Surgical strike would calm markets

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Mervyn King, chief economist at the Bank of England, has been in good form recently. I was amused by an answer he gave at a recent Treasury select committee hearing when he was asked how to calculate real interest rates. It was put to him that the schoolboy would simply subtract the most recent inflation rate from the nominal interest rate, but was that a satisfactory method?

His reply was that the schoolboy would subtract backward-looking inflation from nominal interest rates, while the undergraduate would subtract a forward-looking estimate of future inflation. Meanwhile, the postgraduate would calculate inflation expectations by subtracting the yield on index-linked gilts from that on conventional gilts. Finally, the professor would point out that this postgraduate calculation failed to take account of the inflation risk premium which is also included in the difference between conventional and index-linked yields. Not bad for an off- the-cuff reply.

Then last week, in a lecture at the Institute for Fiscal Studies, Professor King said that bringing down inflation was like giving up smoking, while keeping it down was like learning to eat healthily - although, he added cheekily, the Chancellor and Governor might not approve of these analogies.

His lecture also made the serious point that the role of the central bank was to think about inflation before ordinary people were talking about it. This is akin to the observation made here a few weeks ago that the Government would soon need to think about tightening monetary policy 'out of a clear blue sky'. The implication was that policy would have to be tightened when there was no obvious inflationary trigger for the move. Indeed, inflation could still be falling at the time.

The financial markets are totally unconvinced that this will be done. The first graph shows the path for future inflation which has been built into the gilt market at the time of the last three inflation reports from the Bank of England. If these calculations are to be believed, they demonstrate that the market has recently become much more pessimistic about inflation and now believes that the Government's inflation target will be met at no time between 1996 and 2006.

This total absence of monetary policy credibility should be worrying the Government, since it is always more costly to keep actual inflation low when inflation expectations are high. Furthermore, it means that the market's expectations of future nominal interest rates are also very high.

This is apparent from the second graph, which shows the expected structure of interest rates built into the gilts market at various times in the future. The whole structure of interest rates is expected to move upwards continuously throughout the next two years and base rates are expected to be above 9 per cent in mid-1996. These pessimistic expectations must surely be harming the prospects of an investment-led recovery in the economy.

If we put together the two graphs - showing that the markets expect both higher inflation and higher interest rates - we can only infer that there is deep scepticism about whether the authorities will in fact tighten policy when the sky is clear blue. Instead, they are expected to wait until after the inflation storm clouds have gathered and then raise interest rates in an atmosphere of crisis. In other words, the cynical financial markets expect it to be 'business as usual' in the UK.

What should the authorities do about this? One possibility would be to raise base rates unexpectedly early in the hope that this would restore credibility to the monetary regime, leading to a sharp decline in inflation expectations and forward interest rates. But to change strategy so abruptly after the mistaken base rate cut of early February might backfire. In fact, in the present nervous environment, such a move might induce the markets to say: 'Aha] We were right all along about inflation. There must be something to worry about.'

So far, there has been no sign, either in the Bank's inflation reports or in the minutes of the monthly monetary policy meetings between the Governor and Chancellor, that an increase in base rates might be necessary soon. In fact, entirely the opposite has been true - all the discussion has been on whether to reduce base rates further.

The Governor will probably feel that, for the sake of policy coherence, a certain amount of groundwork will be needed before he can credibly recommend a base rate rise. This almost certainly rules out any increase before October or November.

By then, however, the Governor might well feel that an increase would be appropriate. The crucial point to recognise is that this will not depend on a worsening in inflation, but on an assessment of what may be necessary to keep economic growth below the 'speed limit' of 3 per cent per annum. This is not a speed limit which needs to be strictly enforced over short periods, but there is plenty of evidence from the past that any sustained run of quarters in which growth exceeds 3 per cent ends in rapidly rising inflation and in a sharply deteriorating balance of payments. On Goldman Sachs' calculations, it would only take growth of 3.5 per cent for two years to ensure a financial calamity in 1996, with inflation above 6 per cent and the trade deficit exceeding 4-5 per cent of GDP.

Of course, this possibility assumes that the growth in domestic demand will remain robust - indeed continue to strengthen - in the next two years. But this does now seem to be the most probable outcome. Although the housing market remains sluggish, the financial situation of households is strong enough to keep consumption growing despite weak house prices and rising taxes. Furthermore, the huge recent improvement in company finances has yet to be fully reflected in higher corporate spending.

I think the authorities should reason as follows. If they do nothing, there is every chance that the recovery will continue to gain momentum in the period ahead, taking GDP growth well above the 3 per cent speed limit. Despite the fact that there still appears to be a good deal of spare capacity in the economy, this would be too risky. At some point in the next two years, a tightening in policy therefore seems inevitable.

Further fiscal tightening may be optimal, but could prove politically difficult, so monetary tightening becomes probable. It is far too early to be precise about the required extent of this tightening, but a rise in base rates of 1.5-2 per cent would probably be sufficient to keep the economy within the 3 per cent speed limit.

One of the deepest fears in the markets at present is that the Governor will see the logic in all this, but that the Chancellor will reject his advice for political reasons. In fact, this is most improbable. Why should the Chancellor wish to delay the inevitable rise in interest rates until closer to the election, risking a financial crisis in the meantime? It is much more likely that he will use the Governor as political cover for doing something he would have chosen to do anyway.

There will be no action until late in the year, and then a swift tightening in policy. A surgical strike of this sort would persuade the markets that they have become too pessimistic, both about inflation and about interest rates in the longer term.

(Graphs omitted)