response, even when the inflation target is within reach.