Monday 03 October 1994
In 1979, if not before, we abandoned the belief that monetary and budgetary policy should be used to manage the level of demand in the economy so as to smooth out fluctuations in real growth and activity.
The orthodoxy of the day was that the economy was basically stable and the government itself was responsible for most of the fluctuations; it should set medium or long-term objectives and ignore the cycle. The objective of monetary policy was to reduce the rate of inflation. Inflation was caused by too much money chasing too few goods, and the government could control the money supply.
This led to the UK's monetarist phase in which the idea was to keep a monetary aggregate growing at a stable rate. The government's responsibility began and ended there. There was no need to forecast what the economy would do next, no need to worry too much about economic models or economic analysis. Move monetary instruments in view of the current state of the economy? What an error] Adapt them to the supposed or forecast state of the economy in the future? Hubristic folly]
This approach went out of style when the government proved unable to control a monetary aggregate in the early 1980s, but monetary policy was still tight enough to plunge the country into the deepest recession of any large country in the Organisation for Economic Co-operation and Development in that cycle. What was thrown out, as a result, was the faith in monetary targeting but not the faith in running the economy on automatic pilot. Fiscal policy was confined to the tram-lines of the Medium Term Financial Strategy. Monetary policy was unconfined for a while, but another rule was sought, and found - this time, fix the exchange rate.
Stability in the ERM
In an open economy with free capital flows, so the story goes, if monetary policy was too lax, the exchange rate would depreciate. If the policy was too tight, and the government was not allowing as much credit and money creation as the economy needed, the exchange rate would appreciate. After all, the exchange rate is just the price of this country's money in terms of other currencies. Stabilise the price and you must be producing just the right amount of money.
So international monetarism succeeded the domestic variety and monetary policy was returned to automatic pilot. Before and during the period of the European exchange rate mechanism, the sole objective of monetary policy was to stabilise sterling against the mark.
It would be tedious to repeat the story of how that new orthodoxy collapsed, but at its root was the same problem as confronted the original monetarists. Yes, governments are often a source of instability and, yes, politically induced fluctuations in monetary policy can be a problem. But they are not the only problem. If there is some other shock to the system, which alters the equilibrium real exchange rate or the demand for money as an asset, mechanically sticking to the target can lead to fiasco. A reasonable guideline becomes a menace when treated as an iron law.
After the pound was blown out of the ERM, the Government adopted an inflation target. The rhetoric of long-term stability and the avoidance of fine-tuning were retained but the reality is utterly changed. It would have been possible to treat the inflation target in a mechanical way, too. In other words, if inflation is in the target range, change nothing; if below, lower interest rates; if above, raise them.
Of course, if you did that, you would not keep inflation continuously in the target zone. There would be a lag between the policy response to an overshoot or undershoot and the return of inflation to the target band. But that is only to be expected. If you cannot fine-tune real activity and growth in the economy, why on earth should you be able to fine-tune inflation? The spirit of a rule-based policy is that the target zone defines the points at which you will shift policy; it is not a promise always to have the target variable within the target zone.
That is not what is happening however. The Government is treating its inflation target not as a guide to policy action but as a promise that it has to keep. In the absence of a big supply-side shock, like a surge in the oil price, inflation is a lagging indicator in the business cycles. Activity picks up first, then inflation generally follows. So it is tempting for a policy- maker targeting inflation to anticipate future price rises if real activity picks up, and to raise interest rates while inflation is within its target range.
That is exactly what the Chancellor, egged on by the Bank of England, recently did. Inflation was not only within the band, but it was also falling when the action was taken.
We are now back in a situation of complete discretion in setting monetary policy. There is no objective rule or basis for policy at all. Bring back those economists and those economic models] Economic forecasts have moved from redundancy to centre stage. The Governor of the Bank of England considers that inflation might be a problem in a year or two so interest rates must rise now. His forecast is the most decisive influence.
The whole ideology of macroeconomic policy over the past 20 years has been overturned. It appears you can and must forecast; you can and must change policy in anticipation of what you think will happen. With an inflation target of 'the bottom half' of a band of 1 to 4 per cent - a spread of one and a half percentage points - it appears that fine-tuning is not folly at all. Indeed, it is obligatory.
If you can really fine-tune inflation, ironing out cyclical rises of a percentage point or two, a year or two before they were due to happen, what is the rationale for ignoring other policy objectives? If demand is to be managed to smooth out fluctuations in inflation, surely the policy-maker should take responsibility for output fluctuations too? You can be sure that Mr George will not want to do that.
How did we get into this muddle? The answer lies partly in the mental model that many economists have of the inflation process and which they have communicated to policymakers. They see it as an unstable, 'knife-edge' process. Supposedly, inflation is either stable, at whatever rate history has bequeathed - that occurs when the economy is at its 'natural' unemployment rate; or it is accelerating or decelerating without limit, which happens when the unemployment (or capacity utilisation) rate is too low or too high.
If you really believe that, every rise in inflation is treated as the precursor of a continuous acceleration. A Financial Times leader recently remarked that since inflation was no longer falling, the economy must be close to equilibrium levels of capacity utilisation (the famous natural rate). The implication was that just a bit more growth would see the inflation genie out of the bottle and swelling to unimaginable size. The same hysteria is perceptible among otherwise sane Bank of England officials.
In fact, the inflation process is more complicated than this simple model depicts. Some limited rise in inflation is a normal accompaniment to a cyclical upturn. It does not entail a continuous acceleration into hyperinflation. The last UK cycle was aberrant, because of the Lawson credit boom. In the US, for example, inflation ticked up by about 1.5 percentage points between 1987 and the cyclical peak in 1989. It was broadly stable then before falling in the subsequent recession.
The grotesquely exaggerated 'knife-edge' view of inflation is tempting the authorities to try to fine-tune inflation in a way that they would not attempt for the real economy. If the hysteria, which also infects the bond market, catches on internationally, the resistance to a perfectly normal post-recovery inflation turn-up will keep the recovery itself anaemic.
The author is director of the Institute for Public Policy Research.
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