Wayward and treacherous friends

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The financial markets have so far co-operated with Chancellor Clarke's avowed wish to have a quiet and contemplative running-in period, but this is unlikely to last forever. In fact, sterling has been showing signs of persistent strength against the European currencies in recent weeks, and the currency markets may soon force Mr Clarke to show his hand on monetary policy.

A Chancellor who wants to be seen 'putting the needs of commerce first' is unlikely to feel comfortable with much further erosion of last autumn's sterling devaluation. On the other hand, a Chancellor who wishes to send out austere signals on inflation control will not yield too easily at the first whiff of currency appreciation.

The Treasury's Forecasting Panel (on which I sit) thought about this issue quite carefully, and unanimously concluded that any significant and persistent sterling appreciation should be met with a further cut in base rates. Despite this unanimity, the panel came in for some heavy criticism last week from Anatole Kaletsky of the Times, who accused us of being 'unfit to run a whelk stall'. I assume he was arguing that the panel should be expected to be unanimous more often.

Mr Kaletsky clearly views with deep suspicion anyone who comes within a country mile of Great George or Threadneedle Streets - perhaps a healthy enough attitude for a journalist to adopt. But he has serious misconceptions about the role of the Forecasting Panel. The panel consists of seven individuals who come together for very short periods three times a year, in effect to do little more than compare notes.

It should be seen as surprising if we ever reach unanimity on any subject, not the other way round. And considerable variety is to be anticipated in our individual submissions to the Chancellor, in which we have been asked to produce our own individual best guesses about how the economy may actually perform, and what should be done about it. This guarantees variety - indeed, unlike Mr Kaletsky, I was rather under the impression that variety was a crucial part of the whole idea. If the Treasury had wanted unanimity, or even full coherence, it would have structured the panel entirely differently, and picked different people to serve on it.

Anyway, I digress. In the panel's discussions on interest rates - which I suspect mirror quite closely those going on behind closed doors at the Treasury and Bank - much time was spent on the recent behaviour of the monetary aggregates. The Chancellor would clearly prefer to be guided by domestic factors at present, rather than by the exchange rate, so it would be extremely convenient if the monetary aggregates were giving him unambiguous signals about interest rates. But unfortunately they are not.

In order to be able to rely on the monetary aggregates, there must be some reason to suppose that their behaviour will be systematically linked to that of nominal gross domestic product. In economists' jargon, the velocity of circulation - the ratio of GDP to the money supply - must be predictable (though it does not necessarily have to be stable). If velocity is not predictable, signals will be untrustworthy, and interest-rate policy cannot rely entirely, or perhaps even at all, on money growth.

For much of the past 20 years, the narrowest measure of money (M0) has been the most reliable, with its velocity increasing fairly steadily at a rate of around 4 per cent per annum. This means that if the Government wishes to see nominal GDP growing at 6 per cent per annum (as it does now), it should set a target range for M0 centred on 2 per cent, producing a band width of 0-4 per cent. This is precisely what has been done this year.

The current growth rate of M0 is 4.4 per cent, slightly above the official monitoring range. So does this mean that the Chancellor should be contemplating an increase in base rates? Well, according to the Treasury itself, probably not. The trouble is that after two decades of stability, the trend in the velocity of M0 has suddenly started to misbehave. Instead of rising by 4 per cent a year, it has recently been falling by 2 per cent a year.

The most likely explanation for this change in behaviour is that interest rates have fallen to exceptionally low levels, so people have become less eager to economise on their holdings of cash (which of course earn no interest). This has potentially important consequences for policy. If M0 velocity is, for the sake of argument, now exhibiting a stable trend, instead of falling by the usual 4 per cent, then the official monitoring range for M0 should be increased from 0-4 per cent to 4-8 per cent. This would in turn leave the current growth rate of M0 running just inside the bottom end of the appropriate target band, implying that base rates should be cut rather than increased.

The Treasury's Budget Statement prepared the ground for this dilemma by warning that the velocity of M0 might be changing, and thereby hinting that the authorities might be willing to turn a blind eye to above-range M0 growth. This is what they are now doing.

Given this uncertainty about M0 velocity, it would be helpful if M4 velocity were performing in a more predictable fashion, since this could then be used as the ultimate arbiter for policy decisions. But if M0 is sometimes a wayward friend, M4 is nothing short of treacherous. M4 velocity on average has declined by 2 per cent a year in the past two decades, but during the 1990s it has been broadly stable - and the Treasury has assumed that it will remain stable from now on.

The change in trend in M4 velocity may be due to the fact that the impact of financial liberalisation has now worked fully into the economy, in which case the new trend would be expected to be permanent. On the other hand, it might be due to some other factor - such as the recent decline in housing wealth - which could easily reverse itself.

At present, M4 is growing at a annual rate of 3.8 per cent, almost at the bottom of the 3-9 per cent monitoring range. Some monetarists have suggested that this growth rate is too low to be consistent with a sustained recovery in activity, and have been arguing either for lower base rates, or for a direct boost to M4 growth through an easing in government funding policy.

But the recovery so far has been triggered without any marked recovery in M4 growth, and the graph shows that a similar phenomenon has been occurring recently in the US. The recovery there has been proceeding steadily, if gradually, for about three years, even though broad money has continuously declined in real terms throughout this period.

Interpretation of monetary growth is almost always beset with difficulties and ambiguities of this kind, which is the main reason why Lord Lawson and others became enamoured with the exchange rate mechanism in the first place. Sterling often emerges by default as the swing factor in interest-rate decisions, and whatever the Chancellor is willing to say in public, it may well be doing so again. If the pound renews and then sustains its recent strength, I expect this to be enough to persuade Mr Clarke to reduce base rates.