Teething troubles for the new money team

WHEN the Chancellor gave the Bank of England operational independence in the setting of interest rate policy on 6 May last year, one common criticism of the new regime was that it would make the co-ordination of fiscal and monetary policy more difficult.

Previously, all of the key decisions relating to economic management were in the hands of the Treasury, so there was simply no one else to blame when things went wrong. Now, even if there is no technical reason why co-ordination between the Bank and Treasury should prove problematic, it is only human nature that each of these institutions should seek to establish that it is the fault of the other if the economy is mismanaged.

In giving evidence to the Treasury Select Committee last week, Tim Congdon and I were faced with a series of questions which essentially amounted to an attempt to apportion blame between the Treasury and the Bank if the economic cycle should run off the rails in the next year or two. Since both of us happen to believe at the moment that domestic monetary policy should have been tightened more aggressively in the past two years - and especially from mid 1996 mid 1997 - this was interpreted in one of our more sensationalist national newspapers as a direct attack on the Governor. This is an absurdity, and I would now like to set the record straight.

Few people would contend today that policy has been optimal in the past two years, since at the very least the economy finds itself in a highly unbalanced state in the spring of 1998. But even with the considerable benefit of hindsight it is far from clear how matters could have been improved. Some observers (the City consensus) believe that fiscal policy should have been tightened much more markedly in order to take the pressure off base rates and sterling. Others (like Congdon and myself) reckon that fiscal policy actually was tightened very substantially, and that an earlier and more decisive tightening in base rates would have killed the excess growth in domestic demand and thus dampened the rise in the exchange rate. A further group (centred around Ken Clarke) contends that no policy tightening was in fact necessary, since no inflation risk has become apparent, and that the problem with sterling has developed because base rates have risen too much, not too little.

The fact that this debate can still be raging about 18 months after many of the key decisions were actually taken graphically illustrates how difficult it is to set economic policy in the real world. As Eddie George says, the best economists are those who know how little they know, and this principle should be applied to policy post-mortems as much as to anything else. Nevertheless, our new macro-framework in the UK is intended to increase openness and accountability, and we will never get anywhere unless we attempt to learn from past experience. So here goes.

Two years ago, there was an overwhelming consensus among British policy- makers that the one thing that must never be allowed to happen again was to allow domestic monetary policy to remain too loose as the upswing of an economic cycle gathered momentum. This was seen (rightly) as the cardinal sin of the late 1980s, and all of the officials who were even tangentially involved in this episode vowed that it could be repeated only over their dead bodies. The exemplary monetary tightening undertaken in late 1994 was implemented with exactly this in mind, and it was a remarkable success. Yet the puzzling aspect of the past two years has been how little base rates have risen in the face of an intense and prolonged consumer boom.

Three entirely separate regimes have been in command of interest policy over this period. Funnily enough, all them have leaned in a dovish direction when they have actually been in control of the decision themselves, while at least two of them have been more hawkish for the remainder of the time.

In the run-up to the election, Ken Clarke rejected the repeated advice of the Governor to raise base rates faster than his electoral instincts allowed him to do. The Governor was clearly right about this, and many of our subsequent headaches stem from the fact that his advice was rejected. Then, when Gordon Brown was in control of base rates for a fleeting period, he opted to raise rates by only a quarter point on 6 May, when some were arguing the case for moving by at least a half point. Finally, the new Monetary Policy Committee of the Bank unanimously chose to raise rates very gradually last summer (and actually to announce a rate "freeze " last August) despite overwhelming evidence of a rampant consumer boom. In all of these episodes, the strength of sterling was given as the main reason for caution on base rates (and as the graph shows this is now seriously denting the export sector) but the upshot has been that the consumer sector has never really been stopped in its tracks, and this has left the economy in today's unbalanced condition.

The key question is how policy could have been adjusted last year to have brought sterling down more quickly. In order to answer this question, it would help to have a model which could explain the rise in sterling in the first place, but the Bank's best efforts in this direction have concluded that about seven-eighths of the appreciation cannot be explained by monetary or other measurable factors. This means that we are inevitably in the realm of conjecture when we argue about whether a tighter fiscal stance, or a more decisive increase in base rates, would have led to an earlier peak in the exchange rate. My own conjecture is that the only thing that would have affected sterling would have been a slowdown in domestic demand - and that the only thing powerful enough to have quashed the growth in demand would have been considerably tighter domestic money. But the truth is that we shall never really know.

What we do know, however, is that the Treasury is giving some very aggressive hints to the Bank that monetary policy is still too loose. When Gordon Brown set the Bank free last year, he instructed them to achieve the Government's inflation objective and "without prejudice to this objective, to support the Government's economic policy, including its objectives for growth and employment". This perhaps allowed some wriggling room for the Bank in interpreting the precise meaning of the inflation objective, at least in terms of timing.

It now appears that the Treasury wants to tighten matters up. In the 1998 Budget, the Treasury simply says: "The inflation target is 2.5per cent at all times: that is the rate which the MPC is required to achieve and for which it is accountable ... Inflation has so far been above the target rate most months. The effort and vigilance required to maintain low inflation should not be underestimated."

In other words: base rates need to go up; get on with it; and remember who said what to whom if inflation should rise in the years ahead.