The importance of being earnest on inflation

ECONOMIC VIEW

Nobody believes Labour will not return to its tax- spend-and- borrow past, or so Gordon Brown, for one, appears to think. The solution - a Labour government will beef up the panel of independent forecasters to make sure the party keeps its word to be sounder than sound on the public finances. Only that will ensure the credibility of fiscal policy.

Credibility, it seems, is everything in economic policy nowadays. The calls for an independent Bank of England are grounded on the idea that this would confer greater credibility on monetary policy.

Gordon Brown's pathfinding speech yesterday, spelling out the reforms Labour would make to the Bank, was peppered with references to the need for credibility. The issue lay at the heart of the row between Kenneth Clarke and Eddie George. But just how credible is the claim that credibility is now all-important?

Credibility means you are believed when you set out your economic objectives and the policies that flow from them. When the Bundesbank wrongfooted the markets at the end of March with its cut in rates, nobody seriously thought the German central bank was going soft on its anti-inflation resolve. A reputation built up over generations commands credibility.

Contrast that with Kenneth Clarke's move to keep interest rates on hold on 5 May. When the Chancellor sprang his surprise, few in the City doubted that he was doing anything other than wavering on the Government's commitment to low inflation, for all his fine rhetoric to the contrary. A gaping credibility gap opened immediately.

But why should credibility matter so much? Most of the electorate takes it for granted that politicians are irredeemably untrustworthy. Why this ardent desire of our economic policy-makers to be believed?

The answer is that they are not seeking to convince electors, whom in their heart of hearts they still think they can gull with pre-election booms, bribes and promises. Economic policy-makers are trying to convince an altogether more formidable proposition - the financial markets.

If the Clinton administration goes down in history for one remark, it will be for the notorious desire of one of the President's advisers to be reborn as the vigilante of the bond market. "You can intimidate everybody," said James Carville. Forget about aircraft carriers, ballistic missiles and all the obsolete armoury of the Cold War; in the hot economic war, markets are seen as commanding the firepower that really matters.

And financial markets have long memories. They have seen one government after another in Britain swear undying allegiance to sound money and finances, only to renege on the pledges in the run-up to an election.

Cynics one and all, the vigilantes of the financial markets exact a price for Britain's inflation-prone past. This price can be measured by comparing two kinds of government debt: index-linked gilts, which compensate investors for inflation, and ordinary gilts which do not offer that guarantee.

The Bank of England made waves last week when it forecast that inflation would breach the Government's target of 1-2.5 per cent by the spring of 1997. But even the Bank, which has been consistently over-pessimistic in its forecasts in the past two years, did not think it would much exceed 3 per cent.

The markets, however, take a notably more cynical view of the outlook. The chart shows the implied forward inflation rates which the Bank of England calculates from the comparison between index-linked and ordinary gilts. On 4 May, expectations of inflation in two years stood at over 4.5 per cent.

The bill for the markets' cynicism is presented in the first instance to the taxpayer in the form of higher borrowing costs running potentially into billions of pounds. It doesn't end there. Long-term interest rates are higher than they need be. This suppresses investment and holds back long-run modernisation of the economy.

What is more, the pound is seen as an endemically soft currency, as its recent fall illustrates. When in doubt, dealers mark it down. There is an ever-present danger that a shift in sentiment in the foreign exchange markets will spark renewed inflation.

Then comes the final mark-up on the bill for market cynicism. Like most mark-ups, it packs a punch. The more successful you are in the short run in getting down inflation, the higher those rates of interest become in real terms. Suppose for example that inflation comes in at the Government's target of 2.5 per cent in two years. Then interest rates in real terms end up at a usurious 6 per cent - 2.5 percentage points higher than they needed to be.

No wonder governments are so keen on credibility. It lowers the cost of bringing down inflation. It offers a quick fix to governments that have forfeited the trust of markets. Hence the moves by Norman Lamont and Kenneth Clarke to enhance the role of the Bank of England: if governments cannot command credibility, maybe a central bank can. Steady Eddie can wow those market vigilantes in a way Canny Ken will never be able to.

Now we know that Labour, too, has bought the argument that greater autonomy for the Bank offers a passport to credibility. Gordon Brown may have ruled out independence in his speech yesterday. But the reforms he set out for the Bank would lay the ground for a further move towards independence by making decisions by the Bank more politically acceptable.

This new bipartisan consensus on credibility - the importance of being in earnest - should alert our suspicions. There is nothing politicians like better than a free lunch. That is what they are hoping to get from credibility and its key instrument - a more independent Bank.

The very reluctance of both parties to contemplate full independence tells a story. It is not simply a matter of seeking to retain the key levers of power. It is also a recognition that the British are not as sold on the merits of low inflation as the Germans or the French. If they were, the Government would not trail so lamentably in polls.

Policies will only command credibility with financial markets when they are seen to be anchored in public acceptance. When the Government raised interest rates on Black Wednesday, it was not believed by the markets, who had a better perception of just what the public would and would not take.

We have a fatal yearning in Britain for economic policies that are the equivalent of the alchemists' stone. The obsession with credibility through institutional change at the Bank is just the latest version.

The Bank of France was made independent two years ago. But Jean-Claude Trichet, its governor, said in London this week that he did not believe earlier independence would have done much to enhance credibility.

Quite so. Credibility has to be earned. Economic policies have to command the respect of ordinary people as well as markets if they are to be believed and acted on. Oversell credibility as a soft option that bypasses democracy, and it will itself lose credibility.

Arts and Entertainment
arts + entsWith one of the best comic roles around, it's no wonder she rarely bothers with films
News
people
News
i100
News
Davis says: 'My career has been about filling a niche - there were fewer short actors and fewer roles – but now I'm being offered all kinds of things'
PeopleWarwick Davis on Ricky Gervais, Harry Potter and his perfect role
PROMOTED VIDEO
Voices
A Russian hunter at the Medved bear-hunting lodge in Siberia
Save the tigerWildlife charities turn to those who kill animals to help save them
Sport
Frank Lampard will pass Billy Wright and equal Bobby Charton’s caps tally of 106 caps against
sportFormer Chelsea midfielder in Etihad stopgap before New York contract
News
i100
Sport
Usain Bolt of Jamaica smiles and shakes hands with a competitor after Jamaica won their first heat in the men's 4x100m relay
sport
News
ebookA unique anthology of reporting and analysis of a crucial period of history
News
Chancellor George Osborne, along with the Prime Minister, have been 'complacently claiming the economy is now fixed', according to shadow Chancellor Ed Balls
i100... which is awkward, because he is their boss, after all
Arts and Entertainment
The first film introduced Daniel Radcliffe to our screens, pictured here as he prepares to board the train to Hogwarts for the first time.
booksHow reading Harry Potter helps children grow up to be gay-friendly
Life and Style
A small bag of the drug Ecstasy
Health
News
i100
Life and Style
Floral-print swim shorts, £26, by Topman, topman.com; sunglasses, £215, by Paul Smith, mpaulsmith.co.uk
FashionBag yourself the perfect pair
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

Financial Analyst - Forecasting - Yorkshire

£300 - £350 per day: Orgtel: Financial Analyst, Forecasting, Halifax, Banking,...

Business Architect - Bristol - £500 per day

£500 per day: Orgtel: Business Architect - Banking - Bristol - £500 per day A...

Regulatory Reporting-MI-Bank-Cardiff-£300/day

£200 - £500 per day + competitive: Orgtel: I am currently working on a large p...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: Real Staffing are currently lo...

Day In a Page

Save the Tiger: Meet the hunters tasked with protecting Russia's rare Amur tiger

Hunters protect Russia's rare Amur tiger

In an unusual move, wildlife charities have enlisted those who kill animals to help save them. Oliver Poole travels to Siberia to investigate
Transfers: How has your club fared in summer sales?

How has your club fared in summer sales?

Who have bagged the bargain buys and who have landed the giant turkeys
Warwick Davis: The British actor on Ricky Gervais, how the Harry Potter set became his office, and why he'd like to play a spy

'I'm a realist; I know how hard this business is'

Warwick Davis on Ricky Gervais, Harry Potter and his perfect role
The best swim shorts for men: Bag yourself the perfect pair and make a splash this summer

The best swim shorts for men

Bag yourself the perfect pair and make a splash this summer
Has Ukip’s Glastonbury branch really been possessed by the devil?

Has Ukip’s Glastonbury branch really been possessed by the devil?

Meet the couple blamed for bringing Lucifer into local politics
Dress the Gaza situation up all you like, but the truth hurts

Robert Fisk on Gaza conflict

Dress the situation up all you like, but the truth hurts
Save the tiger: Tiger, tiger burning less brightly as numbers plummet

Tiger, tiger burning less brightly

When William Blake wrote his famous poem there were probably more than 100,000 tigers in the wild. These days they probably number around 3,200
5 News's Andy Bell retraces his grandfather's steps on the First World War battlefields

In grandfather's footsteps

5 News's political editor Andy Bell only knows his grandfather from the compelling diary he kept during WWI. But when he returned to the killing fields where Edwin Vaughan suffered so much, his ancestor came to life
Lifestyle guru Martha Stewart reveals she has flying robot ... to take photos of her farm

Martha Stewart has flying robot

The lifestyle guru used the drone to get a bird's eye view her 153-acre farm in Bedford, New York
Former Labour minister Meg Hillier has demanded 'pootling lanes' for women cyclists

Do women cyclists need 'pootling lanes'?

Simon Usborne (who's more of a hurtler) explains why winning the space race is key to happy riding
A tale of two presidents: George W Bush downs his paintbrush to pen father’s life story

A tale of two presidents

George W Bush downs his paintbrush to pen father’s life story
Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover

The dining car makes a comeback

Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover
Gallery rage: How are institutions tackling the discomfort of overcrowding this summer?

Gallery rage

How are institutions tackling the discomfort of overcrowding this summer?
Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players

Eye on the prize

Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players
Women's rugby: Tamara Taylor adds fuel to the ire in quest to land World Cup

Women's rugby

Tamara Taylor adds fuel to the ire in quest to land World Cup