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?
Independent Dating
and  

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

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Sales Assistant / Buyer

£15000 - £17000 per annum: Recruitment Genius: This company offers a range of ...

Recruitment Genius: Customer Service Advisor

£15000 - £16000 per annum: Recruitment Genius: Customer Service Advisors are r...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45K: SThree: SThree were established in 1986....

Recruitment Genius: Compliance Manager

£40000 - £60000 per annum: Recruitment Genius: A Compliance Manager is require...

Day In a Page

Greece debt crisis: What happened to democracy when it’s a case of 'Vote Yes or else'?

'The economic collapse has happened. What is at risk now is democracy...'

If it doesn’t work in Europe, how is it supposed to work in India or the Middle East, asks Robert Fisk
The science of swearing: What lies behind the use of four-letter words?

The science of swearing

What lies behind the use of four-letter words?
The Real Stories of Migrant Britain: Clive fled from Zimbabwe - now it won't have him back

The Real Stories of Migrant Britain

Clive fled from Zimbabwe - now it won’t have him back
Africa on the menu: Three foodie friends want to popularise dishes from the continent

Africa on the menu

Three foodie friends want to popularise dishes from the hot new continent
Donna Karan is stepping down after 30 years - so who will fill the DKNY creator's boots?

Who will fill Donna Karan's boots?

The designer is stepping down as Chief Designer of DKNY after 30 years. Alexander Fury looks back at the career of 'America's Chanel'
10 best statement lightbulbs

10 best statement lightbulbs

Dare to bare with some out-of-the-ordinary illumination
Wimbledon 2015: Heather Watson - 'I had Serena's poster on my wall – now I'm playing her'

Heather Watson: 'I had Serena's poster on my wall – now I'm playing her'

Briton pumped up for dream meeting with world No 1
Wimbledon 2015: Nick Bollettieri - It's time for big John Isner to produce the goods to go with his thumping serve

Nick Bollettieri's Wimbledon Files

It's time for big John Isner to produce the goods to go with his thumping serve
Dustin Brown: Who is the tennis player who knocked Rafael Nadal out of Wimbeldon 2015?

Dustin Brown

Who is the German player that knocked Nadal out of Wimbeldon 2015?
Ashes 2015: Damien Martyn - 'England are fired up again, just like in 2005...'

Damien Martyn: 'England are fired up again, just like in 2005...'

Australian veteran of that Ashes series, believes the hosts' may become unstoppable if they win the first Test
Tour de France 2015: Twins Simon and Adam Yates have a mountain to climb during Tour of duty

Twins have a mountain to climb during Tour of duty

Yates brothers will target the steepest sections in bid to win a stage in France
John Palmer: 'Goldfinger' of British crime was murdered, say police

Murder of the Brink’s-MAT mastermind

'Goldfinger' of British crime's life ended in a blaze of bullets, say police
Forget little green men - aliens will look like humans, says Cambridge University evolution expert

Forget little green men

Leading evolutionary biologist says aliens will look like humans
The Real Stories of Migrant Britain: An Algerian scientist adjusts to life working in a kebab shop

The Real Stories of Migrant Britain

An Algerian scientist struggles to adjust to her new life working in a Scottish kebab shop
Bodyworlds museum: Dr Gunther von Hagens has battled legal threats, Parkinson's disease, and the threat of bankruptcy

Dying dream of Doctor Death

Dr Gunther von Hagens has battled legal threats, Parkinson's disease, and the threat of bankruptcy