The importance of being earnest on inflation
Thursday 18 May 1995
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.
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