Seat-of-the-pants economics

The world is round and so, it seems, is the world of economic policy-making. By heading off in one direction you can reappear from the opposite one. Consider the way that the UK is currently running monetary policy.

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.

Knife-edge process

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.

Start your day with The Independent, sign up for daily news emails
Arts and Entertainment
musicOfficial chart could be moved to accommodate Friday international release day
Sport
Wes Brown is sent-off
football
News
i100
Sport
Italy celebrate scoring their second try
six nations
Sport
Glenn Murray celebrates scoring against West Ham
footballWest Ham 1 Crystal Palace 3
Arts and Entertainment
Drake continues to tease ahead of the release of his new album
music
ebooks
ebooksA special investigation by Andy McSmith
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: HR Benefits Manager

£40000 - £50000 per annum + pro rata: SThree: SThree Group have been well esta...

Recruitment Genius: Office Manager / Financial Services

£30000 - £37000 per annum: Recruitment Genius: Established in 1999, a highly r...

Jemma Gent: Year End Accountant

£250-£300 Day Rate: Jemma Gent: Are you a qualified accountant with strong exp...

Jemma Gent: Management Accountant

£230 - £260 Day Rate: Jemma Gent: Do you want to stamp your footprint in histo...

Day In a Page

The Last Word: For the good of the game: why on earth don’t we leave Fifa?

Michael Calvin's Last Word

For the good of the game: why on earth don’t we leave Fifa?
HIV pill: Scientists hail discovery of 'game-changer' that cuts the risk of infection among gay men by 86%

Scientists hail daily pill that protects against HIV infection

Breakthrough in battle against global scourge – but will the NHS pay for it?
How we must adjust our lifestyles to nature: Welcome to the 'Anthropocene', the human epoch

Time to play God

Welcome to the 'Anthropocene', the human epoch where we may need to redefine nature itself
MacGyver returns, but with a difference: Handyman hero of classic 1980s TV series to be recast as a woman

MacGyver returns, but with a difference

Handyman hero of classic 1980s TV series to be recast as a woman
Tunnel renaissance: Why cities are hiding roads down in the ground

Tunnel renaissance

Why cities are hiding roads underground
'Backstreet Boys - Show 'Em What You're Made Of': An affectionate look at five middle-aged men

Boys to men

The Backstreet Boys might be middle-aged, married and have dodgy knees, but a heartfelt documentary reveals they’re not going gently into pop’s good night
Crufts 2015: Should foreign dogs be allowed to compete?

Crufts 2015

Should foreign dogs be allowed to compete?
10 best projectors

How to make your home cinema more cinematic: 10 best projectors

Want to recreate the big-screen experience in your sitting room? IndyBest sizes up gadgets to form your film-watching
Manchester City 1 Barcelona 2 player ratings: Luis Suarez? Lionel Messi? Joe Hart? Who was the star man?

Manchester City vs Barcelona player ratings

Luis Suarez? Lionel Messi? Joe Hart? Who was the star man at the Etihad?
Arsenal vs Monaco: Monaco - the making of Gunners' manager Arsene Wenger

Monaco: the making of Wenger

Jack Pitt-Brooke speaks to former players and learns the Frenchman’s man-management has always been one of his best skills
Cricket World Cup 2015: Chris Gayle - the West Indies' enigma lives up to his reputation

Chris Gayle: The West Indies' enigma

Some said the game's eternal rebel was washed up. As ever, he proved he writes the scripts by producing a blistering World Cup innings
In Ukraine a dark world of hybrid warfare and murky loyalties prevails

In Ukraine a dark world of hybrid warfare

This war in the shadows has been going on since the fall of Mr Yanukovych
'Birdman' and 'Bullets Over Broadway': Homage or plagiarism?

Homage or plagiarism?

'Birdman' shares much DNA with Woody Allen's 'Bullets Over Broadway'
Broadchurch ends as damp squib not even David Tennant can revive

A damp squib not even David Tennant can revive

Broadchurch, Series 2 finale, review
A Koi carp breeding pond, wall-mounted iPads and a bathroom with a 'wellness' shower: inside the mansion of Germany's 'Bishop of Bling'

Inside the mansion of Germany's 'Bishop of Bling'

A Koi carp breeding pond, wall-mounted iPads and a bathroom with a 'wellness' shower