Clarke wins first skirmish but not the war

"To have overturned the Governor's advice the day after disastrous local election results was to advertise as dramatically as possible that politics still matter for British monetary policy."

The Chancellor and Governor will resume combat on base rates at the monthly monetary meeting on Wednesday, when it is likely that both sides will leave their views unchanged from last time. Given that the Governor's concerns about inflation are essentially long-term in nature, there is little chance that he will have been swayed by the isolated pockets of information pointing to an economic slowdown which have been published since the last meeting.

Likewise, though, the Chancellor will see no reason to change his position. In fact, if he were to allow a base rate rise this month, he would simply be confirming that the veto he played on the day after the local election results was entirely motivated by politics. This he could not, and now need not, do. The evidence published since the last meeting has clearly gone the Chancellor's way, as has the behaviour of the financial markets. This has left the Governor in the trickier tactical position. He will obviously not want to stick to his view on base rates for one moment after it has ceased to be tenable. But if he eventually has to withdraw his advice to raise rates, the Bank's credibility will be dented relative to the Chancellor's. The Governor is therefore facing a nice balancing act, while the Chancellor can afford to relax for a while. But while Mr Clarke has won this skirmish, he will only win the war if the Government hits its inflation objective in two years' time and, separately, if the credibility of the new monetary framework remains intact.

It has been insufficiently recognised that these two points are different. Even if the Chancellor turns out to have been right about the substance of the decision - about which more later - it does not automatically follow that he was justified to take the action he did.

The new monetary framework, which has really been in place only since the monthly monetary minutes started being published last year, could conceivably represent an asset with a rising long-term value. But this will happen only if the financial markets can be fully persuaded that base rate decisions are genuinely removed from political influence.

For this to happen, whenever there is a "finely balanced" decision on base rates (as the Chancellor described it last month), the expectation should be that the Governor's advice should be followed. To have overturned the Governor's advice on the day after disastrous local election results was to advertise as dramatically as possible that politics still matter for British monetary policy, and to show insufficient appreciation of the value of policy credibility.

There are tangible costs to be paid for undermining policy credibility, and these costs can be political as well as economic. The first graph contains a particularly dramatic illustration of this. For most of the Conservatives' period of government, their poll lead over Labour has been quite closely linked with changes in consumer confidence. People have felt good about the Government when they have felt good about the economy.

But this link has broken down dramatically since the autumn of 1992 with Conservatives' opinion poll ratings slumping even though consumer confidence has recovered to quite normal levels. If there has been a "feel-bad" factor, it seems since then to have applied more to the Government than the economy. And of course the crucial date, autumn 1992, was when the Government's policy credibility was shot to pieces by the ERM debacle.

This is an extreme example of the costs to be paid for lost credibility. The present situation is not remotely comparable in degree. Nevertheless, the Chancellor has taken a risk with financial confidence, and the markets will remember this. (As Professor Rudiger Dornbusch once put it, the markets have the heart of a mouse, the legs of a deer and the memory of an elephant.) Of course central bankers make mistakes, and of course chancellors may occasionally get things right when the central bankers get them wrong. But it is motivation that matters. Central bankers have no motivation other than to hit the targets presented to them by the Government - in this case, an inflation target of 1-2.5 per cent by the spring of 1997. Chancellors have other fish to fry.

Some commentators have attacked Eddie George's base rate advice on the grounds that the inflation target is too low, or too narrow, to be optimal. But this is not good enough. If the inflation target is flawed, then it is hardly the Bank's fault - they did not set the target in the first place. To set a target with a fanfare of trumpets, and then deliberately miss it, is the kind of absurdity that has dogged British policy-making far too long. I am not suggesting Ken Clarke is doing this today, but he would be if he followed the advice of some of the opinionated classes.

Enough of that. What about the substance of the decision itself? Is there yet enough evidence of an economic slowdown to justify a change of heart by the Governor? It is doubtful. Surveying the world scene in recent weeks, economic developments have been split into two camps. In the main camp - the Anglo-Saxon economies, led by the US, with Japan and Germany - there have been signs of a setback in economic activity, and interest rate pressures have subsided sharply.

Both Japan and Germany have reduced official interest rates, and the US Federal Reserve is thought likely by some to follow suit in the summer. But in the minor camp - the devaluing countries of Western Europe - activity has not slowed, and Spain and Italy have recently increased official interest rates to combat rising inflation.

It is far from clear how Britain - a devaluing European economy with Anglo-Saxon tinges - fits into this picture. The official data for manufacturing production and retail sales suggest that activity has ground to a complete halt in recent months. But there are great uncertainties surrounding both these series. On manufacturing production, the official government statistics show that output has risen by only 0.5 per cent in the last two quarters, but the CBI survey indicates a rise of 3.2 per cent in the same period, which would imply that real GDP has continued to rise at an annualised rate of around 4 per cent, dangerously above trend. Meanwhile, the official series for retail sales volume has failed to expand at all this year, but these statistics could have been seriously distorted by the National Lottery, which is not included in the data. If all of the lottery expenditure has been deflected from other retail items, the true rate of annualised growth in sales volume this year may have been around 2.5 per cent. A monetary mechanism that was truly risk-averse on inflation, and genuinely committed to the 1-2.5 per cent target range by spring 1997, would be raising interest rates in these circumstances. But unhappily such a monetary mechanism no longer seems to exist in the UK.