Stephen King: Lessons from history cast doubt on fine-tuning

I wonder whether the fine-tuning of interest rates is achieving very much

I've recently been reading a superb account of Britain's history from Suez to the Beatles. Entitled Never Had It So Good, Dominic Sandbrook's book offers all sorts of interesting views about an extraordinary period of British history.

For those with an artistic bent, the sections covering John Osborne and the other angry young men will doubtless appeal, but for me, the description of Peter Thorneycroft's resignation from the Cabinet held a certain fascination.

In 1957, Thorneycroft was Harold Macmillan's Chancellor of the Exchequer. Unlike Macmillan, Thorneycroft was a fiscal and monetary conservative, a man who saw inflation lurking around each and every corner. He was egged on by a relatively young Enoch Powell who, at the time, was Financial Secretary to the Treasury.

Whereas Thorneycroft and Powell feared inflation, Macmillan and the vast majority of his cabinet colleagues feared stagnation and rising unemployment. Thorneycroft's attempts to control public spending were met by deaf ears in the Cabinet. In response, the Treasury team - Thorneycroft, Powell and Nigel Birch, the Economic Secretary - chose (or were in effect forced) to resign. Expansionary policies were the order of the day.

Who was right? As it turned out, earlier attempts to deliver a degree of austerity were already succeeding. Thorneycroft's - and Powell's - fears of excessive inflation were unjustified. Inflation faded rather quickly and, by 1959, was less than 1 per cent - the lowest rate in the post-war period. Thorneycroft's resignation can, therefore, be attributed to inaccurate predictions as much as to differences in values.

The 1950s and 1960s were, of course, the period of so-called "stop-go" policies. A bit too much growth one year threatened too high an inflation rate or a balance of payments crisis the following year, so the brakes were slammed on. A lack of growth one year threatened rising unemployment the following year, so a foot went on the economic accelerator. This "fine tuning" occurred because policymakers at the time believed that it was up to them to deliver full employment and that they were always able to regulate the economy appropriately.

These days, policymakers no longer believe they should be targeting employment. Instead, they want to achieve low and stable inflation. The methods they use to achieve this goal are, though, looking increasingly like the techniques last pursued in the 1950s and 1960s. At the beginning of 2005, some members of the Bank of England's Monetary Policy Committee (MPC) were aching to raise interest rates. Later that year, interest rates were cut. At the beginning of last year, some members were rather keen on cutting interest rates. Summer arrived and interest rates went up. These changes of direction suggest that "fine tuning" is back.

Of course, these days politics is less important. Whereas Thorneycroft and Macmillan were engaged in something of a philosophical debate about the state's role in the conduct of economic policy - Thorneycroft favouring sound money to allow private enterprise to flourish and Macmillan favouring Keynesian demand management - the MPC is faced with a simpler technical issue. The Bank of England's only job is to deliver price stability.

Nevertheless, there is still an issue of judgement. The unemployment rate has traditionally been used as a gauge of inflationary pressures. If unemployment is low, there's a danger wages rise rather too quickly, triggering a period of elevated inflation. Equally, if unemployment is too high, there's a danger of persistent inflationary undershoots.

There are two problems with this approach. First, the level of unemployment consistent with ongoing price stability may be constantly changing. A few years ago, unemployment at today's levels would have been regarded as a clear indication of mounting inflationary pressures yet, for the most part, inflation has been well behaved. With more and more over-55s returning to the workforce and with a seemingly endless supply of additional workers coming from central and eastern Europe, the relationship between the unemployment rate and wage increases appears to have weakened.

Second, even if unemployment diverges from its so-called "natural rate", the inflationary impact is hard to predict.

To see why, I've plotted UK inflation rates against unemployment rates over three separate periods since the 1950s (drawing so-called Phillips curves). The Thorneycroft/Macmillan/Powell debate took place in the first period. The second period marked the arrival of stagflation. The final period begins in the early 1990s, when the then-Conservative government first employed inflation targeting.

The trade-off between unemployment and inflation is very different across the three periods. In the early days, unemployment did not move around very much but inflation was rather variable. In the 1970s and 1980s, unemployment and inflation rose a long way. Inflation was eventually brought to heel but only through even bigger increases in unemployment. More recently, unemployment has come down a long way with no significant change in the inflation rate whatsoever.

This latest development is a cause for celebration. The Bank of England, though, seems rather ambivalent about it. Obviously, lower unemployment for a given rate of inflation is good news. The Bank worries, though, about the implications of an unexpected rise in inflationary pressures. Putting the chart into "reverse", how far would unemployment have to rise to bring inflation back under control? Taken literally, the chart seems to indicate the need for an almost infinite increase in unemployment. Thus any slight pick-up in inflation has to be brought under control as quickly as possible to avoid the "infinite unemployment" outcome.

I'm not sure this is right. We may simply be returning to the conditions last seen in the 1950s and 1960s, when the relationship between inflation and unemployment was not particularly close. Inflation will surprise from time to time, but it will surprise in both directions. Take a world in which inflation in any one year is determined only in part by domestic monetary conditions. Assume that inflation is also influenced by the rather unpredictable effects of globalisation on wages and commodity prices. It is likely that, under these conditions, inflation will tend to bob up and down, a little too high in some years but a little too low in others.

Arguably, the central bank really should not worry about these oscillations. If price movements are influenced by events beyond the Bank of England's control, there's little reason to react unless the central bank believes a failure to react will ignite a sudden shift in the public's inflation expectations.

So far, inflation expectations have been remarkably stable. Maybe that's a tribute to the Bank's occasional tinkerings with interest rates, raising them when inflation looks a bit uppity and lowering them when inflationary pressures seem to be abating. I wonder, though, whether this fine tuning really is achieving very much.

Perhaps, instead, the Bank should be prepared more frequently to write a letter to the Chancellor explaining why a bit of extra volatility in inflation is no bad thing from one year to the next, given the varied and unpredictable effects stemming from globalisation.

Indeed, there is a good chance that Mervyn King, the Bank of England's governor, will be doing just that over the next few months should inflation pop up above 3 per cent. By that stage, Gordon Brown may, of course, have moved next door. Unlike Macmillan, though, at least he will not have to think about reappointing Enoch Powell. As Sandbrook notes, Macmillan rearranged the seats around the cabinet table when Powell became the Minister of Health in 1960 because "I can't stand those mad eyes staring at me a moment longer".

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com