Alas, the market is almost certain to be disappointed. It would be very difficult to construct an intellectually credible alternative to the anchor of the ERM, given the failure of the alternative anchors such as monetary targets and the Medium-Term Financial Strategy, without stirring in a large discretionary element: 'trust us to look at all the indicators and do the right thing.' That is hardly credible at the moment, given that no one trusts the Treasury to do anything, nor will until it improves its performance.
But what turns a very difficult task into an impossible one is the continuing commitment to rejoin the ERM at some stage. The proposition that whatever policy is announced is just a second best, a holding operation until the external anchor can be put back in place, inevitably devalues that policy. It is not just that no one in their right mind trusts the Treasury; the Treasury does not trust itself.
The problem is compounded by that silly, silly decision to cut base rates by 1 per cent last week. It was right to ease monetary policy, but a devaluation represents an easing in itself. From an intellectual point of view it would have been far more sensible to wait and see where sterling settled and then make a separate decision about interest rates. From a practical point of view, grabbing a quick base rate fall gave exactly the wrong signal to the market: it said that the Government was only interested in a short-term political gain, and that it was prepared to ignore the advice of the Bank of England not to cut rates at that stage. (The Bank has not given any public indication of its views on this, nor could it; but it is not difficult to work out what it thinks.)
The result of this muddle has been the plunge of sterling against the mark, which continued yesterday. The fall has probably wiped out the chance of any further cuts in base rates this year, and it is even possible (although most people would find the suggestion absurd) that the next base rate change will have to be up, not down. Certainly, no one should look for a floor for rates of below 7.5 per cent this cycle.
The hunt for another discipline until sterling rejoins the ERM (if it ever does) was discussed yesterday at a seminar at Kleinwort Benson. Peter Spencer, the group's chief economist, has developed another measure of money, which functions as an alternative to the tired old M1s, M2s, M3s and M4s. The idea, in a nutshell, is to produce a weighted index of money supply, in rather the same way as weights are used for most other economic indices, like the retail price index.
But what weights? The easy part is weighting the amounts of money held in various forms - a large weight for building society savings, which comprise nearly one third of the broad money stock, a small weight for interest-bearing current accounts at banks.
The harder part is weighting the different forms of money by the likelihood that they will be spent. (Monetarists do not worry about the cash that people intend to keep as savings for that does not feed through into demand: they worry about the money that people are about to spend.) The solution, first proposed in the 1930s by a French economist, Francois Divisia, is to grade the various types of money by the interest that the holder is forgoing by holding it in that form.
An example may make this clearer. Money in cash or on a non-interest-bearing current account carries a high penalty, because it earns nothing. So people only keep money in that form if they are about to spend it. Three-month money on the money markets (for the lucky people who have sufficient funds to get those rates) gets the highest rates, and therefore can count as pure savings. So the Divisia index weights cash by the full 100 per cent, but money on the money markets hardly at all. Building society deposits, which pay a little less than money market deposits, rank in between.
One can fiddle with the index to take into account the number of credit cards in issue and the fact that people only switch accounts to get higher interest rates after a time-lag. Mr Spencer has done this and claims a pretty stable relationship between this measure of money and demand. Its use is that it gives an early warning of shifts in demand, which is one of the key things which the money supply figures are supposed to do.
Come the Mansion House speech, the Chancellor (be he Norman Lamont or someone else) will have to reinstate the basis for monetary policy. If he is wise, he will give the markets as much meat as possible to chew on. There will have to be an explicit target for underlying inflation, perhaps with a target range for both wholesale and retail prices. It would be helpful for there to be an understanding of the expected movement in house prices. There should certainly be a target range for the exchange rate, measured on the sterling index, although given the blood on the floor of the Bank of England's trading room, maybe that would be one range that should not be published. Let the market work it out for itself.
Further, there will have to be an indication that fiscal policy will be tightened in the next Budget. The details will come in the Autumn Statement, but a sneak preview of the order of magnitude of the PSBR would be very helpful.
But when all this is done, monetary targets have to be restated. These have to be explicit, for the idea that the Chancellor, the Treasury and the Bank can be left to make wise judgements is simply not credible. It is harsh and to some extent unfair, but the financial markets think the people who make these judgements are complete dopes. Aside from targeting broad and narrow money, the authorities should seriously think about publishing other measures of money, which should include a Divisia index on the lines noted above. This is not a holy grail; it is just one more tool to help get policy back on to some sort of sensible track.Reuse content