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From a Nice decade to 'not-so-bad' Samuel Brittan Financial Times 11/05/07 One aspect of Tony Blair's legacy that has been almost unanimously acclaimed is the regime establishing the operationally independent Bank of England monetary policy committee. Mercifully, we can discuss this achievement without going into any of the past Blair-Brown tensions. The MPC was Gordon Brown's baby. Mr Blair's role was to accept a set-up that in effect barred the prime minister from interfering in monetary decisions - a step that neither Margaret Thatcher nor John Major was ever willing to contemplate. Having said this, I would quote the footnote devised by the British satirical weekly Private Eye on the lines of "that's enough tribute - Ed". It is time to turn to future challenges. I will make no revolutionary institutional proposals. As the American saying goes: "If it ain't broke, don't fix it." What is needed is a shift in the way people think of the MPC's work, which is too dominated by financial analysts trying to predict whether or not there will be a further 1/4 per cent change in the bank rate in the next couple of months. Indeed, the popular belief that the Bank determines interest rates is a mistake, based on the confusion of nominal with real. One analyst has even tried to devise an equation showing how large an increase in bank rate would be required to reduce inflation by 1 percentage point. This confuses the issue. At the very most, the MPC determines the short-term nominal rate of interest. If it had made a horrendous error and instead of raising the bank rate on Thursday had, in a fit of madness, slashed it, the effect would have been to boost inflation. Higher inflation brings with it, as surely as night follows day, higher nominal interest rates, not lower ones. The process is an illustration of one of Milton Friedman's sayings, that the long-term consequences of many actions are the reverse of the immediate ones. The real rate of interest is determined by the balance between savings and investment, increasingly in the world as a whole rather than in any single economy. Central bank policies mainly determine the translation of this rate into the familiar nominal headline. Not only do central banks not determine real interest rates, they determine only short-term nominal interest rates. An example is the agonising that recently took place in the US when a series of Federal Reserve increases in short-term nominal rates failed to carry through to the long end of the market, giving rise to the famous inverted yield curve. There have, indeed, been counterproductive attempts by governments and central banks to intervene in securities markets to fix the long-term rate as well. An illustration is provided by the attempt of Hugh Dalton, the first postwar chancellor and himself a former economics lecturer, to inaugurate a cheap money policy that was not justified by the state of the economy - and exploded in his face. There is no one with a less complacent attitude to the challenges facing the MPC than Mervyn King, the Bank's governor. His May 2 lecture to the Society of Business Economists was exceptional in being a celebration of 10 years of achievement. He has previously spoken of the "Nice" decade - non-inflationary, consistently expansionary - from 1992 to 2002. He believes we are now in the not-so-bad decade. In any case, Mr King's tongue-in-cheek hope that the "governor of the Bank of England will be regarded as occupying a technical position similar to that of the chief executive of the National Weights and Measures Laboratory" is unlikely to be fulfilled in his lifetime. A better analogy is with the chief justice of the US Supreme Court, which enjoys considerable discretion in interpreting by majority vote laws it does not itself make. More interesting is the heresy, which separates Mr King from many Bank colleagues, on the importance of the money supply. Beyond a short-term forecasting horizon of up to three years, he states, real changes in variables such as economic growth or imports or energy prices have nothing to do with inflation, which is, as the old saying goes, the result of "too much money chasing too few goods". It is no easy matter to distinguish in practice between changes in the demand for money due to, say, changes in financial practice, and changes in the supply, which can have inflationary consequences. A further complication mentioned by Mr King in earlier utterances is the international dimension. A monetary squeeze at home can be offset by credit obtained from abroad. A paper by David B. Smith of Beacon Economic Forecasting* reveals a better fit between broad monetary growth in the Organisation for Economic Co-operation and Development and UK variables than anything shown by a purely domestic relationship. The Bank of England in its April Financial Stability Report favours small informal meetings "of relevant authorities" to consider responses to "cross-border financial crises". The same principle could be extended to monetary policymakers. Indeed, the two groups of officials could usefully get together. * Cracks in the Foundations, Economic Research Council
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