A small cut towards achieving credibility

Last week's base rate cut has been given an unequivocal thumbs down by the financial markets. The Chancellor will now have to hold base rates higher than otherwise would have been necessary for some time to compensate for this jolt to the credibility of counter-inflation policy.

The graph shows how the gilts market reacted to the base rate cut. The main part of the graph unscrambles the yield curve to estimate the market's implied forecast of likely 12-month interest rates at various years in the future.

The rise in expected interest rates throughout the medium-term future is obvious. And the smaller inset graph shows why interest rate expectations have risen since the Chancellor cut base rates by a quarter of a point. It is because the market is now taking a more pessimistic view of inflation prospects for many years ahead than it did before.

The inset graph shows the gap between yields on conventional and index-linked gilts, which is a rough-and-ready measure of the market's inflation expectation. The setback in the past few days represents the most significant worsening in inflation expectations since sterling left the exchange rate mechanism in September 1992.

The financial markets are, of course, mercurial beasts and the Chancellor might well be tempted to see this as an over-reaction to what was, after all, only a quarter- point cut in base rates. He may well be asking himself: 'So what?'

But the reason for concern is that the world's financial markets are still assessing the reliability of the new monetary control mechanism that was invented after the ERM collapsed.

The quarter-point base rate cut was not important in itself, but because it told the markets something about that mechanism and the people who are running it. In short, it suggested that monetary policy may not lean in quite such an austere direction as the authorities' rhetoric has implied.

This was emphasised by the Bank of England's inflation report, published the same day as the base rate cut was announced. 'Monetary policy,' says the Bank in bald terms, 'is based on an assessment of where inflation is headed some two years hence.'

TARGET RANGE

Straightforward enough, one might suppose. But on the same page as this simple statement is made the Bank publishes its two- year forecast for retail price inflation excluding mortgages - the inflation measure known as RPIX - which the Government says must fall to the bottom half of a 1-4 per cent target range by the end of this Parliament.

The Bank expects this measure of inflation to rise from the current 2.7 per cent to about 3 per cent on average in 1995. It is therefore forecasting that inflation will stay in the top half of its target range for the next two years.

Furthermore, it believes that the risks relative to this forecast are asymmetrical, with more chance that inflation will exceed the central forecast than that it will fall short of it.

The Bank says that a series of factors contribute to this asymmetry. The personal savings ratio could fall further than expected and company stockbuilding could rise more rapidly than forecast, both of which would produce a faster pick-up in demand than anticipated.

In addition, there is a risk that wage bargainers could attempt to recoup the effects of higher taxes by pushing up wage settlements - especially in an environment where inflation expectations have not yet adjusted downwards fully in line with actual inflation.

A further asymmetry, not mentioned by the Bank, is that when inflation is very low it becomes extremely hard to reduce it further. Therefore an upward shock to inflation may have a larger impact on prices than the same shock in the opposite direction.

For all these reasons, a risk- averse Chancellor who was really serious about getting inflation into the bottom half of the target band would not be seeking early opportunities to reduce base rates, unless offset by a significant strengthening in sterling.

The only counter-argument that can be gleaned from the inflation report is that the true underlying rate of inflation will be lower than the Government's target variable in the next couple of years.

This is because RPIX includes the impact of higher indirect taxes, so it will be boosted by about 0.5- 1 per cent over the forecast horizon as the Budget tax increases take effect.

As a result, RPIY - retail prices excluding both mortgages and indirect taxes - is expected by the Bank to hover between 2 and 3 per cent next year.

The trouble with this argument is that the Government set its 1-4 per cent inflation target by reference to RPIX and it cannot now slide on to another definition which temporarily looks more convenient. In any case, it is not clear whether it is appropriate to exclude indirect taxes from the target variable.

If increases in VAT and excise duties are built into wage increases, and if they are accommodated by easier monetary policy, they will become permanent shocks to the inflation rate.

A government that increases VAT, then excludes its effects from the inflation rate and then reduces base rates because the doctored inflation rate is so low is surely running exactly these risks.

All of these points would stand even if the timing of the base rate cut had not coincided so exactly with an intense wave of political problems hitting the Government. Under the new monetary control system the Bank is supposed to determine the precise day of the base rate cut after receiving instructions to go ahead from the Chancellor.

The official line is that the Bank decided several days in advance that the cut should be announced to coincide with the publication of the inflation report.

This raises two questions. First, why was this simultaneity thought to be appropriate, given the fact that the inflation report certainly did not appear to justify the cut?

(In fact, the report was prepared on the assumption that base rates would remain at 5.5 per cent, which suggests that the authors did not know of, or expect, the cut.)

Second, what is the advantage of fixing the exact time of the cut so far in advance? Base rate cuts can be implemented in the UK within minutes of the decision being taken, so there is no need for any premeditation. This can only invite unexpected political events to intervene while the base rate fuse is burning.

(Graph omitted)

THIRD IN A ROW

Two weeks ago this column argued that further base rate cuts would be appropriate if forced by a rising exchange rate.

Stronger sterling, if allowed to persist, would potentially reduce RPIX below the bottom of its target band next year. The only coherent case for the Chancellor's action is that it headed off a damaging and unnecessary rise in sterling.

But this is the third successive cut in base rates that has come with the sterling index trading at around 81-82.

If the Chancellor is not careful, this could start to look like the ceiling of an exchange rate 'target', which is not supposed to be part of policy at all.

At the very least, Mr Clarke should be worried about the political consequences of triggering the Tory right into making more unfavourable comparisons between the present thrust of policy and Lord Lawson's phase of 'Deutschmark shadowing' in 1988.