Good reasons for inflation optimism

From money supply targets to membership of the European exchange rate mechanism, the Government has long been searching for a credible framework to govern the setting of interest rates. In the judgement of the financial markets, it still has not found one.

But this is to ignore the institutional changes that have taken place in the last two years, which have tilted the balance of power in monetary policy in favour of the Bank of England. Every quarter the Bank is free to comment on the development of inflation against a specific target; every month, with a delay before publication of six weeks, the Governor is able to argue publicly the case for higher, or lower, or unchanged interest rates, as he sees fit.

In principle the final decision on rates lies with the Chancellor, but in practice the penalty he would pay for ignoring the Governor's advice would be severe. Whether by accident or design, the Government has put in place a framework that binds it, and its successors, to the pursuit of low inflation into the medium term.

Following the withdrawal of the pound from the ERM in September 1992, the then-Chancellor, Norman Lamont, had to come up with a new policy framework. The centrepiece of the new regime is the objective of keeping underlying inflation within a range of 1-4 per cent, with the added ambition of achieving 1-2.5 per cent by the end of the parliament. Can the authorities deliver?

Yes, but at a cost. The Government has in fact already achieved its medium-term target: underlying inflation is currently 2.4 per cent. But today's low inflation is the product of a deep recession, from the middle of 1990, followed by a modest recovery from early 1992. The level of onshore output (gross domestic product excluding oil and gas) has only in the last three months moved above its pre-recession peak. The lesson is clear: hold output down for a long enough period, and by a large enough amount, and inflation will subside to whatever level the Government chooses.

Now comes the difficult bit. It is one thing to obtain low inflation in a recession; it is another when output is rising and unemployment is falling. So to rephrase the question: can the authorities deliver a combination of low inflation and continuing recovery? It is here that the credibility of monetary policy comes into play.

The more credible the policy stance, the lower the costs, in terms of output and unemployment, of delivering a given inflation rate. If economic agents believe that the authorities will deliver the low inflation target, their actions will reflect this belief. If they doubt the Government's commitment, this makes it more difficult for the Government to deliver.

For example, if industry expects to be able to raise its prices by, say, 5 per cent in the years ahead and on this basis can afford (let us say) 8 per cent pay rises, then it may require a policy tightening to disabuse price and wage setters. We then have to ask whether the Government is so committed to its inflation targets that, in the run-up to the next general election, it will tighten policy and suffer the cost of lower output to get inflation back down again.

The financial markets implicitly expect inflation to rise back above the 4 per cent target range, reaching 6 per cent by the end of the decade. In the light of our record, this is not surprising. But it must be disappointing to the Government, not least because it makes the task of obtaining low inflation that much more difficult to achieve.

It is easy to see why the Government might suffer a credibility gap. The track record and the timing of the next election are against it. Some would argue that, outside the ERM and without the rigours of a discipline like the early medium-term financial strategy, there is nothing to stop backsliding. Even these did not prove sufficient.

But there are good reasons for optimism:

For the first time the Government has set a specific inflation target;

This is underpinned by the medium-term target of eliminating government borrowing;

It is also strengthened by the greater power of the Governor of the Bank, through both the quarterly Inflation Report and the minutes of his monthly meetings with the Chancellor.

The crucial piece of the jigsaw is the last. Imagine official confirmation in the minutes that the Governor wished to raise interest rates but the Chancellor had refused. Immediately the latter's commitment to low inflafion would be queried and markets would punish this by pushing for higher short rates, selling sterling and raising long-term bond yields. Unless the Chancellor is convinced that the Governor's assessment is wrong and is prepared to see such market turbulence out, he would have no choice but to meet the Governor's demands.

This prospect does not confer credibility instantaneously, but it goes a long way. Under a cautious governor, interest rates are likely to be raised sooner rather than later, and by more rather than by less. It is for this reason that we expect base rates to rise to 6 per cent in November.

The Chancellor's fiscal freedom is also limited, for he must know that largess in tax policy is certain to be countered by a call for monetary tightening by the Bank. This in effect binds the Government into its deficit-reduction programme and limits the scope for tax cuts ahead of the election.

Okay, we are convinced. But one factor underpinning market forecasts of higher inflation into the medium term is the possibility of a Labour government. Labour's track record is not good; its preference for public spending goes deep; its relationship with the trade unions may make wage control more difficult. None of this is reassuring.

But the framework that the Conservatives have put in place should be robust to a change in government. On current targets, an incoming Labour government will inherit an inflation rate in the range 1-2.5 per cent. If it has not already published its target in its election manifesto, it will be asked on day one by the Bank for its inflation objectives. It could decline, but more likely a Labour chancellor would endorse the current range of 1-4 per cent.

On this basis the Bank's role in monetary policy and its pivotal influence on interest rates would be unchanged. So even if Labour opted for a more expansionary fiscal policy, the Bank would insist that monetary policy be tightened to keep demand under control.

After the failure of inflation policy in the UK for the past 30 years, a certain amount of scepticism is no doubt justified. But this is to ignore the genuine institutional change that has been made. We may not have a constitutionally independent central bank but in practice we are well on the way.

This should ensure a better inflation performance in the years ahead even under a Labour government. But it remains to be seen how quickly industry and the markets will be convinced. As long as they have their doubts, the cost of achieving low inflation will be higher than it needs to be.

The author is director, UK economics, at NatWest Markets.