The Monetary Policy Committee of the Bank of England should not be afraid of undershooting the Chancellor’s inflation target

There is a famous American saying: "If it ain’t broke, don’t fix it". The 5 per cent base rate now prevailing in the UK is about right. The rise to 6 per cent at the end of this year and 7 per cent at the end of next, foreseen by the sterling futures market is not necessarily appropriate. There is still no reason to encourage speculation either on further reductions or on forthcoming increases.

NIESR probability distribution Inflation: probability of 12 month RPIX inflation falling in the following ranges
	1999 Q4	2000 Q4
Less than 1.5 %	37%	20%
1.5% to 2.5%	41%	17%
2.5% to 3.5%	19%	21%
More than 3.5%	3%	42%
Growth: probability of annual growth rate falling in the following ranges
	1999	2000
Less than 0%	7%	7%
0% to 1%	33%	12%
1% to 2%	44%	18%
2% to 3%	15%	22%
3% to 4%	1%	19%
More than 4%	0%	22%
Source: National Institute Economic Review July 1999

The much-advertised UK recession never took place. And after a soft landing the British economy is smartly recovering towards a normal growth rate. According to preliminary official estimates Gross Domestic Product in the second quarter was growing at an annualised rate of two per cent - and liable to be revised upwards. If the more detailed figures from the first quarter are a pointer, domestic demand increased a good deal more quickly and growth was dragged down by imports and inventories.

Further base rate cuts at this stage are almost inconceivable. But it is still instructive to examine why such cuts were being urged by some analysts until very recently. One was the chance - put by the National Institute Economic Review at almost 50-50 - that inflation, measured by the RPI excluding mortgage interest, will fall more than one percentage point below the 2½ per cent target some time in the next few months. The Bank would then obliged to send an open letter to the Chancellor explaining the undershoot.

This is a bogus problem. The general public rightly regards inflation as bad. An undershoot of the inflation target is a success and not a failure. The reason why the Chancellor insisted in his remit that an inflation undershoot was as undesirable as an overshoot was that he wanted to put in a safety catch to prevent monetary policy from being too restrictive.

There are still a few members of his party who know enough history to recall the deflationary policies of the former governor Montagu Norman in the 1920s. The fear was that if the Bank went too hard for a very low inflation target, this would depress the economy and raise unemployment unnecessarily.

In fact none of these things are happening. Output is recovering. Unemployment has confounded expectations by continuing to fall even in the face of the earlier slowdown in growth.

A 5 per cent nominal interest rate corresponds to a 3 to 3½ per cent real rate - which is as good a guess as anyone can make of a neutral rate which neither stimulates the economy nor put a brake on it.

In these circumstances, below target inflation is an unqualified good. There is no real symmetry with above target inflation, which in itself is always bad, even if occasionally worth tolerating to prevent some greater evil.

The Bank of England maintains that a change of monetary policy takes two years to reach its full impact. Therefore any action it takes now would not prevent a shortfall below 1½ per cent inflation this autumn or winter. We thus have a good chance of seeing that return to the "lost art of letter writing" to which the deputy governor Mervyn King has been looking forward.

As it is already more than two years since the Bank became operationally independent it cannot claim lack of responsibility. Its first independent actions - strongly supported by the Chancellor Gordon Brown - were to raise interest rates in the face of what it feared was an inflationary threat. In the light of current developments, it obviously overestimated inflation two years ahead. (You cannot see this from the published forecasts which always assumed no further change in interest rates.)

But the Bank can still say that there was a strong risk of inflation rising; and that this did not happen because of a series of unforeseeable developments such as the continued very high level of sterling, the low level of world commodity prices and the repercussions of the East Asian recession and Russian default.

So much for the sophistry. The political pressures for further rate reductions have come from two sources: the manufacturing lobby, and those impatient for Britain to join EMU and who want to make a start on narrowing the interest rate gap with the euro countries.

The National Institute regards E1.30 as an appropriate UK entry rate and has canvassed suggestions as low as E1.15. The financial markets, however, are behaving as if the UK were likely to join in 2003 at a rate above E1.40. The Institute concedes, however, that wage and price setters would adjust even to the higher rate if it were announced "well in advance".

The obstacles to such an announcement extend beyond domestic politics. A euro entry rate is not something that "Gerhard" and "Tony" can just fix up on the telephone. European governments and central banks are determined that, in contrast to what happened when Britain joined the Exchange Rate Mechanism, this time there will be a genuine negotiation. And even if the Euro 11 were prepared to accept British wishes at the time of entry, they are certainly not going to do so years beforehand when the government cannot even say if and when it will recommend entry.

For those of us who are highly sceptical of estimates of equilibrium exchange rates these obstacles are really a blessing. Even at the present exchange rate several recent surveys have shown an upturn in manufacturing optimism. But even if, overall, manufacturing is a partial exception to the overall picture of buoyant activity, so be it. It is no more reasonable to overstimulate the economy because of the problems of the manufacturing sector than to depress it because of an overheating property market in the south east.

How about the opposite case for an early pre-emptive strike to prevent a reappearance of above target inflation by the year 2001? The main case for saying that base rates will have to rise is the that the output gap has already been exhausted and that the economy may well be growing faster than its safe rate by next year.

Another reason is that a future depreciation of sterling could involve an inflationary threat.

Unfortunately we have no real idea of either the size of the output gap or the appropriate speed limits for the British economy. Nor do we know if, how far and when sterling will depreciate. Alan Greenspan is entirely right to want to base policy on actual signs of inflation and overheating rather than debatable hypotheses. In particular he does not want to exclude the possibility that the sustainable level of unemployment may have dropped or that underlying growth may have speeded up either temporarily or permanently.

The valid criticism of Greenspan is that he has not taken sufficient account of visible inflationary signs such as the stock exchange bubble, the enormous widening of the US trade gap, and the acceleration in broad measures of money. A few of these signs are present in the UK, but they are in very much muted form.

The British equity boom is mainly a faint overspill from the American one. The Halifax, whose house price index has been the source of some scare media headlines, itself insists that there is as yet no comparison with the 1980’s boom. Moreover UK broad monetary growth has fallen in the last couple of years and is well within the old "monitoring range", while US monetary growth is much the highest this decade.

The time to raise interest rates will be when there are some inflationary signs rather than because of some forecast or theory that they might eventually appear.