ECONOMIC VIEW : Learning to live in the policy spotlight
Thursday 11 May 1995
Blink though it may, the Bank had better get used to the glare of publicity. After last week's decision on interest rates, both current economic policy, which assigns such overriding significance to targetting inflation, and the Bank's own role in helping to achieve this objective are bound to come under more intense and critical scrutiny.
Born from the shambles of Black Wednesday, the inflation target was designed to create a credible replacement for the counter-inflationary defences that had come with membership of the exchange rate mechanism.
In October 1992, Norman Lamont committed the government to a target range for underlying inflation of 1-4 per cent, narrowing to 1-2.5 per cent by the end of the Parliament. Underlying inflation is defined as the annual increase in the retail price index less mortgage interest payments, known as RPIX. It is the government's progress towards that objective which the Bank monitors each quarter in the Inflation Report when it sets out its latest projection for RPIX over the following two years.
So far, this new policy regime has been of more interest to the "teenage scribblers" of the City than to the public at large. Inflation has surprised again and again by coming in lower than expected - a tribute to the disinflationary momentum carried over from Britain's agonies in the ERM.
But now the point of testing is upon us. A maturing economic recovery means that the factors that kept the devaluation of the pound after Black Wednesday from feeding through to inflation are no longer so favourable. Sterling's weakness this year is much more likely to lead to higher prices. Taking the trade-weighted index, sterling closed in London yesterday 6.5 per cent down on the start of the year.
As the risk intensifies of an upsurge in inflation following the fall in the pound, so the merits of low inflation are bound to become more and more controversial. In its new-born role as defender of the counter- inflationary faith, the Bank has done its best to argue the case for stable prices. However, the best that can be said for its advocacy is that the jury is still out.
In the Quarterly Bulletin that accompanies the Inflation Report today, the Bank publishes an article that assesses whether inflation stymies economic growth. On the basis of empirical research across a hundred countries from 1960-1990, Robert Barro, a Harvard Professor, finds that inflation does exact a cost.
However, what impresses is how small the cost is: a 10 per cent increase in inflation apparently brings about a quarter of a per cent reduction in the growth of real income. Furthermore, the statistical fit that Professor Barro finds is dominated by countries where the rate of inflation is between 10-20 per cent. For lower inflation rates, "the relation between growth and inflation is not statistically significant".
More important than this empirical failure to prove the case for low inflation is the clear political failure to make the case. Clapped out cliche though it has become, the lack of the feelgood factor does point to something important: the low inflation of recent years has brought no real cheer for the government. The reality is that a British public that has been spared the worst excesses of inflation this century does not have the same horror of rising prices as, say, the Germans who have lived through two periods of hyperinflation.
The essential case against inflation is that it rips off savers and creditors and brings unearned gains to borrowers and debtors - and thus to the biggest debtor of them all, the government. The erosion of money values leads ultimately to a corrosion of social values.
All this, however, is a far cry from success or failure in keeping inflation within the bounds of a target range set as low as 1-2.5 per cent. That may win the plaudits of the City cognoscenti: it is unlikely to form the basis of an electoral comeback.
Nor will inflation targets per se form a sound foundation for the Bank to achieve genuine independence. Following the clear perception of short- term political interference in the decision on interest rates last Friday, the calls for independence are likely to grow.
However, even if the Bank's antiquated constitution could be reformed and ways found to make it accountable, it will only be able to assume such a powerful role if is validated by the political and social culture at large.
The British public may not be sold one way or the other on the merits of low inflation, but we are all keen to avoid another savage recession. This is something that Eddie George himself quite clearly recognises - hence his defence of pre-emptive interest rate increases along the lines of "a stitch in time saves nine".
There lies the potential basis for an enhanced role for the Bank: in helping to avoid the worst excesses of the exaggerated electoral boom and bust cycle that has so plagued the postwar British economy. The irony is that the Labour Party, with its intention to combine an inflation and growth target could be better placed to give the Bank that firmer basis than a Conservative government which is seen to interfere with the taking of interest rate decisions.
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