Economic Commentary: New regime allows base rate cuts

There was something distinctly puerile about the gigantic media build-up to the 'new' economic policy that the Chancellor unveiled last week. On almost every news bulletin for a fortnight we were informed that there existed a 'vacuum' at the heart of economic policy, and that the Chancellor's political future depended on his filling it, in double quick time, to the satisfaction of the financial markets.

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.

(Graph omitted)

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Telesales Executive - OTE £25,000

£13000 - £25000 per annum: Recruitment Genius: Would you like to be part of a ...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + competitive: SThree: Are you passionate about sale...

Ashdown Group: Graduate Developer (Trainee) - City, London

£25000 per annum + benefits: Ashdown Group: A large financial services company...

Ashdown Group: Marketing Assistant - Financial Services Sector - London

£20400 per annum: Ashdown Group: An established and highly reputable organisat...

Day In a Page

The Silk Roads that trace civilisation: Long before the West rose to power, Asian pathways were connecting peoples and places

The Silk Roads that trace civilisation

Long before the West rose to power, Asian pathways were connecting peoples and places
House of Lords: Outcry as donors, fixers and MPs caught up in expenses scandal are ennobled

The honours that shame Britain

Outcry as donors, fixers and MPs caught up in expenses scandal are ennobled
When it comes to street harassment, we need to talk about race

'When it comes to street harassment, we need to talk about race'

Why are black men living the stereotypes and why are we letting them get away with it?
International Tap Festival: Forget Fred Astaire and Ginger Rogers - this dancing is improvised, spontaneous and rhythmic

International Tap Festival comes to the UK

Forget Fred Astaire and Ginger Rogers - this dancing is improvised, spontaneous and rhythmic
War with Isis: Is Turkey's buffer zone in Syria a matter of self-defence – or just anti-Kurd?

Turkey's buffer zone in Syria: self-defence – or just anti-Kurd?

Ankara accused of exacerbating racial division by allowing Turkmen minority to cross the border
Doris Lessing: Acclaimed novelist was kept under MI5 observation for 18 years, newly released papers show

'A subversive brothel keeper and Communist'

Acclaimed novelist Doris Lessing was kept under MI5 observation for 18 years, newly released papers show
Big Blue Live: BBC's Springwatch offshoot swaps back gardens for California's Monterey Bay

BBC heads to the Californian coast

The Big Blue Live crew is preparing for the first of three episodes on Sunday night, filming from boats, planes and an aquarium studio
Austin Bidwell: The Victorian fraudster who shook the Bank of England with the most daring forgery the world had known

Victorian fraudster who shook the Bank of England

Conman Austin Bidwell. was a heartless cad who carried out the most daring forgery the world had known
Car hacking scandal: Security designed to stop thieves hot-wiring almost every modern motor has been cracked

Car hacking scandal

Security designed to stop thieves hot-wiring almost every modern motor has been cracked
10 best placemats

Take your seat: 10 best placemats

Protect your table and dine in style with a bold new accessory
Ashes 2015: Alastair Cook not the only one to be caught in The Oval mindwarp

Cook not the only one to be caught in The Oval mindwarp

Aussie skipper Michael Clarke was lured into believing that what we witnessed at Edgbaston and Trent Bridge would continue in London, says Kevin Garside
Can Rafael Benitez get the best out of Gareth Bale at Real Madrid?

Can Benitez get the best out of Bale?

Back at the club he watched as a boy, the pressure is on Benitez to find a winning blend from Real's multiple talents. As La Liga begins, Pete Jenson asks if it will be enough to stop Barcelona
Athletics World Championships 2015: Beijing witnesses new stage in the Jessica Ennis-Hill and Katarina Johnson-Thompson heptathlon rivalry

Beijing witnesses new stage in the Jess and Kat rivalry

The last time the two British heptathletes competed, Ennis-Hill was on the way to Olympic gold and Johnson-Thompson was just a promising teenager. But a lot has happened in the following three years
Jeremy Corbyn: Joining a shrewd operator desperate for power as he visits the North East

Jeremy Corbyn interview: A shrewd operator desperate for power

His radical anti-austerity agenda has caught the imagination of the left and politically disaffected and set a staid Labour leadership election alight
Isis executes Palmyra antiquities chief: Defender of ancient city's past was killed for protecting its future

Isis executes Palmyra antiquities chief

Robert Fisk on the defender of the ancient city's past who was killed for protecting its future