The Bank's St George faces a new kind of dragon
Things have been easy until now, not so much because the dragon has been docile, although it has. It is more that fear of inflation has led the country to land a good deal of veneration on the Bank of England and its boss. The Bank - rather than the Department of Trade and Industry, the Wise Men, the International Monetary Fund or the Treasury Select Committee - has been allowed to fill the policy vacuum left in the aftermath of the exchange rate mechanism debacle. The decision to publish (albeit with some delay) the Bank's view of monetary policy was quite the most significant British economic decision of last year.
But this year, the real challenge begins. Now it's not that the Governor should be worried over the possibility that inflation will return and tough decisions will have to be made. Eddie George will have no problem in being tough. After all, his role in the economic constitution of the nation is to have responsibility without power - a position from which it is relatively easy to demonstrate firmness.
And the return of inflation? Well, it could return soon, but on past form it's still likely to be more than a year away. The economy is a beast that is slow to stir; turning points often arrive far later than impatient forecasters predict. More importantly, the economy still has considerable slack. And anyway, as far as the Bank of England is concerned, even if inflation does snort its fiery breath in the distance, that would only enhance the role of the inflation slayer.
No, the threat to Eddie George comes not from the possibility that inflationary signs will return this year, but that they will remain subdued. If the Bank's forecasts remain as consistently wrong - almost always pessimistic - as they have been (see graphic), then instead of looking like a responsible monitor of monetary policy, the Bank will look as though it is out of touch and out of mind. Last year, the Bank gained credibility by overstating the inflationary danger. This year it will not be able to repeat the trick.
Robust credibility So Eddie George's mission for 1995 must be to establish a new credibility for the Bank that is robust enough to withstand the possible non-return of inflation. He needs to give a credibility to the Bank and the new monetary policy framework that is not dependent on immediate fear.
Establishing that credibility was foremost among its goals for 1994. Certainly its economists believe that it is easier to get inflation down when people believe you are going to get inflation down. But while that is true, the Bank has been overwhelmingly concerned with credibility in the financial markets - to the detriment of its credibility everywhere else.
Credibility in the City can be gauged by looking at the short-term fluctuations in long-term interest rates. Every quarter the Bank updates us on its view of its credibility in the bond markets. For example, after the September interest rate rise, long-term bond rates fell - implying that the market thought that higher rates then would mean lower inflation and interest rates later.
But this notion of credibility is only interesting in the way that poll ratings of mid-term governments are interesting. It says how well you are doing, but not in a way that should drive you to respond on a daily basis. Confidence crises apart, credibility in the City is not the foundation of a successful anti-inflationary policy.
Indeed, more credibility in financial markets has a paradoxical negative effect on the impact of monetary policy. Base rate rises are effective at beating inflation substantially by pushing up interest rates across the whole spectrum and suppressing demand. Well, if credibility makes long-term rates fall in response to a short-term rate rise, it has hardly been helpful to the suppression of demand.
Long-term image So in 1995 the Bank of England should be far less concerned about its daily poll rating in the bond markets and far more concerned about its image in two other quite distinct markets instead, markets that will determine the Bank's long-term fate.
First, there are the wage-bargainers and price-setters. We don't need them to have faith in the policy-making framework and inflation 10 years hence. Indeed, the credibility effects of the medium-term financial strategy and the ERM turned out to be unimportant. But we do want them to believe that inflation will be low in the next 12 months. To help them to believe that, however, the Bank should be doing more to sing about how much lower inflation is than most people realise, rather than warning them that it is about to attack again. It is news about low inflation that this audience needs.
The second audience to please is that of policy-makers and politicians. The type of credibility that matters here is the one that encourages decision-makers to put their trust in an independent Bank and overcome their desire to interfere politically in the monetary process.
For the Bank to establish authority, however, it primarily needs to be seen as wise. If the Bank's forecasts consistently make mistakes - all in the same direction - no Chancellor will face the criticism of the intelligent public for overriding the Bank's advice. The politicians will in effect take power back. It is credibility in these respects that will benefit UK monetary policy as much as a short-term quarter of a percentage point off gilt yields.
The Bank may defend itself by arguing that it has been no worse than anyone else in the City at forecasting inflation. But while that is true, most business decision-makers would not use other City forecasts as a benchmark of good performance. That boastwill carry little weight once you get more than three miles away from Bank Underground station.
So that means for 1995, the Bank must make one change. It must stop believing that there is something to be gained by adopting too careful a stance in its forecasts and advice. It has a bigger and more important audience to impress than just the bond markets. For the Bank, 1995 will show that it is better not to err than to err on the side of caution.
Evan Davis is the BBC's economics correspondent.
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