Economics: Tasting blood at the Bank

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THE BANK of England last week used its quarterly Inflation Report to savage the Chancellor of the Exchequer for cutting interest rates in February against its advice. Kenneth Clarke has reason to be nervous; the Bank has tasted blood and may be back for more.

The whole point of asking the Bank for a quarterly report is for it to criticise chancellors for decisions that take risks with inflation. The Bank has clearly taken this task to heart, but in the long term its warnings - even if well justified - could do the fight against inflation more harm than good.

The problem is that expectations of higher inflation are often self-fulfilling. If people think prices are going to rise more rapidly, they try to compensate by demanding bigger pay rises. This increases their employers' costs, squeezing their profits and compelling them to raise their prices. If employees compensate again, a wage / price spiral gets under way.

So when the Bank warns that the Government is taking risks with inflation, as it did last week, it may exacerbate the very problem it is supposed to guard against by fuelling inflationary expectations.

Even so, it is still in the Bank's interest to take a consistently hawkish line. Norman Lamont and Kenneth Clarke have pushed the Bank a long way on the road towards independent control over interest rates and, unsurprisingly, it is keen to complete the journey. It can best do this by depicting its current political masters as incurable inflation junkies from whom control over interest rates should swiftly be removed.

Last week's Inflation Report was part of this process. It avoided a personal attack, but was none the less a stinging rebuke to Mr Clarke for pushing though February's cut. The Bank said that although it was more optimistic that inflation would stay low for the rest of the year, it was more worried about it rising thereafter. Crucially, it hinted that the Government was not on course to meet its target for underlying inflation of 1 to 2.5 per cent at the end of this Parliament.

But was the Bank merely acting tough to enhance its reputation? After all, it has been too gloomy about short-term inflation trends in four of its five reports so far. This may have done as much to stir up inflationary expectations as any foibles of Mr Clarke.

We know from the minutes of February's meeting to discuss interest rates that the Bank's Governor, Eddie George, 'strongly advised against' any cut in interest rates and only accepted the quarter-point move on 8 February with great reluctance. He said there was no evidence that tax increases would significantly slow the recovery and that 'to cut rates now in advance of this evidence would run a risk of higher inflation and some loss of credibility'.

His message in the Inflation Report was simple: 'I told you so.' The Bank said the decision to cut rates in February had made independent forecasters, the financial markets and its own contacts in industry less convinced the Government was serious about keeping inflation down. It argued that rising inflationary expectations were already infecting the process of pay negotiation, threatening a vicious circle of higher earnings growth and inflation which might have to be punctured by an interest rate rise.

'The credibility of the medium-term target has proved fragile', the Bank said. 'If it is not restored, and people's behaviour is based on higher inflation expectations, then containing inflationary pressures will be more difficult.'

The thrust of the Bank's criticism of Mr Clarke was perfectly justified; both February's cut and the text of the minutes show that he is instinctively too keen to keep rates down. But at the same time the Bank exaggerated the weight of evidence in support of its view, sometimes in rather implausible ways. This does not bode well.

The Bank's main evidence for the damage of the rate cut was its impact on the gilts market. The yield on the 10-year benchmark gilt rose from around 6.6 per cent before the base rate cut to nearly 8.5 per cent by the end of April.

The Bank said that the markets had become both more pessimistic and more uncertain about future inflation prospects. By comparing the yields on conventional and inflation-proofed stocks, the graphic shows how the inflation forecasts in the gilts market have changed.

Before the rate cut the market was predicting 4 per cent inflation in 1998, well above the 1 to 2.5 per cent target for the end of the Parliament in early 1997. By the beginning of this month that forecast had risen to over 6 per cent, although this also reflects greater market volatility. This was a more dramatic shift than seen in most overseas bond markets.

The Bank blamed the magnitude of this change of heart both on February's rate cut and John Major's political problems, which in the long term may mean a new government - or at least a new Tory leader - and a less robust approach to the inflation fight.

But the change in sentiment on inflation may not have owed quite as much to Mr Clarke as the Bank suggested. The Bank admitted it was part of a global correction to the unjustified boom in bond prices late last year, but as gilts did better than most other bonds during the upswing, it was natural they should worsen during the reversal.

The US Federal Reserve also raised its interest rates just days before British rates fell, leaving many dealers to conclude that with the United States a year further down the road to recovery, British rates might also have to rise within a matter of months as a natural result of the cycle. Expected exchange rate movements also had an impact: the belief that the dollar was set to rise deterred many USinvestors from buying gilts for fear of losing money when they sold them again for dollars.

The Bank also argued that the rise in average earnings growth since the autumn could be a bad omen for inflation, as it was faster and earlier than expected. It went on to warn that earnings growth might have been boosted by growing concern over the Government's anti-inflationary resolve. But this smacks of the Bank putting the boot in unnecessarily; the mechanics of wage negotiation suggest that the upturn in the inflation rate since last autumn is a much more likely culprit.

Barclays Bank provides further evidence for this view with its latest quarterly survey of inflation expectations. This found that the general public had become more pessimistic about inflation a year in advance for the first time since 1990, other than in the immediate aftermath of Black Wednesday. As the graphic shows, this coincided with a sharp uptick in the published headline rate.

But the Bank is right to argue that the performance of the labour market is crucial to Britain's long-term inflation prospects, as the chain between wages, company costs and prices is the most important mechanism through which inflationary pressure builds up. Inflation may, in the words of Milton Friedman, 'always and everywhere be a monetary phenomenon', but only in that it is always possible to squeeze inflation out of the labour market by raising interest rates sufficiently to cripple the economy.

The Department of Employment will publish average earnings figures for March on Wednesday this week. Most economists expect them to show earnings growth unchanged at an underlying 3.5 per cent a year, but another rise is quite possible and would give inflation fears extra momentum.

There are even signs that some employers, such as Massey Ferguson the tractor-maker, are conceding higher pay settlements explicitly to compensate their employees for the tax increases announced last year, which will add to the pressure.

There are good reasons to expect earnings growth to pick up steadily if slowly through the rest of the year, reinforcing inflationary pressure. Last week's revisions to the 1993 trade figures suggest that the recovery may have been accelerating more dramatically through last year than the gross domestic product figures currently show. This could impart significant momentum to the labour market.

So if Mr Clarke is serious about keeping to his inflation target, interest rates may have to rise more quickly than markets expect. The fact that the Bank will be seizing gleefully on every piece of bad news will only make things worse.

(Graphs omitted)

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