Governor leads Chancellor by two goals to one

`Nobody pointed out last week that Mr Clarke's decision involved a tacit admission that his previous key judgement - to reduce base rates in June - was a mistake'
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The Chancellor received a generally favourable press for raising base rates last week, and his decision certainly represents a feather in the cap for the new monetary mechanism in Britain. Were it not for the fact that the Governor of the Bank of England was threatening to become ever more awkward in the run-up to the election, it would have been all too easy for Kenneth Clarke to have done nothing before polling day, probably using the excuse of a rising pound to leave base rates unchanged.

Instead, he no doubt reckoned that a small move now was not only justified economically, but would also keep the Governor off his back as polling day approached. Admittedly, there would still have been a large element of political calculation in the move, but it was a calculation that had to be made within completely different confines from those faced by previous Chancellors. For that, we should be grateful.

It is interesting that nobody pointed out last week that Mr Clarke's decision involved a tacit admission that his previous key judgement - to reduce base rates in June - was a mistake. For some reason, the overall public perception is clearly that the Chancellor has generally proved right in his disputes with the Governor, and certainly the Governor appears to attract more flak from the press when he is deemed to be wrong. But I would argue that the Bank of England has nothing to be ashamed about so far in its track record under the new mechanism.

There have been three significant differences of view since the present monetary framework was launched. In February 1994, with the economy about to embark on a period of rapid GDP growth and rising inflation pressure, the Chancellor announced a cut in base rates from 5.5 to 5.25 per cent, saying that he was concerned that his advisers were too often "erring on the side of caution". The Governor on the other hand said that he thought the existing setting of policy was already easy enough to ensure that GDP growth would soon exceed 3 per cent, and he opposed the cut in base rates.

The Governor was clearly right on this occasion. Growth in real GDP soon surged above 4 per cent, and by September the Chancellor was forced to change tack with a 0.5 per cent increase in the base rate. One-nil to the Bank.

The second important episode was the high-profile difference from May to September 1995. At that time, the Bank recommended an increase in base rates from 6.75 to 7.25 per cent, and this was rejected by the Chancellor on the grounds that it would "result in a tighter policy stance than was necessary to meet the inflation objective, and depress activity further when it was already slowing". Mr Clarke was certainly right in the second part of this assessment, and the emergence of weaker economic activity last summer forced the Governor to shelve his request for higher rates by the end of July.

Without exception, economic commentators have scored this as a goal for Mr Clarke, but there is room for doubt. Mr George's recommendation to raise base rates rested on a belief that the odds of hitting the Government's 2.5 per cent inflation target over the next 18-24 months were less than 50 per cent. This, after all, is what the Chancellor asked the Bank to do when he established the new monetary mechanism. And, so far, the Bank forecasters have not been far wrong.

Eighteen months after the dispute of May 1995, inflation remains well above the official target, though this has happened in the context of generally lower interest rates than the Bank anticipated when its advice was given. If base rates had been held at the original level of 6.75 per cent indefinitely, the inflation target may well have been hit. On reflection, it would be churlish to deny this was an equaliser for Mr Clarke.

The third dispute came in June 1996, when the Chancellor cut base rates from 6 to 5.75 per cent, citing a lack of inflationary pressure, and worries about the sustainability of the recovery for his decision. Mr George, meanwhile, opposed the cut, arguing that consumer demand remained strong, and any further slowdown in growth would prove temporary. As noted above, there is little doubt that this was another goal for the Governor.

On my subjective scoring system, the Governor therefore leads the Chancellor by two goals to one, with the game deep into the second half. So why does the vast bulk of the body politic seem to believe the advantage lies the other way around? I suspect it is for the depressing reason that so few genuinely share the objective of keeping inflation below 2.5 per cent, or at least they are unwilling to make any output sacrifice to achieve it.

Accordingly, when the Bank recommends policy changes necessary to hit the inflation target, it attracts much criticism from those who do not share the objective in the first place. And whenever Mr Clarke leans in the direction of taking risks with the inflation target, he seems to be loudly applauded, especially if house prices rise at the same time. Those stick-in-the-muds at the Bank who are charged with policing the inflation target are never likely to win much gratitude, even if they are proved absolutely right in retrospect - but then unpopularity is generally the fate of a good central banker.

Having got that off my chest, let us turn briefly to the state of macro- economic policy. The graph shows the recent changes in base rates, along with an index of overall monetary conditions, calculated by Goldman Sachs. The latter index includes long-term interest rates and the sterling exchange rate along with base rates in a composite measure of the stance of monetary policy. It is obvious from the graph that changes in base rates are far from the only determinant of the overall monetary stance, and in fact there are clearly occasions when monetary conditions tighten even though base rates are falling.

One such occasion was the first half of this year, when the decline in base rates was not sufficient to offset the strong rise in sterling, so overall monetary conditions tightened, even though the Chancellor was trying to achieve the exact opposite. In this regard, developments in 1996 have been the precise mirror image of those in 1995, when a decline in sterling meant that monetary conditions eased, though base rates remained largely unchanged.

Base rates are still 0.75 per cent below the levels that were reached late last year, but overall monetary conditions have nevertheless now tightened almost as much as they did in the last phase of stringency in 1994. Of course, it is never entirely safe to rely on the foreign exchange markets to tighten policy on behalf of the Chancellor - and it is certainly not optimal to do so for very long - but the strength of the pound means that monetary conditions are tighter than they look. If this persists, Mr Clarke may not need to raise base rates again before the election.