Challenged by concerned friends, he explained cheerfully that the elephants no longer came into the garden. On reflection, the Government's economic policy framework has much in common with the elephant powder.
The replacement economic policy framework hastily assembled in the weeks following sterling's exit from the exchange rate mechanism was founded on the formal adoption of a 1-4 per cent target for the underlying inflation rate and supported by 20 flimsy paragraphs of text. The central tenet of the new framework was that 'the only lasting basis for sustainable growth and secure employment is low inflation'.
As we approach the second anniversary of the liberation of British economic policy, it is time to question whether the existence of the inflation target has had even the slightest connection with the low inflation outcomes observed and whether we are any closer to achieving sustainable economic growth or secure employment.
The table (right) compares domestic manufacturing prices in 11 of the largest OECD countries, showing that global manufacturing inflation has been negligible in each of the past three years. Where inflation rates differ from the world average, this is mostly due to currency movements.
Thus, the drop in UK producer price inflation from 3.9 per cent in 1993 to 1.9 per cent in July was principally due to the removal of price increases induced by sterling's depreciation in September 1992.
Even so, Britain's inflation performance falls well short of the world's best: our ranking was 11th in 1992, 10th in 1993 and is now eighth.
As far as manufactured prices are concerned, the historically low British inflation rate is merely a reflection of intense global competition.
A perverse by-product of this competitive environment is that it has conferred an unexpected benefit on countries that have devalued their currencies.
Economic theory predicts that domestic prices will quickly absorb the impact of the currency change on imported items and will ultimately reflect the full effect as wage-earners demand compensation for their loss of purchasing power.
By contrast, the current experience is that exporters to devaluing countries do everything in their power to maintain the local currency price at its pre-devaluation level. Such is the degree of global excess capacity in many manufactured goods sectors that the full costs of devaluation are borne by the exporter's profit margin and by his local workforce. British consumers of many Japanese durable goods enjoy sterling prices lower than they were in August 1992, despite an intervening 36 per cent currency move.
A third significant contribution to the low rate of underlying inflation has arisen from the home-grown recession in domestic distribution and service sectors. The intensification of competitive pressures in these previously secluded markets has arisen partly because of the greatly diminished volume of turnover in the residential housing market and the demise of its subsidiary role as a source of cheap personal credit.
Whereas the supermarket price war is a recognised phenomenon, the collapse in private sector retail inflation in other goods and services has received less attention. In fact, retail inflation rates for food, clothing, footwear and housing are very similar to those of two years ago.
Slower price movements for household services, fares, travel costs, motoring expenditure and other leisure goods and services have supplied most of the good news at the retail level. Only for entertainment and some other recreation services does it appear that the inflation franchise is intact. Profit margins in distribution and service sectors are being eroded and this is reflected in a lower rate of pay inflation in services than in manufacturing.
It is difficult to root any of these favourable developments to British economic policy since September 1992. This raises two key issues. Firstly, if the reaction of prices and wages to the currency devaluation had followed a more conventional course, the inflation target would have been no protection against it. The only change from what has happened is that policy credibility would have been damaged and base rates would probably have been increased once or twice already.
Secondly, if the benign inflationary out-turn owes much to an external deflationary process (which lies beyond the control of British policy), the narrow domestic focus on an inflation target is misguided. After three years of virtually stagnant manufacturing prices, the possibility of a sustained global deflationary bias deserves serious consideration.
Under this scenario, companies striving to keep the real return to capital employed comfortably in excess of a rising real cost of capital require total cost inflation to be negative. The imperative of rapid productivity growth applies irrespective of whether output is growing enough to keep employment or not. Ultimately, the deceleration of domestic labour incomes drives down output growth, with a further negative feedback to employment and real wages.
If global traded goods deflation is coupled with further rationalisation in the domestic distributive and services sectors, as seems likely, the implications for British output growth and employment in 1996 would become extremely worrying. The failure of part-time employment growth to develop into a greater number of permanent jobs, even after two years of economic recovery, is a sign of the vulnerability and reversibility of the present high growth rate. Employers have a ready-made strategy for preserving productivity through the reduction of staff hours.
If it is accepted that the main source of British inflationary success is external, then the Government's success in meeting its inflation target is little more than a happy coincidence. Because of its institutional focus on the prevention of inflation in 18 months to two years, the Bank will soon be tempted to declare its support for a damaging sequence of base rate increases. This action will result in a further increase in real borrowing costs, complementing the 2.8 percentage points rise in real 10-year bond yields that has already occurred this year.
Talk of pre-emptive rate rises belongs to a world in which wild swings in credit and money growth were commonplace. In today's world of high personal sector debt-to-income ratios, private sector debt aversion, stagnant demand for bank borrowing and high and rising real interest rates, the probability of a resurgence of economy-wide inflationary pressures is minimal.
Nobody denies that domestic inflationary pressures could resurface, but the monetary pre-conditions for this are not yet satisfied. It is pertinent to ask whether the existing policy framework is sufficiently flexible to address the potential economic threat posed by a costcutting deflationary spiral.
The author is chief economist at Robert Fleming Securities. Gavyn Davies is on holiday.
----------------------------------------------------------------- WORLD INFLATION LEAGUE ----------------------------------------------------------------- % pa (using domestic manufactured goods prices) June 1992 1993 1994 Japan -1.6 -2.9 -1.9 Switzerland 0.1 0.2 -0.4 France -1.6 -2.8 -0.1 US 1.2 1.3 0.1 Germany 1.4 0.0 0.4 Belgium 0.2 -1.0 0.5** Australia 1.5 2.0 0.7 UK 3.1 3.9 2.1 Italy 2.1 5.2 3.5* Spain 1.4 2.4 4.2* Canada 0.5 3.3 5.5 Weighted average 0.7 0.7 0.5 *May 1994 **April 1994 -----------------------------------------------------------------Reuse content