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.

Start your day with The Independent, sign up for daily news emails
PROMOTED VIDEO
Sport
football
News
Tangerine Dream Edgar Froese
people
News
Rob Lowe
peopleRob Lowe hits out at Obama's snub of Benjamin Netanyahu
News
Davies (let) says: 'Everybody thought we were having an affair. It was never true!'
people'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'
Arts and Entertainment
Over their 20 years, the band has built a community of dedicated followers the world over
music
News
Staff assemble outside the old City Road offices in London
mediaThe stories, the writers and the changes over the last quarter of a century at Britain's youngest paper
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Life and Style
The Oliver twins, Philip and Andrew, at work creating the 'Dizzy' arcade-adventure games in 1988
techDocumentary looks back at origins of the computer-games industry
Arts and Entertainment
Krall says: 'My hero player-singer is Elton John I used to listen to him as a child, every single record
music
Arts and Entertainment
The Wu-Tang Clan will sell only one copy of their album Once Upon A Time In Shaolin
musicWu-Tang Clan and The Sexual Objects offer fans a chance to own only copies of their latest albums
News
i100
Environment
Number so freshwater mussels in Cumbria have plummeted from up to three million in the 20th century to 500,000
environment
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

Recruitment Genius: Tax Assistant

Negotiable: Recruitment Genius: A Tax Assistant is required to join a leading ...

Recruitment Genius: Outbound Sales Executive - OTE £25,000

£16000 - £25000 per annum: Recruitment Genius: This is an exciting opportunity...

Ashdown Group: Java Developer / J2EE Developer - Watford - £45,000 - £47,000

£45000 - £47000 per annum + bonus + benefits: Ashdown Group: Java Developer / ...

Ashdown Group: Marketing Product Manager - (Financial Services) - SW London

£35000 - £38000 per annum + Benefits: Ashdown Group: Marketing Manager - Marke...

Day In a Page

Iraq invasion 2003: The bloody warnings six wise men gave to Tony Blair as he prepared to launch poorly planned campaign

What the six wise men told Tony Blair

Months before the invasion of Iraq in 2003, experts sought to warn the PM about his plans. Here, four of them recall that day
25 years of The Independent on Sunday: The stories, the writers and the changes over the last quarter of a century

25 years of The Independent on Sunday

The stories, the writers and the changes over the last quarter of a century
Homeless Veterans appeal: 'Really caring is a dangerous emotion in this kind of work'

Homeless Veterans appeal

As head of The Soldiers' Charity, Martin Rutledge has to temper compassion with realism. He tells Chris Green how his Army career prepared him
Wu-Tang Clan and The Sexual Objects offer fans a chance to own the only copies of their latest albums

Smash hit go under the hammer

It's nice to pick up a new record once in a while, but the purchasers of two latest releases can go a step further - by buying the only copy
Geeks who rocked the world: Documentary looks back at origins of the computer-games industry

The geeks who rocked the world

A new documentary looks back at origins of the computer-games industry
Belle & Sebastian interview: Stuart Murdoch reveals how the band is taking a new direction

Belle & Sebastian is taking a new direction

Twenty years ago, Belle & Sebastian was a fey indie band from Glasgow. It still is – except today, as prime mover Stuart Murdoch admits, it has a global cult following, from Hollywood to South Korea
America: Land of the free, home of the political dynasty

America: Land of the free, home of the political dynasty

These days in the US things are pretty much stuck where they are, both in politics and society at large, says Rupert Cornwell
A graphic history of US civil rights – in comic book form

A graphic history of US civil rights – in comic book form

A veteran of the Fifties campaigns is inspiring a new generation of activists
Winston Churchill: the enigma of a British hero

Winston Churchill: the enigma of a British hero

A C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
Growing mussels: Precious freshwater shellfish are thriving in a unique green project

Growing mussels

Precious freshwater shellfish are thriving in a unique green project
Diana Krall: The jazz singer on being friends with Elton John, outer space and skiing in Dubai

Diana Krall interview

The jazz singer on being friends with Elton John, outer space and skiing in Dubai
Pinstriped for action: A glimpse of what the very rich man will be wearing this winter

Pinstriped for action

A glimpse of what the very rich man will be wearing this winter
Russell T Davies & Ben Cook: 'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'

Russell T Davies & Ben Cook: How we met

'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'
Bill Granger recipes: Our chef serves up his favourite Japanese dishes

Bill Granger's Japanese recipes

Stock up on mirin, soy and miso and you have the makings of everyday Japanese cuisine
Michael Calvin: How we need more Eric Cantonas to knock some sense into us

Michael Calvin's Last Word

How we need more Eric Cantonas to knock some sense into us