How monetary policy was tightened by mistake

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The Independent Online
I apologise for harking back to past mistakes, but the continuing collapse in the gilt market since the quarter-point base rate cut on 8 February forces me to do so.

Some may accuse me of making a mountain out of a molehill, but whichever way one attempts to measure the financial markets' response to the base rate cut, it has been little short of disastrous.

Of course, the UK markets have not been collapsing entirely in isolation. They have obviously been affected by the general malaise in the world's bond markets since the American Federal Reserve started to tighten policy in early February. Since the UK markets are more liquid than many others, they have suffered disproportionately from the hedge funds' need to dump assets to effect deleveraging. But the hedge funds would not be selling assets that they expected to perform relatively well, and the truth is that UK assets have been performing very badly indeed.

Since the Chancellor's decision on base rates, the spread between 10-year bond yields in the UK and Germany has widened by 80 basis points (one basis point is 1 100 th of 1 per cent).

Furthermore, the British yield curve has steepened much more than has been the case in any other country.

The spread between 10-year gilt yields and three-month rates in the UK has widened from 160 basis points before the base rate cut to 250 basis points now, which implies that the market is taking a much darker view of the prospects for interest rates in the years ahead than it was previously.

There is more. The long-term expectation of inflation built into the market, as measured by the gap between conventional gilt yields and indexed-linked yields, has increased by about 40 basis points - a very large increase in the anticipated inflation rate over a period of 15-20 years.

In fact, the market no longer expects the Government to hit its inflation target of 1-4 per cent over the medium term, having been quite confident that it would do so before Mr Clarke acted.

Moreover, UK equities have been among the worst-performing stock markets since the base rate cut and - perhaps most worrying to the Government - the money markets now say that base rates will be above 6 per cent at the year- end.

These facts show how easily the financial markets can, if they choose, take domestic monetary conditions into their own hands, and out of the hands of the Chancellor. All that the Treasury can do in co-operation with the central bank is determine the 'spot' rate (today's rate) of interest on very short-term assets, perhaps up to three months in duration at most. All other rates, now and in the future, may or may not be affected by the authorities' actions at the short end of the money markets - it depends on how the market reads the runes.

The Chancellor may not realise it, but he has perversely succeeded in tightening domestic monetary conditions since he reduced base rates in February. Although the 'spot' three-month rate is, as he intended, a quarter of a point lower than before, the markets believe that base rates at the end of the year will be almost a full point higher than they previously anticipated.

Since no one in their right minds would borrow money without having some idea of how interest rates might fluctuate over the life of the loan, this combination of events could easily depress economic activity rather than the reverse. Furthermore, many companies - and nowadays fixed-rate mortgage holders - are affected more by long-term rates than by short rates. For them, yields are 130 basis points higher than they were before.

I can well imagine the Chancellor dismissing these developments as being the result of the antics of the braces brigade in the City, a breed for which he has little sympathy. If he is inclined to give this topic more than a moment's thought, he may well be saying to himself that the City has over-reacted in its usual absurd fashion to what was, after all, only a quarter- of-a-point cut in base rates. But the point is that, like it or not, money talks, and the markets have immense power over policy-makers. It should be of some concern to the Chancellor that he has, in effect, tightened domestic monetary conditions when he thought he was doing just the opposite.

One lesson to be learned from the markets' behaviour is that there is still a great deal of latent suspicion about the UK monetary regime that has been operated since sterling left the ERM in September 1992. After the sterling debacle, Mr Lamont moved quickly to put in place a new regime, which relied on the 1-4 per cent inflation target and the opening up of the policy process. He deserves credit for instigating the Bank of England's Inflation Report, and the Treasury Panel of Independent Forecasters, both of which may prove to be durable reforms. For as long as the markets continued to be mesmerised by the pleasant inflation surprises of 1993, this regime seemed acceptable.

But under the surface all was not well. The crucial lacuna in the new system was of course that base rate decisions were left in the hands of politicians, rather than being handed over to an independent central bank.

Initially, Mr Clarke was rather cagey about whether the Bank of England might move swiftly towards greater independence, but more recently he has been happy to give the clear impression that nothing much would change while he is at the Exchequer.

Furthermore, the markets remember that the over-riding objective the new Chancellor set for himself almost a year ago was the success of British industry and commerce, a clear and intended break with the anti-inflationist language of the previous 15 years.

The importance of all this is that the policy soil was appropriately prepared for a small weed to spread alarmingly quickly. Although well satisfied with Mr Clarke's exemplary Budget decisions last November, the markets had almost no evidence on which to judge the monetary mettle of the new Chancellor until February. They were inclined to give him the benefit of the doubt, and also to believe that the Governor of the Bank of England had achieved a new importance, perhaps even dominance, in the setting of base rates.

This confidence suffered a sharp setback on 8 February. Of course, the base rate cut was tiny, but it had the effect of signalling that the Chancellor was capable of easing policy when output was booming, when the Bank of England Inflation Report was specifically stating that inflation would not, as officially intended, drop into the bottom half of the target band, and when political circumstances hardly seemed irrelevant in the timing of the move. In other words, it was business as usual in the UK.

Now that the markets have this experience uppermost in their minds, it will be quite difficult to shake them free of it. Suddenly to turn turtle and raise base rates would appear totally incoherent, even if the Chancellor could be persuaded to contemplate such an action, which is dubious. But any further base rate cut now or in the near future would be a very bad mistake indeed.

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