Economic Commentary: New regime allows base rate cuts
Monday 12 October 1992
When the details of the Treasury's new monetary framework eventually emerged last Thursday, City economists dutifully appeared on screen to pronounce themselves 'disappointed' with the outcome. (The markets, incidentally, ignored this and rose anyway.)
But what on earth did the analysts think could be found deep within the interstices of the Treasury computer to dazzle the Chancellor's expectant public? Surely no one still believes that the immense economic and political difficulties involved in setting monetary policy can be solved simply by selecting the 'right' monetary target.
There is, in fact, a finite limit to the number of macro-economic policy variations available to any Chancellor, just as there is a finite limit to the number of flavours of Haagen Dazs ice cream. When all have been tried, there is no choice but to return to an earlier favourite. And that is what the Treasury has done. The new policy framework is all but identical to that in operation from the mid-1980s until sterling joined the exchange rate mechanism in 1990 - not, as it happens, a notably happy period for monetary management.
There are only two minor novelties in the new monetary framework. First, inflation is officially promoted for the first time to target status. Second, asset prices (especially house prices) will be used as an important indicator of monetary conditions. Otherwise, we are treated to the same mix - a not-quite-target for the exchange rate, an official objective for M0 and a 'monitoring range' for M4 - that we had for much of the 1980s.
What about the two novelties? At first sight it might seem obvious that inflation should be formally targeted, since a low rate of inflation officially remains the only objective of the Government's monetary policy. So why not cut out the middle man? But the trouble is that targeting the inflation rate, if applied literally, absolutely guarantees that monetary policy will be inappropriate for most of the time. This is because interest rates affect economic activity with a one to two-year lag, with changes in inflation lagging a further one to two years behind activity.
Therefore setting interest rate policy by reference to published inflation figures guarantees that policy will always be running two to four years behind events. In fact, if the Treasury were to act like this (which it will not), then policy could only conceivably be appropriate by changing so far behind the last economic cycle that it happens to be in the right place for the next one. This is rather like a lapped middle distance runner who happens to be in the finishing straight at the same time as the winner.
There is always a tendency for governments to over-react to the most recent inflation figures when setting monetary policy, and this is one of the prime causes of stop-go in the economy. For example, if base rates had not been held for so long at 15 per cent while inflation was rising to 11 per cent in 1990, the current recession would have been much less painful.
Indeed, this - and the earlier failure to raise interest rates in 1985-88 because inflation was falling - was the chief instigator of both the boom and the recession. The ERM, by comparison, was a bit player in the tragedy.
Of course, the Treasury knows all this. What it actually intends to use is a series of indicators (including one crucial variable strangely unmentioned in the official documentation - the seat of the Treasury's pants) to judge whether inflation will be broadly on a rising trend, or broadly on a falling trend in the next couple of years, and will then attempt to lean monetary policy in the opposite direction. It will be as straightforward, pragmatic - and difficult - as that. But one malign aspect of inflation targetry is that it will be even more difficult than before to ignore current inflation figures when operating this sensible process.
The asset price or house price target will work the other way for two good reasons. The first is that it is quite clear that they have an important effect on consumer spending and therefore on economic activity. This works through several routes that are now very familiar - the impact of rising wealth on consumer confidence, the potential for 'equity withdrawal' from the housing market, and the link between housing activity and consumer durable sales. Second, house prices seem to have an important impact on wage settlements as workers seek to compensate through the pay packet for changes in their dwelling costs.
The graph shows how asset prices (defined as a weighted average of housing, equity and bond prices) have behaved relative to the prices of goods and services (the GDP deflator) in the past 25 years. Asset prices are generally more volatile than the GDP deflator, and do not always move in advance of it, but by and large they seem to give the right signals about monetary conditions. This was especially true in the late 1980s, when the asset price 'bubble' was of quite unprecedented magnitude. The bad news is that this bubble is so far only about half-eradicated from the system, which is not very encouraging for housing or equity prices. The good news, though, is that the Government can respond to this problem by cutting base rates, at least for as long as we remain outside the ERM.
Nevertheless, the Chancellor's television appearances last week suggested that he will back the 'slow and steady' line being urged by his senior Treasury officials, rather than going for broke with a rapid three or four-point cut in base rates. In the end, the decision comes down to how much weight should be given to the exchange rate as against the monetary aggregates and asset prices in the new policy regime.
My current impression is that Treasury officials are adjusting only reluctantly to life outside the ERM, so for a time policy may give rather too much weight to the exchange rate. If so, the consequence would be that base rate cuts are more likely to be too slow than too fast.
However, with German interest rates now clearly on a downward path, even the most cautious of government officials would probably concede that 7 per cent base rates look a good bet within six months.
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