The inflation target that nobody wants to hit
Monday 04 September 1995
The new mood was well captured in a leader in the Times last Tuesday. "The last few months have produced a catalogue of economic disappointments, due partly to threats too readily wielded by the Governor of ever higher interest rates," it thundered. "If Mr George clings stubbornly to a view which has been overtaken by events, he will do nothing but harm to his own reputation and the future credibility of the Bank."
Admittedly, recent developments appear to undermine the Governor's view. GDP rose by only 0.5 per cent in the second quarter, and a sharp rise in stocks accounted for the whole of this increase. Stocks will be cut back. Export volume has actually fallen in the latest two quarters as global activity has flagged. Unemployment increased in July for the first time in two years. The housing market remains chronically weak, with mortage lending in July reaching barely half of the level of a year earlier. And inflation pressures, which had been rising steadily earlier in the year, are now shown in business surveys to be declining in line with commodity prices. If the Chancellor agreed to a base rate rise against this background, he would be met by a lynch mob at next month's Conservative Party Conference.
So we can be fairly confident that Mr Clarke will not permit a base rate rise now or for the foreseeable future. But can we be so confident that Mr George will drop his advice to raise rates - advice which is said to be depressing confidence in the economy? Not only do I expect the Governor to stick to his line, but I am one of the few who still believes he is fully justified in doing so.
In the first place, it is far from clear that the slowdown in the economy is more than a blip. How many people would be aware from reading the newspapers in the past few weeks that consumers' expenditure has actually rebounded strongly since the end of the winter? Consumption rose by 0.8 per cent in the second quarter, while retail sales - benefiting from the familiar upward revisions to historic data - have resumed the 4 per cent annualised growth trend which was in place before the policy-tightening took effect last year. Now that the tax rise is fully implemented, the consumer has ample funds to fuel strong growth in spending, despite the weakness in housing. And consumer confidence, ususally reported to be a rock bottom levels, is in fact quite stable at around mid-cycle readings. Investment has also at last started to rise quite strongly. There is little doubt that GDP growth will be quite subdued for at least a couple more quarters, since companies have allowed their stocks to rise above desired levels, and will for a while meet rising demand from the shelves instead of from extra production. But this slowdown is actually the desired result of the timely increase in interest rates last year and, on a medium-term view, there is nothing to suggest that the economic recovery will suddenly peter out.
Recessions do not appear out of thin air - they require precipitating forces, such as a clash between rising inflation and tight monetary policy, and/or the appearance of cashflow and balance sheet problems in the private sector. Not only are these forces wholly absent from the current environment, but monetary policy, by any objective measure, remains highly expansionary. Quite how the monetarists can support interest rate cuts when both narrow and broad money are accelerating sharply is beyond simple comprehension. After stocks stabilise, growth and inflation will re-acclerate.
It is therefore not too surprising that the strong consensus opposed to a further rate rise is not matched by any confidence whatsoever that the Government will succeed in reducing the underlying inflation rate to 2.5 per cent or less by the end of this Parliament. Out of 48 independent forecasters tracked by the Bank of England's Inflation Report, only five believe that the Chancellor's inflation objective will be hit by the end of next year, and two of those assume that interest rates will need to go up to achieve this.
Few in the financial markets believe that the Chancellor is singlemindedly trying to hit his official objective of 2.5 per cent or less. Some believe that he might hit it by accident, while others think that his real objective is to keep inflation within the wider 1 per cent to 4 per cent band. The implied inflation expectation built into long-dated bonds has risen from 4.4 per cent to 4.9 per cent since the Chancellor rejected the Governor's advice to raise rates in May. The only possible explanation for this is that the credibility of the monetary framework has been damaged by more than enough to offset the slowdown in the economy.
History shows how difficult it will be to achieve the Chancellor's new target. In the past 20 years we have been offered M3 monetarism and then the ERM, both of which involved "immutable" objectives which were subsequently torn to shreds. And according to the Bank of England, the UK has enjoyed an inflation rate of less than 2.5 per cent for only one-fifth of the time since the war, while even Germany has managed it for less than half the time.
So we are faced with a curious situation in which consensus opinion shares two very strong beliefs - first, that monetary policy should not be tightened, and second that the Government's inflation objective will not be hit. The logical implication must be that the consensus is not bothered whether or not the inflation target is achieved, or at least is not willing to pay the necessary price to make sure that it is. Yet there is almost no one who is willing to stand up and avow that the inflation target is too low. Only in Britain could the majority support setting an inflation objective with a fanfare of trumpets, and then ask for policy to be set so that the target is missed.
It is not the Governor's fault that the inflation target is ambitious, or that further output sacrifices may be needed to ensure that it is achieved consistently for a run of years. Although he might be justified in soft- pedalling on the timing of a rate rise for a month or two, he should stick to his guns on the general direction of interest rates at this stage. Otherwise, the Chancellor might sneak in a cut in base rates, which really would be a bad mistake.
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