The monetary policy dilemma: Will interest rates have to rise?

UK interest rates are now at their lowest level for more than two decades, and the government is hoping that interest rates can be kept at a low and sustainable level comparable to the 1960s. Indeed, some commentators are calling for still lower interest rates to offset the risk that the £12bn tax increases and cuts in government spending that will come into effect in the next financial year will lead to stagnant consumer spending and a stalled recovery. Against this must be weighed the risk that the recent very good run of inflation figures will prove temporary. Both headline and underlying inflation will be pushed up by indirect tax increases and there is the possibility that wages will follow too, as employees seek to maintain their living standards in a tightening labour market. That risk would point to a much more cautious monetary policy stance and the possibility that the government may need to raise rates from their present level if it is to achieve its inflation objective. The Chancellor faces a clear dilemma. In this Viewpoint, we assess the evidence available to guide him in his decisions and draw out the implications for the future path of interest rates.     

INVESTMENT IN FIXED CAPITAL AND COMPETITIVE INDUSTRY DYNAMICS

This paper explores the possibilities for complex dynamic behaviourin an industry where a fixed capital good, once acquired andinstalled, is specific to that industry. A central theme isto understand the sorts of factors which can impose bounds onthe behaviour of market price and which can impart stabilityto the system. The analysis highlights the significance notonly of the durability and specificity of physical capital goodsbut also of capacity (under-) utilisation decisions and of thecautiousness of producers when expanding their capacities.     

Savings and the Budget

The fall in the personal sector savings ratio to a record low last year has been a major factor behind the rapid growth of domestic demand in the past two years and the associated deterioration in the current account. It is also a major uncertainty in the Chancellor's Budget judgement. Existing econometric relationships for the consumption function have failed to predict the fall in personal savings over the past few years. Possible explanations include statistical error, the effects of financial deregulation, the housing boom, expectations of higher growth in incomes, and demographic influences. In this Viewpoint, we report on a new consumption function that successfully explains the decline in savings. It provides evidence of a major demographic influence resulting from the decline in the proportion of the population in the 45–64 age cohort, the main savers in society. Subsidiary effects arise from the boom in house prices, and statistical mis-measurement. The equation predicts an appreciable revival of savings over the next few years as the 45–64 age cohort grows again. These shifts in demographic structure reflect the after-effects of the Second World War. This new evidence suggests that the Chancellor has done quite enough to ensure a slowdown in consumption, and that he would be ill-advised to heed calls for special measures to boost savings. By contrast, well conceived tax changes that remove microeconomic distortions in the tax system (perhaps moving in the direction of an expenditure tax) would improve the tax structure, and may well increase the scope for tax cuts in future budgets. Our new consumption function also lends weight to the Chancellor's argument that the current account deficit is not a source of concern, insofar as it arises from a shift in savings associated with demographic changes that will be reversed in due course.     

The MTFS or the EMS: Which Way for Credible Monetary Policy?

Since the latter part of 1988, the primary policy objective has been to head off a rise to double digit inflation. To this end, interest rates have been raised from 7112 per cent to 14per cent, while the public sector is running a large fiscal surplus. Despite this apparently very tight policy stance, policy is deficient in a crucial respect: it lacks credibility. The all too public divisions within government have weakened the efficacy of monetary policy, especially in financial markets. The ongoing uncertainty over who is in charge of the conduct of policy - No. 10 or No. 11 - further undermines confidence. The most urgent priority must be to reassert clear priorities and guidelines. In this Viewpoint, we consider how best to restore the credibility of monetary policy. There are two main possibilities: first, to reassert the Medium Term Financial Strategy (MTFS) in an appropriate form; or to join the (Exchange Rate Mechanism of the) European Monetary System (EMS). We argue that it will be very hard to derive credibility benefits from a reassertion of the MTFS: because of the inflation record of the past decade and the twists and turns of past versions of the MTFS, a mere restatement will not resolve the uncertainties that result from known differences within the government. In particular, any restatement will rely on discretion and judgement in its implementation and this will weaken its beneficial effects on expectations. Instead we argue that entry into the EMS offers a tougher and more credible commitment for monetary policy. The Chancellor has been pushed to rule out UK entry until the second half of 1990 at the earliest, but the government should make a virtue of this by announcing a firm dale for entry next year. In the interim, it should encourage a debate about the appropriate rate for entry, a debate which will increasingly guide the foreign exchange market. The government should make it clear that in choosing this rate it will do so with the commitment to low inflation very much in mind, favouring a high exchange rate. Once in the EMS, the government should rule out the possibility of devaluing the pound in an EMS realignment. This provides a firm non- discretionary anchor for both monetary policy and inflation expectations. With this commitment, the principal gain from EMS entry will be establishing a regime of low inflation for the next decade: in this, choice of the exchange rate will be less crucial than the fact of entry.     

An end to boom and bust - can the Chancellor deliver?

In his Mansion House speech, the Chancellor of the Exchequer emphasised his desire to avoid the boom and bust cycle that has characterised the UK economy in recent years. The objective of a more stable economy is one with which it is hard to disagree. It strikes a chord with all those who have to take long-term decisions in the business community. But can the Chancellor deliver? In this article, we argue that despite the changes to the government's economic policy framework in recent years, many of the causes of the past instability of the UK economy remain. And while the Chancellor seeks to retain short-term control of interest rate decisions, there is always the risk that political pressures on monetary policy will be an added source of volatility.     

A Policy Framework for the New Chancellor

In the Mansion House speech, Mr. Clarke, the new Chancellor, left his options very clearly open. He reconfirmed his commitment, like his predecessors, to low inflation; but added that low inflation is not enough, asserting the importance of commerce. He asserted the need to reduce the public sector deficit, but did not commit himself to further measures beyond those already announced by Mr. Lamont. He argued for lower taxes, but said that taxes cannot always fall. He acknowledged the importance of narrow and broad money, but said that he would monitor a range of indicators in formulating policy. Even the greater emphasis relative to his predecessors on growth may have been more a matter of presentation, not a shift in policy emphasis.     

The Narrow Band Option for Mr. Lamont

The dilemma facing Mr. Lamont as he prepares his first Budget is the conflict between the need to keep interest rates high to maintain the commitment to sterling's ERM band and the wish to reduce interest rates to ease the severe recession in the domestic economy. In large part, this conflict is intrinsic to the government's aim to bring down UK inflation to German levels through membership of the ERM: the process of reducing inflation is always painful and costly in terms of lost output and higher unemployment. But the dilemma is made worse by the uncertainties over future policy direction, reflected in the differential between UK and German interest rates. German monetary policy is set to remain tight to hold in check the inflationary pressures that might otherwise arise from German unification. Against this background success in reducing UK interest rates will depend on the government's success in establishing the credibility of its anti-inflation policy and of its ERM commitment. An expansionary Budget aimed at easing the recession would undermine this credibility, and remove the scope for additional interest rate reductions. An abandonment of the ERM commitment would signal the accommodation of inflation, and condemn the UK to continuing high inflation and interest rates. We argue in this Viewpoint that the best course open to the Chancellor is to adopt a broadly neutral Budget stance, and to strengthen the ERM commitment by moving to a narrow band for sterling within the ERM. This should enable the Chancellor to reduce UK interest rates again at around the time of the Budget and lay the basis for further subsequent cuts.     

The First Unified Budget What Should Mr. Clarke Do?

Mr. Clarke has the distinction of presenting the first Unified Budget, an innovation introduced by his predecessor. He does so against a subdued inflation outlook and a recovery from recession that has been proceeding since the first half of last year. But he is also aware that there are risks to this favourable outlook: European recession may slow growth, and there is the worry that underlying inflation may breach the Government's 4 per cent ceiling. III this Viewpoint, we argue that the Chancellor should go further that his predecessor in curbing public borrowing, aiming for a reduction of sonic £4-5bn; this fiscal contraction could be accompanied by a further 0.5 per cent reduction in interest rates, or more if the recovery shows signs of faltering. A rebalancing of monetary and fiscal policy in this way reduces the risks associated with a high level of public borrowing, can help in reducing the excessive level of consumption (private and public) in the UK economy, and offers the best means of maintaining a competitive exchange rate without inflation. A curious feature of the first Unified Budget is that, having moved tax decisions to the autumn, the Chancellor appears to have ruled out further government spending cuts beyond those agreed by the Cabinet before the summer: with more favourable inflation arid the public sector pay limit, there would seem to be scope for a further reduction in the Control Total. On the revenue side, the Chancellor should seek to raise revenues in such a way that does not adversely affect incentives. Here he has several options: to extend the VAT net; to eliminate income tax allowances or reduce them to the 20p rate of tax; or to introduce new user charges. There is also the opportunity, one year on from the UK's exit from the ERM, to restate the basis for a sustainable macroeconomic framework. This should include a rebalancing of monetary and fiscal policy, and a move to enhance the powers of the Bank of England but with parliamentary accountability.