Who's pulling the purse strings?
Monday 05 September 1994
The new transparent procedure is certainly a big improvement on its predecessor. In Mrs Thatcher's day, the Chancellor would phone the Governor out of the blue and instruct him to cut base rates that same morning. Now, the Governor advises the Chancellor about interest rates in a formally minuted meeting, and Mr Clarke takes the final decision.
Where the real power lies in this procedure has yet to be proven. By all accounts, Eddie George's contributions to the monthly monetary meeting are assiduously read from a script which has been crawled over in advance by his officials. But the Chancellor breezes into the meeting without notes, and apparently without much formal preparation. His senior officials are sometimes in doubt about what he will decide until they hear his unscripted summing up.
This disarmingly relaxed approach is of course just the Chancellor's political style, and it should not be mistaken for carelessness. As Mr Clarke still has to answer to Parliament for monetary policy, it is clear that the Treasury does not believe that it has abdicated all of its power in this area to the Bank.
Unless the Chancellor felt there could be some circumstances in which he could overrule the Governor's advice, he would not see any mileage in taking the public flak for base-rate decisions. But, equally, he knows that to reject a Bank request for higher rates would probably have disastrous results for sterling and gilts, so he could not do it lightly.
Meanwhile, the Bank insists that the Governor will tender his best advice on all occasions, untramelled by considerations of what the Chancellor might be willing to agree. But life cannot really be so straightforward, at least not in the British system of government. The Bank knows that if it tenders advice which the Chancellor wants to reject, only two out- turns are possible. Either the Chancellor says no, in which case the markets panic, or he reluctantly agrees, in which case the Bank is out on a limb.
It is all very well for the Bank to force a base-rate rise on the Treasury, but what if that move in policy should prove to be misguided? Monetary policy is always a game of risks and probabilities - no one can ever be certain they are right. What, for example, would be left of the Bank's campaign for independence if it forced through a base rate rise in September, only to see economic activity nosedive as the tax increases began to bite in the next few months?
As long as the Bank believes it can cajole the Chancellor into agreeing to a move within a few months, it is most unlikely to force the issue precipitously. So it is a cat-and-mouse game, with neither observer nor participant quite able to distinguish the feline from the rodent.
After watching the new system functioning for a few months, I have come to the conclusion that it is an unstable compromise which must cause trouble sooner or later. The Bank has power without full accountability. The Chancellor has accountability without full power. The markets are nervous because politicians have retained the ultimate power to overrule the Bank, which implies that they might one day want to use it. And for as long as there are two hands on the tiller, it is inevitable that one day they will want to steer the boat in opposite directions. Watch out when this happens.
Fortunately, there is no evidence that it has happened yet. Although the Bank made it clear in its Inflation Report in August that it would soon recommend a base-rate rise, it will probably wait until the Chancellor is good and ready to agree. The Bank's official reason for wanting to raise rates is that, if policy is left unchanged over the next two years, 'then it is probable that inflation would gradually rise to a level above the mid- point of the target range'.
This reasoning is backed by a plethora of detail about recent inflation figures, and by a shopping list of concerns - including M0 growth, inflation expectations, wages, profit margins and commodity prices - which the Governor throws at the Chancellor during their monthly meetings.
It has not escaped Mr Clarke's attention that this list has a somewhat mercurial history, with new concerns cropping up randomly from one meeting to the next. He is inclined to pull the Governor's leg about this. But the mercurial shopping list simply reflects the fact that the Bank does not really want to increase rates just because one or two indicators have turned sour in any given month.
Although they feel that they have to have something new to say in the minutes each month (it is not clear why, since they are not in vaudeville), their real reason for tightening is much more commonsensical than appears from their shopping list.
It is based on a belief that the economy is growing above trend, and that this will not be stopped by the remaining tax increases, which will take effect next April. The margin of spare capacity in the economy is therefore shrinking fast, and in the past the UK authorities have tended to watch this happening for too long before tightening policy. Although there is no urgent need to move precipitously, it would seem sensible to put a touch on the brakes before the end of the year.
This is unlikely to lead to a crunching halt in the economic recovery. As the graph shows, the private sector enjoys an extraordinarily healthy financial surplus, born of high savings ratios in the household and company sectors. This, rather than any 1980s-style boom in borrowing, is what is driving the economy forward.
It is anyone's guess how far interest rates may need to rise to slow this different kind of growth in demand. Higher rates, however, would certainly increase the returns on savings, limiting the chances of a sudden - and disastrous - sharp acceleration in spending.
An alternative way of slowing the economy would be to tighten fiscal policy by cutting public spending in the November Budget. It has not been widely recognised that the combination of strong growth and low inflation in 1994 should enable the Chancellor to announce a large cut in public spending in the Budget, perhaps of the order of pounds 5bn in 1995/6.
Mr Clarke may be tempted to wrap himself in a fiscal hair shirt this autumn, and argue that the decline in public spending obviates the need for any base rate rise. But the Governor must not let him get away with this. The point is that the drop in public spending will be the automatic consequence of high growth in the economy, and of itself will do nothing to dampen that growth. A base- rate rise will still be needed, but it can safely wait until November if that is what it takes to ensure harmony within the policy ranks.
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