The package contains almost every element in monetary policy except the one that really matters. The missing X-factor is credibility: who would buy a second-hand inflation forecast from the Treasury? Due to the Government's lack of economic credibility, interest rates and taxes will have to be higher than they would otherwise. Public spending will be lower, and our indebted economy will recover at a snail's pace.
On the face of it, Normanomics could not be more sensible. For the first time, the Government has stated explicitly what level of inflation it will tolerate at what time, rather than fudging a promise of zero inflation. For the rest of this parliament, underlying retail inflation, excluding mortgage rates, should be between 1 and 4 per cent. (The September figure was 4 per cent.) By the next election, inflation should be 'in the lower part of the range', and far lower than the 3.6 per cent that was the last low point in 1986. In the long run, the target is 2 per cent, the same as that of the German Bundesbank. This is not an accident. If we achieved the target, ERM re-entry and monetary union would be easy.
But the problem with inflation is that it is a long time cooking. Today's economic developments, such as our devaluation since 16 September, may only have their full effect on prices in three or four years' time. So the Chancellor needs advance indicators to help him to assess economic conditions and set interest rates: money, the pound and so on.
Mr Lamont will not set a target for the exchange rate, but he will not let it go where it will, either. The test is whether a change in the sterling trade-weighted index, now some 10 per cent below last year's average level after the pound's recovery last week, is likely to jeopardise inflation. The Chancellor will continue to set a target for M0, the narrow measure of the money supply that includes only notes, coins and bankers' cash held at the Bank of England. But he recognises that this provides no more than a guide to current behaviour in the economy, rather than an advance indication of inflation.
Thank heavens the Chancellor also rejected the setting of clear targets for M4, the broad money measure that adds bank and building society accounts to M0. Such broad measures have been distorted throughout the 1980s by changes in the financial system. They have been a poor guide to spending or inflation, failing rudimentary tests of correlation. The Chancellor will, though, consider setting a 'monitoring range' for M4 growth, beyond which there would be 'increasing cause for concern'.
Other leading indicators - such as 'divisia' money, which weights cash and bank accounts according to their likelihood of being spent rather than saved - are regarded as too untried to put into the system of assessment yet. But the Treasury will conduct more work on them. The Chancellor will also look at expectations about inflation, taking into account the various ways in which market interest rates can provide warning signals. He will also add a dash of asset prices to the brew, paying 'particular attention to periods when house prices are falling or accelerating sharply'.
There is, though, a problem. The Chancellor has said nothing about the relative importance to be given to each indicator, which means that he is effectively left with freedom of action. There will almost always be at least one of the indicators in the brew that is behaving itself. Nor can successive Chancellors or their senior advisers boast a proud record of success in foreseeing economic developments in the past.
We have been buffeted by one policy disaster after another: the overvaluation of 1979-81, which wiped out three times as much of our manufacturing industry as this recession; the Lawson-Thatcher boom of 1987-89, which set new records for fiscal and monetary profligacy and left a damaging legacy of personal indebtedness; and now the public (although less damaging) humiliation of our ejection from the ERM.
At the same time, the Government has been less than wholly successful in meeting its inflation objectives. The table shows the inflation projections in each year's budget documents since 1983-4. In six of the last nine years, inflation has been higher than the Government's initial projection. On average, inflation has been 1.6 percentage points higher. The markets will take some persuading that the Treasury's leopards have changed their spots.
How, then, does the Government regain its credibility? ERM membership is clearly one way of doing so. Part of the cost of leaving is summed up in the graph: the Government will have to pay 1 2 percentage point more to borrow long-term money to fund the budget deficit (and refinance maturing debt) than it did before we left the ERM.
That reflects the markets' belief that inflation will now be higher, eroding the value of repayment. Judging by the difference between the returns on inflation-linked and normal bonds, the market expects inflation to average between 4.5 and 5.5 per cent, rather than the Chancellor's 2 per cent. This distrust also infects the foreign exchanges, limiting our ability to cut interest rates without a fall in the pound.
However, the Government is clearly not going to resume our ERM membership until German interest rates come down (and a British recovery is under way, so that UK interest rates can rise). So the Chancellor needs to find another way of persuading the markets that he means what he says. The distrust is not of the use of judgement per se, which is merely the intelligent use of information. The real problem is that the secrecy surrounding that judgement means it can be abused.
Openness about policy would not in itself safeguard the currency from ministerial debauchery, or ensure the Government's economic advisers get things right. But it would mean that the markets could see that policy-makers were grappling fairly with the issues. Any mistakes would be made in the honest pursuit of declared objectives, rather than the dishonest pursuit of secret objectives such as bribing the electorate.
The best solution would be an independent Bank of England, accountable to parliament for the pursuit of low inflation. But a more politically palatable change, half hinted at by the Chancellor, would be a regular review assessing monetary conditions, like the Bundesbank's monthly report.
Without some such change, the Chancellor will have to re-establish his credibility by taking tougher measures to control inflation than are either necessary or wise during a deep recession. Britain could have low inflation and growth more easily if our establishment were prepared to kick the secrecy habit.Reuse content