ECONOMICVIEW : Flexibility or credibility - that's the monetary policy question

Click to follow
The Independent Online
Last week's cut in base rates turned out to herald pre-Christmas reductions in the cost of borrowing in Europe and the US. But the decision to kick off here revealed exactly what is wrong with British economic policy. It is what has always been wrong with it - the inability to resist the temptation to meddle.

Fine-tuning, as economists prefer to call it, has been the source of most of our past mistakes in economic policy. We are making the same mistakes again - although thanks to Kenneth Clarke's lucky streak, we are making them in a sunnier economic climate of low inflation and reasonable growth.

The result will be the same lacklustre performance as in the past. Britain will continue to suffer a chronically sinking currency, higher average inflation and lower and more variable growth than our main competitors. As the table shows, our relative economic performance is dismal, even including the peak of the most recent recovery.

British politicians over the decades have failed to stick to hands-off policies even when they proclaimed the importance of doing so. Monetarism was tried and abandoned. Membership of the ERM lasted just less than two years, and ended in ignominy. The rules of engagement the Government brought in to restore the credibility of economic policy after that episode are now also falling into tatters.

The rules are that the Chancellor and Governor of the Bank of England discuss a range of indicators at their meeting every month, the Chancellor reaches a decision about interest rates after the meeting, and the minutes are published six weeks later.

The aim of policy is to keep underlying inflation within a 1-4 per cent range and less than 2.5 per cent on average over a two-year horizon.

Three types of indicator of inflation two years hence are considered: indicators of financial conditions, the real economy, and costs. The real economy has certainly slowed - although most forecasters predict that it will pick up again. Inflation itself remains low, although above target.

Almost all the other indicators are buoyant - especially the monetary ones, the bell-wether of policy a decade ago. New figures published yesterday showed bank and building society lending growing by more than 8 per cent year-on-year, while broad money growth popped above the top of its target range.

The evidence on inflation prospects is therefore mixed. Mr Clarke admitted as much by cutting only a quarter point from base rates yesterday. It is not just one or two indicators that are misbehaving, but about half of the list.

It is difficult to imagine that the German Bundesbank would be in a rush to cut interest rates in these circumstances. The trouble is - as two researchers at the Institute for Public Policy Research point out in a recent book* - that the Chancellor bases policy on an estimate of what inflation will be in the future. This lets fine-tuning in by the back door. Having to use a forecast makes setting interest rates entirely a question of judgement; Mr Clarke's guess about inflation in two years' time is as good as anybody's.

As the authors, Gerald Holtham and Dan Corry, put it, the problem with the current inflation target is its "futuristic" interpretation. "The Government could ignore current inflation as irrelevant to its purposes and, since anyone can forecast what they like, set current policy how it likes."

Making monetary policy a matter of judgement - and a politician's judgement at that - brings its problems. Sometimes it does make sense for the Government to react flexibly to changes in the pace of economic growth or in the external environment, when sticking to a policy rule would prevent it. Sometimes flexibility and judgement do lead to a better outcome for the economy.

But generally leaving policy-makers free to exercise their judgement leads to the steady upward drift of inflation, as at any time there seems no harm in a small increase in inflation from where it is now. There is a trade-off between the flexibility to adjust policy and the general anti- inflationary credibility of policy.

What's more, the stronger the anti-inflationary credibility of the authorities, the more effectively they will be able to intervene on growth when the need arises.

The two IPPR authors wrongly dismiss the importance of credibility as a practical matter, arguing that inflation has more to do with world trends than individual countries' policies. They overlook the penalties that financial markets impose on countries with unsustainable policies. These can be a sharp fall in the exchange rate or a sharp rise in the government's borrowing costs - neither at all trivial.

It is also clear that Britain starts from a low-credibility base. The markets put sterling assets in the same risk league as those of Italy and Spain. Beefing up our anti-inflationary credibility would help prevent further falls in the exchange rate and cut the amount of interest the Government has to pay on its debt.

There is by now pretty compelling evidence that countries which give up governmental discretion over monetary policy, through an effectively independent central bank with low inflation its top priority, do indeed get low inflation. This evidence is surveyed in a new book by a Bank of England economist, Eric Schaling, who also finds that independent central banks do not cause recessions.

There is no evidence that central bank independence, by limiting the policy reaction to the strength or weakness of the economy, makes for a more violent business cycle. He writes: "The establishment of central bank independence is a free lunch."

A Bank of England man would say that. Even so, the arguments for leaving well alone rather than tinkering with interest rates are overwhelming. The best the Chancellor can do is get them about right and then leave them.

Apart from anything else, half-point changes in base rates have virtually no effect on the economy's rate of growth. It takes a change of three or more percentage points to have any noticeable impact. Mr Clarke is not so confident in his judgement that we have won victory over inflation to have given us 3.5 per cent base rates as a Christmas present.

* Growth with Stability, Dan Corry and Gerald Holtham, IPPR.

Institutions and Monetary Policy, Eric Schaling, Edward Elgar.

Economic comparisons 1976-94

average GDP Variability of Inflation

growth, % GDP growth* rate %

United States 2.5 4.0 5.5

Japan 3.6 2.6 3.2

W.Germany 2.3 2.9 3.2

France 2.1 1.9 6.6

Italy 2.3 3.2 10.7

UK 2.0 4.5 8.0

Canada 2.6 6.0 5.9

*higher figure means more volatile business cycle

Source: OECD

Comments